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JOHN MAYNARD KEYNES: 1883 TO 1946 Descended from a knight who had crossed the English Channel with William the Conqueror, Keynes was the son of a Cambridge.

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Presentation on theme: "JOHN MAYNARD KEYNES: 1883 TO 1946 Descended from a knight who had crossed the English Channel with William the Conqueror, Keynes was the son of a Cambridge."— Presentation transcript:

1 JOHN MAYNARD KEYNES: 1883 TO 1946 Descended from a knight who had crossed the English Channel with William the Conqueror, Keynes was the son of a Cambridge University economist. Educated at Eton and Cambridge, he demonstrated from his early years a dazzling, wide-ranging intellect, along with an arrogance and what seemed to some a dismissive elitism. His establishment habits (including the signature homburg normally associated with a City of London stockbroker) and his pride in being a member of what he called the "educated bourgeoisie" were combined with chronic social and intellectual rebellion, orneriness, and the lifestyle of a Bloomsbury bohemian and aesthete. His daunting mathematical dexterity was complemented by a considerable literary grace, whether the subject was the subtleties of economic thought or his obsession with the hands of statesmen. He celebrated "vigilant observation" of the real world as one of the requirements of a good economist, and he loved to pore through statistics. His best ideas, he liked to say, came "from messing about with figures and seeing what they must mean." Nevertheless, he could not resist endlessly toying with ideas, and he compulsively sought to spin out all-encompassing theories and generalizations from particulars. ed/minitext/prof_johnmaynardkeynes.html ed/minitext/prof_johnmaynardkeynes.html

2 KEYNES BIO Keynes was born in Cambridge and attended King’s College, Cambridge, where he earned his degree in mathematics in He remained there for another year to study under ALFRED MARSHALL and ARTHUR PIGOU, whose scholarship on the quantity theory of money led to Keynes’s Tract on Monetary Reform many years later. After leaving Cambridge, Keynes took a position with the civil service in Britain. While there, he collected the material for his first book in economics, Indian Currency and Finance, in which he described the workings of India’s monetary system. He returned to Cambridge in 1908 as a lecturer, then took a leave of absence to work for the British Treasury. He worked his way up quickly through the bureaucracy and by 1919 was the Treasury’s principal representative at the peace conference at Versailles. He resigned because he thought the Treaty of Versailles was overly burdensome for the Germans. ALFRED MARSHALL ARTHUR PIGOU After resigning, he returned to Cambridge to resume teaching. A prominent journalist and speaker, Keynes was one of the famous Bloomsbury Group of literary greats, which also included Virginia Woolf and Bertrand Russell. At the 1944 Bretton Woods Conference, where the International Monetary Fund was established, Keynes was one of the architects of the postwar system of fixed exchange rates (see F OREIGN E XCHANGE ). In 1925 he married the Russian ballet dancer Lydia Lopokova. He was made a lord in Keynes died on April 21, 1946, survived by his father, John Neville Keynes, also a renowned economist in his day.F OREIGN E XCHANGE

3 MEMBER OF THE "BLOOMSBURY GROUP” That glittering group of bohemian thinkers and doers who revolted against the manners and morals of Victorian England included the great economist john Maynard Keynes; Virginia Woolf and her husband, Leonard, a famed British civil servant; The novelist E.M. Forester; And any number of poets, philosophers, artists and titled eccentrics. They flaunted convention, scoffed at religion, and had mad affairs with one another, writing down every word in diaries and letters in the secure belief history would want to know.

4 QUOTES BY KEYNES: I do not know which makes a man more conservative - -to know nothing but the present, or nothing but the past. The day isn't far off when the economic problem will take the back seat where it belongs, and the heart and head will be occupied or reoccupied, by our real problems of life and of human relations, of creation and behavior and religion. It is ideas, not vested interests, which are dangerous for good or evil.

5 QUOTES BY KEYNES (CONT): The difficulty lies, not in the new ideas, but in escaping from the old ones which ramify... into every corner of our minds. Most men love money and security more, and creation and construction less, as they get older.

