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BUS327: Macroeconomics B

Lecture 3

Keynesian Neoclassical Synthesis

BUS360: Macroeconomics B: Lecture 3

J. M. Keynes, The General Theory of Employment, Interest and Money

To understand my new state of mind, however, you have to know that I believe myself to be writing a book on economic theory which will largely revolutionize not I suppose at once but in the course of the next ten years the way world thinks about economic problems. When my new theory has been duly assimilated and mixed with politics and feelings and passions, I cannot predict what the final upshot will be in its effect on action and affairs, but there will be a great change and in particular the Ricardian Foundations of Marxism will be knocked away.

I can’t expect you or anyone else to believe this at the present stage, but for myself I don’t merely hope what I say. In my own mind I am quite sure”.

(From J. M. Keynes’ letter to George Bernard Shaw)

BUS360: Macroeconomics B: Lecture 3

Introduction:

1930s – (early) 1970s: Keynesian Macroeconomics (KM): Dominant Paradigm.

Or, was it “a modernised version of pre-Keynesian classical system where Keynes’s policy suggestions for solving the unemployment problem were grafted on to the axiomatic foundations of neo-classical microeconomic theory”? (Stanley Jevons, Leon Walras, Carl Menger and Alfred Marshall)

1936, the year of the publication of Keynes’ General Theory (GT), was the YEAR ZERO OF MACROECONOMICS.

BUS360: Macroeconomics B: Lecture 3

To Samuelson, KM, “ the most significant event in twentieth-century economic science”.

To Hayek, Keynes was fundamentally mistaken.

To James Tobin (a Keynesian) GT was moderately conservative.

To Joan Robinson GT was a revolutionary break from mainstream classical and neoclassical doctrines.

One of the reasons for this difference and confusion is the very issue with which Keynes was concerned i.e., the effectiveness of market mechanism in generating a stable full-employment equilibrium without active government intervention.

An ongoing debate.

BUS360: Macroeconomics B: Lecture 3

Keynes’s Rejection of Classical Theory Axioms:

Money - more than medium of exchange and therefore not neutral. Money matters in both the long and short run. Money affects real decisions making, employment and output outcomes. Say’s Law does not represent real world economy.

Time prevents everything from happening at once.

Economic agents’ spending decisions of today will affect their economic circumstances in the future. (Nassim Nicholson Taleb, Black Swan, 2007)

Past and present market data will not necessarily provide correct signals regarding future outcomes.

BUS360: Macroeconomics B: Lecture 3

Contracts in money terms characterize entrepreneurial economies.

Entrepreneur’s decisions regarding production and employment depend on expectations of revenues (cash inflows) in excess of cost (cash outflows).

Since production and exchange in such economies is organised on a money contract basis, liquidity implies access to money to meet purchase and/or debt payments as they come due.

Uncertainty of future and unpredictability of cash flows over time make it sensible to demand and hold money and other liquid assets as precaution. Under Say’s Law since money is only the medium of exchange there is no rational need to hold money for liquidity purposes.

BUS360: Macroeconomics B: Lecture 3

Unemployment, rather than full employment is a normal outcome in any entrepreneurial, market-oriented, money-contract-using system in a laissez-faire environment.

National income and output depend on the volume of employment. (Does growth create jobs or jobs create growth?)

The principle of effective demand and changes in output rather than prices play a crucial role in maintaining equilibrium.

BUS360: Macroeconomics B: Lecture 3

The Effective Demand Principle:

The principle of effective demand states that in a closed economy with spare capacity the level of output (Y) is determined by the aggregate planned expenditure (E) which consists of two components, consumption expenditure from households (C) and investment expenditure from firms (I).

E = C + I

In the classical model consumption, saving and investment are all functions of the rate of interest (r). At equilibrium E must equal Y. Thus,

E = C(r) + I(r) = Y

(contd...)

BUS360: Macroeconomics B: Lecture 3

Since households do not automatically spend all their income another equation can be written as follows:

Y – C(r) = S(r)

Combining these two yields,

S(r) = I(r)

The higher is the rate of interest the more willing are savers to replace present consumption with future consumption. In the classical model r is the reward for abstinence or thrift.

In KM consumption is endogenous and essentially passive. It depends on income (Y) rather than on r; thus (C=f Y). Investment depends on the marginal efficiency of capital (I=f(MEC) which depends on the expected profitability of projects to be invested in.

(contd...)

BUS360: Macroeconomics B: Lecture 3

Thus, in KM employment depends on an unstable factor, investment expenditure. But because of large swings and great volatility investment expenditure is unstable.

