ECON 272 - Notes on Keynesian
Economics
Leading character:
John Maynard Keynes
Published
The General Theory of Employment, Interest and Money in 1936.
Basic point was that recessions and depressions can occur because of inadequate aggregate demand for goods and services. Was a critic of the Classical School of Economics because it only focused on the long run and not the short run. Famous quotation: “In the long run we are all dead.”
Summary:
The
economy is demand driven.
Short-run
economics.
Markets
are chaotic, not self-correcting.
Focus
is on unemployment.
The
market can be in equilibrium but not at full employment.
Planners
have the knowledge necessary to “smooth out” the cycles of the economy.
Disagreed
with the four cornerstones of the Classical School:
Deficit Spending and Crowding Out: As we will see, Keynesians call for deficit spending as a policy tool. With respect to crowding out, the theory has merit but when there are a lot of excess reserves in banks (due to expansionary monetary policy, for example), there is no reason that interest rates would increase -- thereby crowding out private investment.
Graphically:
Keynes' different reasons for demanding money:
1.
2.
3.
Therefore - according
to Keynes, Monetary policy (change in MS) not effective during a
depression due to “liquidity preference” or the liquidity trap:
Supply and Demand of money and the interest rate.
Supply of money determined by the FED, not a function of the interest rate.
Demand for money is a
function of the interest rate. The
interest rate is the opportunity cost of holding money.
If you hold cash instead of an interest-bearing bond,
you are foregoing the interest. An
increase in the interest rate raises the cost of holding money and therefore
decreases the speculative demand for money and vice versa.
The interest rate will adjust to equate the supply and demand for money.
When
interest rates are low people will hold money.
Furthermore, they are speculating that bond prices will fall when
interest rates go up – so they don’t want to be holding bonds, they want to
be holding money.
So
if the money supply is increased by the FED, people simply hold the money (this
is the liquidity trap) –
and aggregate demand does not increase.
Therefore Keynes wanted to use:
Fiscal Policy effective (change in G and/or T) according to Keynes.
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The Simple Keynesian Model (Income-Expenditures Model or 45 degree Model)
Remember - to a Keynesian, the economy is driven by aggregate demand -- or aggregate expenditures or consumption in the economy.
The most important variables that determine the level of aggregate consumption are:
Current disposable income:
Household wealth:
Expected future income:
The price level:
The interest rate:
Notice how income (current and expected) is very important. In the simple Keynesian model, a certain level of national income (Y) in the economy will correspond to a certain level of expenditures in the economy -- which in turn corresponds to a certain level of unemployment. Higher levels of AD and Y will decrease unemployment.
All of the above will impact one or all of the four components of aggregate demand.
AD = C + I + G + Net Exports. If income is higher, for example, consumption will be higher, etc.
Graphically, the Keynesian model adds up the components of expenditures (AD) in the economy. Equilibrium is where AD = AS (GDP).
Consumption function:
Autonomous expenditure or consumption:
So what will savings do?
Investment:
Government spending:
Net Exports:
GRAPH:
Showing a recession on the 45 degree model:
Marginal Propensity to Consume (MPC):
Marginal Propensity to Save (MPS):
Paradox of Thrift (or Savings):
Keynes also talked about the paradox of thrift (or paradox of saving) - that as individuals save, then aggregate demand will go down (remember, there is no link between savers and investors in the Keynesian world) -- thereby causing output and employment to also drop. Therefore, as the economy becomes worse, individuals are able to save even less -- this will actually lead to lower savings in the economy overall because of the state of the economy.
The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy. So basically, while individual savings might be good for the economy if it leads to future investment in capital goods, etc., this paradox says that "collective" savings may be bad for the economy. Deb saves - good for her - but if Deb and Bob and Betty, etc. are all saving, not buying - then the economy tanks - Deb and Bob both lose their jobs and aren't able to save any more!! So it becomes almost self-defeating to save!!
Therefore, saving is not good for an economy (generally speaking) to Keynes. Instead -- consumption is better. Spend! And this spending will lead to a multiple (positive) effect in the economy.
The Keynesian Multiplier Effect: an increase in expenditure leads to a larger increase in income (Y) and real GDP. Remember, Y = GDP in equilibrium.
A
change in C or I or G or NX will cause a multiple change in National Income (Y)
and real GDP.
This is the Keynesian multiplier effect.
Example: when C increases, Y
increases, which in turn will increase C & S, and then Y again, then C &
S again, and so on. Depends upon
the Marginal Propensity to Consume (MPS) and Marginal Propensity to Save (MPS).