6 QUOTES BY KEYNES (CONT): Keynes was on the staff of the British delegation that negotiated peace after World War I, but he regarded the terms as the seeds of disaster, resigned in protest, and wrote his criticisms in The Economic Consequences of the Peace (1919), "...bursting" (as Schumpeter wrote) "into international fame when men of equal insight but less courage and men of equal courage but less insight kept silent."

7 MORE KEYNES QUOTES Paul Samuelson, the Nobel laureate from the Massachusetts Institute of Technology, recalled that John Maynard Keynes once was challenged for altering his position on some economic issue. “When my information changes,” he remembered that Keynes had said, “I change my mind. What do you do?” s-change-mind/ s-change-mind/

8 MORE KEYNES QUOTES Letter to George Bernard Shaw: "I believe myself to be writing a book on economic theory which will largely revolutionize - not, I suppose, at once but in the course of the next ten years - the way the world thinks about economic problems.“ To Henry Clay: "I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking twenty years ago.“

9 Economic Consequences of the Peace Keynes became a celebrity before becoming one of the most respected economists of the century when his eloquent book The Economic Consequences of the Peace was published in Keynes wrote it to object to the punitive reparations payments imposed on Germany by the Allied countries after World War I. The amounts demanded by the Allies were so large, he wrote, that a Germany that tried to pay them would stay perpetually poor and, therefore, politically unstable. We now know that Keynes was right. Besides its excellent economic analysis of reparations, Keynes’s book contains an insightful analysis of the Council of Four (Georges Clemenceau of France, Prime Minister David Lloyd George of Britain, President Woodrow Wilson of the United States, and Vittorio Orlando of Italy).The Economic Consequences of the Peace Keynes wrote: “The Council of Four paid no attention to these issues [which included making Germany and Austro-Hungary into good neighbors], being preoccupied with others— Clemenceau to crush the economic life of his enemy, Lloyd George to do a deal and bring home something which would pass muster for a week, the President to do nothing that was not just and right” (chap. 6, para. 2).chap. 6, para. 2

10 Keynes and Monetarism In the 1920s Keynes was a believer in the quantity theory of money (today called MONETARISM ). His writings on the topic were essentially built on the principles he had learned from his mentors, Marshall and Pigou. In 1923 he wrote Tract on Monetary Reform, and later he published Treatise on Money,both on MONETARY POLICY. His major policy view was that the way to stabilize the economy is to stabilize the price level, and that to do that the government’s central bank must lower INTEREST RATES when prices tend to rise and raise them when prices tend to fall. MONETARISM MONETARY POLICY INTEREST RATES One should note... Monetarism is associated with the work of Milton Friedman

11 Keynes’s General Theory Keynes’s General Theory revolutionized the way economists think about economics. It was pathbreaking in several ways, in particular because it introduced the notion of aggregate demand as the sum of consumption, INVESTMENT, and government spending; and because it showed (or purported to show) that full employment could be maintained only with the help of government spending. Economists still argue about what Keynes thought caused high unemployment. Some think he attributed it to wages that take a long time to fall. But Keynes actually wanted wages not to fall, and in fact advocated in the General Theory that wages be kept stable. A general cut in wages, he argued, would decrease income, consumption, and aggregate demand. This would offset any benefits to output that the lower price of labor might have contributed. INVESTMENT Why shouldn’t government, thought Keynes, fill the shoes of business by investing in public works and hiring the unemployed? The General Theory advocated deficit spending during economic downturns to maintain full employment. Keynes’s conclusion initially met with opposition. At the time, balanced budgets were standard practice with the government.

12 General Theory Keynes became editor of the Economic Journal, certainly one of the most important of journals of professional work and research in economics then as now. After the disaster of the Great Depression, Keynes was the leading figure in a group of (mostly) younger and very creative economists who attempted to understand and explain the disaster. Borrowing freely from their ideas, Keynes published The General Theory of Employment, Interest and Money,

13 General Theory (cont) The General Theory, as it is known, also founded modern macroeconomics, and virtually all of the work in that field emerges from Keynes' work, if not positively as extensions and adaptations then negatively as criticism or the extension of criticism of it.

