The Keynesian School

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The Keynesian School

• John Maynard Keynes

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The Keynesian Revolution

• The Keynesian revolution was a reaction against
  both classical and neoclassical economics.
• Keynes aimed his big guns at AC Pigous revised
  and updated version of classical economics.
• He all but destroyed the Quantity Theory of
  Money.
• He turned Says Law on its head. He emphasized
  the demand side to the exclusion of the supply
  side.
• Keynes lumped all previous writers
  togethercalled them classicals.
• This makes some sense in that he did not argue
  with the micro portionin fact, he largely
  ignored it.

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The Keynesian Revolution

• Keynes directed his attack against AC Pigous
  more modern version of the Macroeconomic model,
  not Adam Smiths version.
• The Keynesian Revolution all but destroyed
  classical economics.
• i.e., it destroyed the macro part of neoclassical
  economics.
• It left intact the micro portion.
• Keynesian revolution was so overwhelming that at
  one point Richard Nixon said, We are all
  Keynesians now!

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Historical Background

• Keynes was part of the emerging trend toward
  macroeconomics.
• In fact, the term macroeconomics did not exist
  until 1933 when it was first used by Norwegian
  economist, Robert Frisch.
• The Great Depression and the secular stagnation
  of the 1930s gave root to Keyness thinking.
• Many others had similar ideas before Keynes, but
  he introduced a unique analytical framework.
• Many others criticize the failings of classical
  economics, but no one could offer an
  alternative.
• Keynes did!

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Major Tenants

• Macroeconomic emphasis aggregate consumption,
  saving, investment, output, and employment.
• Demand Orientation stressed effective demandhe
  introduced the idea of inadequate aggregate
  demand.
• Instability in the economy recurring booms and
  busts.
• Wage and price rigidity wages tend to be
  inflexible downward.
• Active monetary and fiscal policy government
  intervention necessary to maintain adequate
  demand.

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What is Classical Economics?

• Keynes was a product of the neoclassical school.
• He was sharply critical of his old teacher,
  Pigou, although he was steeped in the Marshallian
  tradition.
• Together with Ricardian doctrines, Keynes lumped
  certain aspects of neoclassical economicsmainly
  its macroeconomics partinto a system which he
  called Classical Economics.
• He used many of the neoclassical toolsmarginal
  concepts, static equilibrium, etc.
• He was not critical of the neoclassical theory of
  value and distribution, i.e., microeconomics.

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Whom did the Keynesian school seek to benefit?

• Almost everyone
• Society as a whole
• Laboremphasis on job creation.
• Business.
• Banks.
• Reformers and intellectuals.
• Farmers.
• Dealt with unemployment and depression, main
  issue of the times.

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How was it valid, useful, or correct at its time?

• He geared economic theory to policy making.
• He rejected Says Lawturned it on its
  heademphasized the demand side.
• He provided an explanation of fluctuations in the
  economystressed the inherent instability of the
  economygave us a program to mitigate the
  problem.
• He gave us a new set on analytical tools to
  analyze the aggregate economy.

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Lasting Contributions

• Consumption Function marginal propensity to
  consume.
• Saving function marginal propensity to save.
• Marginal efficiency of capital.
• Liquidity Preference transaction, precautionary,
  speculative demand.
• Multiplier.
• Fiscal and Monetary policy.
• IS-LM analysis (Keynesian, not Keynes).

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Lasting Contributions(continued)

• Many of the Keynesian policy prescriptions have
  been discredited, but Keynesian tools of analysis
  still dominate macroeconomic theory.
• He demonstrated the inadequacies of Classical
  economics, and in the process established a
  system that is not, itself, without flaws.
• The importance of his contribution is not its
  correctness, but its role in advancing the
  debatein stimulating the argument and in
  providing the framework for that debate.

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Biographical Information

• Born 1883. Died 1946.
• Eminently intellectual parents.
• Father, John Neville Keynes, logician and
  political economist.
• Student of Marshall and Pigou.
• Financial whiz. Made a fortune in foreign
  currencies and commoditieslost it, then made it
  back.
• Had a practical as well as an academic side.

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Biographical Information(continued)

• He was a businessman, a government bureaucrat, a
  scholar, a connoisseur and supporter of the arts.
• Had lots of trendy friends.
• He represented the British Treasury at the Treaty
  of Versailleswas appalled at the conditions of
  the peace treaty wrote, The Economic
  Consequences of the Peace.
• Instrumental in organizing the International
  Monetary Fund and the International Bank for
  Reconstruction and Development.

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Keynesian System

• An explicit theory of aggregate demand.
• Consumption Function.
• saving function.
• marginal propensities to consume and save.
• Investment.
• marginal efficiency of capital.
• rate of interest.
• Role of Government.
• Equilibrium income and employment.

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Keynesian System (Continued)

• Liquidity Preference.
• Depends on three motives
• transaction motive.
• precautionary motive.
• speculative motive.
• Motives create a downward sloping curvenegative
  slope due to lower interest rates causing a
  desire to hold money.
• Liquidity Trap.

