John Maynard Keynes (1883-1946) Born in 1883 in Cambridge, England Son of John Neville Keynes Neville was a professor of Economics and Logic at Cambridge Univ., and wrote on Economic Methodology Won a scholarship to Eton Boy Genius Won prizes for his work in the classics, mathematics, history, English essays Wrote papers on contemporary social problems, participated in crew and debate, acted, read everything Became an expert in medieval latin poetry Part of Eton’s social elite Won a scholarship to King’s College, Cambridge
Keynes’ Tract Relates money supply variability and uncertainty to inflation and deflation. Variability of prices is a major cause of business cycles. Wages and other costs of production adjust more slowly than prices. Therefore price variability affects profits and therefore investment. Investment cycles cause business cycles.
Keynes’ Treatise on Money Early elements of the General Theory. Expectations are quasi-rational? Swings in investment, based on changes in profits, generate business cycles. Saving is passive. Introduces a stock-flow analysis. Written following Britain’s return to the gold standard at parity in 1925. Argued that under a fixed gold standard, there is no opportunity for independent domestic policy.
The General Theory“ 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 the world thinks about economic problems.” -- John Maynard Keynes
The General Theory1. If the consumer is an economic optimizer, he/she must be unable to buy the goods they planned to buy because of some kind of constraint—risk, convention, social institutions, cash, or ...? a) According to the classical model, the consumer has insatiable wants. b) The consumer sells his/her labor in exchange for enough income to buy the goods. c) The money value of the incomes received must be equal to the value of the output produced. d) So how can unsold goods pile up in warehouses, causing firms to lay off workers?
The General Theory (2)2. Say’s Law cannot hold. (“Supply creates its own demand.”) a) If spending constraints are in effect, then there will be a difference between (unlimited) demand and “effective demand”. b) Actual (effective) demand will usually be “deficient” to purchase total output.
The General Theory (3)3. Microeconomics and macroeconomics do not operate on the same basis. One cannot assume that what is true for the economic agent at the level of the individual consumer or firm is true in aggregate. This amounts to the fallacy of composition. In microeconomics, relative price effects dominate. This is not true in macroeconomics. In macroeconomics, income effects dominate, making income more important in determining aggregate economic behavior.
The General Theory (4)4. Therefore, consumption depends primarily upon income, not interest rates. C ≠ C(r), but rather C = C(Y) “People don’t change their standard of living simply because the interest rate changes a few points.”
The General Theory (5)5. Saving occurs as the result of a habit, convention, or social norm. People on average set aside a certain percentage of their income. Saving is not a function of interest rates. S ≠ S(r), but rather S = S(Y)5. Investment is related to interest rates, but also to businesspeople’s expectations for the future. That is, I = I(r,E).
The General Theory (6)7. If S = S(Y) and I = I(r,E), then there is no coordinating variable to bring supply and demand together in the loanable funds (capital) market. There is no reason to assume that supply equals demand in this market. There is no reason to believe that there will be adequate funds available to provide adequate investment demand. Since AD = C + I + G + NX, if investment demand is deficient, then AD < AS, and inventories may pile up, with unemployment a natural outcome. Without the coordinating variable, this will be the normal outcome, with AD = AS only happening accidentally.
The General Theory (7)8. Investment is a large and long-term commitment, and is based on weakly supported expectations about the future. This makes investment very different from consumption. Investment decisions will be erratic and emotional, and the risks associated with investment are very high. As a result, business decision makers will tend to under-invest, further worsening the problem of deficient investment.
The General Theory (8)9. It may be a natural outcome of the organization and institutions of modern economies that prices and wages may not be fully flexible. This would result in markets (like the labor and goods markets) being unable to clear, leading to unemployment and aggregate supply exceeding demand.
The General Theory (9)10. Money plays a key role in the economy. The use of money leads to uncertainty, and makes “piercing the veil” impossible. A money economy is fundamentally different from a barter economy. The classical dichotomy cannot hold. Interest rates are established in the money market. People may rationally hoard money, holding money for purposes other then making transactions.11. Equilibrium is not AD = AS. It is a state that persists.
