THE KEYNESIAN

1. THE KEYNESIAN

2. THE KEYNESIAN SCHOOL • One of the most significant schools of economic thought. • The school began with the publication of Keyne’s The General Theory of Employment, Interest and Money in 1936. • It arose out of the neoclassical school. • Although Keynes criticized certain aspect of neoclassical economics which he lumped with Ricardian doctrines, under the heading of “classical economics,” he used many of its postulates and method.

3. OVERVIEW OF THE KEYNESIAN SCHOOL The Historical Background of the Keynesian School •  The Great Depression of the 1930’s was a driving force towards the acceptance of Keynes’s ideas. • He adopted the macroeconomic approach. • World War 1 requires an overall view of the economy.

4. This approach became increasingly necessary as the public became more eager for the government to deal actively with unemployment. • After the World War 1, rate of population was declining, most of the world had already been colonized, no room for further geographic expansion., production outrun consumption as incomes and savings rose.

5. After 1930’s many economist in the US advocated policies later known as Keynesian. • Interestingly, these policies were presented before the publication of Keynes’s The General Theory. • But it was Keynes who provided the analytical framework that integrated these ideas and touched off the “Keynesian revolution” in economics.

6. MAJOR TENETS OF THE KEYNESIAN SCHOOL • Macroeconomic emphasis. • Concerned with the determinants of the total or aggregate amounts of consumption, saving, income, output and employment. Not interested in individual firm decision.

7. Demand orientation • Stressed the importance of effective demand (now called aggregate expenditures) as the immediate determinant of national income, output and employment. AE = C + I + G + NX • The effective demand establishes the economy’s actual output, which is less than the full employment level of output (potential output)

8. Instability in the economy • Changes in investment plans cause national income and output to change by amounts greater than the initial changes in investment. Equilibrium level of I and S change due to changes in national income.

9. Wage and price rigidity • Wages tend to be inflexible because of institutional factors such as union contracts, minimum wage laws and implicit contracts. Wages and prices are sticky.

10. Active fiscal and monetary policies • Government should intervene through appropriate MP and FP. To fight recession or depression government should increase spending or reduce taxes. It should also increase the money supply to drive down interest rates in the hope that it will increase investment.

11. WHO BENEFIT FROM KEYNESIAN SCHOOL? • The greatest success of Keynesian is that it addresses the problem of the day: depression and unemployment. • Labor objected specific Keynesian proposal but on the whole strongly approved of Keynesian larger goals. • Rising aggregate demand for tight labor market allowed unions to negotiate improved wages and working conditions with less fear of unemployment.

12. WHO BENEFIT FROM KEYNESIAN SCHOOL? • Business interests benefit from government contracts and stimulus to get the economy out of depression. • Government control gave the banking system the liquidity, security and stability. • Reformers and intellectuals increased employment in government service due to Keynesian thinking.

13. Farmers had long favored easy MP and low interest rates. • 1960s and 1970s, consumers were in favor of tax cut and 1980’s was a supply-side orientation which was consistent with the Keynesian principles

14. How was Keynesian useful and correct in its time? • Keynes geared economic theory to policy making. • World wars, worldwide depressions and the growing complications of modern life undermined laissez-faire. • The role of economist and economic analysis in shaping the direction of government policy was greatly increased.

15. How was Keynesian useful and correct in its time? • Keynesian view of nominal wage was timely due to the massive unemployment problem. • Keynes view was that reduction of nominal wage makes bad economic policy. • Keynes approach becomes very useful even to those who did not accept Keynes’ policy conclusions.

16. How was Keynesian useful and correct in its time? • It established a new set of analytical tools in viewing economy. • Encouraged further development of national income accounting led to fruitful effort in empirical studies of the real world. • Accelerate the development of econometrics and created new liberalism.

17. Lasting Contributions • Contemporary economics could be said as a combination of neoclassical microeconomics and Keynesian-inspired macroeconomics. • Keynesian concepts such as C function, MPC, S function, MPS. • Marginal efficiency of capital: transaction, precautionary and speculative demands for money

18. Lasting Contributions • The multipliers. • FP and MP. • IS-LM analysis. • The idea that the economy can be fine-tuned to a position of noninflationary full employment was discredited. • But Keynesian still dominates macroeconomics.

