The sorry history of Macroeconomics

1
The sorry history of Macroeconomics

• Steve Keen

2
In the beginning

• Were the Physiocrats!
• First school of thought with clear macro-economic
  concepts
• Circular flow of income
• Production distribution of surplus
• Multiplier effects from change in investment
• With Smith, a great leap backward
• Macro issues almost completely disappeared
• Belief market system would not suffer from
  permanent glut
• Invisible hand comment misinterpreted, but gist
  correct as statement of belief
• Ricardos framework admitted macro issues, but
  bizarrely

3
Was Jean Baptiste Say

• Accepted Says macro vision (no general glut)
  even though value systems fundamentally different
• Ricardo heir to Smith in classical scheme
• Value reflects effort, not utility
• everything rises or falls in value, in
  proportion to the facility or difficulty of
  producing it, or, in other words, in proportion
  to the quantity of labour employed on its
  production. (Ricardo, Principles)
• Utility a pre-requisite for exchange, but plays
  no role in setting value

4
Was Say

• Utility then is not the measure of exchangeable
  value, although it is absolutely essential to
  it. Ricardo, Principles.
• Caveat that If a commodity were in no way useful
  it would be destitute of exchangeable value,
  however scarce it might be, or whatever quantity
  of labour might be necessary to procure it.
• Changes in perceived utility/demand may change
  temporary market price, but ultimately when
  equilibrium restored, value determines price
• Despite this very non-neoclassical
  microfoundation, Ricardo accepted Says
  microeconomic argument that there could not be
  macroeconomic problems

5
Was Say

• M. Say has, however, most satisfactorily shewn,
  that there is no amount of capital which may not
  be employed in a country, because demand is only
  limited by production. No man produces, but with
  a view to consume or sell, and he never sells,
  but with an intention to purchase some other
  commodity, which may be immediately useful to
  him, or which may contribute to future
  production. By producing, then, he necessarily
  becomes either the consumer of his own goods, or
  the purchaser and consumer of the goods of some
  other person (Ricardo Principles emphasis
  added)

6
Was Say

• Productions are always bought by productions, or
  by services money is only the medium by which
  the exchange is effected. Too much of a
  particular commodity may be produced, of which
  there may be such a glut in the market, as not to
  repay the capital expended on it but this cannot
  be the case with respect to all commodities the
  demand for corn is limited by the mouths which
  are to eat it, for shoes and coats by the persons
  who are to wear them but though a community, or
  a part of a community, may have as much corn, and
  as many hats and shoes, as it is able or may wish
  to consume, the same cannot be said of every
  commodity produced by nature or by art.
• So according to Ricardo, following Say, there
  cannot be insufficient aggregate demand

7
Says Law

• Say (writing 1821-34)
• Utility theory of value (contra. Smith
  Ricardo)
• Give to a thing, to a material which has no
  value, utility, and you give it a value that
  is, you create wealth. (Catechism of Political
  Economy)
• Utility subjective
• you call only useful that which is so to the eye
  of reason, but you ought to understand by that
  word whatever is capable of satisfying the wants
  and desires of man such as he is... He is the
  sole judge of the importance that things are of
  to him,... We cannot judge of it but by the price
  he puts on them.

8
Says Law

• Crises caused by disproportionality only
• Excess supply in one market, excess demand in
  others
• General gluts or general slumps impossible
• Argument
• Money only an intermediary in barter
• People sell only to buy again (increase in
  utility the object)
• Each persons supply is matched to his/her demand
• Sum of all supply thus cannot exceed sum of all
  demand (no general gluts) but

9
Says Law

• Slumps in one market can occur if supply of X
  exceeds demand for X at price producers of X
  want however
• Unless government regulations, monopolies
  intervene
• Price of X falls, demand for X rises
  equilibrium
• Basic logic micro in nature
• Hypothesis about behaviour of each individual in
  market system (micro)
• Aggregate hypothesis to overall economy (macro)
• Argument also essential real rather than
  monetary

10
Says Law

• Every producer asks for money in exchange for
  his products, only for the purpose of employing
  that money again immediately in the purchase of
  another product for we do not consume money, and
  it is not sought after in ordinary cases to
  conceal it . It is thus that the producers,
  though they have all of them the air of demanding
  money for their goods, do in reality demand
  merchandise for their merchandise.
• So micro balance of each consumer/producer
  ensures overall macro balance
• Some markets may have over-supply others will be
  under-supplied changes in prices will
  equilibrate.
• All markets in aggregate balanced

11
Marx and the Circuits of Capitalism

• Marx provides best rejection of Say
• Not true that Every producer asks for money in
  exchange for his products, only for the purpose
  of employing that money again immediately in the
  purchase of another product
• Some producers motivated not by consumption but
  by accumulation capitalists
• Capitalist objective not commodities but
  money/wealth
• Will withdraw from market if fear cant turn
  produced commodities into money profits
• They do seek in ordinary cases to conceal
  money
• Demand not merchandise for their merchandise
  but more money for their money
• Says Law fits economy of simple commodity
  producersbut not capitalism

12
Marx and the Circuits of Capitalism

• Marx worked out flaw while writing Rough Draft
  of Capital in 1857
• The commodity is exchanged for money money is
  exchanged for the commodity. In this way,
  commodity is exchanged for commodity, except that
  this exchange is a mediated one. The purchaser
  becomes a seller again and the seller becomes
  purchaser again. In this way, each is posited in
  the double and the antithetical aspect, and hence
  in the living unity of both aspects. (Marx 1857
  197)
• Circulation of commodity A to money to commodity
  B
• One moment of circulation is that the commodity
  exchanges itself through money for another
  commodity. (204)
• But there is a second, vital, unbalanced
  capitalist circuit

