Keynes and the Keynesians

1. Keynes and the Keynesians ECON 205W Summer 2006 Prof. Cunningham

2. John Maynard Keynes (1883-1946) • Born in 1883 in Cambridge, England • Son of John Neville Keynes • Neville was a professor of Economics and Logic at Cambridge Univ., and wrote on Economic Methodology • Won a scholarship to Eton • Boy Genius • Won prizes for his work in the classics, mathematics, history, English essays • Wrote papers on contemporary social problems, participated in crew and debate, acted, read everything • Became an expert in medieval latin poetry • Part of Eton’s social elite • Won a scholarship to King’s College, Cambridge

3. Keynes at College • President of the Student Union • President of the University Liberal Club • Rowed, studied philosophy, played bridge, visited art galleries, collected rare books, went to the theatre • Became a member of the “Apostles”, a secret and highly exclusive Cambridge intellectual society • Became a member of the literary set called “the Bloomsbury Group.”

4. Keynes After College • Studied economics for perhaps 1 year, but did poorly on his exams. • Took a civil service exam and took a job at the India Office for 2 years. • 1908, his father managed to get him a job as a lecturer at King’s College. Later he became a Fellow. • 1911, he became editor of the Economic Journal. • Worked at the Treasury during WWI. • 1921, he published A Treatise on Probability. This was his dissertation. It won him a fellowship at King’s College, Cambridge. • Marries Lydia Lopokova.

5. Keynes, Inter-war Years • Keynes wrote the Economic Consequences of the Peace (1919), regarding reparation payments • Best Seller • Made him a public celebrity • 1923, Tract on Monetary Reform (against returning to the pre-war gold standard) • Economic Consequences of Mr Churchill (1925, warned of depression) • 1930, Treatise On Money • Makes millions in the stock market, commodity, and forex markets. • 1936, General Theory of Employment, Interest and Money • 1937, he has a serious heart attack

6. Keynes’ Tract • Relates money supply variability and uncertainty to inflation and deflation. • Variability of prices is a major cause of business cycles. • Wages and other costs of production adjust more slowly than prices. • Therefore price variability affects profits and therefore investment. • Investment cycles cause business cycles.

7. Keynes’ Treatise on Money • Early elements of the General Theory. • Expectations are quasi-rational? • Swings in investment, based on changes in profits, generate business cycles. • Saving is passive. • Introduces a stock-flow analysis. • Written following Britain’s return to the gold standard at parity in 1925. • Argued that under a fixed gold standard, there is no opportunity for independent domestic policy.

8. The General Theory “ I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems.” -- John Maynard Keynes

9. Comment by Paul Samuelson “It is a badly written book, poorly organized; any layman who, beguiled by the author’s previous reputation, bought the book was cheated of his 5 shillings. It is not well suited for classroom use. It is arrogant, bad-tempered, polemical, and not overly-generous in its acknowledgements... In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding on its relations to its predecessors. Flashes of insight and intuition intersperse tedious algebra. An awkward definition gives way to an unforgettable cadenza. When it is finally mastered, we find its analysis to be obvious and at the same time new. In short, it is the work of genius.”

10. The General Theory • If the consumer is an economic optimizer, he/she must be unable to buy the goods they planned to buy because of some kind of constraint—risk, convention, social institutions, cash, or ...? • According to the classical model, the consumer has insatiable wants. • The consumer sells his/her labor in exchange for enough income to buy the goods. • The money value of the incomes received must be equal to the value of the output produced. • So how can unsold goods pile up in warehouses, causing firms to lay off workers?

11. The General Theory (2) • Say’s Law cannot hold. (“Supply creates its own demand.”) • If spending constraints are in effect, then there will be a difference between (unlimited) demand and “effective demand”. • Actual (effective) demand will usually be “deficient” to purchase total output.

12. The General Theory (3) • Microeconomics and macroeconomics do not operate on the same basis. One cannot assume that what is true for the economic agent at the level of the individual consumer or firm is true in aggregate. This amounts to the fallacy of composition. • In microeconomics, relative price effects dominate. This is not true in macroeconomics. In macroeconomics, income effects dominate, making income more important in determining aggregate economic behavior.

13. The General Theory (4) • Therefore, consumption depends primarily upon income, not interest rates. • C  C(r), but rather C = C(Y) • “People don’t change their standard of living simply because the interest rate changes a few points.”

14. The General Theory (5) • Saving occurs as the result of a habit, convention, or social norm. People on average set aside a certain percentage of their income. Saving is not a function of interest rates. • S  S(r), but rather S = S(Y) • Investment is related to interest rates, but also to businesspeople’s expectations for the future. • That is, I = I(r,E).

15. The General Theory (6) • If S = S(Y) and I = I(r,E), then there is no coordinating variable to bring supply and demand together in the loanable funds (capital) market. • There is no reason to assume that supply equals demand in this market. • There is no reason to believe that there will be adequate funds available to provide adequate investment demand. • Since AD = C + I + G + NX, if investment demand is deficient, then AD < AS, and inventories may pile up, with unemployment a natural outcome. • Without the coordinating variable, this will be the normal outcome, with AD = AS only happening accidentally.

