Download Keynesian economics

KEYNESIAN ECONOMICS
ECON 434 | Spring 2011
How do we explain this?
Or this?
Economic impact
1929
1933
Banks in operation
25,568
14,771
Prime interest rate
5.03%
0.63%
1.1 B
0.65 B
Privately earned income
$45.5B
$23.9B
Personal and corporate savings
$15.3B
$2.3B
Volume of stocks sold (NYSE)
Impact on consumer spending
1929
1933
Food
$19.5
$11.5
Housing
$11.5
$ 7.5
Clothing
$11.2
$ 5.4
Automobiles
$ 2.6
$ 0.8
Medical care
$ 2.9
$ 1.9
Philanthropy
$ 1.2
$ 0.8
Value of shares on the
NYSE
$89.0
$19.0
Does this hold?
LRAS (Ɛ = 0)
P
D0
D1
Q
John Maynard Keynes (1883-1946)


One of the most (if not
the most) influential
economists of all time.
Most of modern
macroeconomics is
based on his The
General Theory of
Employment, Interest,
and Money (1936)
Keynesian theory (in very brief)



Demand creates its own supply
Unemployment can happen in the short run (it can
be a semi-permanent situation, absent some
external force to reduce it; read: the government)
Governments can revive the economy through
changes in fiscal policy (government spending)
Keynesian theory






Keynesian theorists and classical
macroeconomists would be most
likely to agree about how this
economy will adjust if:
(a) Aggregate Demand declines
from AD1 to AD0.
(b) classical full employment
requires output Q1.
(c) the recessionary gap equals the
GDP gap.
(d) severe stagflation occurs at
point a.
(e) Aggregate Demand increases
from AD1 to AD2.
Keynesian theory






Keynesian theorists and classical
macroeconomists would be most
likely to agree about how this
economy will adjust if:
(a) Aggregate Demand declines
from AD1 to AD0.
(b) classical full employment
requires output Q1.
(c) the recessionary gap equals the
GDP gap.
(d) severe stagflation occurs at
point a.
(e) Aggregate Demand increases
from AD1 to AD2.
Keynesian theory

For Keynes: Ensuring adequate AD is the most important
for ensuring full employment
Expansion of productive capacity and price-level stability
are secondary goals (pursued after the achievement of full
employment).
 AD alone determines output and employment in the midst of
a depression because AS in this range would be relatively
flat.
 Assumes that idle productive capacity allows production and
income to stretch to accommodate growth in AD without
causing inflationary pressure

Aggregate expenditures


GDP = C + I + G + (X – M)
C: consumption
Autonomous consumption: unrelated to income
 Induced consumption: occurs only because people have
income to spend






Marginal propensity to consume: the relative change in
consumption induced by a small change in disposable income
(ΔC/ΔY)
I: investment
G: government spending
X: exports
M: imports
Investment


While consumption is the most stable component of GDP,
investment is the least stable.
According to Keynesian theory, the volatility of investment
(due, in part, to “animal spirits”) is the root cause of most
business cycles



Greenspan: Irrational exuberance
Keynesian macroequilibrium occurs when saving and
investment are equal
Investment is only mildly influenced by interest rates but very
sensitive to even minor changes in the expectations of
business.

Pessimism causes investment to plummet, while optimism causes
sudden surges in investment
Macroequilibrium
Savings
S > i: Undesired inventory
accumulates; firms reduce
production
Savings,
investment
Investment
I > s: Inventories
shrink; firms boost
production
National income
The multiplier

The multiplier effect occurs when one person’s
spending becomes someone else’s income, and some
of the second person’s income is subsequently spent,
becoming the third person’s income, and so on.
 1/(1
– mpc)
The paradox of thrift

What happens if we try to save more?
Classical analysis: Saving promotes investment and growth
 Keynes: Attempts to save more may cause income to fall so
much that actual saving shrinks

Consumption falls when households try to save more. Firms will
counter declining sales and swelling inventories by cutting
production, employment, and investment.
 Saving is the natural reaction to hard times; if a growing number
of households start saving, the momentum for a recession can build
 The paradox of thrift, however, is probably irrelevant in an
economy operating at full steam

Fiscal policy debates
Policy change
Keynesians
Supply side
Tax rates raised
Generates more revenue for
govt. In a recession, higher
tax rates may also worsen
the economic conditions and
actually reduce tax revenue
b/c high taxes dampen
consumer spending
Reduces AS because of
incentive effects.
Disincentives from high tax
rates may cut AS so much
that revenues fall (see the
Laffer curve)
Government purchases
raised
Raises AD and income both
directly and via a multiplier
effect
Reduces AS because people
have fewer incentives to
produce and generate
income if the government
does more for them
Functions of money

Medium of exchange


Measure of value (standard unit of account)


Used as a common denominator to rank relative prices
Store of value


Money is used to execute transactions
Held as an asset because it is less risky or because they view the
transaction costs of conversion to other assets as too high
(*Keynesian notion)
Standard of deferred payment

Allows for intertemporal contracts (i.e., money is good for more
than immediate purchases [the classical view])
Demand for money

Transaction demand


Precautionary demand



People want money so they can spend it
People want money because they know that unanticipated
spending is required at times
Keynesian invention; classical economists would agree with this,
however, because it assumes money is closely related to income
Asset demand


Major Keynesian invention that clashes with classical theory
People hold money because (a) they expect the prices of stocks
and bonds to fall in the near future, (b) are reluctant to hold only
assets that tend to swing widely in value, and (c) believe that
transaction costs are higher than any expected returns from
investment in stocks/bonds.
Cost of holding money
Classical view: Cost of a dollar is what you
could buy with it
Keynesian view: Cost of a dollar is the
interest you sacrifice by not making a
different financial investment
Nominal
interest
rate
1/P
Quantity of money
demanded
Quantity of money
demanded
Keynesian monetary theory




Velocity of money is NOT constant
Full employment is NOT the natural state of a market
economy
Asset demand for money: Rising uncertainty (not
income) is a major reason for the growth of money
demanded.
The liquidity trap: At very low interest rates, growth of
the money supply yields neither extra spending nor
declines in interest rates; extra money is absorbed
through hoarding into idle cash balances (put it under
your mattress)
Some material taken from Economics,
Byrns and Stone, 6th edition