13
Marx and the Circuits of Capitalism

• But there is, equally, the other moment, not
  only that commodity exchanges for money and money
  for commodity, but equally that money exchanges
  for commodity and commodity for money hence that
  money is mediated with itself by the commodity,
  and appears as the unity which joins itself with
  itself in its circular course.
• Then it appears no longer as the medium, but as
  the aim of circulation (as e.g. with the merchant
  estate) (in commerce generally). If circulation
  is looked at not as a constant alternation, but
  as a series of circular motions which it
  describes within itself, then this circular path
  appears as a double one Commodity-Money-Money-Com
  modity and in the other direction
  Money-Commodity-Commodity-Money i.e. if I sell
  in order to buy, then I can also buy in order to
  sell.
• In the former case money only as a means to
  obtain the commodity, and the commodity the aim
  in the second case the commodity only a means to
  obtain money, and money the aim. (Marx 1857
  201 emphases added).

14
Marx and the Circuits of Capitalism

• Balance of value makes sense in 1st circuit
• Exchange one commodity for another
• Equivalents exchanged value of commodity A
  equals value of commodity B
• Differences in qualitative utility the result
• Seller of A/Buyer of B prefers B to A
• Ditto in reverse
• But balance doesnt make sense in 2nd circuit
• Exchange of money for money only sensible if
  second quantity exceeds the first

15
Marx and the Circuits of Capitalism

• Now one can say to exchange commodity for
  commodity makes sense, since commodities,
  although they are equivalent as prices, are
  qualitatively different, and their exchange
  ultimately satisfies qualitatively different
  needs.
• By contrast, exchanging money for money makes no
  sense, unless, that is, a quantitative difference
  arises, less money is exchanged for more, sold at
  a higher price than purchased
• In the real process of buying in order to sell,
  admittedly, the motive is the profit made
  thereby, and the ultimate aim is to exchange less
  money, by way of the commodity, for more money,
  since there is no qualitative difference between
  money and money.
• All that given, it cannot be denied that the
  operation may come to grief and that hence the
  exchange of money for money without quantitative
  difference frequently takes place in reality.
  (Marx 1857 20102 emphases added)

16
Marx and the Circuits of Capitalism

• Money incidental to barter merely makes it
  easier
• But money essential to understanding capitalism
• money functions neither only as measure, nor
  only as medium of exchange, nor only as both but
  has yet a third quality. It appears here firstly
  as a end in itself, whose sole realization is
  served by commodity trade and exchange.
• Secondly, since the cycle concludes with it at
  that point, it steps outside it, just as the
  commodity, having been exchanged for its
  equivalent through money, is thrown out of
  circulation. It is very true that money, in so
  far as it serves only as an agent of circulation,
  constantly remains enclosed in its cycle.
• But it appears here, also, that it is still
  something more than this instrument of
  circulation, that it also has an independent
  existence outside circulation, and that in this
  new character it can be withdrawn from
  circulation just as the commodity must definitely
  be withdrawn. We must therefore observe money in
  its third quality. (Marx 1857 202-03)

17
Marx and the Circuits of Capitalism

• So one component of exchange is balanced
• Of the part of the revenue in one branch of
  production (which produces consumable
  commodities) which is consumed in the revenue of
  another branch of production, it can be said that
  the demand is equal to its own supply (in so far
  as production is kept in the right proportion).
• It is the same as if each branch itself consumed
  that part of its revenue. Here there is only a
  formal metamorphosis of the commodity C-M-C'
  Linen-money-wheat. (Marx 1861 233)
• Second is necessarily not balanced

18
Marx and the Circuits of Capitalism

• The circuit C-M-C starts with one commodity, and
  finishes with another, which falls out of
  circulation and into consumption. Consumption,
  the satisfaction of wants, in one word,
  use-value, is the end and aim.
• The circuit M-C-M, on the contrary, commences
  with money and end with money. Its leading
  motive, and the goal that attracts it, is
  therefore mere exchange-value. (Marx 1867148)
• Says Law is thus wrong from first principles
• Capitalism is more complex than simple commodity
  production exchange
• One vital class of agent in capitalism is
  motivated not by consumption but accumulation
• Sum of demands of two circuits is aggregate
  demand
• CAN be deficient if capitalist expectations of
  profit deflated

19
Marx and the Circuits of Capitalism

• Possibility of aggregate, macroeconomic
  deficiencies/ excesses in demand come from M-C-M
  circuit neglected by Say (and subsequent
  neoclassicals)
• Complexities of capitalist system arise from this
  second essentially capitalist circuit
• Neoclassical failure to understand
• cyclical nature of capitalism
• Possibility of financial crises etc.
• Arises from failure to appreciate existence of
  M-C-M circuit its fundamentally different
  nature to C-M-C

20
Marx and the Circuits of Capitalism

• It must never be forgotten, that in capitalist
  production what matters is not the immediate
  use-value but the exchange-value, and, in
  particular, the expansion of surplus-value. This
  is the driving motive of capitalist production,
  and it is a pretty conception thatin order to
  reason away the contradictions of capitalist
  productionabstracts from its very basis and
  depicts it as a production aiming at the direct
  satisfaction of the consumption of the
  producers. (Marx 1861 495).
• Marx puts motive of capitalist well (if
  verbosely)