Consumption 7000 6000Consumption 5000 4000 3000 2000 1000 0 0 2000 4000 6000 8000 10000 Real GDP U.S. Annual Data, 1929 - 2001
Consumption Function c = mpc = ∆ C/∆ Yd = marginal propensity to consume C C = C0 + mpc x Yd ∆C Or ∆ Yd C = C0 + cYd C0 Yd
Original AggregateExpenditure Model Z=ASNominal Valueof Output (Py) C e D = AD E* There is a limit to the profitable expansion of output. If Say’s Law held, there could be no obstacle to full employ-ment. Output could profitably be increased until excess labor was absorbed. Thus, this is N* a refutation of Say’s Law. Law Nf
o Real GDP exceeds 45 line (trillions of 1992 dollars/year)Aggregate planned expenditure planned expenditure 10.0 Total Expenditure C+I+G 8.0 f d e 6.0 4.0 b c Equilibrium expenditure a Planned C0 expenditure exceeds G real GDP I 0 2 4 6 8 10 Real GDP (trillions of 1992 dollars per year)
Policy PlannedExpenditures E1 E0 ∆G Y0 Yf Y
Alvin Hansen (1887-1975) Background Taught at Brown Univ., Univ. of Minnesota, and finally Harvard (1937) Famous students Wrote a paper pointing out a math error in Keynes’ Treatise on Money; not enthusiastic about the General Theory at first. Business Cycle Theory (1927) 1941, Fiscal Policy and Business Cycles Extended Keynes’ Policy Recommendations Supported Keynes’ analysis of the 1930s A Guide to Keynes (1953)
Hansen (2) Hicks-Hansen Synthesis (IS-LM) r LM r* IS y* y
Hansen (3) Hicks (1939) had pointed out problems with Keynes’ theory, utilizing his own IS-LM apparatus. Hicks and Hansen worked out the indeterminacy of the interest rate and other problems. Extensive revision of Keynes’ aggregate expenditure model. 1937-38, Advisory Council on Social Security Economic advisor to Federal Reserve Board Participated at Bretton Woods Involved in the Full Employment Act and the creation of the Council of Economic Advisors
Hansen (4) Stagnation Thesis 1938, Full Recovery or Stagnation Inadequacy of investment of keep pace, making it impossible for the economy to naturally maintain full employment Advocated (gov’t) compensatory finance to compensate for inadequate private sector investment
Abba P. Lerner (1903-1982) Background Taught by John R. Hicks, Lionel Robbins, von Hayek Socialist at London School Focus on policy recommendations, including functional finance.
Paul Samuelson (1915- ) 1970, 1st American Nobel in Economics Textbook, Economics PhD, Harvard Phillips Curve with Solowwage Consumerinflation price inflation u u Phillips’ curve Samuelson-Solow Curve
Samuelson (2) Contributions Comparative statics Revealed preference theory Efficient markets hypothesis Product and factor mobility Public goods theory Methodological innovations Use of mathematics • Called economics “full of inherited contradictions, overlaps, and fallacies.” • Dissertation Foundations of Economic Analysis, published in 1947.
Samuelson (Accelerator) The desired capital stock is proportional to the level of output: K td = αYt Investment is the process of moving from the current level of capital to a desired level: I n,t = K td − K t −1 We assume that whatever the capital stock ended up being last period was the level of capital that businesses actually wanted: K t −1 = K td−1 = αYt −1
Accelerator (2) This allows us to rewrite: I n,t = K td − K t −1 As I n,t = K td − K t −1 = αYt − αYt −1 = α (Yt − Yt −1 ) I n,t = α∆Yt Thus investment is related to the rate of change in output. If the economy is growing rapidly, then investment grows rapidly. If the economy is not growing, then investment slows, and net investment (after depreciation) may actually be negative.
