Lecture 7 of Advanced Macro -- see: sites.google.com/site/az4macro -- explains how Keynesian theories of effective demand and unemployment depend crucially on details of microfoundations, left unspecified by Keynes. Different ways of filling out these details leads to different results.

1. Keynes’ Effective Demand

2. Understanding Keynesian Theory of
Effective Demand
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Lecture 7 of Advanced Macroeconomics,
26th September 2018. by Dr Asad Zaman VC PIDE
WEBSITE: https://sites.google.com/site/az4macro

3. FIRST: Understand Say’s Law
the aggregate demand price of output as a whole is equal to its
aggregate supply price for all volumes of output
Production of goods has a COST = Aggregate SUPPLY price.
Payment to factors of production + Profits.
Total Money generated as factor income is ALL the money that
is available as demand. ALL goods are for sale. Money will be
exactly enough to buy all the goods !
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4. Consider Thought Experiment in Simple Model
◉ Two factors of production: 40 Acres land and 40 laborers
◉ Land Rent is 40xR, Payment to labor is 40x100=4000
◉ Factor Income = 4000 + 40R, Total Product = 400 Corn.
◉ Price of Corn = (4000+40R)/400=10+R/10
◉ Demand = Supply; Price equilibriates.
This is Say’s Law – Factor Income is exactly the amount needed
to purchase the entire amount produced – price creates equality
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5. Crucial Question: What determines Rent & Wages
Share of Capital and Share of Labor?
◉ Classical Answer: Rent is Marginal Product of Land, Wage is
Marginal Product of Labor.
◉ The two sum to total income from production under zero
profit long run equilibrium.
◉ Keynes: W=MPL; this determines capital share as well.
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6. (neo)-classical Analysis
For sake of comparison
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7. According to Neoclassical Theory:
Shares are Determined by Marginal Product – Why?
Assume 40 Mini-Landlords, each has one acre of Land (K).
𝑄 = 10𝐾 𝛼 𝐿 𝛽  K=1, L=1 produces 10 Units of Corn.
Suppose W=100 Rp, this is the numeraire. One price can be set
arbitrarily, all others will adjust proportionately.
SOLVE for competitive equilibrium in this economy.
Fix K=1, every landlord has K=1  𝑄 = 10𝐿 𝛽
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8. First Order Conditions for Profit Maximization
𝑀𝑃𝐿 =
𝜕(𝑝𝑄)
𝜕𝐿
= 𝛽 𝑝10𝐿 𝛽−1 = 𝑤 = 100 𝑅𝑝
Firms are price takers, p,w fixed in above equation, which gives
the demand for labor by firms. At competitive price p, demand
MUST come out to 1 unit of labor, otherwise excess or deficit
demand for labor. Set L=1 to solve for competitive price. Fix
value of  arbitrarily, say =0.8. Solving for p in above we get:
𝛽 10𝑝 = 100𝑝 =
10
𝛽
=
10
0.8
= 12.5
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9. Competitive Solution
Each LL hired 1 unit of L at wage 100 Rp, produces 10 units of
corn worth 12.5/unit, sells for 125 units, makes profit of 25 Rp,
enough to buy 2 units of corn. Laborers buy 8 units of corn with
100 Rp. Factor Payments exactly equal demand. Say’s Law
holds.
FOCs: : 𝑟𝐾 = 𝛼𝑝𝑄, 𝑤𝐿 = 𝛽𝑝𝑄  𝑟𝐾 + 𝑤𝐿 = 𝛼 + 𝛽 𝑝𝑄
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10. Disequilibrium Dynamics: What Happens if p=15?
Revenue from Sales is 150=15x10, 100 goes to Labor, 50 to LL.
Laborer buys 6.66, LL buys 3.33, Demand=Supply for Corn.
BUT MPL > w.
Competition for additional laborers will drive up the wage,
until the shares of capital and labor are 20-80
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11. Cobb-Douglass First Order Conditions
𝑄 = 𝐾 𝛼 𝐿 𝛽
𝜕(𝑝𝑄)
𝜕𝐾
= 𝛼𝑝𝐾 𝛼−1 𝐿 𝛽 =
𝛼𝑝𝑄
𝐾
= 𝑟
Similarly:
𝜕(𝑝𝑄)
𝜕𝐿
= 𝛽𝑝𝐾 𝛼 𝐿 𝛽−1 =
𝛽𝑝𝑄
𝐿
= 𝑤
Thus: 𝑟𝐾 = 𝛼𝑝𝑄, 𝑤𝐿 = 𝛽𝑝𝑄  𝑟𝐾 + 𝑤𝐿 = 𝛼 + 𝛽 𝑝𝑄
Competitive Equilibrium exists ONLY with Constant Returns to
Scale. If 𝛼 + 𝛽 ≠ 1 , then total revenue from sales will not
equal payments to factors.
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12. Other Production
Functions Lead to
Different Results 12