21
Marx and the Circuits of Capitalism

• The expansion of value, which is the objective
  basis or main-spring of the circulation M-C-M,
  becomes his subjective aim, and it is only is so
  far as the appropriation of ever more and more
  wealth in the abstract becomes the sole motive of
  his operations, that he functions as a capitalist
  
• Use-values must therefore never be looked upon as
  the real aim of the capitalist. Neither must the
  profit on any single transaction. The restless
  never-ending process of profit making alone is
  what he aims at.
• This boundless greed after riches, this
  passionate chase after exchange-value, is common
  to the capitalist and the miser but while the
  miser is merely a capitalist gone mad, the
  capitalist is a rational miser.
• The never ending augmentation of exchange value,
  which the miser strives after, by seeking to save
  his money from circulation, is attained by the
  more acute capitalist, by constantly throwing it
  afresh into circulation. (Marx 1867 151
  emphases added)

22
Critique of Says Law

• A capitalist economy is therefore the sum of two
  processes C-M-C and M-C-M
• CommodityMoneyCommodity (CMC)
• Objective to increase utility
• Monetary value constant, utility (qualitative)
  increased
• Says Law applies
• MoneyCommodityMoney (MCM)
• Objective to increase monetary-value
• Utility irrelevant, monetary value increased,
  surplus produced
• Says Law invalid in economy with accumulation
• Aggregate Balance explicit in Says Law
  Walras Law does not apply in capitalism

23
Critique of Says Law

• The capitalist throws less value in the form of
  money into the circulation than he draws out of
  it Since he functions as an industrial
  capitalist, his supply of commodity-value is
  always greater than his demand for it. If his
  supply and demand in this respect covered each
  other it would mean that his capital had not
  produced any surplus-value His aim is not to
  equalise his supply and demand, but to make the
  inequality between them as great as possible.
  (Marx 1885 120-121)
• So if it is true that
• There are capitalists in the capitalist system
• Then
• Modelling capitalism as if there arent any
  capitalists wont work

24
Critique of Says Law

• In particular
• Demand for labour a derived demand
• Only hired if capitalists expect profit
• Demand derived from
• Demand from CMC circuit plus
• Demand from MCM circuit
• Former relatively stable latter very volatile
• Only if sum of two equals supply of labour do we
  get full employment
• Unemployment/underutilised capacity/cycles
  predictable features of capitalist economy
• Interestingly, Keynes agreed with Marx on this
  issue

25
Critique of Says Law

• One of the rare occasions in which Keynes
  praised Marx occurred in a 1933 draft of the
  General Theory. Here Keynes credits Marx with the
• pregnant observation that the nature of
  production in the actual world is not CMC',
  i.e.. of exchanging commodity (or effort) for
  money in order to obtain another commodity (or
  effort). That may be the standpoint of the
  private consumer. But it is not the attitude of
  business, which is a case of MCM' , i.e.. of
  parting with money for commodity (or effort) in
  order to obtain more money (1971, Vol. 29, p.
  81, Keynes's emphasis).
• Dillard 1984 Keynes and Marx a centennial
  appraisal Journal of Post Keynesian Economics p.
  424

26
Critique of Says Law

• In the immediately following paragraphs, Keynes
  emphasized that business firms subordinate making
  goods to making money
• An entrepreneur is interested, not in the amount
  of product, but in the amount of money which will
  fall to his share. The firm is dealing
  throughout in terms of money. It has no object in
  the world except to end up with more money than
  it started with. That is the essential character
  of an entrepreneur capitalist economy. (1971,
  Vol. 29, pp. 82, 89. Keynes's emphasis)
• Favourable comments on Marx did not make it into
  General Theory as published (political reasons?)
  but
• Keynes gave very similar but far more obscure
  analysis as basis for rejection of Says Law

27
Critique of Says Law

• This theory can be summed up in the following
  propositions
• (1)  In a given situation of technique, resources
  and costs, income (both money-income and real
  income) depends on the volume of employment N.
• (2)  The relationship between the community's
  income and what it can be expected to spend on
  consumption, designated by D1, will depend on the
  psychological characteristic of the community,
  which we shall call its propensity to consume.
  That is to say, consumption will depend on the
  level of aggregate income and, therefore, on the
  level of employment N, except when there is some
  change in the propensity to consume.  
• (3)  The amount of labour N which the
  entrepreneurs decide to employ depends on the sum
  (D) of two quantities, namely D1, the amount
  which the community is expected to spend on
  consumption, and D2, the amount which it is
  expected to devote to new investment. D is what
  we have called above the effective demand.