MPC + MPS = 1. The higher
the MPC, the higher the multiplier effect.
GRAPH:
Keynesian Goal
is full employment.
Most
powerful fiscal policy is to increase G but do not increase T (i.e. deficit
spend) in order to stimulate demand and therefore income and employment.
Why?
So Keynes recommended deficit spending as a policy tool. He did not foresee the large deficits (and therefore debt) that many countries have today. He thought - in good times when tax revenue is high - pay down the debt. But in bad times -- stimulate the economy through deficit spending in the short run.
There are many critics of this - but I want to mention one now: James Buchanan.
He said that what Keynesian economics did (by making deficit spending a policy tool by the government) was change the "cultural norm" of the government (which was to keep a balanced budget except in perhaps war time). This change in the norm has lead to very large deficits. It "opened the door" for politicians to use deficits for political reasons. Remember, it was not that Keynes himself said we should run large deficits all of the time -- but what Buchanan said was that Keynes was naive of the political consequences of this policy. Politicians like deficits. Why?
How might the government debt be paid? "Public Choice argument" -
The Modern Debate and THE NEW KEYNESIANS vs. NEW CLASSICAL ECONOMISTS:
The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust.
New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible (as did the original Classical model). They believe that prices “clear” markets—balance supply and demand —by adjusting quickly.
New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models that assume “sticky” wages and prices. New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy and/or fiscal policy have such a strong influence on economic activity. These economists would recommend Quantitative Easing in a recession (like we have had).
In other words -- if there is a lack of demand in the economy -- prices should fall to clear markets and wages should also fall to make sure unemployment stays low. But the New Keynesians argue this does not happen quickly - and in the meantime there is unemployment that government policy should address.
Here are their theories regarding why wages and prices are "sticky" - especially downward:
New Keynesian explanations of sticky prices often emphasize that not everyone in the economy sets prices at the same time. Instead, the adjustment of prices throughout the economy is staggered. Staggering complicates the setting of prices because firms care about their prices relative to those charged by other firms. Staggering can make the overall level of prices adjust slowly, even when individual prices change frequently.
So one firm might lower its price a little bit -- waiting to see what other firms do. Other firms might follow -- lowering it a little more, etc. This process takes time.
Another important part of new Keynesian economics has been the development of new theories of unemployment. Persistent unemployment is a puzzle for economic theory. Remember, with flexible wages, the new classical economists presume that an excess supply of labor would exert a downward pressure on wages. A reduction in wages would in turn reduce unemployment by raising the quantity of labor demanded. Hence, according to standard economic theory, unemployment is a self-correcting problem (in the long run).
New Keynesian economists often turn to theories of what they call efficiency wages to explain why this market-clearing mechanism may fail. These theories hold that high wages make workers more productive - so firms don't cut wages even when the market says they should (there's an excess supply of labor, for example). Even though a wage reduction would lower a firm’s wage bill, it would also—if the theories are correct—cause worker productivity and the firm's profits to decline.
There are various theories about how wages affect worker productivity:
a). Higher wages reduce labor turnover. By paying a high wage, a firm reduces the frequency of quits, thereby decreasing the time spent hiring and training new workers.
b)
Higher wages pull in the most productive employees. If a firm reduces wages, the best employees may take jobs elsewhere, leaving the firm with less-productive employees who have fewer alternative opportunities. By paying a wage above the market clearing level, the firm may avoid this, improve the average quality of its workforce, and thereby increase productivity. (Commentary - then doesn't that just mean that the "market clearing wage" for any given firm might be different than for another)?
c) A third efficiency-wage theory holds that a high wage improves worker effort. This theory posits that firms cannot perfectly monitor the work effort of their employees and that employees must themselves decide how hard to work. Workers can choose to work hard, or they can choose to shirk and risk getting caught and fired. The firm can raise worker effort by paying a high wage. The higher the wage, the greater is the cost to the worker of getting fired. By paying a higher wage, a firm induces more of its employees not to shirk, and thus increases their productivity.
Keynesians generally:
Discretionary
fiscal policy (government spending on public works. etc.)
Discretionary monetary policy:
New Keynesians: In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new Keynesian economics provides a rationale for government intervention in the economy, such as countercyclical monetary or fiscal policy.
Summary: So basically, Keynesians (old and new) would recommend discretionary fiscal AND/OR monetary policy depending upon the situation.
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