Economics essay

ECON 1110 Intermediate Macroeconomics

James R. Maloy

Spring 2020

Lecture Notes for Topic 5: Keynesian Macroeconomics (I)

Readings: Froyen Ch. 5 (8th Ed. Ch. 6)

I. The Foundations of the Keynesian Revolution

The Great Depression of the 1930s and the enormous long-term persistency of high unemployment and low output could not be explained by the classical model. In the classical framework, recessions were possible but were expected to be of relatively short duration and would correct themselves. A depression that lasted for years with no sign of recovery was unfathomable. According to the classical model, output was entirely determined by supply factors, and no change in aggregate demand, and no government policy, could be effectively used to alleviate the problems. Indeed, many of the policies undertaken at the time, such as tax and tariff increases, were exactly opposite of those we typically expect to see from government policy in a recession. For example, governments at the time faced falling tax revenues due to the high level of unemployment. To close the resulting budget deficit, governments raised taxes. Under the classical analysis, such tax increases should not affect the economy, but in reality caused great harm. Indeed, it is generally agreed that governmental mistakes greatly lengthened the Depression. However, we shall see in this course that there is considerable disagreement on precisely what was wrong about these policies and what (if anything) should have been done instead.

The fundamental problem was that the assumptions of the classical model were not realistic in describing the state of the US economy in that period. Two main approaches emerged. One, espoused by some such as Mises, centered on interferences with market mechanisms that prevented efficient, market-clearing outcomes. These arguments varied but typically centered on market imperfections and interventionist policies in the 1920s that created an economic bubble, which collapsed in the 1930s, which were in turn made worse by more interventionist policies. These ideas argued that markets work properly but the conditions for them to do so were impeded during this entire time period, such as by rampant expansionary monetary policy in the 1920s or Hoover's policies on preventing wage cuts in the misguided belief that high wages cause prosperity.

An alternative approach centered on free markets being fundamentally inefficient. Some were fundamental criticisms of the system, such as Marxism or economic fascism (corporatism), the latter of which was proposed by Mussolini as a "third way" between the extremes of capitalism and communism, and was a major influence on Hoover and FDR's market intervention policies. Many of these types of communist and corporatist policies involve micro-level intervention, e.g. controlling production, wages, etc. (often via government-managed cartels) in individual firms or industries.

Keynes too looked at markets and viewed them as fundamentally inefficient, but developed a radical new way of looking at the problem. Rather than focusing on micro-management of individual industries, he proposed macro-management that focused on macro aggregates without consideration for what was actually being done at the micro level. This is simultaneously a strong point and weak point of his model. He correctly noted a fundamental flaw of micro-intervention that has led to extreme inefficiency and eventual collapse of all such attempts: lack of information. Central planning of micro-level production decisions requires an amount of information and co-ordination that simply does not exist. For example, if you order your automobile industry to produce a certain amount of cars, you must ensure that all industries that produce components such as steel or tires also produce the correct amount. One of the key strengths of private markets is that efficiency does not require much information: all that you need to know are your own costs and revenues. If there is a shortage of tires, the price will rise and supply will follow!

Heavily influenced by mercantilism , he argued that aggregate demand, not aggregate supply, was the factor that determined output. He asserted that the Depression was the result of aggregate demand being too low; the economy had become stuck in a sub-optimal equilibrium with low demand causing low production, which in turn causes low levels of employment, which of course leads to low demand. At a micro level this behavior was optimal: if you own a firm and no one is buying your product, the optimal strategy is to lay off workers and cut back production. However, at a macro level this leads to poor economic outcomes, contradicting the classical view that micro optimality leads to macro optimality. He argued for a positive role for government to intervene in markets: to ensure that aggregate demand was sufficient to achieve full employment levels of production. Essentially, this is macro-planning: the job of the government is to ensure that total demand is at a sufficient level, but let the private sector decide which products are actually produced. This reduces the inefficiencies of micro-planning; Keynes recognised that the private sector, not the government policymaker, was best placed to make individual production decisions. However, this strength is also a weakness: his model therefore does not distinguish between $1tn on infrastructure such as roads and rail and $1tn on worthless gadgets at Walmart. Indeed, Keynes wrote that in the extreme, a government could create the necessary aggregate demand by burying a big pile of money and then letting the private sector decide how to dig it back out again. In reality, the long-run effects are very much dependent on what is bought-and how it is paid for, e.g. borrowing the money and then burying it, which leaves future generations with a bill for the $1tn that was buried. Keynes ignored these long-run effects; his model was a short-run model and only was concerned about the jobs created today by burying money, not the long-run effects of such a blatant misallocation of scarce resources. This is a key problem: Keynesians argue that these policies are socially optimal but do not properly account for long-run costs and benefits in their analysis.

