Evolution of Economic Thought

John Maynard Keynes (1883 – 1946) and Keynesian Economics

John Maynard Keynes was born in Cambridge  to an upper-middle-class family. His father was an economist and a lecturer in moral sciences at the University of Cambridge and his mother a local social reformer.  His career was varied -- writer, civil servant, financier, diplomat, advisor, etc. 

He was a student of Alfred Marshall at Cambridge University and later taught at Cambridge himself.

Keynesian macroeconomics theory grew out of the so-called Great Depression of the 1930s when orthodox (neoclassical) economic theory was unable to either explain the causes of the severe economic collapse or to provide an adequate public policy solution.

Indeed, Keynes believed that the very mechanism by which the economy was supposed to return to full employment---price adjustments---would only worsen the crisis.

In a series of lectures in 1933, Keynes explained why he rejected the idea that price adjustments would provide the means of restoring a "full employment equilibrium", as well as other aspects of the mainstream approach and provided an alternative theoretical framework. These lectures were the basis for his General Theory of Employment, Interest, and Money, published in 1936. This work is now considered one of the most significant texts in the history of economic thought.

Must remember that Keynes was a "capitalist" in the sense that he didn't want a complete change in the economic system (as Marx did) but he wanted to intervene in it.

The central ideas of the Keynesian School are:

• The market economy is inherently unstable and is subject to erratic shocks.  The shocks are due to "animal spirits" of investors or a change in the state of business confidence (savings vs. consumption)
• The market is not self-adjusting.  Without outside correction, the market can take a long time to return to full employment after being disturbed.  Prices and wages are not flexible.  SHORT RUN time frame.
• Active role for government:  The aggregate level of output and employment is determined by aggregate demand (he disagreed with Say's Law as being a "general" law).  Government can intervene to influence the level of aggregate demand.  Discretionary policy -- policy should be at the discretion of the government planners.
• Fiscal policy (change in government spending or taxes) is sometimes preferable to monetary policy because the effects of fiscal policy are considered to be more direct and faster than those of monetary policy.  And in some cases, people will hold money and not spend it, not increasing aggregate demand.  However, both policies are seen as viable ways the government can intervene in markets and increase stability.  Generally:

Policy:  Government must take an active role intervening in the economy to correct the failures inherent in the market system. 

•     The goal of these interventions is the achievement of full employment.   
•     Preferable fiscal policy:  Increases in government spending (G)  (i.e. spending on public works for example) with NO simultaneous increases in taxes (or could decrease taxes).  This was Keynes himself -- however, today monetary policy is just as important to Keynesians.
•     Aim is to stimulate aggregate demand, increase income and employment.
•     Deficit spending may be necessary to accomplish this goal.

The Business Cycle:

The national income accounts (including GDP - Gross Domestic Product) were greatly expanded in the 1930s under Keynesian economics.  Since aggregate demand (AD) became the driving force behind the economy - that's what was "measured."  So we get AD = C + I + G + NX

C =

I =

G =

NX (not included in his basic model) =

The most volatile component of AD is investment. 

In the General Theory, Keynes identified the catalyst of economic downturns, recessions and depressions, in changes in the investment policies of the boards of directors of capitalist firms.

Keynes argued that it was precisely the volatility of investment spending, or the demand for investment goods (capital goods and inventory), that created the so-called business cycle.

And this volatility resulted from the uncertainties faced by these boards of directors when they attempted to maximize corporate profits: the members of the board are necessarily operating in an environment of uncertainty about future revenues and future costs and form expectations about these variables based on a wide range of factors out of their immediate control, including but not limited to interest rates, as well as variables within their control.

If members of boards expect relatively low profit rates from investment spending, then they would be less likely to approve such spending.

However, when enough firms cut back on investment spending plans, the overall economy can be hurt. Jobs can disappear, consumers can find their income constrained and be forced to cut back on consumer spending, government revenues---tax revenues are linked to income in a positive relationship---fall, more and more firms find the demand for their goods and services declining---as demand falls, expected future revenues are adjusted downward---and corporate boards may further cut back on investment spending. The result is an economy that can move into a sustained period of decline in gross domestic product.

This demand-side analysis of the consequences of changes in profit expectations is at the core of the theoretical rethinking of macroeconomics embodied in Keynes' General Theory (GT).

"It follows, therefore, that, given what we shall call the community's propensity to consume, the equilibrium level of employment, i.e., the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment.  The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex rates of interest on loans of various maturities and risks." (GT, pp.27-28)

So Keynes is known for trying to incorporate both uncertainty and expectations into economic analysis.

