VIII Keynesian revolution – economic policies

1. VIII Keynesian revolution – economic policies

2. Legacy for economic policy • Keynesian theory suffered significant setbacks, BUT • Two Keynesian conclusions survived till today: • Capitalist economy, if left to market forces, can operate for a long time with substantial involuntary unemployment For practical purpose, it is not important whether the economy might converge towards full employment equilibrium, if this happens with long delay • Insufficient demand is the principal culprit of depression situation, hence fiscal and/monetary demand stimulation are the principle tools of short term economic policies It is the role of the Government to perform this demand stimulating policies

3. VIII.1 Fiscal and monetary stimulation of aggregate demand

4. Keynes’ policy prescriptions • His principal focus – the depression situation • Aggregate demand requires stimulation • Subsequent simplifications: fiscal and monetary multipliers in the framework of ISLM model • Easy illustration of the basic idea, bellow we will do the same • Keynes himself – much wider considerations: • Concern about autonomous components of consumption and – especially – investments (famous quote on “socialization of investment”) • Understanding the role of expectations • Concern about the political forces and the role of trade unions • All this quite often quoted by his disciples, but almost nothing survived as to the practical recommendations • Entire victory of simplified, “hydraulic” ISLM interpretation

5. Policy innovations (1) • Fiscal and monetary policies • Preference of fiscal policies • Monetary policy less efficient due to almost flat LM curve and interest-inelastic investment • Sharp departure from pre-1930 policy taboos: • Accepts budget deficits • Refuses the crowding-out effect – remember LIV: fiscal stimulation via increase of government spending is crowding-out the either personal consumption of private investment • Here his views were shared by many economists, but widely opposed by British Treasury (Finance Ministry) – the “Treasury view” problem

6. Policy innovations (2) • Refused wage cuts as a remedy for depression • Both on political and economic ground • Political power of trade unions and social tension during the depression • In the US, real wages were falling during most of 1930’s, without any practical impact • Similar situation observed in many other countries (except Britain, due to overvalued currency) • Fiscal multiplier and its effect on growth and employment • The policy role of the governments: the theory provides the tools to increase the product (and employment) by stimulating aggregate demand • Government is the only “agent” on the market, capable to perform this role

7. VIII.2 ISLM illustration

8. ISLM vs. complete model • The complete model multipliers (as we did for Classical model in LIV) – see Sargent’s textbook in Literature • Requires more theoretical discussion on specification of consumption and investment function – beyond the scope her • Instead – ISLM illustration • Keep in mind that it is a simplification

9. VIII.2.1 Fiscal policy in ISLM • Changes of governmental expenditures • Changes in tax rates • Transfers to population (not included in the simple model here) • Time aspect

10. Increase of governmental expenditures • Initial equilibrium in • Increase: → higher AD • Shift of IS (when each level of interest corresponds to higher level of Y) → at given interest, point A represents new equilibrium on goods market • However, in A, disequilibrium on money market (off LM curve), EDM→ interest  → I → AD  → Y  • New equilibrium in

11. LM r A Y

12. Multiplier of governmental expenditures • Differentiation of both equations: , hence • Substituting in the first equation for dr from second equation and after arrangement we have • By assumptions and

13. Crowding out effect (1) • In ISLM model, multiplier of governmental expenditures is lower than the same multiplier for the goods market only (when interest is given) • Full model (and in reality) – higher governmental expenditures are partially offset by decrease of investment (due to the increase of interest) - G crowds out private investment • Formally: impact of the term

14. Crowding out effect (2) • Keynes (short term): increase in governmental expenditures will have higher impact on product when • Interest elasticity of demand for money is high (LM curve almost horizontal) • And/or interest elasticity of investment is low (IS curve very steep) • Hence • Classical model (long term): vertical LM ↔ increase of governmental expenditures fully crowds out private investment

15. Tax policies • Simplification: • Tax multiplier (derived equally as above) • Policy induced change: impact of the tax change enabled first through the change of disposable income, than impact on consumption, AD and product (income); only than multiplier applies. • Effect less certain – the reaction of consumers to a tax change might modify MPC .

16. Balanced budget multiplier • Keynes – allowed for budget deficit • Reality – budget balance is always watched • Question: what is the multiplier in case of equal change in governmental expenditure and amount of taxes, i.e. and after arrangement • Balanced budget multiplier is equal one.

17. VIII.2.2 Monetary policy in ISLM • Original equilibrium in E1 • Increase of money supply • At given Y, excess supply of money → higher demand for bonds, higher price of bonds and lower interest → shift of LM to the right, new equilibrium on money market at point A • However, disequilibrium at goods market (EDG) → low interest increases investment, AD and product. Higher product increases demand for money → increase of interest → overall equilibrium at E2

18. r A IS Y

19. Multiplier of monetary policy • Again, differentiation of both equilibrium conditions, hence • After arrangements

20. Efficiency of monetary policy • The higher efficiency (impact on product growth) of monetary policy, • The lesser interest elasticity of demand for money (the steeper is demand for money and LM curve as well) • The higher is interest elasticity of investment (the flatter is IS curve • If (flat LM) , than multiplier of monetary policy is equal to zero and monetary policy is entirely ineffective → liquidity trap

21. VIII.2.3 Some crucial differences with Classical model • Equilibrium at less than full employment • and demand does not have to equal supply on some markets • Quantitative adjustment, wages and prices adjust slowly • Money in not neutral • It is not a veil • Demand stimulation is not completely crowded out

22. VIII.3 Lessons for the policy

23. Basics • Capitalist economy must be steered towards full employment output by policies, performed by the governments, stimulating aggregate demand • Monetary policies less efficient → crucial role of fiscal policies • Multiplier effect • When output at less than full employment level, then wages and prices adjust slowly • Downward wage rigidity as general concept • At full employment out put level – classical model applies again

24. Keynes’ wrong predictions (1) • Estimate if numerical value of fiscal multiplier • Expectations up to value of 3, in reality just above 1 • Inherent stagnation of the capitalist economy, APC falls with growing income • Not proved by the data (Kuznets) • High interest elasticity of money demand (reason for liquidity trap) or low interest elasticity of investment • Not validated by the data

25. Keynes’ wrong predictions (2) • Expectation about the return of recession after the end of WWII • Lack of aggregate demand, either because of lack of consumer demand (low income and/or falling APC) or investment demand (after the war economy stops to generate government military demand) • Completely refuted by the post-WWII economic development • Till today discussion of this was result of the application of Keynesian recommendations of not • See next Lectures, but: after WWII, it was mainly the effect of private investment that filled the gap between AD and AS

26. VIII.4 Conclusions

27. Lasting impact on economic policy • After Keynes: for more than 3 decades, a prevailing view was that the governments must intervene to steer capitalist economy towards production at full employment • This remained accepted by many (not only economists), even by those who criticize Keynes or understand his fallacies • After 1970 – a reversal in prevailing views (see chapters later) • Today: • his model is considered as one stage in the development of macroeconomics • new Keynesian economics (see later)

28. Literature to Ch. VIII Again, the literature to this Lecture is immense, bellow are 3 recommendations • ISLM model as policy instrument – any intermediate textbook on macroeconomics • Snowdon, B., Vane, H.: Modern Macroeconomics, Edvard Elgar, 2005, namely Chapter 3 (and the literature given here) • Blaugh, M.: Economic Theory in Retrospect, CUP 1997 (5th edition), Chapter 16, namely parts 16.1-16.5 and 16.19-16.23