Keynes therefore questioned the efficacy of interest rate adjustments as a way of influencing the volume of investment. Reduction in interest rate does not necessary increase investment.

(contd...)

BUS360: Macroeconomics B: Lecture 3

Keynesian Consumption Function:

The concept of marginal propensity to consume (mpc) plays a crucial role in determining the size of the multiplier and aggregate demand. Because of the importance of the multiplier any volatility in investment expenditure will have a magnified effect on aggregate demand.

mpc (c) = ∆C/ ∆Y and C = cY

Thus, Y = cY + I

Since, Y – cY = I and Y – cY = Y(1 - c)

Y = I (1/ 1-c)

1/ 1-c is the multiplier.

(contd...)

BUS360: Macroeconomics B: Lecture 3

Thus, ∆Y = ∆I (1/1-c)

Y changes by a multiple of the change in investment expenditure. The size of the multiplier depends on the value of c.

In an economy with spare capacity extra demand creates more output and employment.

Is there spare capacity in Australia’s economy? In OECD economies? (Students to think)

BUS360: Macroeconomics B: Lecture 3

Keynes’ Rejection of the Classical Theory of Interest:

The classical idea that interest rate is determined by thrift, abstinence, and the marginal productivity of capital was rejected by Keynes

Interest rate is purely a monetary phenomenon determined by the supply of money by the monetary authorities and peoples’ liquidity preferences.

To the classical transactionary motive for holding money Keynes added the precautionary and speculative motives (Diagram 3.1). If liquidity preference can vary depending on the confidence of the public and the supply of money then the velocity of circulation in the quantity theory of money is also liable to vary. Therefore V is not constant in the short run.

(contd...)

BUS360: Macroeconomics B: Lecture 3

Speculative demand for money

Diagram 3.1

An uncertain future makes investment unstable and the same uncertainty varies liquidity preferences. Thus the classical notion of neutrality of quantity theory of money is rejected. An increase in money supply by reducing the rate of interest can stimulate aggregate spending via an increase in investment and the subsequent multiplier (see attached model).

BUS360: Macroeconomics B: Lecture 3

Aggregate Output and Employment

Aggregate Planned Expenditure – Effective Demand

Government Expenditure

Household

Consumer Expenditure

Business

Investment Expenditure

Tax Policies

Rate of Interest

Business Expectations and The Marginal Efficiency of capital

Money Supply

Uncertainty

The Demand for Money – Liquidity Preference

The determination of output and employment

Keynes and the labour market:

To Keynes labour market does not always operate at the market clearing level.

There can be involuntary unemployment because of rigidity of money wages.

Suppose while the economy is at full employment and labour market operates at market clearing level, AD experiences a negative shock while prices remain flexible. This means price will fall which will increase the real wage and that will create a fall in demand for labour, which will lead to involuntary unemployment. Keynes’ solution to this problem is not cutting money wage but pressurising price to rise by increasing aggregate demand.

BUS360: Macroeconomics B: Lecture 3

Interpretations of Keynes

Hydraulic interpretation: (Allan Coddington: Hydraulic Keynesianism – “conceiving the economy at aggregate level in terms of disembodied and homogenous flows”)

The IS-LM model is the backbone of this orthodox approach developed by J.R. Hicks, Modigliani, Klein, Samuelson, and Hansen. Samuelson’s text book introduced the Keynesian Cross which popularised Keynesian economics among economics students and teachers. This approach failed however, to explain the reasons for wage and price rigidities.

Fundamentalist approach:

This approach regards the influence of unstable expectations due to uncertainty as the key feature of Keynesian economics. George Shackle and Joan Robinson are the leading lights of this approach.

(contd...)

BUS360: Macroeconomics B: Lecture 3

The modified general equilibrium approach:

Don Israel Patinkin (Chicago) analysed Keynesian contribution and called it the economics of unemployment disequilibrium and that involuntary unemployment should be viewed as a problem of dynamic disequilibrium. Patinkin’s emphasis on the speed with which markets are able to absorb and rectify shocks shifted attention away from the degree of price and wage rigidities to the issue of coordination.

BUS360: Macroeconomics B: Lecture 3

The IS-LM Model

IS curve:

The IS-LM model (Diagram 3.2) became the established model for macroeconomic theorizing and had tremendous influence over macroeconomic policy until the mid 1960s.In this model the IS curve relates to the goods market. Equilibrium in the goods market occurs when aggregate demand equals aggregate supply. In a closed economy

AD = C + I + G. In the orthodox Keynesian model employment and output are determined entirely by AD and supply constraints are ignored. C depends on disposable income, I is the function of r and G is exogenously determined. The IS curve is the locus of interest rates and income associated with equilibrium in the goods market. It is downward sloping because I is inversely related to r .