28
Critique of Says Law

• (4)  Since D1 D2    D    f(N), where f is the
  aggregate supply function, and since, as we have
  seen in (2) above, D1 is a function of N, which
  we may write c(N), depending on the propensity to
  consume, it follows that f(N) - c(N)    D2.
• (5)  Hence the volume of employment in
  equilibrium depends on (i) the aggregate supply
  function, , (ii) the propensity to consume, and
  (iii) the volume of investment, D2.
• This is the essence of the General Theory of
  Employment. (Keynes 1936 pp. 28-29 bold
  emphases added)
• Reiterated in key 1937 paper The general theory
  of employment

29
Critique of Says Law

• The theory can be summed up by saying that,
  given the psychology of the public, the level of
  output and employment as a whole depends on the
  amount of investment.
• I put it in this way, not because this is the
  only factor on which aggregate output depends,
  but because it is usual in a complex system to
  regard as the causa causans that factor which is
  most prone to sudden and wide fluctuation.
• More comprehensively, aggregate output depends on
  the propensity to hoard, on the policy of the
  monetary authority as it affects the quantity of
  money, on the state of confidence concerning the
  prospective yield of capital-assets, on the
  propensity to spend and on the social factors
  which influence the level of the money-wage.
• But of these several factors it is those which
  determine the rate of investment which are most
  unreliable, since it is they which are influenced
  by our views of the future about which we know so
  little. (Keynes 1937, p. 221 emphases added)

30
Critique of Says Law

• Micro fact that production is not solely
  motivated by consumption means that
• Total employment depends on consumption demand
  and investment
• Investment depends on volatile expectations of
  profit in an uncertain world
• Involuntary unemployment can arise if low
  expectations of profit depress investment
• Monetary nature of capitalism vs commodity nature
  of simple commodity production the key reason why
  unemployment exists
• Not money is the problem but money is the
  object and employment incidental to making
  money
• Expectations crucial here too

31
Expectations uncertainty

• Previous (neo)classical theory ignored
  expectations, asserted Keynes
• at any given time facts and expectations were
  assumed to be given in a definite and calculable
  form
• The calculus of probability, tho mention of it
  was kept in the background, was supposed to be
  capable of reducing uncertainty to the same
  calculable status as that of certainty itself
  (1937 212-213)
• I accuse the classical economic theory of being
  itself one of these pretty, polite techniques
  which tries to deal with the present by
  abstracting from the fact that we know very
  little about the future. (1937 215)

32
In Marshall ( Walras) We Trust

• So what was classical economic theory?
• Prior to Great Depression, neoclassicals simply
  assumed macro was scaled up micro
• Aggregate balance assured by Says Law
• Individual market could have excess supply but
• Had to be balanced by other market(s) with excess
  demand
• Solution was for price of good in excess supply
  to fall
• If there were unemployed workers, it was because
  wages were too high
• Cut wages
• demand for labour would rise and
• supply of labour would fall
• Equilibrium restored

33
Neoclassical Macro

• And then, a funny thing happened on the way to
  equilibrium

The Great Depression
Arguably began with Stock Market Crash
And just one week before, the leading
neoclassical economist said that
34
Irving Fisher

• Stock prices have reached what looks like a
  permanently high plateau.
• I do not feel that there will soon, if ever, be a
  fifty or sixty point break below present levels,
  such as Mr. Babson has predicted.
• I expect to see the stock market a good deal
  higher than it is today within a few months.
  (Irving Fisher, October 15 1929)
• In the next few years, Irving Fisher lost12
  million dollars!
• Thats more than 100 million in 2000 prices
• Crash occurred on October 23rd 1929

35
A 120 Point Break in just 15 Days...
Crash continued for another 3 years
36
The Great Wall Street Crash
and thats the index 1948 SP had many stocks
that didnt exist in 1929 while many of 1929
firms had gone bankrupt
SP 500 from 32 at its zenith
25 years to recover
To below 5at its nadir
in less than 3 years
Not only theStockmarketcrashed
37
The Great Depression
WW II
38
The Great Depression
To 25 in 3 years
WW II Brings Sustained Recovery
From effectively zero...
39
Pre-Keynesian Macro

• After the event, neoclassicals tried to construct
  a truly macro rendition of their theory
• Example Hickss typical classical theory
  (outlined in Mr Keynes and the Classics)
• 2 industries Investment goods X consumption
  goods Y
• 2 factors of production labor (variable)
  capital (fixed in short run)
• Given capital stock in both industries

40
Hickss typical classical theory

• Output a function of employment Nx Ny
• Xfx(Nx) Yfy(Ny) where f has diminishing
  marginal productivity
• Prices equal marginal costs marginal product of
  labour times wage rate (since labour is only
  variable input)
• Marginal cost is increase in labor input (dNx
  dNy) for each increment to output (dx dy)
• Pxw.dNx/dx Pyw.dNy/dy
• Income value of output price times quantity
• I Ix Iy w.(dNx/dx) .x w.(dNy/dy) .y

41
Hickss typical classical theory

• Quantity of Money M a given, and fixed relation
  between M and income I (transactions demand for
  money only money a veil over barter)
• M k.I (k constant velocity of money)
• Demand for investment goods a function of
  interest rate
• IxC(i)
• Supply of savingsa function of interest rate
• IxS(i)
• Higher savings meanshigher investment (a
  familiar argument?)

Determines Nx
42
Hickss typical classical theory

• Causal chain
• M determines I (total output)
• i determines Ix (output of investment goods)
• Ix determines Nx (given w)
• I-Ix determines Iy (output of consumption goods
  is a residual)
• Iy determines Ny (given w)
• Lower money wage means higher employment
• Lower wage means lower prices
• Unchanged money I means higher income relative to
  prices, so higher sales
• Higher sales mean increased employment (and lower
  real wage due to diminishing marginal product)
• Against which Keynes argued that

43
Expectations uncertainty

• the level of output and employment as a whole
  depends on the amount of investment because
  this .. factor is most prone to sudden and wide
  fluctuation since it is influenced by our
  views of the future about which we know so
  little.
• Investment undertaken in order to generate profit
• Likelihood of profit depends on the future
• Need expectations of future now to decide how
  much to invest
• How do we form those expectations
• By rational calculation?

