Keynesian Economics Flashcards
Classical theory of the labour market
unemployment if real wage too high
real wage/price level must fall and it will to reduce unemployment
19th century facts didn’t contradict classical theory
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
Policy leaves classical theory behind
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
Keynes and wage cuts
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
why hadn’t classical economists pointed out Keynes’ wage cut theory
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
£1 of income doesn’t have to lead to £1 of spending
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
Breaking into this circle of saving etc
Circle of a slump leading to deficient demand and pessimistic expectations and thus speculative demand for money
- Persuasion - public speaking etc
- Pump-priming - small increase in the money supply
- fiscal policy to raise aggregate demand
Determinants of speculative demand for money
You hold your wealth of money if:
- You fear that borrower would go bankrupt and default
- rate of interest too low
- (bonds) fear that their price would fall (capital loss)
Bond market: interest rate and price expectations
- 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
Keynesians have inelastic expectations to the bond market
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:
- return on bonds is poor
- 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
The LM curve (interest rates against income)
Y = M/a + (b/a)r
- 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
The Goods Market
- 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
Why is demand for capital goods treated as independent of income
because level of income:
- doesn’t have predictable effect on income
- isn’t main determinant of income
If output level isn’t main determinant of investment what is?
Keynes:
- rate of change of income: its a fast growing economy that needs a lot of investment
- cost of borrowing (rate of interest)
Why is government spending independent of Y?
because higher income doesn’t automatically raise government spending
ie income = I + G/s+t -br/s+t
therefore curves slopes down (IS curve)
The IS curve (equilibrium points in the goods market)
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
Is IS/LM the real Keynes
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
Keynes: investment an unstable function of interest rates
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
Speculative demand for money also unstable function of interest rates
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
Was full employment due to Keynesian Policies?
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
what to do about inflation?
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
The Jay Triangle
Full employment
Steady prices
Free collective bargaining
Jay: you can only have 2 of these at the same time
1970’s stagflation
even Jay seemed too optimistic as it got harder to achieve either high employment or low inflation
Keynesian diagnosis: problem was cost-push inflation
Cost push inflation
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
What can the government do about cost-push inflation?
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
Friedman and the Quantity Theory of Money
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^
How inflation starts
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
Why inflation is bad
- Uncertainty about prices and hence profits deters investment
- 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
Answer to Friedman
- 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
The x% rule
Money supply grows at x% where x% tends to steady prices
what determines x%?:
P’ = M’ + v^ - y^
Thus P’ = 0 -> M’ = y^ - v^
So you give up trying to stabilise the economy
- 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
Keynes vs Friedman on Crises and Instability
- 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
Debt Deflation
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
2007-8 Crisis: Keynes right, Friedman wrong?
Friedmanites argue this crisis caused by:
- Federal reserve bank keeping interest rates too low
- President Clinton leaning on Fannie Mae to underwrite subprime mortgages
Friedman and the Philips Curve
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
The natural rate of unemployment
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
So you can’t hold unemployment below the natural rate
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)
Limitations of political democracy
Market democracy is a continuous election where as political democracy you have certain votes in a lifetime
- choice of few, often similar alternatives
- Must choose list of policies
- Losers not represented
- 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’
Robert Lucas
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
New classical economics policies
- Rational expectations
- agents expectations not systematically biased
- they correct for systematic errors and only make random errors - 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