13. Key Point of this Lecture: Micro-Structure Matter
Little, Apparently Un-important Details, Make Huge Difference
◉ Cobb-Douglass, CRTS, lead to W=MPL, R=MPK.
◉ If IRTS, then MPL+MPK is less than Total Revenue
◉ If DRTS, than it is more.
◉ Competitive Equilibrium fails in either case.
◉ SO LET US ASSUME CRTS!
◉ Ideological commitment to Free Markets & Competitive Eq
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14. In Leontief Production: Rents,Wages not equal to MPL
In constant proportions production function, both factors have
FULL output as marginal product. When K=1, L=0, adding L=1
gives 10 units of output. When L=1,K=0, adding K=1 also gives
10 units of output. So BOTH factors have FULL output, factor
payments CANNOT be made according the marginal products.
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15. Central Question: What Determines Wage/Rent Shares?
Ideological Propaganda: Technical Details are suppressed.
Impression: S&D holds everywhere: Reality: ONLY in Comp Eq
Impression: W=MPL, R=MPK; Reality: ONLY in CE with CRTS
What if NO CE or NO CRTS?
THEN what determines share of capital and labor?
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16. Marxist View: Labor Gets Subsistence Wage
◉ Note that FULL output is Marginal Product of Labor = Labor
Theory of Value (of course Full output is ALSO MPK).
◉ Start at arbitrary 50-50 share; determined by social norms.
◉ Capitalism is competition among capitalists for profits.
◉ Profits come from exploitation of labor.
◉ Exploitation increases until laborers revolt.
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http://www.slate.com/blogs/moneybox/2015/07/28/labor_s_declining_share_of_income_american_capitalism_is_not_ok.html

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20. So: Is Wage Equal to MPL?
Economists List Six Theories
1. Cheaper Capital lead to rise in investment in capital
2. Increased Capital Mobility – substitution of cheap labor
3. Resultant Reduced Bargaining Power. Fewer Unions.
4. “Superstar Effect”: Externality gives massive returns to top
5. Rents: Excess profits from patents, non-market effects
6. Tax Policy
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https://democracyjournal.org/magazine/43/labor-and-capital-in-the-global-economy/