So therefore:

His treatment of uncertainty:

•         Investment:

in a certain world, would be determined by the interest rate (Classical)

in an uncertain world, motivated by expectations of profit.

Expectations of profit were volatile and based on flimsy foundations:

•         Expect current state of affairs to continue;

•         Trust current prices, etc., as correct;

•         Trust mass sentiment.

Say's Law: 

Review the Classical model where AS = AD (the equilibrium version of Say's Law - of which Keynes picks up on - see pp. 25 and 26 in GT) - because if people save some of their earnings, thereby leaving some of what was produced on the shelves - the interest rate would adjust to make sure that businesses would borrow the savings and spend them via Investment.  Therefore, S = I and AS = AD.  No problem with over supply (or lack of demand).

With Keynes, Investment might not offset this savings, leaving goods on the shelves and therefore, a lack of demand in the economy. 

·          Private Expenditures in the economy has 2 components (in his basic model Keynes did not have NX -- his model was a closed economy model, and also government spending is not included here because it is separate from private spending)

–        D1, related to current output (consumption):

–        D2, not related to current output (investment):

 According to Keynes:

·         Say’s Law (rejected by Keynes) requires (and these are not the "general" case):

–        either D2=0 (and there are no savings); or

–        Increased savings causes increased D2.

But

–        The decision to invest is based on expectations of profit in an uncertain future - not based on the interest rate (especially in the short run).  Therefore,

–        Furthermore, increased savings means decreased consumption now.  So an increase in savings not only does not necessarily mean an increase (offsetting) amount of investment - but also that consumption is pulled down as well.

So saving is not a good thing to Keynes because it pulls down consumption.  Quite the opposite from the French and Classical economists we have discussed.  Saving was necessary in order to invest in capital and pay workers until a return comes in.

            The Paradox of Thrift: 

May lead to lower expectations and less investment (and less consumption if people are saving).

“The theory can be summed up by saying that, given the psychology of the public, the level of output and employment as a whole depends on the amount of investment... More comprehensively, aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital-assets, on the propensity to spend and on the social factors which influence the level of the money-wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little.”

 The Keynesian Multiplier:

 The Keynesian multiplier explains how spending of money by one sector in the economy will lead to spending in other sectors, and it goes on and on.  Spending, spending, spending......

So let's take the Investment multiplier:

            Investment (determined by expectations - E, output or income - Y, capital stock - K) determines income via multiplier. 

Example:  increase in investment - means an increase in income of others - since consumption (C) is a function of income - C increases (and so does savings - also a function of income).  With this additional increase in C, others income increases and therefore C and S increase again, and so on, and so on.....

–       So Investment = f (E,Y,K) (E is the component highly volatile)

–        Y= f (Investment)

All of this depends upon the Marginal Propensity to Do Something:

    Marginal Propensity to Consume (MPC):

    Marginal Propensity to Save (MPS):

•         Y= C + S

•         Savings a residual function of income:

 S = Y - C

So the strength of the multiplier depends upon the MPC and the MPS.  This is why Keynesians today are constantly trying to determine these:

Keynes on Policy During the Depression:

"If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again . . . there need be no more unemployment. . . . It would indeed be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing." (GT)

Keynes and the Liquidity Trap 

            Why fiscal and not monetary policy (esp. during the Depression)?

Liquidity Trap:  interest rates are low and savings rates are high, making monetary policy ineffective.

Keynes:  People hold their wealth in money or bonds.  In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the belief that interest rates will soon rise

Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

Therefore, when the money supply is increased, people will simply hold the money in savings – and will not spend.  AD will not go up – so the policy is ineffective.

However:  when interest rates are not so low (close to zero, for example), then monetary policy can be effective.  Hence we have the Phillips Curve trade-off:

·         “Reflate” domestic economy to escape Depression:

Government deficit funding of public works:

•         Multiplier impact on output, employment with an increase in deficit spending.

•         This will be a boost to investor expectations as well.

Graphically:

This was the first time that deficit spending becomes a "tool" of government to boost the economy.  Keynes opened the door for politicians to deficit spend!  Prior to this it was culturally unacceptable to do so except in war time. 

The Interpretation of Keynes

·         The General Theory was highly influential, but read by few economists (let alone economic journalists!)

Most relied upon summaries and textbook interpretations.

