lecture six from keynes (& fisher) to the interpretation of keynes is-lm analysis achievements:...

Lecture Six

From Keynes (& Fisher) to the Interpretation of Keynes

IS-LM AnalysisAchievements: The Keynesian Era

(1950-1973) versus Neoclassical/Monetarist (1975 till

now)

UWS Comedy Festival

• The UWS Comedy Festival is on at The Enmore The Enmore TheatreTheatre on October 22 & 23October 22 & 23 and all profits are going to theStarlight Children's Foundation.

• As well as our students performing, our guest acts include Peter Hellier, Corinne Grant and Vince Sorrenti - and tickets can be bought from Ticketek.

• This has been in the making for over six This has been in the making for over six months now so it would be GREAT if our months now so it would be GREAT if our students could support it so we have more students could support it so we have more people from the uni than residents of inner city people from the uni than residents of inner city suburbs.suburbs.

Changed arrangements for Changed arrangements for discussantsdiscussants

• Apologies for stuff-up to seminars because of short semester/trip/October Long Weekend

• Allowances for discussants who have already presented

• Suggestion: Discussants to present on the day as now, but have a week to write full critique

• Also, does anyone need a copy of OREF?

Pre-Keynesian Macro

• Conventional neoclassical macroeconomic theory less elaborate than Walras’s “General Equilibrium” model (discussed last week):– Assumed fixed capital stock in short run, variable

labor supply, etc., rather than “everything variable” as in Walras (but with other strong assumptions needed)

• Example: Hicks’s “typical classical theory” (outlined in “Mr Keynes and the Classics”)– 2 industries: Investment goods X & consumption

goods Y– 2 factors of production: labor (variable); capital

(fixed in short run)– Given capital stock in both industries:

Hicks’s “typical classical theory”

• Output a function of employment Nx & Ny

– X=fx(Nx); Y=fy(Ny) where f has diminishing marginal productivity

• Prices equal marginal costs = marginal product of labour times wage rate (since labour is only variable input):

– Marginal cost is increase in labor input (dNx & dNy) for each increment to output (dx & dy)

– Px=w.dNx/dx; Py=w.dNy/dy

• Income = value of output = price times quantity:

– I = Ix + Iy = w.(dNx/dx) .x + w.(dNy/dy) .y


• Quantity of Money M a given, and fixed relation between M and income I (transactions demand for money only: money “a veil over barter”):– M = k.I (k constant “velocity of money”)

• Demand for investment goods a function of interest rate:

– Ix=C(i)

• Supply of savingsa function of interest rate:

– Ix=S(i)

– Higher savings meanshigher investment (a familiar argument?)

I (I

nte

rest

rate

)

Ix (output of capital goods)

Supply

Demand

Determines Nx


• Causal chain:– M determines I (total output)– i determines Ix (output of investment goods)– Ix determines Nx (given w)– I-Ix determines Iy (output of consumption goods is

a residual…)– Iy determines Ny (given w)

• Lower money wage means higher employment:– Lower wage means lower prices– Unchanged money I means higher income relative

to prices, so higher sales– Higher sales mean increased employment (and

lower real wage due to diminishing marginal product)

Neoclassical Macro

• Asserted unemployment due to excessive wages, until...

Arguably began with Stock Market Crash

Just one week before…

The economists were saying…

• “Stock prices have reached what looks like a permanently high plateau.

• I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.” (Irving Fisher, October 15 1929)

• In the next few years, Irving Fisher lost12 million dollars!

• That’s $102 million in today’s prices• Crash occurred on October 23rd 1929:

A 120 Point Break in just 15 Days...

The Great Crash 1929Vo

lume

Trad

ed

200

220

240

260

280

300

320

340

DJIA

Crash continued for another 3 years:

The Great Wall Street Crash

25/11/21

4/12/27

12/12/33

21/12/39

29/12/45

7/01/52

15/01/58

24/01/64

1/02/70

10/02/76

18/02/82

27/02/88

7/03/94Week

100

101

102

103

2346

2346

2346

S&

P 5

00 C

om

posi

te In

dex

2/01/29 2/04/30 1/07/31 28/09/32 27/12/33Week

0

5

10

15

20

25

30

35

S&

P 5

00 C

om

posi

te In

dex

S&P 500 from 32 at its zenith

To below 5

at its nadir

in less than 3 years

25 years to recover

Not only theStockmarket

crashed…

and that’s the index; the S&P of 1948 had many stocks which didn’t exist in 1929, while many of

