1. The Breakdown of Keynesianism The Neoclassical Revival
Lecture Seven
The Breakdown of Keynesianism
The Rise and Fall of the Phillips Curve
The Neoclassical Revival
The Keynesian Counter-attack: logical flaws in Neoclassicism

2. Recap IS-LM dominates interpretation of Keynes
Keynes a “marginalist”: liquidity preference as marginal cost of interest foregone in holding money
Role of expectations under true uncertainty ignored
Neoclassical synthesis: combination of IS-LM macro with Walrasian micro

3. Breakdown of Keynesianism: “Philips Curve”
1958 study identifies relationship between unemployment & rate of change of money wages
Consonant with Keynes on real wages and employment
Inc. output --> decrease real wages --> prices must rise
“Inflation-unemployment trade-off” perceived as core of Keynesian policy
1960s--accelerating inflation. “Breakdown” of Philips’ Curve opens door to Friedman’s monetarism

4. The Phillips Curve
3 factors which might influence rate of change of money wages:
Level of unemployment (highly nonlinear relationship)
Rate of change of unemployment
Rate of change of retail prices “operating through cost of living adjustments in wage rates… when retail prices are forced up by a very rapid rise in import prices … or … agricultural products.” [Economica 1958 p ]
Cost-based perspective on prices
Developed curve from UK wage change/unemployment statistics from
Only 1st of 3 causal factors shown in curve

5. The Phillips Curve Found a “clear tendency” for
inverse relation between U and rate of change of money wages (Dwm)
Dwm above curve when U falling, and v.v
Fitted exponential curve to data:
Unemployment
Dwm

6. The Phillips Curve Deviations from trend because of:
Fitted through average wage
change & U for 0-2,2-3,3-4,
4-5,5-7,7-11% unemployment
Wage-price spiral
due to wars; falling U
Rising unemployment

7. The Phillips Curve fitted to 1913-1948 data
Rapid rise in U;
13% fall in M prices;
“cost of living” agreements
War-induced
rise in M
prices

8. The Phillips Curve: 49-57 data with time lag
Close fit
of 50s UK
data to
curve
Import price rise

9. The Phillips Curve
Conclusion: Phillips extrapolates from money wages to price inflation:
“Ignoring years in which import prices … initiate a wage-price spiral, which seems to occur very rarely except as a result of war, and assuming an increase in productivity of 2% p.a., … [for] a stable level of product prices … unemployment would be … 2.5%. [For] stable wage rates … about 5.5%” [p. 299]
An inflation-unemployment trade-off?
But Phillips’ main purpose for developing it was to provide an input for his dynamic models in which unemployment, output, etc., varied cyclically.
Nonetheless, trade-off interpretation becomes part of orthodox Keynesianism

10. The Phillips Curve: Breakdown…?
OPEC I
Vietnam war
OPEC II

11. The rise of monetarism
Friedman’s explanation: adaptive expectations, the short run trade-off but long run vertical Phillips curve
Basic model:
Exogenously given money-supply (“helicopters”)
Walrasian economy in long-run equilibrium: all prices currently market-clearing
No sale of capital assets possible
Static-stochastic economy: no growth, aggregates constant, but random disturbances to individuals
“Aggregates are constant, but individuals are subject to uncertainty and change. Even the aggregates may change in a stochastic way, provided the mean values do not.” [OREF II 119]

12. Back to Hicks’s pre-Keynesian “typical classical theory”
Monetarism
Basic model (cont.)
Motives for holding money:
Transactions (barter motive)
“uncertainty” says Milton, but: means of aggregates constant, stochastic variation only? Risk, not uncertainty.
No variation in parameters of risk considered
Holdings of money related to level of transactions:
Md = k.I
Exogenous increase in Ms-->
initial increase in output but constrained by already fully-employed economy
price level bid up till “real value” of money holdings restored
Back to Hicks’s pre-Keynesian “typical classical theory”

13. Monetarism Continuous growth in Ms?
(corresponds to policy for lower U under Phillips curve inflation/U tradeoff)
“which, perhaps after a lag, becomes fully anticipated by everyone”; adaptive expectations [OREF II]
results in…
Adaptive Expectations (with certainty)
“what raises the price level, if at all points markets are cleared and real magnitudes are stable? ... Because everyone confidently anticipates that prices will rise…” [OREF II]
Increasing Ms raises prices, no impact on output in long run (short run impact until expectations adapt)

14. Adaptive Expectations and the Phillips Curve
“Long run Phillips Curve”
Target Rate
Accelerating
inflation needed
to sustain target
Short run gain with long run
pain...
Inflation
SRPC3
DMs causes some growth but…
SRPC2
Expectations adapt
Expected Inflation=
DMs- DLab.Prod
SRPC1
Expectations adapt
Economy returns to pre-existing “natural” rate
Unemployment
Initial “natural” U rate with zero expected inflation

