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Roger W. Garrison 2011 Is government policy the source of macroeconomic instability? Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to.

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Presentation on theme: "Roger W. Garrison 2011 Is government policy the source of macroeconomic instability? Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to."— Presentation transcript:

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2 Roger W. Garrison 2011 Is government policy the source of macroeconomic instability? Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to F. A. Hayek’s Capital-Based Macroeconomics

3 The nature of the Keynesian-styled spiraling associated with recession, depression and inflation becomes more transparent with the production possibility frontier in play. Also, the PPF gives analytical legs to the views of Keynes’s opponents---to Milton Friedman’s Monetarism and F. A. Hayek’s Capital-based Macroeconomics. Y fe EXPENDITURES INCOME C = a + bY N W S D C + I INVESTMENT CONSUMPTION

4 EXPENDITURES INCOME N W S D C + I C = a + bY INVESTMENT CONSUMPTION A waning of animal spirits causes investment to decrease and with it income and consumption. The economy falls inside its PPF. Y fe

5 Note that if investment were to fall to zero, the economy would settle into an income-expenditure equilibrium with Y = C. Thus, the vertical intercept of the Keynesian demand constraint is aligned with the intersection of the consumption function and the 45 o line. EXPENDITURES INCOME N S D W C = a + bY C + I INVESTMENT CONSUMPTION A further waning sends the economy deeper into the PPF’s interior. Movements inside the frontier (and beyond it) trace out a linear relationship, showing how consumption varies with investment. The straight line that passes through these points is the Keynesian demand constraint. Y fe

6 EXPENDITURES INCOME C = a + bY C + I INVESTMENT CONSUMPTION Note that each of the four points that define the economy’s spiral path constitute an actual or potential Keynesian equilibrium. At each of those equilibrium points, Y = C + I. We also know that C = a + bY. But rather than use these two relationships to solve for the equilibrium level of income, let’s use them to determine the implied relationship between investment spending and consumption spending. Y fe C = a + bY where, in equilibrium, Y = C + I Hence, C = a + b(C + I) So, C = a + bC + bI C – bC = a + bI (1–b)C = a + bI C = [ a /(1-b) ] + [ b /(1-b) ] I

7 “The formula is not, of course, quite so simple as in this illustration…. But there is always a formula, more or less of this kind, relating the output of consumption goods which it pays to produce to the output of investment goods…. This conclusion appears to me to be quite beyond dispute. Yet the consequences which follow from it are at the same time unfamiliar and of the greatest possible importance.” “If, for example, the public are in the habit of spending nine-tenths of their income on consumption goods, it follows that if entrepreneurs were to produce consumption goods at a cost more than nine times the cost of the investment goods they are producing, some part of their output could not be sold at a price which covered its cost of production.” + I b (1 – b) a (1 – b) EXPENDITURES INCOME C = a + bY C + I INVESTMENT CONSUMPTION a (1 – b) b 1 – b C = For simplicity, let a = 0 and b = Then C = a + bY becomes C = 0.90Y. C = a/1-b)+ b/1-b)I becomes C = 9I, which led Keynes to write: Y fe C = [ a /(1-b) ] + [ b /(1-b) ] I This is the Keynesian Demand Constraint. Keynes never wrote this equation, but he talk his readers through it.

8 INVESTMENT CONSUMPTION Keynes denied that there are viable market forces that can move the economy along the Production Possibilities Frontier. By similar reasoning, Keynes realized, a waxing of animal spirits (known today as “over exuberance”), will set off an inflationary spiral. Keynes argued that it is the instability of investment spending and, in particular, the waning of “animal spirits” that sends the economy spiralling into recession. Policymakers, in Keynes’s view, should prescribe fiscal and monetary policies aimed countering these destabilizing forces that are inherent in market economies.

9 INVESTMENT CONSUMPTION Friedman didn’t doubt that there are viable market forces that can move the economy along the Production Possibilities Frontier. But he considered those movements to be largely irrelevant to macroeconomic issues. By similar reasoning, Friedman realized, a shrinking (or collapse) of the money supply will cause the economy to spiral into recession (or depression). Friedman argued that it is the central bank’s propensity to create money that accounts for inflationary spirals. Central banks, in Friedman’s view, should abstain from pro-actively managing the macroeconomy and, instead, should increase the money supply year-in and year-out at a rate that maintains long-run price-level stability.

10 INVESTMENT CONSUMPTION Hayek didn’t doubt that there are market forces that can move the economy along the Production Possibilities Frontier. And he considered these forces to be viable---but only if the central bank abstaines from manipulating interest rates. Similarly, a decrease in saving (and hence an increase in consumption) will lead the economy in a counter-clockwise direction. Hayek argued that an increase in saving, which finances more investment, will lead the economy clockwise along its production possibilities frontier. In Hayek’s view, when the central bank lowers interest rates (without there being any increase in saving), it misleads the economy. Resources get misallocated during a policy driven boom, which eventually end in a bust.

11 Roger W. Garrison 2011 Is government policy the source of macroeconomic instability? Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to F. A. Hayek’s Capital-Based Macroeconomics

12 Keynes’s most successful modern critic, Milton Friedman, argued that it is perverse government policy and not any inherent flaw in the market economy that sends the economy into a tailspin. INVESTMENT CONSUMPTION Keynes denied that there are viable market forces that can move the economy along the Production Possibilities Frontier. Keynes’s most formidable critic, Friedrich A. Hayek, argued that there are such market forces but that government policy has often precluded their working in a healthy way. Keynes argued that it was the instability of investment spending and, in particular, the waning of “animal spirits” that sent the economy spiralling into recession. F. A. Hayek Milton Friedman


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