No!
because you can't rationally calculate the future!
44
Expectations uncertainty

• we have, as a rule, only the vaguest idea of any
  but the most direct consequences of our acts.
• Sometimes we are not much concerned with their
  remoter consequences, even tho time and chance
  may make much of them.
• But sometimes we are intensely concerned with
  them, more so, occasionally, than with the
  immediate consequences.
• Now of all human activities which are affected by
  this remoter preoccupation, it happens that one
  of the most important is economic in character,
  namely, Wealth.
• The whole object of the accumulation of Wealth is
  to produce results, or potential results, at a
  comparatively distant, and sometimes at an
  indefinitely distant, date.
• Thus the fact that our knowledge of the future is
  fluctuating, vague and uncertain, renders Wealth
  a peculiarly unsuitable subject for the methods
  of the classical economic theory (213)
• What does uncertain knowledge mean?

45
Expectations uncertainty

• By uncertain knowledge, let me explain, I do
  not mean merely to distinguish what is known for
  certain from what is only probable.
• The game of roulette is not subject, in this
  sense, to uncertainty nor is the prospect of a
  Victory bond being drawn. Or, again, the
  expectation of life is only slightly uncertain.
  Even the weather is only moderately uncertain.
• The sense in which I am using the term is that in
  which the prospect of a European war is
  uncertain, or the price of copper and the rate of
  interest twenty years hence, or the obsolescence
  of a new invention, or the position of private
  wealth-owners in the social system in 1970.
• About these matters there is no scientific basis
  on which to form any calculable probability
  whatever. We simply do not know. (214)
• What do we do then? Can we use probability anyway?

No!
46
Expectations uncertainty

• Imagine you are very attracted to someone
• This person has accepted invitations from 1 in 5
  of the people who have asked him/her out
• Does this mean you have a 20 chance of success?
• Of course not
• Each experience of sexual attraction is unique
• What someone has done in the past with other
  people is no guide to what he/she will do with
  you in the future
• His/her response not risky but uncertain.
• Ditto to investments
• success/failure of past instances give little
  guide to present odds

47
Expectations uncertainty

• How to cope with relationship uncertainty?
• We try to find out beforehand
• ask friendseliminate the uncertainty
• We do nothing
• paralysed into inaction
• We ask regardless
• compel ourselves into action
• We follow conventions
• follow the herd of the social conventions of
  our society
• play the game hope for the best
• So what about investors?
• Have to form some expectations of future

48
Expectations uncertainty

• Nevertheless, the necessity for action and for
  decision compels us as practical men to do our
  best to overlook this awkward fact that we
  simply do not know and to behave exactly as we
  should if we had behind us a good Benthamite
  calculation of a series of prospective advantages
  and disadvantages, each multiplied by its
  appropriate probability, waiting to be summed.
• How do we manage in such circumstances to behave
  in a manner which saves our faces as rational,
  economic men? We have devised for the purpose a
  variety of techniques, of which much the most
  important are the three following

49
Expectations uncertainty

• (1) We assume that the present is a much more
  serviceable guide to the future than a candid
  examination of past experience would show it to
  have been hitherto.
• In other words we largely ignore the prospect of
  future changes about the actual character of
  which we know nothing.
• (2) We assume that the existing state of opinion
  as expressed in prices and the character of
  existing output is based on a correct summing up
  of future prospects,
• so that we can accept it as such unless and until
  something new and relevant comes into the picture.

50
Expectations uncertainty

• (3) Knowing that our own individual judgment is
  worthless, we endeavor to fall back on the
  judgment of the rest of the world which is
  perhaps better informed.
• That is, we endeavor to conform with the behavior
  of the majority or the average. The psychology of
  a society of individuals each of whom is
  endeavoring to copy the others leads to what we
  may strictly term a conventional judgment. (214)
• As a result, expectations are
• subject to sudden and violent changes. All
  these pretty, polite techniques, made for a
  well-panelled Board Room and a nicely regulated
  market, are liable to collapse (214-15)

51
Expectations uncertainty

• As a result investment is volatile
• It is not surprising that the volume of
  investment, thus determined, should fluctuate
  widely from time to time. For it depends on two
  sets of judgments about the future, neither of
  which rests on an adequate or secure
  foundationon the propensity to hoard and on
  opinions of the future yield of capital-assets.
• Nor is there any reason to suppose that the
  fluctuations in one of these factors will tend to
  offset the fluctuations in the other. When a more
  pessimistic view is taken about future yields,
  that is no reason why there should be a
  diminished propensity to hoard which would
  reduce the rate of interest.
• Indeed, the conditions which aggravate the one
  factor tend, as a rule, to aggravate the other.
  For the same circumstances which lead to
  pessimistic views about future yields are apt to
  increase the propensity to hoard driving up the
  rate of interest. (218)
• So investment cant be regulated by the rate of
  interest

52
Expectations uncertainty

• Key aspects of Keyness arguments include
• Uncertainty
• Volatility of investment
• Impossibility of regulating investment using
  interest rate
• So how on earth did we get from this to IS-LM???
• Because Hickss review of the General Theory
  presented an entirely different model
• review taken as convenient summary of Keynes
• But omitted uncertainty entirely
• Presumed investment demand for money were
  stable functions of the rate of interest

53
Keynes according to Hicks

• Mr Keynes begins with three equations,
• ML(i), IxC(i), IxS(I)
• in contrast to (neo)classical theory ... the
  demand for money is conceived as depending upon
  the rate of interest (Liquidity Preference).
• On the other hand, any possible influence of the
  rate of interest on the amount saved out of a
  given income is neglected. Although it means that
  the third equation becomes the multiplier
  equation, which performs such queer tricks,
  nevertheless this second amendment is a mere
  simplification, and ultimately insignificant.

