Intermediate
Macroeconomics
Topic Four (b): Keynes
The Model and Policy Conclusions
The Simple Keynesian Cross Model (45 degree model): GRAPH
Equilibrium with unemployment: AD = AS or C + I = Y but there can still be involuntary unemployment due to lack of AD (excess capacity of both capital and labor).
Also, Saving greater than Investment, since not linked with r.
Investment is the problem!
So, how does Keynes solve the problem?
Keynes’s Policy Conclusions
Is Monetary Policy Effective?
Liquidity Trap
If not, then Fiscal Policy: Should monetary policy not be effective (due to changes in money demand or velocity), then aggregate demand could be stimulated directly via government expenditure or indirectly through tax changes which stimulate consumer spending by raising household disposable income.
Because S > I, the key to reducing aggregate instability was to find ways of stabilizing investment expenditure at the level sufficient to absorb the full employment level of savings.
Socialization of investment: Keynes’s suggestion that “a somewhat comprehensive socialization of investment” would prove the “only means of securing an approximation to full employment” is open to a wide variety of interpretations.
The labor market would not always clear.
Rigid wages: Involuntary unemployment is likely to be a feature of the labor market if money wages are rigid.
Unions, for example, could keep wages rigid.
Also, flexibility of nominal wages would be unlikely to generate powerful enough forces which could lead the economy back to full employment.
Initial equilibrium at full employment QLe and Yf.
AD1 falls to AD2.
Prices are flexible but wages are not.
Prices fall, nominal wages stay the same.
Real wage increases – leading to a decrease in DL and increase in SL – so involuntary unemployment.
The drop in employment decreases income and output. Move to e1.
The AS curve is not perfectly vertical – Y1 is not full employment Y.
So what’s the answer?
Reduce the real wage back down by:
1) money wages must fall relative to the price level or
2) the price level must rise relative to the nominal wage.
Keynes favored the latter -- increase aggregate demand in order to put upward pressure on the price level. In other words, shift AD back to AD1
This will increase prices back to P1 and reduce the real wage back to its equilibrium level of W1/P1 and no more unemployment.
Keynes rejected cutting the nominal wage on both practical and theoretical grounds:
Difficult to cut wages without “wasteful and disastrous struggles”
He rejected wage and price flexibility as a reliable method of restoring equilibrium on theoretical grounds also.
Why would the Classical model of self-correcting forces fail?
There are two reasons Keynes said this might fail:
1. Liquidity trap – where the increase in the real money supply is simply held as speculative demand for money, so the interest rate does not fall. So when C falls, for example, in the Classical model, Savings would increase, the interest rate would fall, and investment would increase to pull AD back up. But if people hold money, savings will not increase, the interest rate won’t fall and investment won’t increase.
2. An interest-inelastic investment schedule – where investment is not responsive to a change in the interest rate (due to animal spirits).
This meant too that monetary policy as a way of stimulating demand might also fail.
Keynes was convinced that the government would need to take positive action in order to eliminate involuntary unemployment.
Underemployment equilibrium might occur otherwise – where the economy could remain in a chronic condition of subnormal activity for a considerable period of time.
In sum, Keynes:
1) Rejected Say’s Law – output and employment are determined by effective demand and the operation of the labor market cannot guarantee full employment.
2) Rejected the idea that the interest rate would ensure S = I.
3) Savings mostly a function of income, not the interest rate.
4) Investment very volatile, a function of the interest rate and animal spirits, uncertainty.
5) The interest rate not determined by the supply and demand of loanable funds (savings and investment); but by the demand and supply of money.
6) The demand for money is also subject to uncertainty due to the speculative demand for money – therefore,
7) Rejected the Quantity Theory of Money - Changes in M may be offset by changes in V in the opposite direction.
8) Market forces cannot be relied upon to return economy to full employment, need government shock through increase in aggregate demand.