21. Real Reason: Financial De-Regulation in 1970s
Rise of FIRE: Finance, Insurance, Real Estate
Massive increase in payments of rents to FIRE sector (Hudson)
Gains are captured by the powerful.
Reagan-Thatcher revolution unchained finance, and created
power necessary to capture gains in productivity.
Economics & Theories – driven by power struggles between
classe.
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22. Back to MAIN question:
How to Understand Unemployment after Great Depression?
Answer: use models which capture essential elements –
Models are necessary, because world is complex.
All intuitions cannot be put together in any simple way.
Models ensure coherence and consistency of entire structure.
Experience cannot be understood without models.
Models cannot be understood without experience.
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23. How to Understand
Unemployment?
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24. What caused Unemployment after Great Depression?
Say’s Law – if producers produce, process of production will
generate enough income for factors to enable purchase of
product. No danger of insufficient demand.
OBSERVATION: Producers had CAPACITY to produce – laborers
were there, factories were there. BUT they did not produce –
WHY? If Say’s Law is VALID, then there was no danger from
producing.
This is why Keynes STARTS by rejecting Say’s Law.
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25. Keynes’ Intuition: Producers thought they would be unable to sell
That is, Say’s Law does not hold. BUT WHY?
◉ Intuition: Producers think there will be insufficient
aggregate demand. (and they are right!)
◉ Intuition: What happens at the aggregate level is DIFFERENT
from a scaled up version of what happens at MICRO level.
◉ IDEA: Work solely at Aggregate Level – Unique Innovations
of Keynes – invented MACROECONOMICS.
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26. Translate Intuition into Model
◉ Keynes painted broad details – Intuition about Complexity:
Behaviors of Aggregates not scaled up Micro Behavior.
◉ Omitted the Micro Picture, concrete details of what
happens at the micro level which leads to this Macro.
◉ Keynesian Economics LACKS Micro-Foundations.
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27. Responses to Micro-Foundations Critique of Keynes
◉ Macro Picture does not depend on Micro – Chemical
properties of molecules have no relation to properties of
sub-atomic particles.
◉ Create Micro Picture – New Keynesian/ Neo-Keynesian
◉ Crucial Issue: Micro Details MATTER – Is production function
Cobb-Douglass CRTS, or Substitutable with IRTS, or
Leontief? This MATTERS for theory of effective demand.
◉ Important Point: Neoclassical Micro-foundations lead to
REJECTION of Keynes (contrary to Keynes own ideas).
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28. Massive Confusion About Effective Demand: Different Ways of
Filling out Micro Details lead to Different Theories
◉ How should we fill out the micro detail?
◉ Try for REALISM – closest approximation to hidden reality.
◉ Approximation is good (enough) if it reproduces observed
phenomena. [This is ONLY Criteria: Friedman’s Folly]
◉ Critical Realism: Trying to find the HIDDEN structures of
reality.
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29. What is the Production Function?
Do We Have Perfect Competition? S&D Theory Holds?
◉ Cobb-Douglass with CRTS required for S&D
◉ Sraffa’s Critique: IRTS & DRTS are not compatible with S&D
◉ CRTS leave SCALE indeterminate.
◉ C-D with CRTS implies MPL is below subsistence level.
So – to find out what model is suitable, we must ask: How did
the real wage behave in GD?
Keynes speculates that it increased.
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30. Bordo, Michael D., Christopher J. Erceg, and Charles L. Evans. "Money, sticky
wages, and the Great Depression." American Economic Review 90.5 (2000): 1447-
1463.
This paper examines the ability of a simple stylized general equilibrium model that
incorporates nominal wage rigidity to explain the magnitude and persistence of the
Great Depression in the United States. …The Taylor contracts model is surprisingly
successful in accounting for the behavior of major macroaggregates and real wages
during the downturn phase of the Depression, i.e., from 1929:3 through mid-1933.
Our analysis provides support for the hypothesis that a monetary contraction
operating through a sticky wage channel played a significant role in accounting for
the downturn
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33. Real wages, working time, and the Great Depression
Hart & Roberts, 2010
British data sets [Engineering Employers’ Federation (EEF)] …
of real wages over the 1927‐1937 Real weekly earnings are
strongly procyclical. Real hourly earnings of pieceworkers are
also significantly procyclical.
Cobb-Douglass: As more labor is hired MPL should decrease.
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35. Links to Relevant Materials
Website for course: Advanced Macroeconomics
Related Post on WEA Pedagogy Blog:
Subtleties of Effective Demand
Information about Author: About Me section of asadzaman.net
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