1. LECTURE NOTES ON MACROECONOMICS ECO306 SPRING 2014 GHASSAN DIBEH

2. Chapter 8 Keynesian Instabilities  Positing the Keynesian revolution as IS-LM plus Phillips curve laid the foundations for the revival of classical theory once assumptions about inflationary expectations (adaptive then rational) and wage and price flexibility were combined to deal a severe blow to Keynesian economics.  The Neoclassical synthesis ushered a period in which most economists agreed on a common framework for macroeconomic analysis and policy. The shapes of the IS and LM functions were assumed to be ‘normal’ (no flat LM, no vertical IS,…) and the IS and LM functions and the Phillips curve were largely stable.  The monetarist and RE counter attack by undermining the foundation of the Phillips curve has led waste to both Keynesian economics and the Neoclassical synthesis.  New Classical Macroeconomics, although not the harbinger of the macroeconomic consensus of the Great Moderation, it was, however, a main ingredient or the specter that guided the Great moderation’s macroeconomic policy.

3.  This chapter will look at Keynesian economics from a different perspective, one that was lost in the Hicksian interpretation of the General Theory. At the beginning though we look at the countervailing forces that may nullify the ‘Keynes’ and ‘Pigou’ effects. This is a very important element of any economic theory of macroeconomic dynamics.  Once wages and prices are assumed flexible, the following question posits itself: Do price and wage flexibility restore full employment equilibrium if the economy is knocked off of it?  Keynes in the General Theory relaxed his early assumption on the rigidity of wages and prices in the capitalist economy then proceeded to show that in the presence of the liquidity trap, the ‘Keynes’ effect would be ineffective and that in the presence of adverse deflationary expectations, the downward spiral of wages and prices would actually intensify the depression rather than cure it.

4.  Irving Fisher, a contemporary of Keynes also advanced a theory of debt deflation that showed that deflation actually makes the depression more severe rather than less.  In addition, James Tobin in the 1970’, and 1980’s advanced the idea that the Keynesian revolution must be understood in a ‘dynamic’ context not a ‘static’ one. The Keynesian underemployment is a dynamic phenomenon and not a static one. The disequilibirating adverse expectations that deflations induce cause the economy to spiral away from full employment. Under such dynamics, the Pigou effect is nullified and the classical stationary state is unattainable.

5. Keynes nullifies the ‘Keynes’ Effect

7. Given that in a depression or a very severe recession, both of the above conditions may hold then the Keynes effect would be ineffective in automatically operating to push the economy into full employment and end the recession.

8. The Reverse Pigou Effect  The notable economist Irving Fisher writing amidst the Great Depression advanced what came to be known as the Debt-Deflation Theory of the Great Depression. The theory says that deflation during the Great Depression was harmful and intensified the downward dynamic of the economy. This makes deflation an intensifier of depressions rather than the cure to recessions and depressions as shown in the Pigou effect.

9. The Reverse Pigou Effect  In the economy, there are two kinds of positions: debtors and creditors.  If the debtors and creditors are not distributed randomly in the population but creditors are concentrated in the wealthier population and the debtors in the poorer population, then given that the marginal propensity to consume by creditors is less than the marginal propensity of debtors, a Fisher Wealth Distribution Effect will occur as a result of deflation. When the real value of debt increases as a result of deflation, consumer-debtors decrease consumption (C) and business-debtors decrease investment (I).  Given that such losses to aggregate demand are not offset by creditors, then the Fisher effect will swamp the Pigou effect.

10. The Reverse Pigou Effect

11. Expectations and Dynamics: Is Price Flexibility Stabilizing?  We have seen that the introduction of price flexibility has led to an ambiguous result in terms of the final equilibrium state of the economy. Is the final state of the economy, the Keynesian underemployment equilibrium or the Pigou full employment equilibrium or what Pigou called the Classical Stationary State?  This indeterminacy can be summarized as follows: Keynesian Underemployment EquilibriumPigou Classical Stationary State -Pigou Effect Dominates

12. Expectations and Dynamics: Is Price Flexibility Stabilizing?  So is there a way out of this theoretical impasse?  The empirical record or historical experience has been interpreted in different ways. It will be discussed later in chapter on macroeconometrics. For now, the theoretical impasse is discussed in terms of further theory this time by taking into account dynamic considerations. Up till now all the macroeconomic models discussed are static models defined in terms of equilibrium states and changes are actually “jumps” form one equilibrium state to another as a result of a change in some exogenous variable (G, T, M, P,…).  Under such a static assumption, many argued (including economists sympathetic to the Keynesian theory) that the Pigou effect dominates and that the Classical Stationary State is the only “stable” equilibrium of the economic system.

13. Expectations and Dynamics: Is Price Flexibility Stabilizing?  The classicals argued that as long as a cut in the price level leads to higher output and employment (however slight), and since prices can go down with no limits, then the economy will eventually move to full employment. The Keynesians have persistently argued against this “eventual” possibility.  The reduction in the price level necessary to make the Pigou effect dominate and push the economy towards full employment as Wassily Leontief quipped would make the economy worth a dime! Which is an impossibility!  A more relevant criticism was the role that expectations would play under such price dynamics.