15. From Monetarism to Rational Expectations
Friedman adaptive expectations
expectations adapt to change after experience of inflation caused by increased money supply
short-term impact of policy neutralised in long term
Rational Expectations (Muth/Sargent): expectations predict consequence of change based on rational model of reality:
“expectations … are essentially the same as the predictions of the relevant economic theory.” [OREF III]
Combined with lag formulae as explanation for cycles:
See chaos
theory,
later
Expected price in cyclical market
a weighted sum of previous prices

16. Rational Expectations Macro
“the public knows the monetary authority’s feedback rule and takes this into account in forming its expectations… unanticipated movements in the money supply cause movements in y [output], but anticipated movements do not.” [OREF III]
“Predictions of relevant theory” are: increased Ms will increase price level --> instant adjustment of prices to government Ms policy --> no impact on output
“Natural rate” of unemployment + rational expectations = policy ineffectiveness hypothesis:

17. Rational Expectations Macro
“by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips curve even for one period.” [OREF]
A vertical Phillips curve in short run
Prediction that policy could never have been effective
Short-run movements in unemployment due to unanticipated shocks

18. Problems for Rational Expectations
(1) Was Keynesian policy “ineffective”? (see next table)
By RE, differences between Keynesian & Neoclassical policy periods should be
Higher M growth, Inflation
No difference in unemployment
(2) Why the Great Depression?
“Natural rate” moves by 30%???
(3) Movement of “natural rate” (hysteresis?)
(4) Nature of expectations
Keynes: behaviour under fundamental uncertainty
RE: behaviour under certainty, using economic theory to predict

19. The Keynesian/Neoclassical Scorecard
Outcomes contradict RE Hypothesis: Keynesian period has Lower Money Growth, Inflation, Interest Rates, Unemployment Higher Growth
How could this be if policy was “ineffective”? Did the economy suddenly deteriorate? (possibly true…)

20. Theoretical Developments
Behind policy fight, theoretical battles
Perfection of Walrasian GE model (Arrow-Debreu)
Classically-inspired critique of neoclassicism (Sraffa)
Arrow-Debreu General Equilibrium
proof of existence/uniqueness/stability/optimality of equilibrium (completing Walras’ work), but
under assumptions of given resources, given tastes, given possible future states of world, “contingent contracts”, and no uncertainty, and peculiar definition of commodities
The Keynesian Critique: reality that “factors of production” are commodities, labour, land applied to show that neoclassical theory is internally inconsistent

21. The “Cambridge Controversies”
Critique of neoclassical economics initiated by Joan Robinson, Piero Sraffa (Cambridge UK) over nature of capital vis a vis land, labour
Theory defended by Paul Samuelson, Robert Solow (Cambridge USA)
Focus of attack: validity of neoclassical theory of distribution based on supply and demand

22. The “Cambridge Controversies”
Neoclassical theory argues that
increasing supply of factor of production will reduce its price
reducing its price will increase its use in production
Factor’s price equals its marginal product
Direct relationship between supply of factor and its price
Models production as
involving “factors of production” (Land, Labour, Capital) as inputs and goods as outputs
versus classical position: goods produced using goods and labour as inputs
The neoclassical position of profit and capital is…

23. The “Cambridge Controversies”
Increasing supply… Decreasing price...
Output
Capital
Labour
Capital
Diminishing marginal product
Increasing use of factor relative to others...
Marginal Product
Rate of profit is the marginal product of capital…
Capital

24. The “Cambridge Controversies”
Sraffa, 1960
Take economy in full general equilibrium
All “marginal” changes complete
What determines prices in full equilibrium if all marginal changes are over?
Self-reproducing system of commodity production
inputs commodities & labour
output commodities
equilibrium prices of outputs must enable their purchase as inputs in next period
System (1): Simple reproduction, commodity inputs only:

25. The “Cambridge Controversies”
240 qr wheat + 12 t iron + 18 pigs --> 450 qr wheat
90 qr wheat t iron + 12 pigs --> 21 t iron
120 qr wheat t iron + 30 pigs --> 60 pigs
450 qr wheat | 21 t iron | 60 pigs (sum of inputs=sum of outputs)
Regardless of demand, prices must allow system to reproduce itself:
450 qr wheat must buy 240 qr wheat, 12 t iron, 18 pigs
21 t iron must buy 90 qr wheat, 6 t iron, 12 pigs
60 pigs must buy 120 qr wheat, 3 t iron, 30 pigs

26. The “Cambridge Controversies”
System of production:
As a matrix equation:
Has the solution:
i.e., price system for simple reproduction independent of demand, marginal utility, etc.; depends instead on system of production

27. The “Cambridge Controversies”
System (2): Expanded reproduction
surplus produced, must be split between capitalists and workers
in equilibrium, a uniform rate of profit r, uniform wage w
Amount of B produced
Amount of
A used to
produce B
Labor fully employed
+ive net output

28. The “Cambridge Controversies”
r & w values determine split of surplus between capitalists, workers. To determine prices, must therefore know either r or w beforehand
Distribution therefore not determined by “market”
Instead, different pattern of prices for every pattern of distribution: marginal productivity theory of income distribution incorrect in general equilibrium
But what about validity of production function, isoquants, when marginal changes still relevant?

