Keynesian Economics

Question 1

Classical theory of the labour market

Answer 1

unemployment if real wage too high

real wage/price level must fall and it will to reduce unemployment

Question 2

19th century facts didn’t contradict classical theory

Answer 2

higher periods of unemployment explained by the trade cycle

1920-39 - unemployment persistently high

persistent unemployment must be because something is keeping up w/p artificially high - trade unions the scapegoat

Question 3

Policy leaves classical theory behind

Answer 3

note contrast between:

1) implications of orthodox theory (cut wages, policies to weaken TU’s)

and 2) actual policies recommenced by most orthodox theorists

• A.C Pigou: proposing almost the same policies as Keynes (boost aggregate demand)

but this didn’t follow the theories he accepted

+Idea that wages were too high was useful to employers

Question 4

Keynes and wage cuts

Answer 4

orthodox theory - wage cuts needed

Keynes: cut money wages and there is social disruption if prices fall too, so w/p doesn’t fall

if prices don’t fall, w/p does fall but aggregate demand falls too

Question 5

why hadn’t classical economists pointed out Keynes’ wage cut theory

Answer 5

they hadn’t taken too much notice of aggregate demand

because the orthodoxy was that it wouldn’t be deficient which rested on Says law

• supply creates its own demand

but £1 of income doesn’t have to lead to £1 of spending

as could be saved or lent out and then spent

Question 6

£1 of income doesn’t have to lead to £1 of spending

Answer 6

as could be saved or lent out and then spent

Keynes said not necessarily

• if price of bonds expected to fall, you hoard ie put in the bank
• if in a slump, bank may not lend it our either (nothing safe and profitable enough)
• what you hoard is your speculative demand for money

Question 7

Breaking into this circle of saving etc

Answer 7

Circle of a slump leading to deficient demand and pessimistic expectations and thus speculative demand for money

1. Persuasion - public speaking etc
2. Pump-priming - small increase in the money supply
3. fiscal policy to raise aggregate demand

Question 8

Determinants of speculative demand for money

Answer 8

You hold your wealth of money if:

1. You fear that borrower would go bankrupt and default
2. rate of interest too low
3. (bonds) fear that their price would fall (capital loss)

Question 9

Bond market: interest rate and price expectations

Answer 9

• Bond pays fixed amount of interest each year

if it pays £20 and priced at £200, return is 10% etc

• therefore fall in price of bonds = rise in interest rates on bonds
• therefore you hoard money instead of buying bonds when you expect price of bonds to fall
  ie when you expect interest rates to rise

Question 10

Keynesians have inelastic expectations to the bond market

Answer 10

expect interest rates to rise when its low and fall when it’s high

so when r is low, reasons for high speculative demand for money:

1. return on bonds is poor
2. expected rise in r = expected fall in price of bonds

so transactions demand for money, ie money needed to buy goods is a function of income

supply of money is a function of interest rates

therefore demand for money = transactions demand for money + supply of money

Question 11

The LM curve (interest rates against income)

Y = M/a + (b/a)r

Answer 11

• gives equilibrium points in the money market

demand for money = aY - br ( a&b constants)
Y = income, r = interest rates

if money market in equilibrium then money supply (m) = money demand = aY - br

ie Y(income) = M/a + (b/a)r

thus LM curve slopes up (if money supply rises, need a higher demand for money so either income rises or interest rates fall)

while increase in money supply means higher income for any given ie LM curve shifts right

Question 12

The Goods Market

Answer 12

• condition for equilibrium is that income causes equals spending (aggregate demand)

in closed economy: income is either consumer, saved or paid in tax

thus Y = consumption (c) + savings(s) + taxation (t)

while all spending comes from consumers, firms or government:

Spending (Yd) = consumer demand (C) + demand for capital goods (I) + demand for government spending (G)

Thus Y = Yd implies savings + taxation = demand for capital goods + government spending

• Keynes: savings and taxes both increase with income
• assumes they’re proportionate
• says that demand for capital goods and government spending don’t automatically increase with income

Question 13

Why is demand for capital goods treated as independent of income

Answer 13

because level of income:

• doesn’t have predictable effect on income
• isn’t main determinant of income

Question 14

If output level isn’t main determinant of investment what is?

Answer 14

Keynes:

• rate of change of income: its a fast growing economy that needs a lot of investment
• cost of borrowing (rate of interest)

Question 15

Why is government spending independent of Y?

