KEYNES AND THE BUSINESS CYCLE

1
KEYNES AND THE BUSINESS CYCLE
2
INTRODUCTION

• Economic fluctuations before the 19th century
• Origin in natural disasters
• Thought of as being outside human control
• A business cycle as a 19th century phenomenon
  why?
• Increasing specialization, division of labor

3

• Increasing industrialization
• Increasing interdependence, and collapse in one
  sector spreading to other sectors
• Decreasing sales
• Layoffs
• Lower income
• Less spending
• A downward cumulative process

4

• A key role for firms
• Production plans, based on expected sales
• Hiring plans, based on production plans
• And for consumers
• Spending plans, based on expected income
• Expected income, based on expected employment

5

• Any role for government in 19th century thought?
• Thought to be unnecessary usually saw eventual
  recovery without intervention
• Could expect small fluctuations in output, but no
  general glut

6
THE GREAT DEPRESSION

• The Classical Faith Shattered

7

• Background the Roaring Twenties
• A time of rapid growth, prosperity
• Relatively stable prices
• Low unemployment-in most sectors
• Growth industries autos construction
  electricity chemicals
• Declining industries agriculture railroads
  coal

8

• Growing use of consumer credit
• Unfamiliar to banks, consumers
• Result overextension
• Growing inequality of income and implications
  for consumer spending

9

• 1929 and after
• Stock market crash, 1929
• Massive wealth loss by 1933 about 80 of stock
  values gone
• Recession beginning in 1929 ordinary through
  1930 then the bottom falls out
• 25 unemployment rate by 1933 never under 10 in
  the 30s

10

• Real GDP fell by about 33 by 1933
• 80 of investment disappears, 1929-1933
• Over 40 of banks disappear-and no deposit
  insurance
• Recovery? Not until World War II

11

• What caused it? Why so deep, so long?
• Ordinary recession, 1929
• Expectations of normal recovery, 1930
• Massive bank failures
• Large decrease in money supply
• Deflation

12

• Effects on financial intermediation of deflation
• Decreases in borrower net worth (heavy debt
  burden)
• Increased risk to lenders
• Massive disruption of allocation of funds
• Investment collapse
• Effects long-lasting

13

• Fed fails the test
• Concern for maintaining the gold standard
• Not serve as lender of last resort
• Note 1935-36 contractionary policies
• Macroeconomic consequences of financial system
  failure, especially
• Large reductions in money supply
• Interference with intermediation process

14

• Decreased consumption, especially consumer
  durables
• Heavy debt burden from 1920s
• Uncertainty, due to stock market collapse
• Restrictions on international trade
  Smoot-Hawley tariff

15

• Political response the new Deal and its reforms
• Monetary already discussed
• Agricultural already discussed
• Industry, and the National Industrial Recovery
  Act
• Goal Reduce ruinous competition

16

• Raising prices to generate higher firm incomes,
  stimulating hiring-but is this backwards??
• In the end
• Declared unconstitutional
• Largely ineffective, in any case
• SEC and securities market regulation
• Social Security an income support mechanism
• Public works programs PWA WPA CCC
• Goals recovery and reform

17
KEYNESS CONTRIBUTION

• The General Theory of Employment, Interest, and
  Money as revolutionizing macroeconomics
• A response to the perceived failure of classical
  economics to explain the Depression
• Classical Presupposition Recessions
  self-correcting via operation of market forces

18

• Key role for wage, price, interest rate
  flexibility
• Says Law, and production occurring in order to
  obtain income for spending
• And yet . . .unemployment stayed over 10 in the
  U. S. for a decade

19

• Keyness diagnosis
• A potential problem with saving
• Primitive society saving (not consuming) as
  simultaneously an act of investing (spending)
• Industrial society will my saving automatically
  find its way into capital accumulation elsewhere
  in the system?
• Classical model yes, via falling interest rates

20

• Keynes maybe not, as investment occurs in
  response to favorable profit prospects
• Further investment is volatile, uncertain
  strongly affected by changeable expectations
• Implication some of income created by
  production process not necessarily find its way
  into new spending

21

• Overall problem may be thought of as a
  coordination failure
• Some initial shock decreases spending
• Firms constrained from hiring workers
• Incomes fall
• Households constrained from buying goods
• Problem who moves first to break the deadlock?

22

• A new framework aggregate demand/aggregate
  supply analysis
• Aggregate demand
• A way to talk about peoples spending plans in
  the aggregate
• Components
• Consumption
• Investment

23

• Government spending on goods and services
• Net exports ( exports - imports)
• Aggregate supply firms willingness to produce
  and sell output
• Economy-wide equilibrium occurs when AD AS

24

• The Great Depression? A collapse of aggregate
  demand
• Causes of such collapse? Still unclear! But
  emphases on a variety of possibilities
• Downward cumulative process worsened
  significantly by collapse of financial system,
  international trade

25

• Policy implications of the General Theory
  include a role for government in stabilizing the
  economy
• Monetary policy, and the central bank
• Fiscal policy
• Changes in government budget taxes spending
• May involve government deficits-which are not
  necessarily bad

26

• If aggregate demand too low, could be raised by
• Tax cuts
• Increased government spending
• Expansionary monetary policy (open-market
  purchases)
• If aggregate demand too high, do the opposite
• Was fiscal policy appropriate during the
  Depression?
• No scale too small
• Depression ended during wartime is war, then,
  good for the economy after all? No . . .

27
SUMMARY

• Keynes as changing the nature of the
  macroeconomic debate
• Whats left of his analysis?
• Focus on
• Aggregate demand as driving short-run
  fluctuations in economic activity
• Volatility of expectations, hence investment (and
  perhaps other) spending

28

• In the long run, the economy may well adjust
  automatically to full employment-but it may take
  considerable time
• Thus, there may be a role for stabilization
  policy on governments part
• Form of stabilization policy is still
  controversial, as is the speed of adjustment to
  full employment