Keynesian economics

Keynesian economics ECON 434 | Spring 2011

How do we explain this?

Or this?

Economic impact

Impact on consumer spending

Does this hold? LRAS (Ɛ = 0) P D0 D1 Q

John Maynard Keynes (1883-1946) • One of the most (if not the most) influential economists of all time. • Most of modern macroeconomics is based on his The General Theory of Employment, Interest, and Money (1936)

Keynesian theory (in very brief) • Demand creates its own supply • Unemployment can happen in the short run (it can be a semi-permanent situation, absent some external force to reduce it; read: the government) • Governments can revive the economy through changes in fiscal policy (government spending)

Keynesian theory • Keynesian theorists and classical macroeconomists would be most likely to agree about how this economy will adjust if: • (a) Aggregate Demand declines from AD1 to AD0. • (b) classical full employment requires output Q1. • (c) the recessionary gap equals the GDP gap. • (d) severe stagflation occurs at point a. • (e) Aggregate Demand increases from AD1 to AD2.

Keynesian theory • For Keynes: Ensuring adequate AD is the most important for ensuring full employment • Expansion of productive capacity and price-level stability are secondary goals (pursued after the achievement of full employment). • AD alone determines output and employment in the midst of a depression because AS in this range would be relatively flat. • Assumes that idle productive capacity allows production and income to stretch to accommodate growth in AD without causing inflationary pressure

Aggregate expenditures • GDP = C + I + G + (X – M) • C: consumption • Autonomous consumption: unrelated to income • Induced consumption: occurs only because people have income to spend • Marginal propensity to consume: the relative change in consumption induced by a small change in disposable income (ΔC/ΔY) • I: investment • G: government spending • X: exports • M: imports

Investment • While consumption is the most stable component of GDP, investment is the least stable. • According to Keynesian theory, the volatility of investment (due, in part, to “animal spirits”) is the root cause of most business cycles • Greenspan: Irrational exuberance • Keynesian macroequilibrium occurs when saving and investment are equal • Investment is only mildly influenced by interest rates but very sensitive to even minor changes in the expectations of business. • Pessimism causes investment to plummet, while optimism causes sudden surges in investment

Macroequilibrium Savings S > i: Undesired inventory accumulates; firms reduce production Savings, investment Investment I > s: Inventories shrink; firms boost production National income

The multiplier • The multiplier effect occurs when one person’s spending becomes someone else’s income, and some of the second person’s income is subsequently spent, becoming the third person’s income, and so on. • 1/(1 – mpc)

The paradox of thrift • What happens if we try to save more? • Classical analysis: Saving promotes investment and growth • Keynes: Attempts to save more may cause income to fall so much that actual saving shrinks • Consumption falls when households try to save more. Firms will counter declining sales and swelling inventories by cutting production, employment, and investment. • Saving is the natural reaction to hard times; if a growing number of households start saving, the momentum for a recession can build • The paradox of thrift, however, is probably irrelevant in an economy operating at full steam

Fiscal policy debates

Functions of money • Medium of exchange • Money is used to execute transactions • Measure of value (standard unit of account) • Used as a common denominator to rank relative prices • Store of value • Held as an asset because it is less risky or because they view the transaction costs of conversion to other assets as too high (*Keynesian notion) • Standard of deferred payment • Allows for intertemporal contracts (i.e., money is good for more than immediate purchases [the classical view])

Demand for money • Transaction demand • People want money so they can spend it • Precautionary demand • People want money because they know that unanticipated spending is required at times • Keynesian invention; classical economists would agree with this, however, because it assumes money is closely related to income • Asset demand • Major Keynesian invention that clashes with classical theory • People hold money because (a) they expect the prices of stocks and bonds to fall in the near future, (b) are reluctant to hold only assets that tend to swing widely in value, and (c) believe that transaction costs are higher than any expected returns from investment in stocks/bonds.

Cost of holding money Keynesian view: Cost of a dollar is the interest you sacrifice by not making a different financial investment Classical view: Cost of a dollar is what you could buy with it Nominal interest rate 1/P Quantity of money demanded Quantity of money demanded

Keynesian monetary theory • Velocity of money is NOT constant • Full employment is NOT the natural state of a market economy • Asset demand for money: Rising uncertainty (not income) is a major reason for the growth of money demanded. • The liquidity trap: At very low interest rates, growth of the money supply yields neither extra spending nor declines in interest rates; extra money is absorbed through hoarding into idle cash balances (put it under your mattress)

Some material taken from Economics, Byrns and Stone, 6th edition

Keynesian economics