(contd...)

BUS360: Macroeconomics B: Lecture 3

Diagram 3.2

ISLM Model

The slope will be steeper the slower the response of I to changes in r and smaller is the value of the multiplier. It will be flatter the larger is the response and greater the value of the multiplier . If investment is perfectly inelastic to r the IS curve will be a vertical straight line (a limiting case).

The IS curve is drawn for a given level of G, taxations and expectations, so that an expansionary fiscal policy shifts the IS curve to the right and vice versa.

(For the derivation of and shifts in the IS curve students are advised to consult any second year macroeconomics textbook).

The LM curve:

This relates to the money market and equilibrium in the money market occurs when demand for money (MD) and supply of money (MS) are equal.

(contd...)

BUS360: Macroeconomics B: Lecture 3

MS is exogenously determined and MD has three components: transactions, precautionary and speculative. The last of these is sensitive to interest rates and is inversely related. The higher the current level of rate of interest the less is the demand for speculative balances and vice versa. There is also a theoretical possibility that, at low level of interest rates the demand for money could become perfectly elastic with respect to the rate of interest and the demand curve for money takes a horizontal shape (Diagram 3.1). At r* everyone expects that the future course of movement for interest rate is to go upwards, the demand for money becomes perfectly interest-elastic. Keynes called this a “liquidity trap”.

The LM curve is a locus of combinations of interest rates and income associated with equilibrium on money market.

(contd....)

BUS360: Macroeconomics B: Lecture 3

Given the assumption that the demand for money is positively related to income and negatively related to interest rate, the LM curve is upward sloping. As income rises the transactions and precautionary demand for money increases which, given the supply of money, necessitates a higher rate of interest to reduce the speculative demand and maintain equilibrium in the money market. The slope of the curve depends on the income elasticity and interest elasticity of MD. The curve will be steeper the higher the income elasticity and smaller the interest elasticity of the demand for money. It will be flatter the smaller the income elasticity and greater the interest elasticity of the demand for money (For the derivation of and shifts in the LM curve students are advised to consult any second year macroeconomics textbook). The generalised IS-LM model is shown in Diagram 3.2.

(contd...)

BUS360: Macroeconomics B: Lecture 3

Equilibrium in both the goods and money markets is simultaneously attained where IS and LM curves intersect, that is at reYe .

The intersection of the two curves represents the only values of r and Y which is consistent with equilibrium in both markets. And, if the level of income is below full employment then both fiscal and monetary policies have a potentially important role to bring back macroeconomic stability. Orthodox Keynesianism relied heavily on the effectiveness of fiscal policy in macroeconomic management.

This was challenged by the monetarists, among others, who argue that in the long run pure fiscal expansion (i.e., expansion without any accommodating changes in the money

(contd...)

BUS360: Macroeconomics B: Lecture 3

supply) will result in crowding out or replacement of components of private expenditure with relatively minor effects on AD, the level of income and employment. Keynesian response to this attack was to bring in the wealth effects of a bond-financed increase in government expenditure (Diagram 3.3).

The lower panel in the diagram shows the government budget and taxes. At Y0 goods and money markets are in equilibrium and the budget is balanced (G0 = T). Suppose the government wants to increase income and employment by increasing G. This will shift the IS to IS1 and the G to G1. At Y1 there is a budget deficit equal to AB. As long as the deficit persists the treasury has to issue more bonds, which will lead to an increase in private sector wealth (owing to increased bond holdings), an increase in private consumption expenditure and increase in demand for money.

(contd...)

BUS360: Macroeconomics B: Lecture 3

IS0

G , T

IS1

Diagram 3.3

The Government budget constraint and bond-financed fiscal expansion

If the wealth effect on consumption, which shifts the IS curve further to the right, outweighs that on the demand for money, which shifts the LM curve upwards to the right, (as indicated by the arrows) then in the long run bond-financed fiscal expansion will result in income increasing to Y2, where the deficit will be removed. The crowding-out effect will be absent. Thus the incorporation of the wealth effect and the government budget constraint into the IS-LM model makes a bond-financed increase in G potentially very effective in raising income and employment.

