Keynesian Approaches

Keynesian Economics: Revolution and Counterrevolution John Maynard Keynes ( ) Son of John Neville Keynes author of Scope and Method of Political Economy (1891) Studied Math at Cambridge, resulted in Treatise on Probability (1921) Attracted into economics by Marshall Brief period at the India Office Returned to Cambridge at Kings College Worked mainly on monetary policy Involved in post WWI peace conference and critical of the settlement

J. M. Keynes The Economic Consequences of the Peace (1919) Tract on Monetary Reform (1923) Treatise on Money (1930) Break with neoclassical theory The General Theory of Employment, Interest and Money (1936) Focus on employment levels and the possibility of an unemployment equilibrium General Theory—it includes full employment equilibrium as a special case Keynes a member of the Bloomsbury Group of artists, writers, and intellectuals

Keynes’ Critique of the “Classical” Postulates: I The Classical Labour Market In classical and neoclassical economics the demand and supply of labour determines the real wage rate Cannot be involuntary unemployment in equilibrium N W/P S D w n D’ w’ n’

Labour Markets The Keynesian Labour Market Wage bargaining is about money wages not real wages Wage bargaining cannot determine the real wage as price level changes may occur Workers react differently to a cut in real wages caused by price level increases than to cuts in money wage rates Workers resist money wage cuts Importance of relative position, no union will want to accept wage cuts in case others do not

Keynesian Labour Market N Money wages S D w n D’ n’ Involuntary employment exists because of downwardly inflexible money wage rates. ISSUE: Is this assumption critical to the Keynesian analysis?

Keynes’ Critique of the Classical Postulates: II The Classical theory of the interest rate, savings and investment The real interest rate is determined by savings and investment The real interest rate co-ordinates saving and investment What is saved will be spent in the form of investment expenditure

Classical Interest Rate Theory Real i rate S & I S I i S’ i’ If the desire to save rises, interest rates fall and investment increases.

Keynesian Theory of Interest, Savings and Investment The interest rate is a monetary phenomenon determined in the money market Savings primarily a function of income and not very responsive to the interest rate Investment determined by the interest rate but, more importantly, by the state of business expectations The amount people wish to save at full employment levels of income may not equal the level of investment planned by businesses

Keynesian Theory of Interest, Savings and Investment i Money i rate i is determined in the money market Both S and I are interest inelastic I can shift in due to adverse expectations so That at i FE levels of S > I I S at FE I’

Keynesian Critique of Classical Postulates: III Classical Theory of the Demand for Money Demand for money for transactions purposes M = PTk Keynesian Theory of the Demand For Money Demand for money for transactions and as an asset At certain times people may rather hold their assets as money than as stocks or bonds

Keynes and Say’s Law Keynes’ critique of the classical savings/investment theory and the classical demand for money theory constitute a rejection of Say’s law At full employment all income is not necessarily spent as desired saving may exceed desired investment or people may wish to increase their money holdings If this happens there is underconsumption in the sense that FE Agg S > Agg D QUESTION: are there adjustment processes that will lead back to FE?

The Keynesian Model Short run analysis, organization, technology and capital stock taken as given Aggregation of Marshallian concepts Aggregate supply and aggregate supply price Agg supply drawn as a function of employment Agg supply price is the amount of income factors would have to earn to maintain that level of employment

Aggregate Supply Z N Proceeds or income Z function rises at an increasing rate due to diminishing returns—increasing marginal supply price Z function in money terms and so assumes a given price level

Aggregate Demand Aggregate demand or aggregate demand price Agg D drawn as a function of employment As employment rises so does income and expenditure but expenditure rises by less than income The equilibrium level of employment is where Agg D = Agg S and this may or may not be full employment

Equilibrium Employment Level N Income and expenditure D = C + I Z n* y* To proceed Keynes examines the components of D (C and I) more closely and as a function of income rather than of employment

Consumption and Savings Keynes lists numerous factors both subjective and objective that might affect the “propensity to consume out of income” Keynes argues that consumption primarily a function of real income Propensity to consume and the marginal propensity to consume The consumption function—consumption as a function of income Keynes thought MPC would tend to decline with income but usually drawn as constant

Consumption and Savings APC = C/Y MPC = Δ C/ Δ Y C = a + bY where b =MPC C Y 45 0 or C = Y C = a+ bY a Slope = b yyFE

Consumption and Savings What is not consumed out of income is saved Y = C + S APC + APS = 1 MPC + MPS = 1 S Y S -a y yFE

Consumption and Savings Important to note that Keynes thought of the consumption function as very stable Changes in consumption and savings due to movements along the consumption function (due to changes in income) not due to shifts in the consumption function (which would be caused by changes in the propensity to consume out of income)

Investment Expenditure Investment depends on interest rate and the expected future earnings from the investment These are long term expectations Lack of a rational basis for expectations of earnings a long time in the future State of expectations has a conventional basis only and can change quite quickly

Investment Expenditure i I MEI MEI curve is very interest inelastic and is unstable—tends to shift with state of expectations Optimistic Pessimistic