the 1929 entrants had gone bankrupt

The Great Depression

0

50

100

150

200

250

1920

1922

1924

1926

1928

1930

1932

1934

1936

1938

1940

1942

GD

P I

nd

ex (

1913

=10

0)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

GD

P C

han

ge

10 years torestore output levels

30% fall inoutput in 4 years

WWII

The Great Depression

0

5

10

15

20

25

30

Apr-2

9

Oct-29

Apr-3

0

Oct-30

Apr-3

1

Oct-31

Apr-3

2

Oct-32

Apr-3

3

Oct-33

Apr-3

4

Oct-34

Apr-3

5

Oct-35

Apr-3

6

Oct-36

Apr-3

7

Oct-37

Apr-3

8

Oct-38

Apr-3

9

Oct-39

Apr-4

0

Oct-40

Apr-4

1

Oct-41

Apr-4

2

Oct-42

US

A U

nem

ploy

men

t Rat

e (S

easo

nall

y A

djus

ted)

Source: NBER data series m08292a

From effectively zero...

To 25% in 3 years WW II BringsSustained Recovery

Keynes’s “Revolution”

• A (partial) rejection of (neo)classical economics– Kept marginal product theory of factor returns, etc.;

but– Rejected theory of investment, money, savings– Key innovation: proper treatment of uncertainty

• Investment:– in certain world, would be determined by interest rate– in uncertain world, motivated by expectations of

profit– Expectations of profit volatile & based on flimsy

foundations:• Expect current state of affairs to continue;• Trust current prices, etc., as correct• Trust mass sentiment

Keynes’s “Revolution”: Investment & Savings

• Investment (determined by expectations, output, capital stock) determines income via multiplier– I=f(E,Y,K) (E component highly volatile)– Y=f(I)

• Consumption a function of income– C=a + c.Y (stable relationship)

• Y=C+I=C+S (ex-post Investment = ex-post Savings)

• Savings a residual function of income:– S=Y-C

• Investment determines Savings• Attempt to increase Savings (by reducing MPC) may

reduce investment & hence output

Keynes’s “Revolution”: Money

• Neoclassical theory:– money a “veil over barter”– transactions motive only for holding money

• Keynes– Money ultimate source of liquidity in uncertain

world– Speculative, precautionary & finance motives for

holding money (latter not in General Theory book, but in 1937 papers)

– Rate of interest the return for foregoing liquidity– Liquidity preference highly volatile because based

on expectations (like Investment)

Keynes’s “Revolution”: Critique “Say’s Law”

• Expenditure has 2 components:– D1, related to current output (consumption)– D2, not related to current output (investment)

• Say’s Law (rejected by Keynes) requires:– either D2=0; or– Increased savings causes increased D2

• But– Decision to invest based on expectations of profit

in uncertain future– Increased savings means decreased consumption

now• May lead to lower expectations and less investment

In a nutshell...

• “The theory can be summed up by saying that, given the psychology of the public, the level of output and employment as a whole depends on the amount of investment... More comprehensively, aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital-assets, on the propensity to spend and on the social factors which influence the level of the money-wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little.” [OREF ]

Keynes and Investment under Uncertainty

• In most of General Theory, Keynes argued that investment motivated by relationship between marginal efficiency of investment schedule (MEI) and the rate of interest

• In Chapter 17 of General Theory, “The General Theory of Employment” and “Alternative theories of the rate of interest” (1937), instead spoke in terms of two price levelstwo price levels– investment motivated by the desire to produce

“those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228)• Demand price determined by prospective yields,

depreciation and liquidity preference.• Supply price determined by costs of production


• Two price level analysis becomes more dominant subsequent to General Theory:– The scale of production of capital assets “depends,

of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217)

– MEI analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus”, whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214)

What is “uncertainty”?

• Very hard to grasp, even though essential aspect of our world: we do not know the future

• But we have worked out how to calculate risk• Most of Keynes’s examples were about how

uncertainty is not risk– Negative examples—what uncertainty is not—

rather than what it is:

Keynes on Uncertainty• ‘By "uncertain" knowledge, let me explain, I do not mean

merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these About these matters there is no scientific basis on which to form any matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.’

What is “uncertainty”?

• Imagine you are very attracted to a particular person• This person has accepted invitations from 1 in 5 of the

people who have asked him/her out• Does this mean you have a 20% chance of success?• Of course not:

– Each experience of sexual attraction is unique– What someone has done in the past with other people

is no guide to what he/she will do with you in the future

– His/her response is not “risky”; it is uncertain.• Ditto to

– individual investments• success/failure of past instances give no guide to present

“odds”

How to cope with relationship uncertainty?

