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11. THE KEYNESIAN REVOLUTION

1. The role of aggregate demand

2. The multiplier

3. Money and the rate of interest

4. The issue of wage rigidity

5. A benchmark model

6. The Keynesian doctrine

The prolonged depression of the 1930’s is not explicable in terms of the simple classical (or neoclassical) model, which claims that full employment is the natural state of affairs, and which does not deal with financial instability issues.

Keynesian economics is the creation of John Maynard Keynes, notably trough his ’General Theory of Employment, Interest and Money’ (1936).

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1. The role of aggregate demand

John Maynard Keynes turned Say’s law upside down: supply does not create its own demand (Say’s law); it is rather the case that demand calls forth a corresponding supply of output.

It is identically true that total production = total income = total expenditure (with appropriate definitions and according to national income accounting) but the identity does not tell at what level this equality will hold (need not be at the full employment level).

Implication: total output may be at a level with less than full resource utilization.

Demand is the driving force (in the short to medium term): private consumption, private investment, exports, public exenditure in focus of analysis.

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2. The multiplier

Assume that firms increase their investment expenditure. Assuming available resources this will increase production and employment and total income.Part of the increase in income of households will be spent on consumption, which will again increase to that extent production and income, which will again increase consumption to some extent …Also, the increase in profits and in the rate of capacity utilization may increase investment, which increases production and income …However, some part of the increase of income of households will be saved, and to that extent there will be no corresponding direct increase in consumption demand.Also, part of the increase of income will go to the public sector in the form of taxes.And part of income will be spent on imports, which increases demand for production abroad but not in the home country.The outcome: An increase in ’autonomous demand’ (demand which is not directly caused by income) will increase production and income through both a direct effect and through a chain reaction (feedbacks) such that the total effect may well be different and bigger than the initial demand impulse.

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3. Money and the interest rate

Keynes assumed that holding money is an alternative to holding interest-bearing assets (stocks or notably bonds). So how is the portfolio allocation decided?Some money is held for transactions purposes (like in the quantity theory of money), being a function of the level of transactions and income.Some money is held for precautionary purposes, to have reserves if something unexpected happens.The amount of money will be a negative function of the expected yield on bonds, because that is the relevant opportunity cost of holding money (which bears no interest). If the interest rate on bonds is very low, close to zero, then there may be expectations that it is likely to rise (understandably). But a rise in the interest rate on bonds is equivalent to a fall in the market price of the bond, meaning that the bond holder suffers a capital loss. For very low interest rates it may therefore be the case that portfolio holders prefer to stick to cash in order to avoid an expected loss on bond holdings. An increase in money supply, generated by the central bank buying bonds, wold in this case be met by an increase in the demand for money; it would not lead to a further fall in the bond yield, this is the ’liquidity trap’.

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4. The issue of wage rigidity

It has been claimed that Keynes reasoning, when taking it that unemployment may prevail, is based on the assumption of wage rigidity (due to unions or wage regulation). This would then be the cause of unemployment.

A counterargument is that falling wages will not reduce real wages unless they fall faster than prices. Also, the question anyway remains: who is buying the additional production.

Furthermore, deflation would cause expectations of further deflation, which would reduce expenditure on, say, consumer durables and houses (why buy now if you can buy at a cheaper price tomorrow?), which is a recepy for depression.

Even if wage rigidity exists, it may not be due to unions or authorities but to firms and labor markets behaving in a different manner than assumed by the (neo)classical economists (e.g. ’efficiency’ wage theory).

Expansionary policy with a view to raising employment may therefore be a more practical way of achieving positive results than just waiting for automatic reactons in the labor market.

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5. A benchmark model

The following is the standard textbook model, the origin which is an article by John Hicks in 1937.

Y = C + I + G + X – M and S = (Y – T) – C gives

(S - I) = (G - T) + (X - M)

(which implies, e.g., that a rise in S and/or fall in I must have a counterpart in a rise in G-T or in X-M. So it may be difficult to raise S-I and T-G at the same time (without a big increase in X-M). Assuming S=sY and M=mY:

sY – I = G-T + X – mY gives Y = (G-T+I+X)/(s+m)

So the ’multiplier’ is 1/(s+m), which can be rather big. Note also that an increase in the saving rate s will decrease income and will have little effect on saving (and none at all if m=0) = ’the paradox of thrift’.

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A benchmark model (cont.)

Assume that I = I(r), that investment is a function of the rate of interest. The we get

Y = (G – T + X – I(r))/(s+m) or the IS-curve (negative slope)

Assume also that money supply M (not imports!) equals money demand L(Y,r), then LM:

So short-term equilibrium is r IS LM determined by the required

equilibrium in the goods market(demand = supply/output) the money market (portfolio balance) .

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A benchmark model (cont.)

r LM Fiscal expansion shifts IS to the right and IS’ the equilibrium from A to B with higher IS B output and higher interest rate, the latter A modifying the rise in output. NB: no positive

output effect if IS is vertical, strong effect ifLM is horizontal (the ’liquidity trap case).

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r Monetary expansion shifts LM to the right IS LM LM’ and the equilibrium from A to B with higher A output and lower interest rate. NB: no positive

output effect if IS vertical or if LM horizontal B (monetary policy is ineffective in the ’liquidity Y trap’).

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6. The Keynesian doctrine

Keynesian economics were felt to be revolutionary not only because of the analytical differences as compared to the classical analysis (big as these are) but above all because it implied quite a different role for economic policies and the state:

The authorities may need to pursue active stabilization policies with a view to mainting a high level of aggregate demand in order to avoid recession or depression and to keep up high employment.

This can in normal circumstances be done by monetary policy and the central bank. However, this channel will not be effective if ’liquidity trap’ prevails and/or if investment is not sensitive to the rate of interest but depends overwhelmingly on ’aimal spirits’.

In such situations there is a need for active, countercyclical fiscal policies. NB: fiscal policy should not be evaluated in terms of the budget balance but in light of its appropriateness for the cyclical situation of the economy.

Wider repercussions: Keynesianism paved the way for a broad reappraisal of the role of government also in the area of financial regulation and even with regard to its wider responisbilities for the welfare of citizens (the welfare state). These repercussions are ideologically controversial.