BUS360: Macroeconomics B: Lecture 3

Underemployment Equilibrium in the Keynesian Model

Within the IS-LM model underemployment equilibrium can occur because of money wage and interest rate rigidities. Keynesian assumption of downward rigidity of money wages is demonstrated in Diagram 3.4. Quadrant a is IS-LM model, c shows short run production function (with given technology and capital stock) depicting that output depends on employment, b shows supply of and demand for labour depends positively/negatively on real wages, and d shows equality between the two axes through a 450 line. Suppose the economy is at an initial equilibrium E0 in ‘a’ but income Y is below full employment level. Quadrant ‘b’ reveals that with a fixed money wage W0 (set exogenously) and price level consistent with equilibrium in the money market (i.e., the LM0 curve) the resultant real wage W/P0 is inconsistent with labour market clearing level (SL > DL). The excess supply of labour has no effect on money wages and the economy is at equilibrium with persistent unemployment. (contd...)

BUS360: Macroeconomics B: Lecture 3

LM1

LM0

450

W/P

(W/P)0

(W/P)1

(a)

(b)

(c)

(d)

Diagram 3.4

The general case with Keynesian Effect

If we now introduce the classical assumption of flexible wages and prices what will be the effect on underemployment equilibrium? With excess supply of labour wages will fall, and as wages fall employer’s cost of production falls and therefore price falls. With falling prices the real value of MS increases causing the LM curve to shift to the right to LM1. Excess real money balances are then channelled to the bond market which bids up the bond prices and reduces interest rate. Falling rate of interest stimulates investment and increases AD. The increase in AD moderates the fall in prices so that as money wages fall at a faster rate than prices the real wage falls towards its market clearing level leading to full employment. The indirect effect of falling money wages and prices which stimulates spending via interest rate is called the Keynes effect. W and P will continue to fall and the LM curve will continue to the right until full employment is reached at equilibrium E1. What is important here is that it is the increase in AD, via the Keynes effect that ensures the return to full employment.

BUS360: Macroeconomics B: Lecture 3

However, there are two limiting cases which make self equilibrating at full employment impossible even with flexible money wages and prices. These cases are:

The liquidity trap, and

interest- inelastic investment.

Diagrams 3.5 and 3.6 demonstrate this.

Diagram 3.5 explains the liquidity trap case. Although there is equilibrium in both markets at E0 the income level Y0 is below full employment level YF with real wages (W/P)0 is above the market clearing level (W/P)1. Excess supply of labour reduces money wages which through fall in cost of production reduces prices and increases the real value of MS. But the excess real balances are entirely absorbed by the idle or speculative balances. This means there will not be a flow on to the bond market to reduce rate of interest in order to induce

(contd...)

BUS360: Macroeconomics B: Lecture 3

LM0

LM1

IS0

IS1

W/P

(W/P)1

(W/P)0

Diagram 3.5

The Liquidity Trap Case

investment expenditure, increase AD and restore full employment. With no increase in AD to moderate the rate of fall in prices, prices fall proportionately to the fall in money wages and real wages remain at W/P0 above their market clearing level W/P1. There is persistent involuntary unemployment and monetary policy remains ineffective to restore full employment.

Diagram 3.6 explains the interest-inelastic investment case.

Let the economy be in equilibrium at E0 where IS and LM intersect and output Y0 which is less than full employment output YF. This means the level of employment L0 in panel b is less than full employment level LF with real wages W/P0 > W/P2 (market clearing level). The excess supply of labour results in falling money wages and prices. Although the

(contd...)

BUS360: Macroeconomics B: Lecture 3

W/P

450

IS0

LM1

LM0

(W/P)2

(W/P)1

(W/P)0

Diagram 3.6

Interest – inelastic Investment Case

(a)

(b)

(c)

(d)

Increase in real balances (which shifts LM0 to LM1) through the Keynes effect results in reduction in the rate of interest, the fall in that rate is insufficient to restore full employment. With investment expenditure is so interest-inelastic, full employment equilibrium could only be restored through the Keynes effect with a negative rate of interest at r1. Theoretically therefore the economy will come to rest at E1 with persistent involuntary unemployment.

Problems with Keynesianism:

All these interpretations however could not still explain the determinants of the levels of absolute price and money wages. In contrast, the classical’s Quantity Theory of money enabled proponents of the classical view to pin down the

(contd...)

BUS360: Macroeconomics B: Lecture 3

absolute price level, and this, together with a knowledge of the full employment wage rate, ω, made the money wage rate a determined variable.

Since money supply is fixed at P, and therefore W/P (ω) is determined at its full employment value through the forces of competition in the labour market, the equilibrium value of W could be determined. No such claims for the Keynesian model.

It was in the late 1950s that A. W. Phillips put forward an ingenious machine (Hydraulic Keynesianism) which demonstrated the functioning of macro-economy by using various dyed liquids to represent different income and expenditure flows and the factors which influenced these flows.

BUS360: Macroeconomics B: Lecture 3