14 Keynes and Free Markets Contrary to some of his critics’ assertions, Keynes was a relatively strong advocate of free markets. It was Keynes, not ADAM SMITH, who said, “There is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them.” ADAM SMITH Keynes believed that once full employment had been achieved by FISCAL POLICY measures, the market mechanism could then operate freely. “Thus,” continued Keynes, “apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before” FISCAL POLICY

15  Earlier economists who focused on long-run issues  Markets were self-regulating through the “invisible hand”  Say’s Law: Supply Creates its Own Demand  The economy would always return to its potential output and target rate of unemployment in the long run  Advocated a laissez-faire economic policy  Classical Economists believe people are perfectly rational and markets are quickly corrected

16  Imagine a wheat farmer who sees declining prices for wheat in the market. What are his/her options?  The farmer can reduce his/her production of wheat. Lower prices signal to producers that there is less demand for what the producer is offering.  But it is likely he/she will also increase his production of another commodity (like corn, etc…)  Because the farmer has output, a decline in prices – caused by a decline in aggregate demand – is not likely to have a long-term impact on the economy.  Hence, it is reasonable to assume that the macro-economy is self-adjusting.

17  Imagine an automobile manufacturer who sees declining prices in the automobile market. What are her/his options?  The auto manufacturer can reduce his/her production of cars. Lower prices signal to producers that there is less demand for what the producer is offering.  Does the auto manufacturer have another option? Since an automobile factory cannot be easily changed so that other goods can be produced, it seems likely that the auto manufacturer has any other options.  And that means a decline in prices – caused by a decline in aggregate demand – will have a longer impact on a manufacturing based economy  Hence, it is reasonable to assume that the macro-economy is not self-adjusting.

18  Like Marshall, Keynes understood that time matters  In the long-run, Keynes thought the economy could return to full employment on its own.  but “in the long-run we are dead”  In the short-run, the economy could remain below full employment. And the short-run could last years.

19 The Essence of Keynesian Economics ◦ First outlined in 1936 by John Maynard Keynes ◦ Problems of the Depression required a short-run, rather than long-run, focus ◦ Keynes famously said: “In the long run, we’re all dead” ◦ Adjustments to equilibrium for a single market (micro issue) and the aggregate economy (macro issue) are different ◦ Keynesians argued that, in times of recession, spending is a public good that benefits everyone ◦ THIS SLIDE AND THE FOLLOWING SLIDES ARE THE STANDARD TEXTBOOK PRESENTATION OF THE KEYNESIAN MODEL (from David Colander’s Macroeconomics, 9 th edition) 10-19

20 Key Insight of the Keynesian AS/AD Model  Short-run equilibrium output may differ from long-run potential output assuming a fixed price level ◦ Equilibrium output is the level of output toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production ◦ Potential output is the highest amount of output an economy can sustainably produce using existing production processes and resources  Market forces may not be strong enough to correct deviations from potential output McGraw-Hill/Irwin 20

21 Key Insight of the Keynesian AS/AD Model  Paradox of thrift ◦ In the long run, saving leads to investment and growth ◦ In the short run, saving may lead to a decrease in spending, output, and employment ◦ Thomas Malthus noted this in the early 19 th century  Aggregate demand management, which is government’s attempt to control the aggregate level of spending, may be necessary  Keynesian economists advocated an activist demand management policy McGraw-Hill/Irwin 21

22 The Components of the AS/AD Model Aggregate Demand Curve (AD) Is a curve that shows how a change in the price level will change aggregate expenditures on all goods and services in an economy Short-Run Aggregate Supply Curve (SAS) Is a curve that specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant Long-Run Aggregate Supply Curve (LAS) Is a curve that shows the long-run relationship between output and the price level McGraw-Hill/Irwin 22

23 Shifts in the AD Curve  A shift in the AD curve means that at every price level, total expenditures have changed. Five important shift factors are: Foreign income Exchange rates Distribution of income Expectations Monetary and fiscal policy  Deliberate shifting of the AD curve is what most policy makers mean by macro policy McGraw-Hill/Irwin 23

24 Shifts in the AD Curve McGraw-Hill/Irwin 24 Price level Real output AD 0 P0P0 AD 1 The AD curve shifts out by more than the initial change in expenditures Initial effect Total effect Exports increase by 100 The multiplier magnifies this shift 300 AD curve shifts to the right by a multiple of 100, in this case by 300 Multiplier effect