19. THE KEYNESIAN SCHOOL OF THOUGHT KEYNESIAN PURE KEYNESIAN POST KEYNESIAN NEW KEYNESIAN ROBINSON STIGLITZ FISHER BLANCHARD AKERLOF KEYNES HANSEN* SAMUELSON C Function Investment Liquidity Preference Equilibrium Y and N Policies to promote full employment & stability. Neo Ricardian Mark-up Pricing Endogenous Money Cyclical instability Income policy. Rejected Neo Ricardian W & P rigidity Menu Cost Formal & implicit contract Efficiency wage Insider-outsider theory IS-LM Equilibrium* Stagnation Thesis* Multiplier Accelerator Keynesian Cross/ PC

20. JOHN MAYNARD KEYNES (1883-1946)

21. JOHN MAYNARD KEYNES(1883-1946) • A student of Marshall and Pigou. • At 28, he became the editor of Economic Journal. • In 1926, he published a brief book entitled The End of Laissez-Faire. He stated in his book that the evils of the day were the fruits of risk, uncertainty and ignorance.

22. KEYNESIAN SYSTEM • In The General Theory he developed the idea of interrelated elements of the economy, and the first is consumption function.

23. Consumption Function • He pointed out the “fundamental psychological law” concerning the relationship between consumption (C) and income (Y). • People will increase their consumption as income increases but not as much as the increase in income. • C = f (Y) • MPC =  C/  Y  is positive and less than 1

24. This implies that saving (S) also rises with income, and is a positive function of income: • S = f (Y) • MPS =  S/  Y  is greater than 0 and less than 1

25. The Consumption Function C C = f (Y) Y

26. Investment • Keynes defined investment as the purchase of capital goods. • He distinguished the difference between economic investment and financial investment. • Financial investment is not investment in Keynesian sense because it does not directly represent purchases of capital goods. • For Keynes, financial instrument simply are alternatives of people savings.

27. Liquidity preference • Liquidity preference depends on three motives for holding money: • Transaction motive • Precautionary motive • Speculative motive

28. These 3 motives translate the money demand curve such as L. • It slopes downward, indicates that people want to hold more cash at lower interest rate. • MS is determined by central bank. • Quantity of MS is independent of r, hence MS is vertical or perfectly inelastic.

29. Equilibrium Income and Employment • Keynes assumed that there is a high correlation between national income and the level of employment. • The immediate determinants of income are C and I. • Y = C + I • S = Y – C • S = I  Equilibrium

30. Policies to Promote Full-Employment and Stability • Keynes proposed a large government role to stabilize the economy at a full employment level of national income. To increase AE: • Stimulate private investment during a depression by forcing down interest rate through CB policy.

31. When r is low people will increase their money holding causing people to hold idle balances rather than buy bonds. Subsequently r will not fall. • Because of liquidity trap, MP will not be effective as a way to reduce r and increase I during severe depression. • A more effective way to overcome depression is for government to undertake expansionary FP.

32. Criticism • Keynes SR static thinking led him to exaggerate trend towards stagnation. • He thought that when most profitable investments were undertaken, leaving behind less attractive one  I would decline. • Keynes underestimated the possibilities of technological change and the new capital I it would stimulate. • He thought that the weakness of the inducement to invest is the key to economic problem.. • He was also criticized for accepting wasteful government spending.

33. Many economist after Keynes helped move their version of Keynes’s approach to economics directly into mainstream of macroeconomic theory. Among them are Alvin Hansen and Paul Samuelson.

34. ALVIN H. HANSEN(1887-1975) • Born in Virborg, South Dakota. • Got his PhD from University of Wisconsim, 1918. • Taught at Brown University and the University of Minnesota. • At University of Minnesota, he published Business Cycle Theory (1927), which gave him the reputation as the nation’s leading macroeconomic scholar.

35. ALVIN H. HANSEN(1887-1975) • A year (1937) after Keynes publication of The General Theory, Hansen joined Harvard. • He pointed out a mathematical error in Keynes’s Treatise on Money. • Hansen’s students was Musgrave, Domar, Samuelson, Tobin and others.