• We try to “find out beforehand”– ask friends—eliminate the uncertainty

• We do nothing…– paralysed into inaction

• We ask regardless…– compel ourselves into action

• We follow conventions– “follow the herd” of the social conventions of our

society– “play the game” & hope for the best

• So what about investors?


• In the midst of incalculable uncertainty, investors form fragile expectations about the future

• These are crystallised in the prices they place upon capital asset

• These prices are therefore subject to sudden and violent change– with equally sudden and violent consequences for

the propensity to invest• Seen in this light, the marginal efficiency of capital is

simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)

Keynes on Uncertainty and Expectations

• Three aspects to expectations formation under true uncertainty– Presumption that “the present is a much more

serviceable guide to the future than a candid examination of past experience would show it to have been hitherto”

– Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects”

– Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214)

• Fragile basis for expectations formation thus affects prices of financial assets

Keynes on Finance Markets

• Conventional theory says prices on finance markets reflect net present value capitalisation of expected yields of assets

• But, says Keynes, far from being dominated by rational calculation, valuations of finance markets reflect fundamental uncertainty and are driven by whim:– “all sorts of considerations enter into the market

valuation which are in no way relevant to the prospective yield” (1936: 152)• ignorance• day to day instability• waves of optimism and pessimism• “the third degree”


• Ignorance due to dispersion of share ownership (shades of Telstra?):– “As a result of the gradual increase in the

proportion of equity ... owned by persons who ... have no special knowledge ... of the business... the element of real knowledge in the valuation of investments ... has seriously declined” (1936: 153)• Anyone here got T2 shares?…

• Impact of day to day fluctuations– “fluctuations in the profits of existing investments,

which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market” (1936: 153-54)


• Waves of optimism and pessimism– “In abnormal times in particular, when the

hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual ... the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.” (1936: 154)

• “The Third Degree”– Professional investors further destabilise the market

by attempting to anticipate its short term movements and react more quickly

• As Geoff Harcourt once remarked, Keynes “writes like an angel”. The next few slides are in Keynes’s own words.


• “It might have been supposed that competition between expert professionals ... would correct the vagaries of the ignorant individual... However,... these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.” (1936: 154-55)


• “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of most skilled investment today is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” (1936: 155)


• “professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; ... It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (1936: 156)


• “If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investment on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets.”


• “Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and ignorance than to beat the gun.”


• “Moreover, life is not long enough;--human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is tolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”

• “Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money...”


• “Finally it is the long-term investor ... who will in practice come in for most criticism, wherever investment funds are managed by committees or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes 1936: 156-58)

• At the same time as Keynes was writing the General Theory, Irving Fisher put forward the very similar “Debt Deflation Theory of Great Depressions”:

Fisher on Depression

• Fisher’s reputation was destroyed by prediction of no crash, but afterwards, he turned to developing theory to explain the crash– “The Debt Deflation Theory of Great Depressions”– Neoclassical theory assumed equilibrium

• but real world equilibrium short-lived since “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium” (1933: 339)

• As a result, any real world variable is likely to be over or under its equilibrium level--including confidence & speculation

Debt Deflation Theory of Great Depressions

• Key problems debt and prices– The “two dominant factors” which cause

depressions are “over-indebtedness to start with and deflation following soon after”• “Thus over-investment and over-speculation are

often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 341)

– When overconfidence leads to overindebtedness, a chain reaction ensues:


• “(1) Debt liquidation leads to distress selling and to• (2) Contraction of deposit currency, as bank loans

are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

• (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

• (4) A still greater fall in the net worths of business, precipitating bankruptcies and


• (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make

• (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

• (7) Pessimism and loss of confidence, which in turn lead to

• (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause

• (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (1933: 342)


• Fisher thus concurs with ancient charge against usury, that “it maketh many bankrotts” (Jones 1989: 55)

• While such a fate largely individual in a feudal system, in a capitalist economy a chain reaction ensues which leads the entire populace into crisis

• Theory nonequilibrium in nature– argues that “we may tentatively assume that,

ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, towards a stable equilibrium”• but though stable, equilibrium is “so delicately

poised that, after departure from it beyond certain limits, instability ensues” (Fisher 1933: 339).


• Two classes of far from equilibrium events explained:– Great Depression, when overindebtedness coincides

with deflation• with deflation on top of excessive debt, “the more

debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing” (Fisher 1933: 344).