Answer 15

because higher income doesn’t automatically raise government spending

ie income = I + G/s+t -br/s+t

therefore curves slopes down (IS curve)

Question 16

The IS curve (equilibrium points in the goods market)

Answer 16

investment = I + G/s+t -br/s+t

high investment means high savings and taxation therefore investment needs to be high (thus interest rates low) for equilibrium

while increase in government spending means higher income for any given interest rates, ie IS curve shifts right

Question 17

Is IS/LM the real Keynes

Answer 17

Keynes to Hicks (who put this forward as summary of Keynes theory): “I found it very interesting and really have next to nothing to say by way of criticism”

and the whole of IS/LM can be found somewhere in the general theory

but fundamentalist Keynesians says that is misses the point of Keynes

as though Keynes though investment and demand for money are affected by interest rates, they ere unstable functions of interest rates

Keynes policy consensus reinforced by fact that western economies were run by Keynesians and doing very well

Question 18

Keynes: investment an unstable function of interest rates

Answer 18

Investment depends on expected returns as well as cost of borrowing

and investors expectations of returns are volatile and driven by waves of optimism/pessimism

especially about the macroeconomics picture (ie other peoples spending)

But then my investment spending depends on my expected return which depends on aggregate demand which depends on your investment spending etc

therefore IS curve very unstable

Question 19

Speculative demand for money also unstable function of interest rates

Answer 19

the theory was that demand for money is a function of interest rates

therefore demand for money is a a function of interest rates

but expected change in interest rates (ie expected change in bond prices) doesn’t only depend on current level of interest rates

like investment, it’s volatile and unpredictable - LM curve unstable too

these criticisms actually strengthen main message of IS/LM:

as left to itself, an economy settles at income = full employment level of national income only through luck

therefor fiscal and/or monetary policies needed to reach full employment level of national income

Question 20

Was full employment due to Keynesian Policies?

Answer 20

R.C.O Matthews said not:

• governments had ran surplus (not boosting economy)
• high demand due to high private investment

high investment could be due to knowing Keynesian policies available

ie businesses invest confidently because it knows government will guarantee aggregate demand

Question 21

what to do about inflation?

Answer 21

post 1960 fashion: abandon free collective bargaining with wage and price controls (incomes policy)

Normal outcome: worked for 1-2 years then collapsed under trade union opposition

Question 22

The Jay Triangle

Answer 22

Full employment
Steady prices
Free collective bargaining

Jay: you can only have 2 of these at the same time

Question 23

1970’s stagflation

Answer 23

even Jay seemed too optimistic as it got harder to achieve either high employment or low inflation

Keynesian diagnosis: problem was cost-push inflation

Question 24

Cost push inflation

Answer 24

rising commodity prices especially oil
-OPEc oil producers raised prices x4 in 1973-4

• growing public sector insulated from market forces so public sector pay running away
• public sector unions had nothing to lose in demanding large pay rises
• easiest for governments to settle (especially now that so many voters worked in the public sector)

lead to general upwards push on wages

• 1945-70: workers and TU leaders remembered 1930’s mass employment and so were cautious about going for pay rises
• 1970+ post war generation came to the fore - used only to full employment and hence assertive and aggressive about getting workers a better share

Question 25

What can the government do about cost-push inflation?

Answer 25

a) keep employment up by increasing aggregate demand (so the money was there to afford higher prices) ie give in to inflation
b) hold down aggregate demand in the face of rising prices
- low real aggregate demand (spending/real prices) and high unemployment

in 1970s governments alternated or did bit of both so led to stagflation - higher inflation and higher unemployment

Question 26

Friedman and the Quantity Theory of Money

Answer 26

MV = PY (fisher equation)

M= quantity of money (currency and bank deposits)

v = velocity of circulation

P = price level

Y = real value of the national product

this equations implies that M’ + V’ = P’ + Y’ (rates of change)

rate of growth of real value of national product (Y’) depends on productivity and thrift (saving)

• In long run, Y’ = y^ (exogenous, ie not determined by M’)

v’ = rate of financial innovation

• in long run v’ = v^ (exogenous - not determined by M’)

Hence M’ + Y’ = P’ + Y’ can be written M’ + V^ = M + (v^ - Y^)

thus P’>0 if and only if M’> y^ - v^

Question 27

How inflation starts

Answer 27

Governments prefer high public spending with low taxes

therefore there’s fiscal deficit - which must be financed by:

1) bond sales - but bond sales push up interest rates
(government borrowing pushes up price of borrowing)