54
Keynes according to Hicks

• In this model
• Money demand/supply determines i

Ms
i

• i determines Ix
• Ix determines I via the multiplier
• Increase Ms-gtincrease I
• Increase propensity to invest, or to consume-gt
  increase I

Md
55
Keynes special theory, according to Hicks
Ms
i
Investment
Money marketdetermines int. rate
i
interest ratedetermines Investment
Md (liquidity preference)
Ixf(i)
Ix
M
I (output)
I (output)
Output determines employment
InvestmentdeterminesOutput
Ix
N (employment)
If(Ix)The multiplier
56
Keynes special theory, according to Hicks
Ms
i
Investment
Money marketdetermines int. rate
i
interest ratedetermines Investment
Increasing Ms increases N
Md (liquidity preference)
Ixf(i)
Ix
M
I (output)
I (output)
Output determines employment
InvestmentdeterminesOutput
Ix
N (employment)
Employment grows more than output because of
diminishing marginal product
If(Ix)The multiplier
57
Keynes special theory, according to Hicks
Ms
i
Investment
Money marketdetermines int. rate
i
interest ratedetermines Investment
Reducing LP increases N
Md (liquidity preference)
Ixf(i)
Ix
M
I (output)
I (output)
Output determines employment
InvestmentdeterminesOutput
Ix
N (employment)
If(Ix)The multiplier
Employment grows more than outputbecause of
diminishing marginal product
58
Keynes general theory, according to Hicks

• something appreciably more orthodox
• The dependence of the demand for money on
  interest does not ... do more than qualify the
  old dependence on income. However much stress we
  lay upon the 'speculative motive', the
  'transactions motive' must always come in as
  well.
• Hickss version of Keyness GT
• ML(I,i), IxC(i), IxS(I).
• vs Hickss version of typical classical theory
• Mk.I, IxC(i), IxS(i)

59
Keynes general theory, according to Hicks

• The LL (LM) curve
• Fixed Ms Md negative fn of i positive fn of I

The LM curve
Exogenous Ms
i
i
Md1 (I2)
Md1 (I1)
I
I2
I1
M
60
Keynes general theory, according to Hicks
I (income)
I (income)
IxS(I)
The IS curve Investment demand -ive fn of i
IxC(i) Savings supply ive fn of Income
IxS(I)
Savings a function of income
S
I (income)
i
Investment a function of interest rate
i
The IS curve
Multiplier
IxC(i)
I(output)
Ix (Investment)
61
Keynes general theory, according to Hicks

• The product IS-LM analysis

i
LL (now LM)
IS
I (output)
62
Keynes general theory, according to Hicks

• Keynes a neoclassical marginalist, according to
  Hicks
• Income and the rate of interest are now
  determined together ... just as price and output
  are determined together in the modern theory of
  demand and supply.
• Indeed, Mr Keynes's innovation is closely
  parallel, in this respect, to the innovation of
  the marginalists.
• Integrating Keynes and the Classics
• Slope of LM curve
• almost horizontal for low levels of I
• almost vertical for high levels of I

63
Keynes general theory, according to Hicks

• In Keynesian region, rightward shift of IS
  curve (by fiscal policy, etc.) mainly boosts
  income
• In Classical region, rightward shift of IS
  curve (by fiscal policy, etc.) mainly boosts
  interest rate
• the General Theory of Employment is the
  Economics of Depression, Classical is Economics
  of full employment

i
LM
Classical region
IS
Keynesian region
I (output)
64
Nice theory, but is it Keynes?

• Whatever Happened to Uncertainty Expectations?
• Hicks Ixf(i) Investment demand a function of
  the rate of interest (and income in more general
  model)
• Keynes Our knowledge of the factors which will
  govern the yield of an investment some years
  hence is usually very slight and often
  negligible
• It would be foolish, in forming our
  expectations, to attach great weight to matters
  which are very uncertain therefore, we are
  guided by the facts about which we feel
  somewhat confident, the facts of the existing
  situation enter disproportionately, into the
  formation of our long-term expectations
• Why not Ixf(i,I,E) where E is expectations?

65
Nice theory, but is it Keynes?

• Keynesian Economics as practised
• Keynes minus uncertainty expectations
• Keynes without uncertainty is something like
  Hamlet without the Prince. (Minsky, John Maynard
  Keynes, 1975, p. 57)
• Evolved towards the Neoclassical synthesis
• IS-LM macro grafted onto neoclassical micro
• Key architects Hicks Samuelson
• Revival of neoclassical economics as Keynes
  criticised for having bad microfoundations
• The accusation
• Cant derive Keynesian results from micro
• Therefore Keynesian macro at fault

66
Nice theory, but is it Keynes?

• Versus Keynes neoclassical microfoundations at
  fault when applied to real world
• I accuse the classical economic theory of being
  itself one of these pretty, polite techniques
  which tries to deal with the present by
  abstracting from the fact that we know very
  little about the future.
• But Hicksian version of Keynes
• Omits uncertainty, expectations, monetary nature
  of system
• Accepts neoclassical marginalism
• A straw man easily demolished in debate
• Ultimate outcome the rational expectations
  revolution