25 ◦ The SAS curve is upward sloping because of: ◦ [from This short-run positive relationship occurs primarily because production costs (e.g., wages) are "sticky" relative to output prices when demand changes. Increases to Aggregate Demand cause movements up along the Aggregate Supply curve in which prices rise more quickly than wages, so higher profit per unit induces more output. Declines in Aggregate Demand reverse these movements along the Aggregate Supply curve---prices fall more quickly than costs, so profits decline and firms reduce production. McGraw-Hill/Irwin 25 The Slope of the Short-Run Aggregate Supply (SAS) Curve

26 Shifts in the SAS Curve  Shifts in the SAS are caused by changes in: Input prices Productivity Import prices Excise and sales taxes  When production costs increase, the SAS curve shifts up McGraw-Hill/Irwin 26 SAS 0 Price level Real output SAS 1 SAS 2

27 The Long-Run Aggregate Supply Curve  The long-run aggregate supply (LAS) curve shows the long-run relationship between output and the price level  The position of the LAS curve depends on potential output which is the amount of goods and services an economy can produce when both capital and labor are fully employed  The LAS curve is vertical because potential output is unaffected by the price level McGraw-Hill/Irwin 27

28 The LAS Curve ◦ Potential output is assumed to be in the middle of a range bounded by high and low levels of potential output McGraw-Hill/Irwin 28 LAS Price level Real output Low-level potential output High-level potential output SAS Underutilized resources Overutilized resources A B C When resources are over-utilized (point C), factor prices may be bid up and the SAS shifts up When resources are under-utilized (point A), factor prices may decrease and SAS shifts down

29 ◦ Increases in the LAS are caused by increases in: ◦ Capital ◦ Resources ◦ Growth-compatible institutions ◦ Technology ◦ Entrepreneurship/Innovation McGraw-Hill/Irwin 29 LAS 0 Price level Real output LAS 1 LAS 2 which of these factors lead to persistent growth?

30 Short-Run Equilibrium in the AD/AS Model ◦ Short-run equilibrium is where the SAS and AD curves intersect and point E is short-run equilibrium McGraw-Hill/Irwin 30 Price level Real output AD 0 P0P0 AD 1 P1P1 Y0Y0 Y1Y1 SAS A shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y 0 to Y 1 and increasing price level from P 0 to P 1 E F

31 Short-Run Equilibrium in the AD/AS Model McGraw-Hill/Irwin 31 Price level Real output AD P0P0 P2P2 Y0Y0 Y2Y2 SAS 1 A shift up in the short-run aggregate supply curve changes equilibrium from E to G, decreasing output from Y 0 to Y 2 and increasing price level from P 0 to P 2 SAS 0 E G

32 Long-Run Equilibrium in the AD/AS Model ◦ Long-run equilibrium is where the LAS and AD curves intersect McGraw-Hill/Irwin 32 Price level Real output AD 0 P0P0 AD 1 P1P1 YPYP LAS A shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P 0 to P 1 but leaving output unchanged E H

33 Application: A Recessionary Gap in the AD/AS Model A recessionary gap is the amount by which equilibrium output is below potential output McGraw-Hill/Irwin 33 Price level Real output P0P0 P1P1 YPYP LAS E SAS 0 SAS 1 AD 0 A Y1Y1 At point A, some resources are unemployed and the recessionary gap is Y P – Y 1 Gap Eventually wages and prices decrease and SAS shifts down to return the economy to a long and short-run equilibrium at E

34 Application: An Inflationary Gap in the AD/AS Model An inflationary gap is the amount by which equilibrium output is above potential output McGraw-Hill/Irwin 34 Price level Real output P0P0 P2P2 YPYP LAS E SAS 0 AD 0 Y2Y2 At point B, resources are being used beyond their potential and the inflationary gap is Y 2 – Y P SAS 2 B Gap Eventually wages and prices increase and SAS shifts to return the economy to a long and short-run equilibrium at E

35 Aggregate Demand Policy  A primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal policy shifts the AD curve ◦ Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates ◦ Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economy McGraw-Hill/Irwin 35

