classical versus keynes

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Keynesian Economics: Revolution and Counterrevolutio n John Maynard Keynes (1883-1946) 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

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Page 1: Classical versus keynes

Keynesian Economics:Revolution and

Counterrevolution• John Maynard Keynes (1883-1946)

– 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

Page 2: Classical versus keynes

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

Page 3: Classical versus keynes

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’

Page 4: Classical versus keynes

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

Page 5: Classical versus keynes

Keynesian Labour Market

N

Money wages

S

D

w

n

D’

n’

Involuntary employment exists because ofdownwardly inflexible money wage rates.

ISSUE: Is this assumption critical to theKeynesian analysis?

Page 6: Classical versus keynes

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

Page 7: Classical versus keynes

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.

Page 8: Classical versus keynes

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

Page 9: Classical versus keynes

Keynesian Theory of Interest, Savings and

Investment

i

Money i rate

i is determined in the money marketBoth S and I are interest inelasticI can shift in due to adverse expectations soThat at i FE levels of S > I

I

S at FE

I’

Page 10: Classical versus keynes

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

Page 11: Classical versus keynes

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?

Page 12: Classical versus keynes

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

Page 13: Classical versus keynes

Aggregate Supply

Z

N

Proceeds or income

Z function rises at an increasing rate due todiminishing returns—increasing marginal supply priceZ function in money terms and so assumesa given price level

Page 14: Classical versus keynes

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

Page 15: Classical versus keynes

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

Page 16: Classical versus keynes

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

Page 17: Classical versus keynes

Consumption and Savings

• APC = C/Y

• MPC = ΔC/ΔY

• C = a + bY where b =MPC

C

Y

450 or C = Y

C = a+ bY

aSlope = b

y yFE

Page 18: Classical versus keynes

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

Page 19: Classical versus keynes

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)

Page 20: Classical versus keynes

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

Page 21: Classical versus keynes

Investment Expenditurei

I

MEI

MEI curve is very interest inelastic and isunstable—tends to shift with state of expectations

Optimistic

Pessimistic

Page 22: Classical versus keynes

Equilibrium Income

For an equilibrium Agg D = Agg SY = C + I

450

C

C + I = Agg DAgg D

Yy*

C

S

At y* Agg D = Agg S and S = IHowever y* need not be FEIf FE > y* then Aggs > Agg D and S > IFirms will find inventories accumulating and will reduce employment and income until S = I

FE

Page 23: Classical versus keynes

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)

Page 24: Classical versus keynes

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

Page 25: Classical versus keynes

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

Page 26: Classical versus keynes

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

Page 27: Classical versus keynes

Money and Interest Rates

• Speculative demand for money and the liquidity trap

i

M

LP

i

Spec Demand

Trans and Precautionary Demand

Ms

Page 28: Classical versus keynes

The Complete Keynesian Model

ii

IM

MEI

Ms

LPi

I

C

C + I

Y

Agg D

y*

I

450

Page 29: Classical versus keynes
Page 30: Classical versus keynes
Page 31: Classical versus keynes

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

Page 32: Classical versus keynes

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

Page 33: Classical versus keynes

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

Page 34: Classical versus keynes

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

Page 35: Classical versus keynes

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

Page 36: Classical versus keynes

LM and IS Curves

• LM and IS curves

Y

i

IS

LM

y

i

Page 37: Classical versus keynes

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

Page 38: Classical versus keynes

Real Balance Effect

Y

i

LM

y*

ISIS’

FE

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

Page 39: Classical versus keynes

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

Page 40: Classical versus keynes

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

Page 41: Classical versus keynes

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

Page 42: Classical versus keynes

Phillips Curve

unemployment

Rate of change in wages

0

5%

Idea of “buying” lower unemployment With higher rate of inflation

Page 43: Classical versus keynes

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

Page 44: Classical versus keynes

The Policy Debate

• Keynesians who favored low unemployment targets argued for further government intervention in the form of wage and price controls

• Many countries experimented with wage and price guideposts or controls in the 1960s and 70s

• The policy alternative came from the Monetarists

• Milton Friedman and Chicago

Page 45: Classical versus keynes

Friedman and Monetarism

• Friedman’s critique of Keynesian economics had several dimensions

• Consumption expenditure responds to changes in permanent income not temporary changes in income

• Monetary factors have greater significance than Keynes or the Keynesians allowed

• Studies in the Quantity Theory of Money 1956

Page 46: Classical versus keynes

Friedman and Monetarism

• Restatement of the quantity theory in the framework of consumer choice theory

• Demand for money will depend on total wealth, the prices and returns on various types of assets, and consumer preferences

• Demand for real money balances is stable

• Increases in money supply will have only a temporary effect on i rates and expenditure

• Longer run effect on the price level

Page 47: Classical versus keynes

Friedman and Monetarism

• Monetary authorities cannot peg interest rates

• Monetary rule—keep the rate of growth of the money supply equal to the long run rate of growth

• This will generate price stability• Monetarist policies introduced

did eventually squeeze out inflation but at the cost of a significant recession and high interest rates in the short run

Page 48: Classical versus keynes

Keynesianism, Monetarism and

Econometrics• Keynes himself was skeptical

about econometric methods

• But Keynesian models could be empirically estimated

• National income data etc

• Cowles Commission, and structural Keynesian Models

• Friedman’s critique—simple models and predictive ability

• Cowles versus Chicago

Page 49: Classical versus keynes

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