RH351 Rhetoric of Economic Thought Transparencies Set 6 Keynes, Keynesianism, and modern macroeconomics

Economic analysis – key contributors, 20 th century Joseph Schumpeter (1883 – 1950) Thorstein Veblen (1857 – 1929) Paul Samuelson (1915 – ) John Maynard Keynes (1883 – 1946) Milton Friedman (1912 – ) Friedrich A. von Hayek (1899 – 1992) Gary Becker (1930 – ) Alfred Marshall (1842 – 1924) Lucas Hayek Friedman Keynes 1950 Robert Lucas (1937 – ) Kenneth Arrow (1921 – ) Ronald Coase (1910 – ) Samuelson

John Maynard Keynes, 1883 – 1946 Biographical Details

G. E. Moore’s Principia Ethica (1903) “… o ur causal knowledge is utterly insufficient to tell us what different effects will probably result from two different actions, except within a comparatively short space of time … Our utter ignorance of the far future gives us no justification for saying that it is even probably right to choose the greater good within the region over which a probable forecast may extend … It does in fact appear to be the case that, in most cases, whatever action we now adopt, ‘it will be all the same a hundred years hence,’ … we can only hope to discover which, among a few alternatives, will generally produce the greatest balance of good in the immediate future.” Chapter V, “Ethics in Relation to Conduct”, sections 93 and 94

Keynes’ road to The General Theory B ut this long run is a misleading guide to current affairs. In the long run we are all dead. Economist set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. Tract on Monetary Reform (1923) I abandon laissez-faire – not enthusiastically.... but because, whether we like it or not, the conditions of its success have disappeared … Our problem is to work out a social organization which shall be as efficient as possible without offending our notions of a satisfactory way of life. The End of Laissez Faire (1926) 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. Letter to G.B. Shaw (1935)

Keynes, The General Theory -- Aggregate Demand The General Theory (pp. 32 – 34)

Keynes, The General Theory -- The Propensity to Consume The General Theory (p. 96)

Keynes, The General Theory -- Investment The General Theory (p. 248)

Keynes, The General Theory -- Animal Spirits The General Theory (p. 161)

Hayek and Keynes on free markets and social justice W e must face the fact that the preservation of individual freedom is incompatible with a full satisfaction of our views of distributive justice Individualism, True and False (1945) Friedrich Hayek 1889 – 1992 O ur problem is to work out a social organization which shall be as efficient as possible without offending our notions of a satisfactory way of life. John Maynard Keynes 1883 – 1946 The End of Laissez-Faire (1926)

The evolution of “textbook” economics Part 1: Basic Economic Concepts and National Income Part 2: Determination of National Income and its Fluctuations Part 3: The Composition and Pricing of National Output 1950: Economics Samuelson, Economics, An Introductory Analysis (1948) 1850: Political Economy Mill, Principals of Political Economy (1848) 1900: Economics Marshall, Principals of Economics (1890) MacroconomicsMicroconomics Early 1800s: Political Economy Mill, The Wealth of Nations (1776) Ricardo, Principles of Political Economy (1817) Keynes’s General Theory

Keynes or Keynesianism? The Employment Act of 1946: The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy … to promote maximum employment, production, and purchasing power. W hat is at stake in our economic decisions today is not some grand warfare of rival ideologies which will sweep the country with passion, but the practical management of a modern economy. What we need is not labels and cliches but more basic discussion of the sophisticated and technical questions involved in keeping a great economic machinery moving ahead. John F. Kennedy, 1962 W e’re all Keynesians now. Richard Nixon, 1971

The Income-Expenditure Model – the “Keynesian Cross” NNP Samuelson, 1961 (5 TH ed.) 45° NET NATIONAL PRODUCT TOTAL SPENDING 0 $ C C+I EQUILIBRIUM POINT

Hicks and the birth of IS – LM analysis I i I S L L 0 P GNP(Y) INTEREST RATE (R) IS LM Hicks, 1937 Hall & Taylor, 1986 “Against a given quantity of money, the first equation, M = L(I,i) gives us a relation between Income (I) and the rate of interest (i). This can be drawn out as a curve (LL) which will slope upwards, since an increase in income tends to raise the demand for money, and an increase in the rate of interest tends to lower it … The curve IS can … be drawn showing the relation between Income and interest which must be maintained in order to make saving equal to investment. “Income and the rate of interest are now determined together at P, the point of intersection of the curves LL and IS. They are determined together; just as price and output are determined together in the modern theory of demand and supply.” J. R. Hicks, “Mr. Keynes and the ‘Classics’; A Suggested Interpretation.” Econometrica 5 (April 1937): 147 – 159. “Hick’s graphical approach, called the IS-LM approach, is still used widely today because of its great intuitive appeal.” Robert E. Hall and John B. Taylor, Macroeconomics: Theory, Performance, and Policy, 2 nd ed. (1986).