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Consumption Function

• Income and consumption expenditures are
  positively related, the slope of the consumption
  function is the MPC.
• People will increase consumption and saving, if
  their income goes up (positive relationship) C
  f(Y) . . . . S f(Y).
• MPC change in C/change in Y value less than
  1.
• MPS change in S/change in Y value 1 MPC.

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Investing

• Economic investingnot same as financial
  investing.
• Investinglook at prospective returns.
• Productivity.
• price firm can sell output for.
• added wage and expense due to capital.
• Look at supply price (replacement cost).
• Marginal efficiency of capital.
• highly variable (result of peoples
  expectations).
• expected profits decline with increase in supply.
• pressure on facilities cause supply price to rise.

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Investing

• To make this a little clearer level of
  investment in the economy is a result of
• the marginal efficiency of capital, and
• the market rate of interest.
• Keynes rejected the Classical and Neoclassical
  idea that the rate of interest will automatically
  balance saving and investment, i.e., that the
  market will be automatically cleared.
• Saving depends on income investment depends on
  interest and marginal efficiency of capital. Is
  there any reason to believe they would be
  automatically equal.

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Interest

• Keynes felt interest was a reward for sacrificing
  liquidity.
• Rate of interest depended on liquidity preference
  and the quantity of money.
• Market interest rate is the price that equates a
  persons desire to hold wealth in cash with the
  available quantity of cash in the system.
• demand for money.
• supply of money.

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Equilibrium Income Employment

• Keynes assumed a high correlation between the
  twobut this in not necessarily true.
• Keynes focused on the short runin the long run
  we are all dead.
• Level of income determines the level of
  employment, and visa-versa
• Y C I G
• Y C S T
• Therefore I G S T i.e., (injections
  leakages).

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Policies to Promote full Employment and Stability

• Role of government.
• Active government intervention
• Monetary policy not all too effective due to
  liquidity trap.
• Fiscal policymore effective.
• Problem arises when society becomes richer the
  more it saves, the more difficult it is to stay
  at full employmentinadequate aggregate demand
• Thus, must use government to stimulate aggregate
  demand.

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Criticisms

• Short run static thinking.
• Neglected the supply side.
• Neglected the output effect on interest rates.
• This shortcoming was seen by other thinkersJR
  Hicks and Alvin Hansen.
• They developed the Hicks/Hansen IS/LM model to
  incorporate interest rates.
• His bonds vs money choice for holding assets was
  too narrow.
• Ideas sometimes promoted wasteful government.

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The Stockholm SchoolA footnote

• Based on Wicksell, Stockholm School mirrored and
  even anticipated Keynes.
• Gunnar Myrdal drew a distinction between ex ante
  and ex post.
• Ex Ante forward looking investment, saving, and
  investment planned for a future period.
• Ex Post already been realized and can be used
  for statistical records.
• To explain fluctuations, must think ex antewhat
  savers and investors plan to do.

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The Keynesian School

• The Keynesians

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The KeynesiansWho were they?

• Alvin H. Hansen
• Abba P. Lerner
• Paul A. Samuelson
• Post Keynesians
• New Keynesian

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Alvin H. HansenBackground

• American economist (1887-1975).
• Published Business Cycle Theory in 1927.
• Didnt initially like Keyness ideas, but changed
  his mind.
• Had many prominent students
• Some called him The American Keynes.
• Huge international influence.

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Hansens Contributions

• The Hicks-Hansen synthesis (IS/LM).
• IS curve represents possible points of
  equilibrium in goods market.
• LM curve shows potential points of equilibrium in
  the money market.
• Combine these 2 to find where goods money
  markets are both in equilibrium.
• Conclusions fiscal policy shifts the IS curve
  monetary policy shifts the LM curve.

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Hansens Contributions(continued)

• Stagnation Thesis
• Shared Keynes concern about investment spending.
• Thought production increased with new capital and
  improved technology to keep up, investment
  spending must grow.
• Thought population was not growing fast enough,
  improved technology only came in spurts, and no
  new industries meant increased investment
  spending was not likelynot as pessimistic as
  Malthus.
• Government could overcome this through
  compensatory financeconcern seems unfounded.

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Abba P. Lerner

• 1903-1982 Born in Russia, raised in London.
• Student of Hicks at London School of Economics.
• Moved to US in 1939 taught at UVA, among other
  places.
• Thinking went through many transitions.
• Started as a socialist when he entered the London
  School.
• Left the London School as a neoclassical
  economists.
• After the General Theory, he became an avowed
  Keynesian.

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Lerners Contributions

• The Lerner Index
• Stated his index of monopoly power in a 1934
  article.
• It varies between 1 0 higher valuesgreater
  monopoly power pure monopoly 1 pure comp 0.
• Extended monopoly theory by focusing on degrees.
• Shows how monopoly violates PMC condition of
  economic efficiency.
• Theory of Keynesian Functional Finance
• economy as a car with no steering wheel analogy.
• to prevent this we should put in a steering wheel
  in form of fiscal and monetary policies.