• Cycles, when one occurs without the other– with only overindebtedness or deflation, economic

growth eventually corrects situation; it• “is then more analogous to stable equilibrium: the

more the boat rocks the more it will tend to right itself. In that case, we have a truer example of a cycle” (Fisher 1933: 344-345)


• Fisher’s new theory ignored• Old theory made basis of modern finance theory• Debt deflation theory revived in modern form by

Minsky (a future lecture)• Fisher’s macroeconomic contribution (which

emphasised the need for reflation and “100% money” during the Depression) overshadowed by Keynes’s “General Theory”

• Many similarities and synergies in Keynes and Fisher, but different countries meant one largely unaware of others work

Keynes and Debt-deflation• Some consideration of debt-deflation in General Theory

when discussing reduction in money wages (the neoclassical proposal for ending the Great Depression--see last lecture):– “Since a special reduction of money-wages is always

advantageous to an individual entrepreneur ... a general reduction ... may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital... On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partially offset any cheerful reactions from the reductions of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency--with severe adverse effects on investment.” (Keynes 1936: 264)

Keynes and Debt-deflation

– “The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (1936: 268-69)

– Thus 2 reasons for favouring reflation/inflation as means to end Great Depression:• accepted neoclassical argument that real wage had to

fall for employment to rise (next slide)• impact of rising price level on debt far safer than that

of a falling price level.

Keynes on Wages

• Since accepted marginal product theory, accepted that real wages had to fall for employment to rise:

• But argued– cutting money wage

would cut prices--no effect on real wage

– solution to depression was reflation, not deflation: increase output, real wages will fall

Marg

inal Pro

du

ct o

f La

bou

rO

utp

ut

Employment

=re

al w

ag

e

NfNu

Increased output

Reduces real wage

(But remember

Sraffa’s critique of

diminishing marginal

productivity [last

lecture])

Keynes on Policy

• Reflate domestic economy to escape Depression:– Government deficit funding of public works

• Multiplier impact on output, employment• Boost to investor expectations

– Maintain low interest rates• International Balance of Payments system to avoid

“beggar my neighbour” currency devaluations– Central world monetary authority– Fixed exchange rates, IMF approval for variation– Trade deficit economies must deflate economies

to reduce imports– Trade surplus economies must reflate to boost

imports

Keynesian Policy in Practice

• Domestic policy recommendations became the norm– Budget deficits to increase employment during

slumps (but surpluses rarely achieved during booms for political reasons)

– Low interest rates• International recommendations only half followed in

“Bretton-Woods” agreement:– Fixed exchange rates, IMF, etc. (US as standard)– Pressure on deficit countries to deflate; but– No pressure on trade surplus countries to reduce

surplus (USA then major creditor--trade surplus--nation)

The interpretation of Keynes

• General Theory highly influential, but read by few economists (let alone economic journalists!)– Most relied upon summaries and textbook

interpretations– GT itself not precise; plenty of room for

interpretation– Key interpretation: Hicks 1937, “Mr Keynes & the

Classics” [OREF II] IS-LM rendition of Keynes• Hicks sets out “typical classical theory”:

– M=k.I (money supply & output), Ix=C(i) (investment demand), Ix=S(i) (savings supply)

– Argues that Keynes’s innovation is the proposition that the demand for money should obey marginal analysis:

A “marginal” interpretation of Keynes

• “On grounds of pure value theory, it is evident that the direct sacrifice made by a person who holds a stock of money is a sacrifice of interest; and it is hard to believe that the marginal principle does not operate at all in this field” [Hicks, OREF II]

• Proposes that– M=L(i) (demand for money a decreasing function

of interest rate) is “Liquidity Preference”• this Keynes’s main innovation

• Multiplier [Ix = S(I)] comparatively “insignificant”

Keynes according to Hicks

• “Mr Keynes begins with three equations,

– M=L(i), Ix=C(i), Ix=S(I)

– [in contrast to (neo)classical theory] “... the demand for money is conceived as depending upon the rate of interest (Liquidity Preference). On the other hand, any possible influence of the rate of interest on the amount saved out of a given income is neglected. Although it means that the third equation becomes the multiplier equation, which performs such queer tricks, nevertheless this second amendment is a mere simplification, and ultimately insignificant.” [OREF II]• (M=L(i) is money demand; money supply M is

assumed to be exogenous)