GT itself not precise; plenty of room for interpretation.

Key interpretation: Hicks 1937, “Mr Keynes & the Classics” - IS-LM rendition of Keynes.

Keynes “general theory”, according to Hicks:

IS-LM analysis - remember it is a macro equilibrium model.

But is it really Keynesian?

Whatever Happened to Uncertainty & Expectations?

Hicks: I=f (the interest rate) Investment demand a function of the rate of interest (and income in more general model) (i – interest rate here)

Keynes: “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible.”

         “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain... therefore, [we are] guided ... by the facts about which we feel somewhat confident, .... the facts of the existing situation enter … disproportionately, into the formation of our long-term expectations…”

Why not I= f (the interest rate and E) where E is expectations?  Perhaps because E can not be measured?

So maybe this is Keynes minus uncertainty & expectations!  Which is a very big loss.

“Keynes without uncertainty is something like Hamlet without the Prince.” (Minsky, John Maynard Keynes, 1975, p. 57)

Neoclassical Synthesis 

Putting Keynes together with neoclassical micro.

IS-LM macro grafted onto neoclassical micro.  But really hasn't been done.

Key architects Hicks & Paul Samuelson.

 “Protest” group of economists (Post-Keynesians) try to develop uncertainty-based interpretation of Keynes in opposition to dominant neoclassical synthesis view.  They have been somewhat successful but the IS-LM model still persists.

Despite Hick’s disapproval of his own model, the interpretation of Keynes was dominated by IS-LM, and Aggregate Demand-Aggregate Supply (AS-AD) analysis.  Still remains today.

Emphasis is still upon fiscal policy and monetary policy (depending upon the assumptions made in the model as to which would be most "effective" at stimulating aggregate demand.)

No attention to the issue of expectations.

Policy focus post-Depression, WWII:

 Full employment primary:       

 Price stability secondary:

The scorecard (depends upon who you ask)!!

Keynesian would say:

Recovery from Great Depression was due to Keynesian economics.

Years of high stable growth, low inflation (also due to Keynes).

Ending with rising inflation during Vietnam War Years, and severe collapse in 1973.

The Breakdown of Keynesianism - The Rise and Fall of the Phillips Curve

A 1958 study identifies the relationship between unemployment and rate of change of money (nominal) wages. 

"The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957", by A. W. H. Phillips was published in the quarterly journal Economica. 

In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined.

Lower rates of unemployment means that wage rates are driven higher due to the fact it is harder to hire people (fewer people looking for work). 

That was his original thesis.

Phillips extrapolates from money wages to price inflation:

·         “Inflation-unemployment trade-off” perceived as core of Keynesian policy.

Became a “cure” for unemployment – a policy tool.  Increase money supply – short run, more spending, prices increase, more revenue and production – hire more people.  But over time, as workers demand higher cost of living raises – the nominal wage must go up as well – and unemployment goes back up as people are fired. 

Graph:

So the trade-off he originally found (money wages and unemployment) was there but in the longer run.  Basically, as the MS increases and there are high rates of unemployment (so low nominal wages), revenue increases for firms - but they don't increase the nominal wage quite yet.  They don't have to since unemployment is so high. The rate of change of the nominal wage is slow.   But as they hire more workers and unemployment decreases, workers ask for higher wages (hence his trade off).

However the “data” didn’t always pan out:

 ·         1960s -- accelerating inflation.  1970s – stagflation - 

·         “Breakdown” of Philips’ Curve opens door to Milton Friedman’s monetarism.

The rise of monetarism (more later):

·         But Philips Curve - Friedman’s explanation: adaptive expectations, the short run trade-off but long run vertical Phillips curve.

Adaptive Expectations:

Therefore, higher money wages built into employment contracts.  Must increase the money supply at a higher and higher rate each time (his analogy – a drug addict).

Graph:

Keynesians Now:

New Keynesian economists - try to provide a microeconomic foundation to Keynesian economics (less aggregation).  

Post Keynesian economists – try to incorporate uncertainty into the Keynesian framework (Paul Davidson a good example)

But generally speaking, the emphasis is still on aggregate demand management (spending, spending, spending) and why markets are not “self-correcting” and need help.

Example is their emphasis on “sticky wages and prices:”

Policy recommendations:

Still – discretionary fiscal and monetary policy in order to stimulate demand (during recessions) and pull it down (during times of inflation).  Monetary policy now called "quantitative easing."

DO ICE NINETEEN