2) printing money - inflation and wage-price spiral

if gov stops printing money, wage spiral still continues

ie quantity of money steady but price Level still rising

so M/P (purchasing power of money supply) falls

• this real balance effect leads to unemployment

Question 28

Why inflation is bad

Answer 28

1. Uncertainty about prices and hence profits deters investment
2. Relative prices are signals about what to produce
   - but when all prices rising fast it’s hard to pick out what’s happening to relative prices
   - is price of shoes going up because shoes are gaining on gloves or because all prices are going up?
   - hence inflation jams the signals and damages resource allocation

Question 29

Answer to Friedman

Answer 29

• it’s variable inflation, not high inflation that does that
• suppose you had an ‘inflationary equilibrium’: money supply, price level, wage level all rising at ready 20%

you could see which prices going up faster than general inflation

• i.e this is as transparent as steady prices , hence 20% inflation is costless

Answer to answer - high inflation always is variable inflation too

Question 30

The x% rule

Answer 30

Money supply grows at x% where x% tends to steady prices

what determines x%?:

P’ = M’ + v^ - y^

Thus P’ = 0 -> M’ = y^ - v^

Question 31

So you give up trying to stabilise the economy

Answer 31

• Friedman says you won’t need to

as business cycles/instability causes by over-active gov in first place

• this goes down to different views of capitalism

Friedman says that instability created by gov will be remedied by private sector when gov gets out the way

Question 32

Keynes vs Friedman on Crises and Instability

Answer 32

• Keynes: instability starts in private sector and remedied by gov
  e. g Great Depression of 1930s: drop in private investment was critical
• Friedman: depression was because US gov contracted money supply or rather allowed it to contract (bank failures = destruction of deposits)

1931-33 - US money stock fell 30% and 1860 banks failed

Question 33

Debt Deflation

Answer 33

Banks fear insolvency and cut Lending

leading to drop in real value of national product and real prices drop leading to borrowers defecting

debt deflation: lower prices increase real value of debt

Question 34

2007-8 Crisis: Keynes right, Friedman wrong?

Answer 34

Friedmanites argue this crisis caused by:

1. Federal reserve bank keeping interest rates too low
2. President Clinton leaning on Fannie Mae to underwrite subprime mortgages

Question 35

Friedman and the Philips Curve

Answer 35

see original Phillips curve

• said original Phillips curves leaves out inflationary expectations
• wage claims don’t just depend on unemployment
• workers (TU’s) say: what weal wage rise do I go for?
• if 3% ask for 3% + Pe (expected inflation)

therefore rate of increase in wage claims are a function of unemployment + expected inflation

or if prices follow wages, rate of price increasing are a function of unemployment + expected inflation

Question 36

The natural rate of unemployment

Answer 36

rate of price increasing are a function of unemployment + expected inflation

natural rate of unemployment (Un) is where f(U) = 0

ie unemployment is at the level where it has a neutral effect on inflation

if U0 and so rate of increase in prices> expected inflation

expected inflation up and so prices up

vice versa

see Friedman’s version of the Phillips curve

Question 37

So you can’t hold unemployment below the natural rate

Answer 37

if you do it leads to ever-acceleration of inflation:

• if employment above natural rate you can cut it
• if its at natural rate but is too high It must cit the natural rate itself with policies to make the labour market work better

ie raise the demand for labour (lower employment taxes, lower minimum wage)

or raise supply of labour (better training, lower unemployment benefit)

Question 38

Limitations of political democracy

Answer 38

Market democracy is a continuous election where as political democracy you have certain votes in a lifetime

1. choice of few, often similar alternatives
2. Must choose list of policies
3. Losers not represented
4. Ignorant voters vs clever consumers
   - voting - you don’t inform yourself because of 1/40 million your vote will make a difference
   - buying - your own money is at stake
   - Bryan Caplam in the Rational Voter: ‘Voting is not a slight variation on shopping. Shoppers have incentives to be rational. Voters do not’

Question 39

Robert Lucas

Answer 39

goes beyond Friedman:

• demand management won’t bring down unemployment even in the short run
• this is the policy ineffectiveness proposition and part of new classical economics

Question 40

New classical economics policies

Answer 40

1. Rational expectations
   - agents expectations not systematically biased
   - they correct for systematic errors and only make random errors
2. Prices perfectly flexible ie always adjust to clear markets
   - so if gov increases quantity of money by 10% then the private sector on average expects prices to rise 10% (rational expectations)
   - so everyone puts up their own prices by 10% (flexible prices) so:

no increase in real balances or aggregate demand and so no increase in employment