Keynes according to Hicks

• In this model:– Money demand/supply

determines i

• i determines Ix• Ix determines I via

the multiplier• Increase Ms-

>increase I• Increase propensity

to invest, or to consume-> increase I

Md

Ms

i

Keynes “special theory”, according to Hicks

Ms

Md (liquidity preference)

Ix=f(i)

I=f(Ix)The multiplier

I (output)

Investment

I (output)

i

M

i

Ix

IxN (employment)

Money marketdetermines int. rate interest rate

determines Investment

Investmentdetermines

Output

Output determines employment


Ms


Ix=f(i)


I (output)

Investment

I (output)

i

M

i

Ix

IxN (employment)




Output


Increasing Ms increases N:

Employment grows more than output because of diminishing marginal

product


Ms


Ix=f(i)


I (output)

Investment

I (output)

i

M

i

Ix

IxN (employment)




Output


Reducing LP increases N:

Employment grows more than outputbecause of diminishing marginal product

Keynes “general theory”, according to Hicks

• “something appreciably more orthodox” [OREF 31]• “The dependence of the demand for money on

interest does not ... do more than qualify the old dependence on income. However much stress we lay upon the 'speculative motive', the 'transactions motive' must always come in as well.” [OREF II]

• Hicks’s version of Keynes’s “GT”– M=L(I,i), Ix=C(i), Ix=S(I).

• vs Hicks’s version of “typical classical theory”– M=k.I, Ix=C(i), Ix=S(i)


• The LL (LM) curve:– Fixed Ms; Md ¯ fn of i; Md fn of I:

Md1 (I2)

Md1 (I1)

i

M

i

II1 I2

Exogenous Ms The LM curve


Ix=S(I)

Savings a function of

income

Ix=C(i)

Investment a function of

interest rate

S

I (income) I (income)

I (income)

I(output)

i i

Ix (Investment)

The IS curve

The IS curve: Investment demand a ¯ fn of i [Ix=C(i)]; Savings supply a fn of Income [Ix=S(I)]

Multiplier


The product: IS-LM analysis

LL (now LM)

IS

i

I (output)


• Keynes as a marginalist [neoclassical], according to Hicks:– “Income and the rate of interest are now

determined together ... just as price and output are determined together in the modern theory of demand and supply. Indeed, Mr Keynes's innovation is closely parallel, in this respect, to the innovation of the marginalists.” [OREF 32]

• Integrating “Keynes and the Classics”:– Slope of LM curve

• almost horizontal for low levels of I• almost vertical for high levels of I:


• In “Keynesian” region, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts income

• In “Classical region”, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts interest rate

• “the General Theory of Employment is the Economics of Depression”, Classical is Economics of full employment

LM

IS

I (output)

“Keynesian region”

“Cla

ssic

al re

gio

n”

i

Nice theory, but is it Keynes?

• Whatever Happened to Uncertainty & Expectations?

– Hicks: Ix=f(i) Investment demand a function of the rate of interest (and income in more general model)

– Keynes: “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible” [OREF 4]

– “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain... therefore, [we are] guided ... by the facts about which we feel somewhat confident, .... the facts of the existing situation enter … disproportionately, into the formation of our long-term expectations…” [OREF 3]

– Why not Ix=f(i,I,E) where E is expectations?

Nice theory, but is it Keynes?

• “Keynesian Economics” as practised– Keynes minus uncertainty & expectations

• “Keynes without uncertainty is something like Hamlet without the Prince.” (Minsky, John Maynard Keynes, 1975, p. 57)

– Evolved towards the “Neoclassical synthesis”• IS-LM macro grafted onto neoclassical micro• Key architects Hicks & Samuelson [see OREF]

– Revival of neoclassical economics as Keynes criticised for having “bad microfoundations”

• “Protest” group of economists (Post-Keynesians) try to develop uncertainty-based interpretation of Keynes in opposition to dominant neoclassical synthesis view

– Curiously, one “protester” was John Hicks!

“IS-LM: An Explanation”

• In 1979/80, Hicks commented that– “The IS-LM diagram, which is widely, though not

universally, accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility.” (OREF III)

– saw two key problems with IS-LM as an interpretation of Keynes

– 2nd problem was time-period of model:• Hicks’s used a week,• Keynes used “a ‘short-period’, a term with

connotations derived from Marshall; we shall not go far wrong if we think of it as a year” (Hicks 1980).


• Not unreasonable to hold expectations constant for a week–and therefore ignore them.