The algebra of the basic IS-LM model IS Curve (Equilibrium in the goods market) Output = Expenditure LM Curve (Equilibrium in the assets market) = f(Output, Interest Rate) Demand for “Real Balances”

Fiscal and Monetary policy with IS – LM analysis GNP(Y) INTEREST RATE (i) IS LM GNP(Y) IS LM IS’ LM’ IS’ LM’ Illustrating equal magnitude Shifts of IS and LM INTEREST RATE (i) Typical “Monetarist” View If d is “large”, IS is flat If h is “small”, LM is steep  Monetary policy is relatively strong Typical “Keynesian” View If d is “small”, IS is steep If h is “large”, LM is flat  Fiscal policy is relatively strong For equal magnitude changes in fiscal or monetary policy, monetary policy is relatively more effective in influencing output. For equal magnitude changes in fiscal or monetary policy, fiscal policy is relatively more effective in influencing output.

Unemployment Rate The Phillips Curve 5.5% Phillips, A. W., “The Relationship Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom,” Economica 25 (November 1958). Samuelson, Paul A., and Robert M. Solow, "Analytical Aspects of Anti-Inflation Policy." American Economic Review 50:2 (1960):

Friedman on the Phillips Curve P hillips’ analysis of the relation between unemployment and wage change is deservedly celebrated as an important and original contribution. But, unfortunately, it contains a basic defect – the failure to distinguish between nominal wages and real wages …Phillips wrote his article for a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages. Milton Friedman (1912 – ) … the Phillips Curve can be expected to be reasonably stable and well defined for any period for which the average rate of change of prices, and hence the anticipated rate, has been relatively stable. For such periods, nominal and real wages move together … The higher the average rate of price change, the higher will tend to be the level of the curve… T o state this conclusion differently, there is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation. “The Role of Monetary Policy,” American Economic Review 58:1 (March 1968), 1 – 17.

Unemployment Rate Inflation The “expectations augmented” Phillips Curve Friedman, Milton, “The Role of Monetary Policy,” American Economic Review 58:1 (March 1968), 1 – 17. Phelps, Edmund, "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time,“ Economica 34 (August 1967). U*

The 1970s crisis in macroeconomic policy T he present situation cannot last… it will either degenerate into hyper-inflation and radical change; or institutions will adjust to a situation of chronic inflation; or government will adopt policies that will produce a low rate of inflation and less government intervention into the fixing of prices.” A s an advice-giving profession, we’ve made a real mess of things. Milton Friedman Robert Lucas

M onetarism is the view that economies are inherently stable, that the quantity of money has a major influence on economic activity and the price level, and that the objectives of monetary policy are best achieved by targeting the rate of growth of the money supply. Monetarists generally express a preference for monetary policy as a stabilizing tool relative to prices only, being generally skeptical of attempts to manage output. K eynesianism is the view that economies are inherently unstable, that they may in fact settle at less-than full employment equilibrium, that Aggregate Demand is the primary determinant of output and employment, and that authorities can intervene in an economy to stabilize it. Keynesians generally express a preference for fiscal policy as a stabilizing tool. FriedmanGreenspanSamuelsonKeynes Schools of thought in mid-20 th century macroeconomics

N ew Classicalism is the view that economies are inherently stable, that fiscal and monetary interventions tend to be destabilizing, and that cyclical fluctuations are caused by either real shocks to the economy or unanticipated policy shocks. New classicals generally express a preference for microeconomic policies aimed at fostering aggregate supply, and a predictable monetary policy to maintain price stability. N ew Keynesianism is the view that market failures and microeconomic coordination failures give rise to macroeconomic instabilities that frequently cause economies to settle at less-than full employment equilibrium, that both aggregate demand and aggregate supply are important determinants of output and employment, and that authorities can intervene with fiscal and monetary policy tools to stabilize an economy PrescottLucasMankiwBernanke Schools of thought in late-20 th century macroeconomics

Harvard / MIT Yale Princeton Penn Stanford Minnesota Chicago Rochester Carnegie - Mellon Saltwater macroeconomics Freshwater macroeconomics Based on David M. Kreps, “Economics – The Current Position” (1997) Cal Berkeley

The Keynesian “revolution” B eyond all this stretched the ‘Keynesian Revolution’ – the logic and practice of managing economies so as to maintain full employment and avoid depressions like that of 1929 – 33. In the form Keynes left it, his Revolution was never wholly accepted; and the debate about its value and relevance, and its author’s place in the pantheon of thought and statesmanship, continues. Robert Skidelsky, John Maynard Keynes, Volume III, Fighting for Freedom, 1937 – 1946 (2000) N ow, after more than three decades in the wilderness, Keynesian-style fiscal policy seems to be staging a comeback. “A stimulating notion,” The Economist, February 16, 2008.