67
Rational Expectations Macroeconomics???

• Why rational expectations?
• Because if you believe neoclassical economics,
  you have no choice!
• Neoclassical vision micro explains macro
• Micro in balancemacro must be in balance
• Cycles, unemployment, etc. anomalies to be
  explained from within paradigm
• Back to basic neoclassical vision
• Demand derived from utility maximising
  individualS given budget constraint
• Supply derived from profit maximising firmS given
  market demand
• Equilibrium determines output AND relative prices

68
In Marshall ( Walras) We Trust
Z
X
Biscuits
q1
q2
q3
II
III
I
Wouldn't it be nice if macro was just...
Bananas
p1
Price Level
p2
Price of Bananas
p3
q1
Bananas
q2
q3
Output
69
In Marshall ( Walras) We Trust

• Only conditions under which this applies are
• When there are no aggregation issues
• Deferred until later, but remember from Advanced
  Political Economy
• Sonnenschein-Mantel-Debreu conditions
• Theory of firm aggregation errors
• When expectations equal predictions of model and
• Predictions are correct
• Prelude the Phillips curve
• Focus of much of neoclassical critique of Keynes
• So why did Phillips develop his curve?

70
Phillips Systems Engineering

• A.W. Phillips originally an engineer
• Learnt dynamic methods of engineering
• Applied them to economics
• Engineers model dynamics using time-varying
  equations
• Ordinary Differential equations
• Rate of change of variable(s) at time t functions
  of values at time t
• Partial Differential equations
• Rate of change of variable(s) at time t place p
  functions of values at t/p
• Difference equations
• Value of variable(s) at time t functions of
  values at previous discrete time intervals
• Engineers add systems flavourmodel interacting
  systems of equations

71
Phillips Systems Engineering

• Graduate British Institute of Electrical
  Engineers
• Apprenticeship at NZ hydroelectric power station
• Social policy interest after being Japanese POW
• Applied Engineering training to social dynamics
• Key question how to stabilise unstable economy
  at desired levels of output growth, employment
  etc.
• The Phillips curve was not constructed by
  someone who regarded himself as a statistician,
  or an econometrician, or even an economist.
• Phillips regarded himself (and was regarded by
  his contemporaries) as an engineer, constructing
  ingenious optimal control solutions to the
  stabilisation problem. (Leeson)

72
Phillips Systems Engineering

• Key observation by Phillips from engineering
  perspective
• The system has fairly satisfactory
  self-regulating properties when prices are
  moderately flexible but becomes unstable when
  there is a high degree of price flexibility.
  (1954, 313)
• In other words, excessive flexibility
  destabilisingopposite to economics belief
• Dynamic systems have tendency to overshoot
  equilibria if rate of adjustment too high
• Phillipss dynamic models considered parameter
  values and policies that could lead to
  stabilisation rather than explosive cycles

73
Hydraulic Keynesianism

• Work pre-dated availability of computers
• Built first models as analog hydraulic computer

• Models implemented differential equations
• Rate of change of prices

• Function of current level of stocks

74
Hydraulic Keynesianism

• Derided as hydraulic Keynesianism by many
  economists, but in reality Phillips an early
  critic of comparative statics in economics
• RECOMMENDATIONS for stabilising aggregate
  production and employment have usually been
  derived from the analysis of multiplier models,
  using the method of comparative statics.
• This type of analysis does not provide a very
  firm basis for policy recommendations
• First, the time path of income, production and
  employment during the process of adjustment is
  not revealed.
• It is quite possible that certain types of policy
  may give rise to undesired fluctuations, or even
  cause a previously stable system to become
  unstable,
• although the final equilibrium position as shown
  by a static analysis appears to be quite
  satisfactory (Phillips 1954, Stabilisation
  policy in a closed economy, Economic Journal p.
  290 e.a.)

75
Hydraulic Keynesianism

• Phillipss dynamic model had proposition of
  nonlinear relationship between factor prices
  and output
• We may therefore postulate a relationship
  between the level of production and the rate of
  change of factor prices, which is probably of the
  form shown in Fig. 11, the fairly sharp bend in
  the curve where it passes through zero rate of
  change of prices being the result of the greater
  rigidity of factor prices in the downward than in
  the upward direction (p. 308)

• After postulating existence of relationship, went
  looking for it in the data
• Intended purpose lost in subsequent debate
• Wildly at variance with how applied in practice

76
A systems approach to economics

• Phillipss ambition to wean economists off
  statics
• Built dynamic systems model of macroeconomy
• Time lags in adjustment of variables rather than
  comparative statics
• Time path of system plotted and analysed
• Basic model
• Production (P) Consumption (E) start in
  equilibrium
• Initial change in E
• Lagged response in P
• On the supply side, the rate of flow of
  current production is adjusted, after a time
  lag, to the rate of flow of aggregate demand
• On the demand side, aggregate demand varies
  with real income or production, without
  significant time lag. (291)

77
A systems approach to economics

• Time lag adjustment parameter of dynamic system
  to change in state
• Simple time lag easily solved and given intuitive
  interpretation
• Basic model the rate of flow of current
  production is adjusted, after a time lag, to
  the rate of flow of aggregate demand