14. Expectations and Dynamics: Is Price Flexibility Stabilizing?  Lawrence Klein early on (in 1947) wrote against such a possibility by bringing in deflationary expectations into the model of the economy. He said that the classicals “have argued themselves directly into a trap” and that the effects of unlimited wage cuts and a proportionate decrease in nominal product prices will be “those of the economics and hyper-deflation and social revolution….. (where) adverse expectations must certainly occur…production plans would be postponed. This process would have to stop…The method of stopping it would be the overthrow of the capitalist system”.  Hence according to Klein, hyper-deflation (that the classical economists were willing to admit to be necessary for bringing about the Classical stationary state), will trigger adverse expectations that would deviate the economy further away from full employment rather than the other way around.

15. Expectations and Dynamics: Is Price Flexibility Stabilizing?

16.  What is important for Tobin (and Keynes of course) is the dynamic trajectory of the economy through time for answering the question: does the economy stabilize after a shock that deviates it from full employment as a result of price flexibility or is price flexibility destabilizing further pushing the economy away from full employment towards a state of Great recession or Depression?  Tobin argued that “the question applies to real time and sequential processes. Therefore the static long-run ‘Pigou-effect’ does not entitle any one to give a positive answer…. (to the question)…does the market economy unassisted by government policy, possess effective mechanisms for eliminating general excess supply of labor and productive capacity.”

17. Dynamic IS-LM models with expectations On the road to dynamics: a ‘static’ IS-LM model with expectations

19. A dynamic IS model with adaptive expectations

21.  Hence, in this economy the flexibility of prices has acted as a destabilizing factor and deflation will further push away the economy from equilibrium.

22. Tobin’s model with price level and price dynamic effects  In our attempt to concentrate on the destabilizing effect of deflation and flexible prices, we have assumed away the Pigou effect. However, the Pigou effect must be taken into consideration when price flexibility is assumed.  Hence again the final determining effect of price flexibility is the relative strength of the two effects: the price level effects (Keynes and Pigou effects) and the price change effect or the expected deflation effect.  The second effect as we have seen is operational when the economic process is occurring in real time which is how things are in reality hence the importance of the assumption that prices follow a certain trajectory when the economy is subjected to demand shocks rather than the assumption of instantaneous price jumps that ensure equilibrium comparisons between two states of the economy at different prices.

23. Tobin’s model with price level and price dynamic effects

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29. Tobin’s model with price level and price dynamic effects

30. Price Rigidity for Economic Stability  We have seen that adverse expectations cause large wage cuts which may cause hyper deflation but according to Klein “in the real world one observes neither hyperdeflation nor full employment. The explanation is that wages are sticky. The solution to the Keynesian system which gives a value of employment not on the supply schedule persists when wage cuts do not occur. Because workers do not bid against each other, we do not experience the hopeless demand spiral.”  Price stability is important to the stability of the capitalist system and price flexibility thought by the classicals as imparting flexibility to the capitalist system that ensure the achievement of the full employment state is wrong.  Tobin said of the centrality of effective demand that “unless a reduction of the money wage would somehow increase aggregate real demand, there is no mechanism by whcich the ….” p.4

31. Keynes’s outline of the Business Cycle

32.  Hence the major determinant of the MEC is the current expectations to the future yield of capital goods. Since these expectations are precarious, economic crisis or downturn occurs as a result of ‘sudden collapse of the MEC rather than as a result of the rise of interest rates.  This happens in the later stages of the boom when optimistic expectations are strong enough to offset the rising abundance of capital, rising costs of production and the rise in interest rates that all occur in the last stages of the boom. A sudden wave of pessimism that hits investors collapses the MEC.

33. Keynes’s outline of the Business Cycle  Moreover, as organized markets are made up of ignorant buyers and speculators, this intensifies the sudden pessimism of market participants which lead to drop in the value of stock markets. This in turn leads to a drop in the MEC if the economy experiencing such events has large “stock-minded” public like the US since the 1920’s and more economies nowadays.  In addition, the collapse of the MEC leads to uncertainty about the future which leads to a large increase in the liquidity preference L(r) which increases interest rates leading to a further drop in investment.

34. Keynes’s outline of the Business Cycle  Keynes attributed to the uncertainty under which investment is being done in the capitalist economy to be the main cause of the cycle. He said “investment is being made in conditions which are unstable and cannot endure because it is prompted by expectations that are destined to disappoint.”  Keynes concluded that “In conditions of laissez-faire the avoidance of wide fluctuations in employment may...prove impossible without a far reaching change in the psychology of investment markets…I conclude that the duties of ordering the current volume of investment cannot be left in private hands.”

35. Keynes’s outline of the Business Cycle