ECONOMIC POLICY Part. I, Unit 3 J.M. Keynes - PowerPoint PPT Presentation


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ECONOMIC POLICY Part. I, Unit 3 J.M. Keynes


ECONOMIC POLICY Part. I, Unit 3 J.M. Keynes General Theory and its influence on the XX century policy debate – PowerPoint PPT presentation

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Title: ECONOMIC POLICY Part. I, Unit 3 J.M. Keynes

ECONOMIC POLICY Part. I, Unit 3 J.M. Keynes
General Theory and its influence on the XX
century policy debate
  • As already mentioned, classical and neo-classical
    (pre-keynesian) economists maintained that market
    mechanisms, provided that free competition held,
    were able to ensure an optimal allocation of
    resources and full employment
  • In the Walras-Pareto general equilibrium models,
    prices adjust very rapidly (instantaneously) in
    order to bring equilibrium both the markets for
    productive services and for consumer commodities

  • L. Walras (1834-1910) The role of government is
    to guarantee the legal framework for free
    competition. In particular, it should
  • i) guarantee the enforcement of contracts and the
    security of private property
  • ii) dismantle monopolies (natural monopolies
    should be nationalized).
  • Discretionary monetary and fiscal policies are
    not even contemplated.

  • More generally, in the neoclassical
    (pre-keynesian) models full employment was taken
    for granted
  • According to the Says Law, supply created its
    own demand
  • Households income was either spent ( C ) or
    saved ( S )
  • Y C S
  • Furthermore, whatever was saved by households,
    was invested in productive projects
  • S I
  • Excess supply or insufficient demand were ruled
    out by definition. In the classical/neoclassical
    world nothing is hoarded or lies idle

  • During the 1930s, however, the classical/neoclassi
    cal model appeared unable to explain the Great
    Depression, characterized by an unprecedented
    worldwide downturn of economic activity and
    prices and by high and persistent unemployment
  • Keynes General Theory (1936) a remarkable
    intellectual effort to explain and counteract
    this unprecedented crisis

  • In Keynes words
  • The composition of this book has been for the
    author a long struggle of escape from
    habitual modes of thought and expression The
    difficulty lies not in the new ideas, but in
    escaping from the old ones, which ramify into
    every corner of our mind (K., 1936, p. viii)

  • The General Theory includes two parts
  • Part I (chapters 1-18) is a fixed price model. By
    adopting a partial equilibrium approach, Keynes
    analyses in sequence the following markets
  • the labour market (chapter 2)
  • the goods market (chapters 3-10)
  • the capital market (chapters 11-12
  • the money market (chapters 13-17)
  • Part II (chapters 19-21) Keynes generalizes the
    previous model by assuming flexibility of wages
    and prices

  • The labour market
  • Keynes summarizes the classical theory of
    employment which was based on two postulates
  • the wage is equal to the marginal productivity of
    labour (N)
  • the utility of wage is equal to the marginal
    disutility of employment

  • Lets draw a Cartesian coordinate plane (vertical
    axis W/P and horizontal axis N). Assuming that
  • i) the marginal productivity of labour is
  • ii) the marginal disutility of labour is
  • the Classical economists were able to draw Nd
    (labour demand) and Ns (labour supply) as,
    respectively, a downward sloping and an upward
    sloping curve
  • Equilibrium real wage and employment were
    uniquely defined by the interaction of Nd and

  • In the Classical analysis unemployment was
    basically voluntary unemployment. This was due
    to the refusal or inability of a unit of labour,
    as a result of legislation or social practice or
    of collective bargaining or of slow response
    to change or of mere human obstinacy, to accept a
    reward corresponding to the value of the product
    attributable to its marginal productivity (K.,
    1936, p. 6)
  • The Classical model was also compatible with
    frictional unemployment.
  • It did not admit on the contrary unvolontary

  • In his analysis Keynes maintained that only the
    first postulate was correct the supply of
    labour, on the contrary, was indeterminate
  • Reasons
  • i) Labour contracts are stipulated for money
    wages (W) rather than for real wage (W/P)
  • ii) If W? ? production costs? ? P? there may
    exist no expedient by which labour as a whole can
    reduce its real wage to a given figure by making
    revised money bargains with the entrepreneurs
    (Keynes, 1936, p. 13)

  • As a consequence the labour market was
    indeterminate in Keynes view the level of
    employment was a function of the aggregate
  • The goods market and the capital market
  • As mentioned before, in the classical and
    neoclassical models aggregate supply creates by
    definition its own demand the goods market is
    always in equilibrium (Says law)

  • Keynes maintained on the contrary that aggregate
    demand could be insufficient and that this indeed
    was case during the Great Depression
  • In the General Theory he analyzed separately
  • i) consumption ii) investment
  • i) Consumption is a function of the disposable
    income and is fairly stable