• Gap between P E

• decays exponentially over time

• by changes in P

• Solving this symbolically

78
A systems approach to economics

• Take equation

• Rearrange to put Ps ts on either side

• Integrate LHS w.r.t. P RHS w.r.t. t

• LHS gives a log, RHS a constant time t

• Take exponential

• Rearrange

79
A systems approach to economics

• Include initial condition of equilibrium so P(0)0

• Solve for constant of integration C1

• Substitute back into equation for P(t)

• Plot the solution

• We can now interpret a
• Tangent to P at t0
• Line through 0,0
• with slope

80
A systems approach to economics

• Find differential

• At t0 this is

• Equation of tangent is thus

• Graphing this with P

81
A systems approach to economics

• Tangent to P intersects E at t0.25 or t1/a

• This is not an accident
• Tangent from initial condition on function f(t)
  intercepts ultimate value of f f(8) at t1/a
• where

• Phillipss a4 means
• Production adjusts to effective demand with a
  lag of ¼ of a year

• Modern systems engineers state lag explicitly
• Use a¼ write equation as

• Well stick with Phillipss notation for now

82
A systems approach to economics

• Phillips designed systems as engineering
  flowcharts

• 50 years after Phillips, systems easily simulated

83
A systems approach to economics

• As flowcharts

84
A systems approach to economics

• Or as equations

85
A systems approach to economics

• Phillips built complex model by series of
  extentions
• Start with simply lagged response of P to ED
• Add stabilisation policies
• Expand model to multiplier-accelerator
• Incorporate flexible prices
• Model price level as response to income demands
• Hence the Phillips curve
• Discounted impact of marginal cost on prices
• if factor prices are absolutely rigid,
  product prices, tending to move with marginal
  costs, will vary directly with the level of
  production.
• This component of the change in product prices is
  probably not very large, and will be neglected in
  the following analysis. (307)

86
A systems approach to economics

• Then provided rationale for factor price
  inflation in context of high demand
• Even with flexible factor prices, there will be
  some level of production and employment which
  will just result in the average level of factor
  prices remaining constant, this level of
  production and employment being lower, the
  stronger and more aggressive the organisation of
  the factors of production.
• If aggregate real demand is high enough to make a
  higher level of production than this profitable,
  entrepreneurs will be more anxious to obtain (and
  to retain) the services of labour and other
  factors of production and so less inclined to
  resist demands for higher wages and other factor
  rewards. Factor prices will therefore rise.
• The level of demand being high, the rising costs
  will be passed on in the form of higher product
  prices (307 emphases added e.a.)

87
A systems approach to economics

• Conversely, if aggregate real demand is so low
  that production at the level which would result
  in constant factor prices is unprofitable,
  entrepreneurs will be more anxious to force down
  factor prices, while at the lower level of
  employment factors will be less able to press for
  higher rewards and more inclined to accept lower
  rewards.
• Factor prices will therefore gradually move
  downwards, and the level of demand being low, the
  falling costs will be reflected in falling
  product prices. (307 e.a.)
• Then drew nonlinear relationship between level of
  production prices the (non-empirical) Phillips
  Curve

88
A systems approach to economics

• Wrote 2 more systems papers then published
• The Relation Between Unemployment and the Rate
  of Change of Money Wage Rates in the United
  Kingdom, 1861-1957
• Went from this conjecture

• To this estimation

89
A systems approach to economics

• How Phillips Curve was used shortly
• How Phillips intended to use it first
• Control engineering background
• Design systems to control fluctuating dynamic
  processes
• Air conditioning systems amplifiers
• First thought how to control fluctuations in
  dynamic changing economy
• First additions control systems to stabilise
  output
• Later addition nonlinear price relationship to
  increase realism of model
• Crucially, model naturally cyclical

90
A systems approach to economics

• Modern dynamics (later than Phillips) tells us
• nonlinear dynamic models normally have endogenous
  fluctuations
• fluctuations often chaotic

91
A systems approach to economics

• Modern example of former Goodwins
  predator-prey model of cyclical growth
• Predator-prey?
• Fish eat seagrass (assumed unlimited supply)
• Sharks eat fish
• Together, a cycle
• Low numbers of fish, sharks die off
• Less sharks, more fish reproduce
• More fish available, shark numbers rise
• More sharks, fish population declines
• Low numbers of fish, sharks die off
• How to model it?
• Use F for Fish and S for Sharks

92
Nonlinear Dynamic Systems

• Simplest population growth model
• (Fish) Population F grows at a p.a.

• Formula is

• Simulated as flowchart

• Simulated as equation

93
Nonlinear Dynamic Systems

• Similar relations apply for sharks

• Formula is

• Simulated as flowchart

• Simulated as equation

94
Nonlinear Dynamic Systems

• Simplest way to introduce interaction between
  fish sharks
• Sharks reduce fish growth rate in proportion to
  number of sharks

• Fish reduce shark death rate in proportion to
  number of fish

• Now have to model populations as linked
• Nonlinear relationships arise naturally
• Fish numbers times shark numbers quasi-quadratic

Linear Bits...
Nonlinear bits...
95
Nonlinear Dynamic Systems

• Generates system with endogenous cycles

96
Nonlinear Dynamic Systems

• Simulated as equation

• Similar logical chain generates cyclical growth
  model
• With Phillips curve as essential component

97
A predator-prey cycle in capitalism

• Goodwin (1967) implemented model of Marxs
• a rise in the price of labor resulting from
  accumulation of capital implies accumulation
  slackens in consequence of