29. The “Cambridge Controversies”
Neoclassical position (by Samuelson):
Concedes Classical position more factual
output produced by heterogeneous commodities and labour, aggregate capital an abstraction
But neoclassical position still defensible as an abstraction
Samuelson (for neoclassicals) argues
isoquants just a parable we use to teach students
reality is different technologies, each with fixed ratio of capital to labour
increase in price of capital will lead to less capital intensive technology being chosen:

30. The “Cambridge Controversies”
Technology 1: low K/L ratio, used when K expensive
Labour
Capital
“Envelope” is isoquant
Technology 5: high K/L ratio, used when K cheap
Decreasing price of capital means more capital intensive methods used, akin to simple parable that decreased price means more capital used

31. The “Cambridge Controversies”
As an aside, Samuelson ridicules classical theory’s problems with labour theory of value, that capital-labour ratios must be the same in all industries.
Problem: Samuelson assumes each technology can be represented by a straight line relationship between capital and labour
Garegnani shows that straight line relationship only applies if capital to labour ratio is the same in all industries
If K/L ratios differ, each technology will be represented by a curve, not a straight line
Curves can cut each other in more than one place:

32. The “Cambridge Controversies”
Technology 1: low K/L ratio, used when K expensive
Labour
Capital
“Envelope” is isoquant
Technology 2: only used in intermediate K/L price range
Technology 1: could also be used when K cheap
Problem known as “reswitching”: simple neoclassical parable does not work when multiple industries considered.

33. The “Cambridge Controversies”
Why a curved relationship?
The definition of capital
What is “capital”?
Money?
Machine?
Both, obviously; but how to “add” machines together?
Money value only common feature
but money value reflects expected profit
“rate of return” and “value of capital” thus linked
Sraffa’s solution: reduce all machines to “dated labour”
Machine today produced with
labour last year, plus
machinery inputs last year

34. The “Cambridge Controversies”
If economy has been in long run equilibrium for indefinite past
then all goods produced earned normal rate of profit r
therefore value of machine now equals
value of previous year’s inputs (labour and capital)
multiplied by 1+r
Do it again: replace last year’s machine inputs with
labour and capital used to produce those machines
Get a whole series of terms for the labor input each year multiplied by 1+r, (1+r)2, (1+r)3
Machine/commodity component reducible to almost (but not quite) zero.

35. The “Cambridge Controversies”
Next: the “standard commodity”
Earlier, Sraffa shows how to devise a “measure of value” unaffected by the distribution of income: the “standard commodity”
When measured using this, there is a simple linear relationship between the real wage w, the rate of profit r, and the maximum possible rate of profit R:
This can be reworked to give an expression for the wage in terms of the rate of profit:

36. The “Cambridge Controversies”
Each year’s labor input to producing a machine today is thus broken down into
the number of units of labor performed (say 1 unit)
times the wage rate w (now expressed in terms of r & R)
times 1+r raised to the power of n, for how many years ago the labor was applied:
Number of years ago that machine was made
Wage in terms of rate of profit
Rate of profit
Expression gives an unambiguous value for today’s capital input in terms of dated labor, but…
the measured value of capital depends on the rate of profit:

37. The “Cambridge Controversies”
So rather than the rate of profit depending on the amount of capital (marginal product theory of income distribution), the amount of capital depends on the rate of profit
Second problem: this relationship is very nonlinear
First part falls uniformly as rate of profit rises
Second part
rises slowly as r rises
rises rapidly as n (number of years ago rises)
Two parts interact very unevenly
For small change in r, second effect outweighs first as n rises
For large change in r, first effect outweighs second for small n
In between, can’t pick whether increasing r will increase or decrease measured amount of capital:

38. The “Cambridge Controversies”
Value of machine produced with one unit of labor applied n years ago at a rate of profit r between zero and 25% when R=25%:
Made this year (n=0)
Made 5 years ago (n=5)
r=0
r=25%
Measured value rises & then falls as rate of profit rises
Made 25 years ago (n=25)
Made 10 years ago (n=10)

39. The “Cambridge Controversies”
Can’t apply marginal productivity theory to capital:
return to capital can’t reflect marginal product of capital
measured amount of capital depends on rate of profit
numerator/y-axis (r) and denominator/x-axis (“amount of capital”) are interdependent
relationship is “messy”
rises as r rises for a while
then falls as r rises
Rate of profit therefore can’t be “marginal productivity of capital”
Output
Capital
Diminishing marginal product

40. The “Cambridge Controversies”
Numerous other facets to Cambridge Controversies
Minority of neoclassicals who got involved in debate (Samuelson, Solow, Hahn, etc.) had 2 eventual responses
Grudgingly conceded critique had validity and started to develop alternative approaches to neoclassicism themselves (Samuelson, Solow)
Abandoned attempt to make neoclassical economics relevant to real world and developed general equilibrium models as abstract thought experiments only (Hahn, etc.)
Majority of neoclassicals assumed (wrongly) that debate won by neoclassicals and continued on as always.
Raises issues of methodology (is economics a science?) discussed in 2 weeks. Next week, finance...