  • ii) Investment according to Keynes (and to I.
    Fisher) investment decisions depend on the
    present value of the flow of profits a firm can
    expect from a particular investment versus its
  • Investment depends therefore on current interest
    rates, and on expectations of the future
  • Crucial point according to Keynes the basis of
    knowledge on which estimates of perspective
    yields have to be made are extreme precarious

  • we have to admit that our basis of knowledge for
    estimating the yield ten years hence of a
    railway, a copper mine, a textile factory, an
    Atlantic liner amounts to little and
    sometimes to nothing (K., 1936, pp. 149-50)
  • The role of the animal spirits

  • In former times investment depended on a
    sufficient supply of individuals of sanguine
    temperament and constructive impulses who
    embarked on business as a way of life, not really
    relying on a precise calculation of perspective
    profit. The affair was partly a lottery though
    with the ultimate result largely governed by
    whether the abilities and character of the
    managers were above or below the average
  • If human nature felt no temptation to take a
    chance, no satisfaction (profit apart) in
    constructing a factory, a railway, a mine or a
    farm, there might not be much investment merely
    as a result of cold calculation (K., 1936, p.

  • The unfortunate consequence, however, was that
  • economic prosperity is excessively dependent on
    a political and social atmosphere which is
    congenial to the average business man
  • Therefore, the fear of a Labour government, or of
    a New Deal can cause a collapse of investment
    simply because upsets the belicate balance of
    spontaneous optimism

  • If business men were reluctant to invest,
    government had to take the lead by adopting
    deficit spending policies aimed at improving the
    countrys infrastructure
  • Unfortunately, this was rarely the case indeed,
    Keynes observed, wars have been the only form of
    large-scale loan expenditure which statesmen have
    thought justifiable (K., 1936, p. 130)

  • The money market
  • In the classical model, the only function of
    money was that of medium of exchange
  • The demand for money was the following
  • Md kPY
  • 0?k?1
  • Keynes focused his analysis on the role of money
    as a store of value money indeed was by
    definition the asset characterized by the highest
    degree of liquidity

  • Demand for money in terms of liquidity preference
  • During a depression people had an obvious
    incentive to postpone investment and consumption
    decisions and to scramble for liquidity. This
    tendency, however, had the very unfortunate
    consequence of worsening the downturn of economic
  • Unemployment develops, that is to say, because
    people want the moon men cannot be employed when
    the object of desire (i.e. money) is something
    which cannot be produced and demand for which
    cannot be readily chocked off

  • In Keynes view the rate of interest is the
    reward for parting with liquidity for a specific
    period (K., 1936, p. 167)
  • The demand for money is a function of both
    income (direct relation) and the interest rate
    (inverse relation)
  • The money supply is exogenous (the amount of
    liquidity is determined by the Central bank)

  • In Keynes view, the transmission mechanism of
    monetary policy is basically indirect
  • provided that the demand for money is stable, an
    increase in money supply (Ms) would cause a
    reduction of the interest rate (i), an increase
    in investment (provided that expectations do not
    change) and an increase in aggregate demand

  • This mechanism, however, can become ineffective
    as a consequence of two factors
  • high interest rate elasticity of the demand for
    money (extreme case the liquidity trap)
  • adverse expectations in the business sectors.
  • In these circumstances monetary policy is totally
    ineffective in order to get out of the
    recession, governments have to adopt
    expansionary fiscal policies

  • Keynes General Theory was a watershed in XX
    century economic policy
  • However, the mainstream macroeconomic theory that
  • emerged in the early 1950s (and remained dominant
    till the
  • early 1970s) was actually a synthesis based on
    the ideas of
  • Keynes and earlier economists (the so called
  • synthesis)
  • The neoclassical syntesis was the result of the
    work of such
  • authors as J. Hicks, A. Hansen, P. Samuelson, F.
  • Modigliani, D. Patinkin
  • .

  • The most influential formalization of Keyness
    ideas was the IS-LM model, developed by John
    Hicks and Alvin Hansen in the 1930s and early
  • Policy discussions became organized around the
    slopes of the IS and LM curves.
  • Another influential tool elaborated by the
    Keynesian economists after WWII was the Phillips

  • The Phillips curve was discovered in 1958 as an
    empirical relation between the rate of
    unemployment and the rate of inflation
  • In 1960 the economists P. Samuelson and R. Solow
    replicated Phillips exercise using U.S. data
  • They identified a stable, negative relation
    between u e p (rate of inflation)
  • 1 pt ? a ut

  • This relation implied that the governments were
    able to choose between different combinations of
    unemployment rates and inflation rates
  • During the 1960s the Keynesian model and the
    Phillips curve were severely criticized by Milton
    Friedman, the leader of the monetarists

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