Post Keynesians Sraffa, Robinson, Pasinetti, Weintraub, Davidson Neo-Ricardian view of production, value, and distribution Oligopolistic corporations. markup pricing Endogenous money Cyclical instability Incomes policy Class struggle for income shares, markup pricing necessitate a permanent incomes policy
New Keynesians Fischer, Taylor, Howitt, and many others Rational expectations, general equilibrium, microfoundations Offer theoretical support at the firm profit maximization level for Keynesian features in the economy Contracting models Menu/transactions costs Efficiency wages Insider-Outsider theory
New Keynesian Theory
New Classical Viewof Keynesian Economics “Failure on a grand scale.” Made up of ad hoc assumptions, not built on a strong foundation of rational agents. Must assume rational, optimizing agents. Must assume that markets clear. Keynesians do not explicitly handle expectations, and expectations have been shown to be critically important. Have not given explicit structural explanations of wage stickiness. How can you explain persistence in business cycles? 32
New Keynesian Economics Most economists believe that short-run fluctuations in output and employment represent deviations from the natural rate, and that these deviations occur because wages and prices are sticky. New Keynesian research attempts to explain the stickiness of wages and prices by examining the microeconomics of price adjustment. slide 33
Small menu costs andaggregate-demand externalities There are externalities to price adjustment: A price reduction by one firm causes the overall price level to fall (albeit slightly). This raises real money balances and increases aggregate demand, which benefits other firms. Menu costs are the costs of changing prices (e.g., costs of printing new menus or mailing new catalogs) In the presence of menu costs, sticky prices may be optimal for the firms setting them even though they are undesirable for the slide 34
Recessions as coordination failure In recessions, output is low, workers are unemployed, and factories sit idle. If all firms and workers would reduce their prices, then economy would return to full employment. But, no individual firm or worker would be willing to cut his price without knowing that others will cut slide 35
New Keynesian Response(1) Persistence: There have been and are persistent and substantial deviations from full employment. There is nothing to the persistence question. • Unemployment in Great Britain was greater than or equal to 10% from 1923-1939. • U.S. Great Depression, unemployment was greater than or equal to 14% for 10 years. 36
New Keynesian Response(2) Extreme Informational Assumptions NK’s accept that adaptive expectations are ad hoc and unrealistic Unconstrained REH implies unrealistically sophisticated agents Bounded rationality Structural impediments 37
New Keynesian Economics Attempts to build Keynesian arguments based upon rational expectations and microeconomic foundations. Examples: Contracting models Sticky price models based upon transactions cost or menu costs Efficiency wage models 38
New Keynesian Models (1) Sticky Prices Menu costs and other transactions costs: • It costs to change prices. A firm might hold prices constant even if demand fell if the firm faced a cost to the price change. • Costs: loss of customer good will • Potential price war • Menu costs 39
New Keynesian Models (2) Efficiency Wage Models Firms wish to buy worker effort, not their “attendance”. Instead of Y = F(K,N), the firm really operates according to Y = F(K,eN), where N is the number of workers or worker-hours, and e is the effort per worker. The firm does not seek to minimize the cost of labor, but rather seeks to minimize the cost per efficiency unit. 40
New Keynesian Models (3) Efficiency Wages, continued By paying the worker more than the equilibrium wage for labor, the firm may reduce the cost per efficiency unit by reducing the costs associated with: • Paying supervisors (monitoring costs) • Hiring replacement workers when the current workers leave (turnover costs) • Poor worker morale. This leads to: • Shirking models, • Turnover cost models, and • Gift exchange models. 41
New Keynesian Models (4) Efficiency wage models identify a market failure: eN s $ Ns Ns > Nd Nd N, eN 42
New Keynesian Response(5) Sticky Prices Menu costs and other transactions costs A firm might hold prices constant even if demand fell if the firm faced a cost to the price change. • Costs: loss of customer good will • Potential price war • Menu costs 43
New Keynesian Response(6) Insider-Outsider Models and Hysteresis Hysteresis: present unemployment is highly related to past unemployment. Past unemployment causes current unemployment by turning insiders into outsiders. Outsiders cannot exert downward force on real wages. 44
The Name The name “New Keynesian Theory” was introduced by Michael Parkin (1982). One of the earliest uses of the term “new- Keynesian Economics” was in an article by Ball, Mankiw, and Romer (1988). “New” is used instead of “neo” to distinguish from “Neoclassical Synthesis Keynesian Economics” (a term used by Samuelson and others), and also to show it is the counter-argument to the New Classical Economics. 45
Founding Researchers“What is New Keynesian Economics”, Gordon(1990) The foundations of New Keynesian Economics are usually attributed to Stanley Fischer, Edmund Phelps, and John Taylor. The focus has been on demonstrating the microfoundations of price and wage stickiness. 46