• But keeping expectations constant over a year in an IS-LM model does not make sense, because– “for the purpose of generating an LM curve, which

is to represent liquidity preference, it will not do without amendment. For there is no sense in liquidity, unless expectations are uncertain.” (Hicks OREF)• I.e., why hold money for precautions/speculation, if

expectations were constant?• Can’t validly derive LM curve, because transactions

are only reason for holding money when expectations constant


• If expectations constant, then can’t be out of equilibrium– if out of equilibrium, expectations must change!:– “I accordingly conclude that the only way in which IS-LM

analysis usefully survives–as anything more than a classroom gadget, to be superseded, later on, by something better–is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate…”

– “When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected–if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium.” (Hicks 1980)

Keynesian Theory in Practice

• Despite Hick’s disavowal of his own model, the interpretation of Keynes was dominated by IS-LM, and Aggregate Demand-Aggregate Supply (AS-AD) analysis

• Emphasis upon fiscal policy• No attention to issue of expectations• Policy focus post-Depression, WWII:

– Full employment primary• Australian 1945 White Paper on Employment:

– "maintain such a pressure of demand on resources that for the economy as a whole there will be a tendency towards a shortage of men instead of a shortage of jobs"

– Price stability secondary

Keynesian Theory in Practice

• “Although we have defined the boundary of the full-employment zone in terms of registered unemployment of 1.0 to 1.5 per cent of the work force, this is by no means to say that Australia should be content with this degree of unemployment. It should be possible to maintain employment at a higher level than this and avoid the difficulties arising from shortages and bottlenecks…” Vernon Committee, 1966

• The scorecard:– Recovery from Great Depression– Years of high stable growth, low inflation– Ending with rising inflation during Vietnam War

Years, and severe collapse in 1973– However the record, compared to neoclassical

policy since 1975, is pretty good:

GDP Growth

USA Real GDP Change

-4%

-2%

0%

2%

4%

6%

8%60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96

Change

Trend

Keynesian PeriodMonetarist/Neoclassical

Unemployment

USA Unemployment Rate

0%

2%

4%

6%

8%

10%

12%

4801

4908

5103

5210

5405

5512

5707

5902

6009

6204

6311

6506

6701

6808

7003

7110

7305

7412

7607

7802

7909

8104

8211

8406

8601

8708

8903

9010

9205

9312

9507

Years

Rate

Trend

Keynesian Period Monetarist/Neoclassical

Inflation

USA Inflation

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96

Year

CP

I In

dex

CPI Change

Trend


Money Supply

USA Money Supply

-5%

0%

5%

10%

15%

20%19

60

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

Year

Per

Cen

t

M1 ChangeTrend


Interest Rates

USA Discount Rate

-2%

0%

2%

4%

6%

8%

10%

12%

14%Ja

n-50

Jan-

52

Jan-

54

Jan-

56

Jan-

58

Jan-

60

Jan-

62

Jan-

64

Jan-

66

Jan-

68

Jan-

70

Jan-

72

Jan-

74

Jan-

76

Jan-

78

Jan-

80

Jan-

82

Jan-

84

Jan-

86

Jan-

88

Jan-

90

Jan-

92

Jan-

94

Jan-

96

Year

Rate

Trend


Government Budget

USA Real Government Balance

-300

-250

-200

-150

-100

-50

0

50

100

59.1

60.3

62.1

63.3

65.1

66.3

68.1

69.3

71.1

72.3

74.1

75.3

77.1

78.3

80.1

81.3

83.1

84.3

86.1

87.3

89.1

90.3

92.1

93.3

95.1

Real Balance

Trend

3rd Order Trend


Balance of Trade

USA Real Balance of Trade

-200

-150

-100

-50

0

50

59.3

61.3

63.3

65.3

67.3

69.3

71.3

73.3

75.3

77.3

79.3

81.3

83.3

85.3

87.3

89.3

91.3

93.3

95.3

Quarter

Ex

po

rts

- I

mp

ort

s


Income distribution

USA: The Top 5% & The Bottom 20% Get...

0

5

10

15

20

25

30

35

40

45

50

1947

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1993

Year

Pe

r C

en

t o

f In

co

me

Lowest fifth

Highest fifth


Next week

• Same deal—Start in LT03 at 10am (still material to catch up with)

• Topics– The Phillips Curve– Decline of Keynesianism– Rise/fall of Monetarism– Keynesian counter-attack: logical flaws in

neoclassicism– If we finish that, a detailed look at finance theory

lecture six from keynes (& fisher) to the interpretation of keynes is-lm analysis achievements:...

Documents