16. The General Theory (7) • Investment is a large and long-term commitment, and is based on weakly supported expectations about the future. This makes investment very different from consumption. Investment decisions will be erratic and emotional, and the risks associated with investment are very high. As a result, business decision makers will tend to under-invest, further worsening the problem of deficient investment.

17. The General Theory (8) • It may be a natural outcome of the organization and institutions of modern economies that prices and wages may not be fully flexible. This would result in markets (like the labor and goods markets) being unable to clear, leading to unemployment and aggregate supply exceeding demand.

18. The General Theory (9) • Money plays a key role in the economy. The use of money leads to uncertainty, and makes “piercing the veil” impossible. A money economy is fundamentally different from a barter economy. The classical dichotomy cannot hold. • Interest rates are established in the money market. • People may rationally hoard money, holding money for purposes other then making transactions. • Equilibrium is not AD = AS. It is a state that persists.

19. Consumption U.S. Annual Data, 1929 - 2001

20. Consumption Function c = mpc = C/Yd = marginal propensity to consume C C = C0 + mpc x Yd Or C = C0 + cYd C Yd C0 Yd

21. Original Aggregate Expenditure Model Z=AS Nominal Value of Output (Py) C e D = AD E* There is a limit to the profitable expansion of output. If Say’s Law held, there could be no obstacle to full employ-ment. Output could profitably be increased until excess labor was absorbed. Thus, this is a refutation of Say’s Law. N* Nf

22. 45o line Real GDP exceeds planned expenditure 10.0 Total Expenditure C+I+G Aggregate planned expenditure (trillions of 1992 dollars/year) 8.0 f e d 6.0 b c Equilibrium expenditure 4.0 a Planned expenditure exceeds real GDP C0 G I 0 2 4 6 8 10 Real GDP (trillions of 1992 dollars per year)

23. Algebra of the Model Y = C + I + G but C = C0 + c(Y-T), so Y = C0 + c(Y-T) + I + G Y = C0 + cY – cT + I + G Y – cY = C0 + I + G – cT Y(1-c) = C0 + I + G – cT But this means that but

24. Policy Planned Expenditures E1 E0 G Y Y0 Yf

25. Alvin Hansen (1887-1975) • Background • Taught at Brown Univ., Univ. of Minnesota, and finally Harvard (1937) • Famous students • Wrote a paper pointing out a math error in Keynes’ Treatise on Money; not enthusiastic about the General Theory at first. • Business Cycle Theory (1927) • 1941, Fiscal Policy and Business Cycles • Extended Keynes’ Policy Recommendations • Supported Keynes’ analysis of the 1930s • A Guide to Keynes (1953)

26. Hansen (2) • Hicks-Hansen Synthesis (IS-LM) r LM r* IS y* y

27. Hansen (3) • Hicks (1939) had pointed out problems with Keynes’ theory, utilizing his own IS-LM apparatus. Hicks and Hansen worked out the indeterminacy of the interest rate and other problems. • Extensive revision of Keynes’ aggregate expenditure model. • 1937-38, Advisory Council on Social Security • Economic advisor to Federal Reserve Board • Participated at Bretton Woods • Involved in the Full Employment Act and the creation of the Council of Economic Advisors

28. Hansen (4) • Stagnation Thesis • 1938, Full Recovery or Stagnation • Inadequacy of investment of keep pace, making it impossible for the economy to naturally maintain full employment • Advocated (gov’t) compensatory finance to compensate for inadequate private sector investment

29. Abba P. Lerner (1903-1982) • Background • Taught by John R. Hicks, Lionel Robbins, von Hayek • Socialist at London School • Focus on policy recommendations, including functional finance.

30. Paul Samuelson (1915- ) • 1970, 1st American Nobel in Economics • Textbook, Economics • PhD, Harvard • Phillips Curve with Solow wage inflation Consumer price inflation u u Samuelson-Solow Curve Phillips’ curve

31. Samuelson (2) • Contributions • Comparative statics • Revealed preference theory • Efficient markets hypothesis • Product and factor mobility • Public goods theory • Methodological innovations • Use of mathematics • Called economics “full of inherited contradictions, overlaps, and fallacies.” • Dissertation Foundations of Economic Analysis, published in 1947.

32. Samuelson (Accelerator) • The desired capital stock is proportional to the level of output: • Investment is the process of moving from the current level of capital to a desired level: • We assume that whatever the capital stock ended up being last period was the level of capital that businesses actually wanted:

33. Accelerator (2) • This allows us to rewrite: • As • Thus investment is related to the rate of change in output. • If the economy is growing rapidly, then investment grows rapidly. • If the economy is not growing, then investment slows, and net investment (after depreciation) may actually be negative.

34. Post Keynesians • Sraffa, Robinson, Pasinetti, Weintraub, Davidson • Neo-Ricardian view of production, value, and distribution • Oligopolistic corporations. markup pricing • Endogenous money • Cyclical instability • Incomes policy • Class struggle for income shares, markup pricing necessitate a permanent incomes policy

35. New Keynesians • Fischer, Taylor, Howitt, and many others • Rational expectations, general equilibrium, microfoundations • Offer theoretical support at the firm profit maximization level for Keynesian features in the economy • Contracting models • Menu/transactions costs • Efficiency wages • Insider-Outsider theory