Basic Principles (1) According to Gordon, sticky prices implies that real GDP is a residual, and is not determined by agents in the economy. If this is the case, then firms optimize by setting prices, and accept quantities (production levels) as given. In the neoclassical and new classical theories, the firms are price takers and optimize by setting quantities (production levels). 47
Basic Principles (2) Price and wage stickiness emerges from microeconomics: Technology of transactions Heterogeneity of goods and factor inputs Imperfect competition Imperfect information Imperfect capital markets These core elements remove any incentive for individual agents to focus on nominal demand in price-setting. New Keynesian Economics is about macroeconomic externalities of individual decisions and coordination failures inherent in free market economies. Note that Gordon omits any topics that are not at the heart of the debate between the New Keynesian and New Classical economists. 48
Demand-side contributions Credit rationing as a source of fluctuations in commodity demand and as a channel for monetary policy. (Blanchard and Fischer, 1989) Feedback from price stickiness to aggregate nominal demand. (Taylor, Summers) How the monetary system interferes with the coordination of intertemporal choices. 49
What are Keynesians?Greenwald and Stiglitz, JEP 1993 The authors claim that Keynesians, new and old, can be identified viz a viz members of other schools by their belief in three propositions: An excess supply of labor may exist, sometimes for prolonged periods, at the prevailing level of real wages. The aggregate level of economic activity fluctuates widely—more widely than can be explained by short- run changes in technology, tastes, or demographics. Money matters, at least most of the time, although monetary policy may be ineffective at times. A lot of this boils down to the proposition that at times quantities adjust rather than prices to bring about cash-flow equilibria. 50
Two Strands of NKResearch1. Nominal price rigidities are the fundamental ways in which real-world economies differ from Walrasian Arrow-Debreu economies. Most of the work here focuses on explaining sources of rigidity. Because of these rigidities, the classical dichotomy breaks down, and policy can be effective.1. Even if prices and wages were perfectly flexible, output would still be volatile. This flexibility is not the central problem. In fact, more flexibility might make things worse. This approach focuses on market failures. Thus monetary policy has real effects even when prices and wages are perfectly flexible. 51
Two Strands (Continued) The flex-price NK school argues that: Natural economic forces can magnify shocks that seems small, and Sticky prices and wages may actually reduce the magnitude of the fluctuations (as Keynes argued). This makes this group less interested in the source of the shocks (unlike the RBC theorists), and more interested in the mechanisms by which they propagate, are magnified or diminished. 52
Three Ingredients to the Flex-price Approach1. Risk-averse Firms.2. A credit allocation mechanism in which credit allocating, risk-averse banks play a central role.3. New labor market theories, like insider- outsider and efficiency-wage theories, play a 1 and 2 explain the magnification of shocks in role. the economy. 3 explains why the shocks may link to unemployment. 53
Risk-aversiveness There are imperfections in the equity market. With equity, firms share risk with the equity holders. With debt, firms alone face the risk. • If equity finance is not available to firms, firms will naturally be risk-averse. Firms do not typically finance a large percentage of their investment with debt. Why? • Equity sales signals future poor performance? 54
Risk-aversiveness (2) How can firms manage to sell equity at all? Owners of firms are risk-averse and do not always have perfect information about their firms futures. Equity sales diversifies risk. Negatives to Investors Negative signal about future performance. The worst, most over-valued firms are the most willing to sell their shares. Principal-agent problem. 55
How does risk-aversivenessaffect the firm? The firm will be sensitive to any risky undertaking. Production is a risky speculation. Firms are concerned about the consequences of any actions they might take (instrument uncertainty), and therefore the bigger the action the bigger the perceived potential risk. Firms know more about the current situation than they will about any potential situation. Hence they will tend to avoid (big) changes. Firms will adopt a portfolio approach to risk management. 56
Risk-averse firms If the demand curve shifts, the firm must determine what to do. The risk-averse firm may choose to adjust quantities rather than prices as a response to risk. In a recession, the aggregate supply curve may shift dramatically. The risk of production increases dramatically as the firms’ willingness to accept risk declines dramatically. This may lead to magnified responses in AS. 57
Another example A decrease in export prices reduces exporters’ net worth. The exporters reduce their output, as well as their demand for factors. Prices fall in the factor sectors, affecting factor firms’ profitability and liquidity, and these firms’ purchases of factors and capital. In response to the increased risk, firms reduce inventories since holding inventory represents a risk. (This explains a long-standing mystery about why inventories don’t smooth output fluctuations.) This further reduces output. NOTE: There is no need to discuss stickiness of prices or wages here! 58