Equilibrium Income For an equilibrium Agg D = Agg S Y = C + I 45 0 C C + I = Agg D Agg D Y y* C S At y* Agg D = Agg S and S = I However y* need not be FE If FE > y* then Aggs > Agg D and S > I Firms will find inventories accumulating and will reduce employment and income until S = I FE

The Multiplier R. F. Kahn (1931) Changes in autonomous expenditures, such as investment, will have a multiplied impact on income Initial expenditure change will affect incomes by that amount Income change will then affect the consumption expenditures of those affected (by change in income x MPC) This will affect other peoples’ incomes and will alter their expenditures in the same way Ultimate effect will be the change in autonomous expenditure times the multiplier where M = 1/(1 – MPC)

Implications of the Analysis so Far Equilibrium is where Agg D = Agg S The consumption function is stable but the investment function is not Investment prone to shifts due to changes in business expectations Shifts in I have multiplied effect on income Economic instability due to real not monetary factors To complete the model need to look at interest rate determination in the monetary sector

Money and Interest Rates Savings depend on income but there is still a choice of how to hold ones savings Desire to hold bonds vs money Liquidity preference Transactions demand for money Precautionary demand for money Speculative demand for money Speculative demand is an asset demand Will hold money if bond prices expected to fall and bonds if bond prices expected to rise

Money and Interest Rates Will expect bond prices to fall if interest rates are expected to rise and vice versa Different people may have different expectations but when interest rates are at very low levels most people will expect a rise rather than another fall and will want to hold money rather than bonds

Money and Interest Rates Speculative demand for money and the liquidity trap i M LP i Spec Demand Trans and Precautionary Demand Ms

The Complete Keynesian Model i i I M MEI Ms LP i I C C + I Y Agg D y* I 45 0

Adjustment Processes to Full Employment? If y* is at less than FE does anything happen to drive the economy back to FE? If wages and prices are inflexible downwards then nothing happens If wages and prices are flexible downward then the price level will fall This will increase the real money supply, reduce i rates, increase investment and increase Agg D and income Keynes Effect

Limitations to the Keynes Effect The Keynes effect will likely not be powerful enough to move the economy back to full employment Liquidity trap—increase in real money supply may simply be absorbed into speculative balances Interest inelasticity of investment Deflation would cause adverse shifts in business expectations

Policy Implications Prolonged recessions due to insufficient Agg D Low and stable interest rates to encourage private investment “Social control” over investment expenditures “Keynesian” policy after WWII became use of fiscal policy (government expenditure and tax policy) to maintain low levels of unemployment Abba Lerner, Joan Robinson and others, “Functional Finance” to maintain very low unemployment levels

Hicks/Hansen Model Problem with Keynesian model is that is goes sequentially from interest rate determination to income determination Level of income will also affect demand for money Need simultaneous determination of equilibrium levels of i and y Aggregated general equilibrium approach—LM and IS curves

LM and IS Curves IS curves shows all the combinations of i and y that will give I = S As i falls, I rises, so to maintain I = S income will have to be higher LM curve shows all combinations of i and y that will give Md = Ms (for a given Ms) As i falls, speculative demand for money rises, so to maintain Md = Ms, income will have to be lower to reduce transactions demand

LM and IS Curves LM and IS curves Y i IS LM y i

Patinkin, Pigou, and the Real Balance Effect Critique of Keynes’ view that there could be an unemployment equilibrium Based on the idea that with flexible wages and prices unemployment will lead to falling prices and an increase in the value of money balances Eventually people will cease trying to increase their money holdings and will increase consumption Does not rely on interest rate declines or investment expenditure

Real Balance Effect Y i LM y* IS IS’ FE Fall price level at y* leads to increase in the Real value of peoples’ money holdings, Eventually shifting the IS curve rightwards

Patinkin Patinkin’s argument was similar but explicitly included the labour market With y < FE both wages and prices fall As they fall in proportion, real wages remain unchanged and involuntary unemployment exists (does not deny the reality of involuntary unemployment even with flexible money wages) Wage and price declines will eventually shift IS curve rightward via real balance effect But long run and slow process

Post War Keynesian/Neoclassical Synthesis Exemplified by Paul Samuelson Neoclassical microeconomics Keynesian macroeconomics treated as a short run model relying on inflexible wages and prices Keynesian model a special case but the relevant special case for policy purposes

Inflation and the Phillips Curve The standard Keynesian models did not incorporate the price level Low unemployment policy began to cause inflation A. W. Phillips (1958) empirical study on the relationship between unemployment and % change in wage rates Phillips curve led to notion of an unemployment/inflation trade off

Phillips Curve unemployment Rate of change in wages 0 5% Idea of “buying” lower unemployment With higher rate of inflation

Phillips Curves and Expectations Difficulty with the trade off idea is that inflation seemed to get worse Notion of inflationary expectations being built into the next round of wage bargains Keeping unemployment below the “natural rate” (consistent with zero inflation) results in the long run in accelerating inflation Long run Phillips curve is vertical at the natural rate Rational expectations

The Present State “Keynesian” models—short run models with various types of market imperfections Long run models of a more “classical” character—rational expectations, policy neutrality More emphasis on long run issues of government debt, growth, intergenerational issues Central banks and inflation targets