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Lerners Contributions(Continued)

• Three rules of Keynesian Functional Finance
• Adjust government spending taxation so that
  aggregate demand in the economy is just
  sufficient to purchase the full-employment level
  of output at current prices.
• Borrow money or repay national debt only if it is
  desirable to change the rate of interest.
• Place into circulation / withdraw from
  circulation the amount of money required to
  reconcile the policies undertaken to adhere to
  laws 1 2.

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Lerners Contributions(Continued)

• Sellers Inflation
• 2 types of inflation.
• government can control buyers inflation
  (demand-pull).
• sellers inflation (cost-push).
• owners of factors of production make claims on
  income that exceed total real value of output.
• Lerners solution was for government to institute
  wage price policy.
• Buzzword - Incomes Policy!

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Lerners Contributions(Continued)

• Sellers Inflation (continued).
• 2 different ways to control sellers inflation.
• Limit average annual wage increase in the economy
  to nations annual rate of productivity growth.
• Issue anti-inflationary credits so the firm
  would have to pay the agency when they want to
  raise price.

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Paul A. Samuelson1915-

• Born in Chicago to Polish immigrants.
• B.A. from University of Chicago.
• Enrolled at Harvard in economics program
• 1970-won Nobel Prize.
• Published Economics- 14th ed. in 1992.

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Multiplier-Accelerator Interaction

• Idea is largely discredited today.
• Accelerator based on the relation between
  investment and rate of income growth.
• MPC determines multiplier.
• Samuelson used his mathematical prowess to show
  relationship between multiplier and the
  accelerator.
• Showed, mathematically, that multiplier,
  accelerator interaction could produce business
  cyclescould produce instability.

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Simple Algebra of Income Determination

• Samuelson invented the Keynesian Cross diagram.
• Developed the simple algebra of the multiplier.
• Very similar to the way we do it today.
• See example on pages 458-460.

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Phillips Curve

• Relationship between unemployment and rate of
  change of prices.
• Used this curve to depict US economy.
• Most important concept of our time.
• Established the notion of a tradeoff between
  inflation and unemployment.
• The decades of the 70s and 80s established that
  the Phillips curve can shiftthereby negating the
  idea of a tradeoff.

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Paul A. Samuelson(Other Contributions)

• Comparative staticsmethod still used today.
• Revealed preference theorycan tell what the
  consumer prefers by watching what he does.
• Efficient markets theorymarket price already
  incorporates all available information.
• Factor-price equalization theorymathematical
  proof of product mobility.
• Public expenditures theoryimportant contribution
  to the definition of public goods and
  externalities.

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Post-Keynesians

• Keynesian principles of macroeconomics, grafted
  onto neoclassical value and distribution theory
  make up the conventional wisdom in economics.
• Post-Keynesians do not accept this synthesis.
• They reject IS/LM analysis and standard
  microeconomics.
• They draw heavily on Michael Kalecki, a Polish
  economist who developed a Keynesian-like model of
  employment prior to The General Theory.
• Small groupmostly English.

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Post-Keynesians Major Tenets

• Neo-Ricardian view of production, value, and
  distribution.
• level of domestic output is entirely independent
  of how it is distributed between wages and
  profits.
• Possible for society to control the distribution
  of income.
• This is fairly left-wing thinking.
• Mark-up pricing.
• Pricing is based on oligopolistic forces.
• Prices do not reflect demand conditions.

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Post-Keynesians Major Tenets(continued)

• Endogenous money.
• Not an exogenous variable.
• Money supply changes in response to changes in
  wages.
• Inflation arises over the fight for shares of
  income.
• Pronounced cyclical instability.
• Even more so than Keynesians would believe.
• Need for an income policy.
• Remember Learner?
• Promoters of class struggleneed for a permanent
  incomes policy.
• See quote, p 466.

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The New Keynesians

• This group rejects neo-Ricardian theory of the
  Post-Keynesians.
• They reject incomes policies.
• They believe the problem lies in downward price
  and wage inflexibility.
• They believe that active monetary and fiscal
  policies are necessary to overcome the
  unemployment caused by the stickiness.
• See Figure 22-6 on page 467.

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The New Keynesians(continued)

• Explanations for downward price and wage
  inflexibility.
• Menu costs.
• Formal and implicit contracts.
• Efficiency wages.
• Insider-outsider theory.
• Is it possible to build an entire theory of the
  supposed stickiness of prices and wages?
• Should they perhaps consider ways to make wages
  and prices less sticky?

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Conclusion

• Keynesianism is not dead. It is alive and
  wellat least in the hearts and minds of the post
  and new Keynesians.
• By the same token, Marxism is not dead - there
  are still a few die-hard Marxists around.
• Keynesian tools have outlasted Keynesian policy
  prescriptions. In that sense, maybe, Were all
  Keynesians now.

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Conclusion(continued)

• The conventional wisdom is somehow a mix of
  Keynesianism, Monetarism, Neoclassicism, and
  Duncanism.
• Who said Hegel is Dead?

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John Maynard Keynes and the Keynesians

• Any Questions?