36. ALVIN H. HANSEN(1887-1975) • 1941, he published Fiscal Policy and Business Cycle, which supported Keynes’s analysis of macroeconomic problems of 1930s and endorsed active government policies to stabilize the economy. • People called him the American Keynes. year (1937) after Keynes publication of The General Theory, Hansen joined Harvard.

37. THE HICKS-HANSEN SYNTHESIS • A year after The General Theory was published, John R. Hicks published a journal article: “Mr Keynes and the Classics: A Suggested Interpretation.” • Hicks pointed out that Keynes’s Theory of Interest and theory of equilibrium income was inconclusive. • In trying to solve this problem, he developed a unified economic model that synthesized the Keynesian and neoclassical perspectives.

38. THE HICKS-HANSEN SYNTHESIS • Hansen elaborated on Hicks’s article in his Monetary Theory and Fiscal Policy – today we refer to Hicks-Hansen synthesis as the IS-LM model. • All values in the IS-LM model are real rather than nominal terms.

39. The IS curve • Represents all the combinations of interest rates and levels of income at which planned investment equals planned saving. • The curve represents equilibrium points in the goods market. • The IS curve is negatively sloped.

40. The LM curve • The LM curve shows potential points of equilibrium in the money market. • It indicates all combinations of interest rates and levels of income at which money supplied and demanded are equal. • It is a trade of between interest rate and the amount of money people desire to hold for speculative purposes. • The demands for money will depend on the price of bonds (high interest rate will cause the price of bonds to fall). • The LM curve is thus positively sloped.

41. The IS-LM Equilibrium • The goods market and the money market are simultaneously in equilibrium when: S = I and L = M • Hansen added government spending and taxation to the IS-LM model and use it to analyze the income effects of FP and MP. • FP shifts the IS curve. • MP shifts the LM curve.

42. STAGNATION THESIS • Hansen shared Keynes’s idea that investment would be increasingly inadequate for the economy to reach its full potential. • In order for national income and output to rise, new investment spending must grow. • But because the population is not growing, investment growth was almost not possible at that time.

43. STAGNATION THESIS • But Hansen recognized that government could overcome the problem through compensatory finance – increasing government expenditures could fill the gap between private sector demand and potential output (income).

44. PAUL SAMUELSON(1915- ) • First American to win the Nobel Prize. • Born in Chicago, graduated from a B.A from University of Chicago and then he enrolled the Harvard graduate school. • Student of Hansen in Harvard. • His doctoral dissertation, The Foundations of Economic Analysis, published as a book in 1947.

45. PAUL SAMUELSON(1915- ) • He used mathematics in his analysis. • After graduating he taught in MIT, and published his introductory economics text, Economics. • He published numerous articles in prestigious economic journals, many are highly mathematical and covered diverse topics. • More interested in expanding theory rather than testing it.

46. The Multiplier-Accelerator Interaction • 1939, he published 2 papers where explored the interaction between the principles of the multiplier and accelerator. • This interaction becomes one of the foundations of modern business cycle theory. • Hansen was the one who suggested to him to use his mathematical skills to explore the idea.

47. The Multiplier-Accelerator Interaction • He used difference equation, demonstrated that change in consumption will depend on the size of the marginal propensity to consume and the size of the accelerator coefficient.

48. The Multiplier-Accelerator Interaction • The Simple Algebra of Income Determination • Y = C + I + G + X – M - basic Keynesian identity • Equation for C :    C = a + bY • C = a + b (Y – T) • C = a + bY – bT • T = T + tY • C = a + bY – b(T + tY) or  C = a + bY – bT – btY • G = G • X = X • M = M + mY • Y = 1/s+bt +m – z (a – bT + I + G + X – M)

49. The Phillips Curve • In 1960 Samuelson and Robert Solow, plotted a Phillip scatter diagram for USA, which they mad a rough estimate of US PC in 1960. • He asked a lot of questions on PC and these questions became the focal point of macroeconomic analysis in the 1960’s and 1970s

50. Other Contributions • Comparative static • Revealed preference theory • Efficient markets theory • Factor price equalization theory • Public expenditure theory