36 Application: Expansionary Fiscal Policy in the AD/AS Model If the economy is at point A, there is a recessionary gap equal to Y P – Y 0 McGraw-Hill/Irwin 36 The appropriate fiscal policy is to increase government spending and/or decrease taxes AD shifts to the right and output returns to potential output Y P and prices increase to P 1 Price level Real output AD 0 P0P0 AD 1 P1P1 YPYP LAS A E Y0Y0 Gap

37 Application: Contractionary Fiscal Policy in the AD/AS Model If the economy is point B, there is an inflationary gap Y 2 – Y P McGraw-Hill/Irwin 37 The appropriate fiscal policy is to decrease government spending and/or increase taxes AD shifts to the left, output returns to potential output Y P and inflation is prevented Price level Real output AD 2 P1P1 AD 0 P2P2 YPYP LAS B E Y2Y2 Gap

38 Limitations of Fiscal Policy  Implementing fiscal policy through changing taxes and government spending is a slow legislative process There is no guarantee that government will do what economists say is necessary  Potential output (the level of output that the economy is capable of producing without generating inflation) is difficult to estimate We do have ways to get a rough idea of where it is McGraw-Hill/Irwin 38

39 Limitations of Fiscal Policy  There are two ways to think about the effectiveness of fiscal policy: in the model and in reality  The effectiveness of fiscal policy depends on the government’s ability to perceive and to react appropriately to a problem  Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycle  Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of income McGraw-Hill/Irwin 39

40 Other Contributions Fiscal Policy and the Multiplier Effect Liquidity Trap He was also the British representative in 1944 at Brenton Wood Conference that set up the International Monetary Fund and the World Bank.

41 Nixon and Keynesian Economics New York Times Article (January 6, 1971) Nixon Reportedly Says He Is Now a Keynesian WASHINGTON, Jan. 6, 1971 (Reuters) -- President Nixon has described himself as "now a Keynesian in economics," according to Howard K. Smith of the American Broadcasting Company, one of the four television commentators who interviewed the President on a television show Monday night.

42 Bartlett, Friedman, and Keynes Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.” Bruce BartlettThe Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take As it happens, (Milton) Friedman had said in 1965 that “we’re all Keynesians now” in the Dec. 31 issue of Time magazine. He later complained that his quote had been taken out of context. His full statement was, “In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.” Friedman said the second half of his quote was as important as the first half.Dec. 31 issue of Time I think Milton Friedman was right that in a sense we are all Keynesians and not Keynesians at the same time. What I think he meant is that no one advocates Keynesian stimulus at all times, but that there are times, like now, when it is desperately needed. At other times we may need to be monetarists, institutionalists or whatever. We should avoid dogmatic attachment to any particular school of economic thought and use proper analysis to figure out the nature of our economic problem at that particular moment and the proper policy to deal with it.

43 Mankiw, W. Bush, and Keynes Who is Gregory Mankiw, the 44-year-old Harvard professor nominated this week as U.S. President George W. Bush's new chairman of his Council of Economic Advisers?The key facts seem to be these. He is highly intelligent, wide-ranging in his economic expertise, and an excellent writer. He is a "New Keynesian" and named his dog Keynes. (This we see as very important.) His mentors have been bright and prominent economists, such as Larry Summers, former treasury secretary, and Alan Blinder, formerly of the Federal Reserve. From his early 20s, Mankiw has been close to the powerful. "Choose your mentors well," is advice he himself gives in an essay on his life. In his research, he has kind words for Bush's great friend, President Bill Clinton, while, on Federal Reserve Chairman Alan Greenspan, Mankiw's words are as opaque as those of the (perhaps) great helmsman himself.George W.Larry SummersBill ClintonAlan Greenspan Bush would appear to have turned to Mankiw for a number of reasons. One reason is that Mankiw's "new Keynesian" approach to economic policy-making may make him a good fit with Bush's current policies. New Keynesians believe in using fiscal policy flexibly to help smooth trends in growth. Thus, at a time of recession, new Keynesians would be comfortable with a widening government deficit if the deficit spending helped to alleviate the downturn in the economy. That has been Bush's policy /#ixzz2kfmZwTDy /#ixzz2kfmZwTDy

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