Keynes' model was fundamentally a disequilibrium model designed to explain how the economy operates when it is not in the full-employment classical equilibrium. He did not really argue that the classical model was "wrong"--he argued that it was a special case of the economy operating the way we'd like it to behave, i.e. the ideal state, akin to the physics assumption of being in a vacuum. However, he argued that this special case was not realistic as the real world was not characterized by perfect information and fully flexible wages and prices. This is expressed in the title of his General Theory: how the economy operates in general, such as during the disequilibrium that classical economists largely ignored as a transitory, self-correcting event, or times when the economy is in an equilibrium, but it is a sub-optimal one. He and his followers produced a model that made aggregate demand the major determinant of output, and argued that aggregate demand was not stable and required government intervention to stabilise it.

It is interesting to note Keynes' rationale for his new model. As one observer of economic thought put it: "The liberal capitalism of the modern age, which Smith had heralded, whose victory Ricardo had proclaimed, and which Marx sought to destroy, was transformed by Keynes and given a new life." During the apparent collapse of capitalism during the 1930's and greater adherence to communist and fascist ideology (although there is some debate about what Keynes actually thought of fascist economics), Keynes decided that his task was to save capitalism--although some opponents of Keynes argue that his system actually destroys it . Keynes was most closely associated with the old UK liberal party, which was mostly centrist, and was not a proponent of socialism/communism/fascism.

The model considered here is VERY incomplete and is not remotely realistic. In the next topic, we will add the effects of money and interest rates. In later topics, we will also look at the role of aggregate supply. For now, we assume that there is no money or interest, prices are constant and the quantity of output demanded will be supplied at that price (e.g. a horizontal AS curve at that price level). In the Keynesian model demand determines output, not supply.

II. Conditions for Equilibrium in the Simple Keynesian Model

The simple Keynesian model hypothesised that equilibrium required aggregate supply (output, Y) to be equal to aggregate demand (E).

Y = E

Assuming that the economy is closed with no imports or exports, aggregate demand (E) consists of three components: consumption (C), investment (I), and government purchases (G). So in equilibrium we have:

Y = C + I + G

Recalling some of the simplification to national income accounts discussed in the first week of lectures, we know that we can define Y as both national income and national product. Defining Y as national product implies that:

Y ≡ C + Ir + G

where Ir is realised, or actual, investment. The difference between realised and planned investment (I) lies in the inventory component of investment. A firm will plan to have a certain quantity of goods in inventory at the end of the year, but unexpectedly high or low sales may leave them with more or less inventory than the management had planned.

So in equilibrium, it must be that:

C + I + G = Y ≡ C + Ir + G

Or that there are no unplanned changes in inventories:

I = Ir

Now defining Y as national income implies that:

Y ≡ C + S + T

since national income is divided among consumption, savings, and taxes.

Therefore, in equilibrium:

C + I + G = Y ≡ C + S + T

Simplifying gives another way to state equilibrium for the model:

I + G = S + T

So the three ways of stating equilibrium are:

Y = E = C + I + G (aggregate demand equals aggregate supply)

I + G = S + T (government spending and investment must be paid for by savings and taxes)

I = Ir (no unexpected changes in inventory)

Note that in this model it is aggregate demand (C + I + G) driving aggregate supply—the reverse of the Classical model and Say’s Law. Unlike the classical theory, aggregate demand in Keynes’ model is neither neutral nor stable. Keynes therefore had to throw out the entire classical model—the vertical AS curve which leads to AD shocks affecting only prices, as well as classical demand theory—the loanable funds framework and the quantity theory of money. Keynes’ attack centered on the role of interest rates in creating the self-balancing and stable classical aggregate demand curve as well as the stability of velocity in the quantity theory. Much of this will be covered in later topics—right now, we will start by analyzing the factors that drive consumption, investment and government spending as a starting place to understanding Keynesian AD theory.

III. The Components of Aggregate Demand

Again, assume a closed economy with no imports or exports.

Consumption:

Unlike classical loanable funds theory which argued that interest rates drove savings and consumption, Keynes argued that consumer expenditures was a stable function of disposable income, where disposable income (YD) is the difference between national income and taxes (Y – T). Keynes proposed the following consumption function:

C = a + b YD a > 0, 0 < b < 1

Or:

C = a + b(Y – T)

The intercept a is autonomous consumption (the amount people would consume if they had no income), and b is the slope of the consumption function, or the marginal propensity to consume (MPC). It gives the percentage of a change in disposable income that will go toward consumption. The MPC can be defined as the derivative of the consumption function with respect to disposable income (dC/dYD).

The Saving Function

Recall that disposable income can be divided into consumption or savings:

YD = Y – T = C + S

Or

S = YD – C

Substituting for C yields:

S = YD – (a + b YD)

S = -a + (1 – b)YD

Why is the intercept of the savings function (-a)? Because remember that if disposable income is zero, consumption is a. So people are therefore dissaving a, and saving is negative at zero income. As disposable income increases, we eventually reach a point where people earn enough to stop borrowing and start saving.

The Keynesian consumption function was a direct result of Keynes' view of the psychology of the consumer from the General Theory:

The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.

The Keynesian consumption function therefore does not show a proportional relationship between consumption and income because of the autonomous consumption (a) term. The ratio of consumption to income is given by the average propensity to consume (APC):