Download VII Keynesian revolution

VII Keynesian revolution theory
Remark
• Lectures VII and VIII – closed economy only
• But see Lectures XI and XII
John Maynard Keynes
• 1883-1946
• Cambridge, UK
• Thinker –
economics, logic,
probability
• Practitioner –
Treasury during
WWI, advisor to the
War Cabinet at
WWII, crucial role at
the birth of IMF/WB
VII.1 General Theory – fundamental
contributions
VII.1.1 Consumption
Three postulates (1)
Three basic conjectures about savings
1. Consumption function of disposable income only
C  CYD 
2. CYD - marginal propensity to consume, MPC, is
positive and less than one: 0  CYD  1
• Savings function
S  YD  C  YD  CYD S  SYD , 0  SYD  1
•
SYD - marginal propensity to save, MPS, and
CYD  SYD  1
Three postulates (2)
3. Average propensity to consume
APC  C Y D
• Keynes assumed that APC falls with increasing
income
• If this is true: danger of secular stagnation of
capitalist economy (see later)
Linear consumption function C  C  cYD satisfies
all three postulates
After Keynes: large body of theory, huge empirical
research – see Literature
VII.1.2 Marginal efficiency of
investment
• Ch. II : investment as a decreasing function of real
interest, I=I(r), Ir<0
• Keynes called this relationship marginal efficiency of
capital, later labeled as marginal efficiency of
investment, MEI
• Keynes assumption: MEI reflects expected return,
these expectations very volatile, investment unstable
and more than on interest, depends on many
exogenous factors (low interest elasticity of
investment)
• After Keynes – more sophisticated investment
functions, for our purpose here we keep simple
investment function, with interest as only explanatory
variable
Real vs. nominal interest
• In the classical model: real interest r, in investment
function only
• On money markets: nominal interest i
– In classical model so far we did not need nominal interest,
as it was neither endogenous, neither exogenous variable
of the model
– In particular, in QTM, neither r, neither i has any role in
demand for money
• In Keynesian demand for money bellow, the decisive
variable is nominal interest i
• Not to complicate the explanation, a simple
assumption:
– Exogenous expected inflation πe and i = r + πe (Fisher
equation)
– More on Fisher equation and Fisher effect in later Lectures
• Investment function: I = I(i- πe), Ii<0, Ii→0
VII.1.3 Multiplier
Multiplier (1)
• The notion of multiplier – see already previous
lecture, in general form
– Here we go back to the origins of the concept
• Theoretical question: how does the equilibrium
change, if there is - ceteris paribus – change in
one of the exogenous variables (e.g. level of
investment)?
• Practical question during Great Depression: if
there is an improvement in investors’ expectations
about the future (i.e. there is an increase in
autonomous investment), what is the impact on
product (and employment)?
Multiplier (2)
• Famous textbook explanation for a simple economy
C = C(Y), Y = C + I, I exogenous
and for impact of change in investment
• Differentiation of equilibrium condition:
dY
1
dY  C Y dY  dI , and

dI 1  C Y
• The term 1 1-CY  = 1 SY  is (given the assumption on
MPC) higher than one and reflects (approximately)
impact of change in investment on the product
• Alternatively: sum of expenditures’ increments after
initial increase of AD


1
dY  dI  C Y dI  C dI  ...  dI 1  C Y  C  ... 
dI
1  CY
2
Y
2
Y
Keynes’ assumption on
multiplier
• Assumed unrealistically high levels,
approaching to 3
• If this was true, than the impact of an
exogenous change very strong (see next
Lecture discussion on policy
implications)
VII.1.4 Labor market, involuntary
unemployment
• Classical labor market: demand, supply, flexible
nominal wage, equilibrium
• Keynes:
– Does not dispute classical demand for labor
– Refuses the construction of the labor supply
• Workers do not adjust to real, but to nominal wage
• Nominal wage much less flexible:
– general political reasons after WWI (workers not ready to accept
wage cuts)
– during Great Depression it was possible to hire labor even
without increasing nominal wage
– On the labor market: possibility of an equilibrium with
involuntary unemployment
Nominal wage rigidity and
involuntary equilibrium
W/P
NS
ND
Y
F
Y1
Y2
W1/P2
W1/P1
N2
N1
N3
N
Fall of price → increase of real
wage → if nominal wage rigid
→ unemployment N3 – N2
N2
N1
N
If equilibrium employment N2
→ equilibrium output Y2, lower
than full employment output Y1
VII.1.5 Liquidity preference and
interest
• Keynes abandoned QTM
• Disregarding investment volatility – interest is
a key variable for Keynes, but
– It is not determined in interaction between
investment and savings
– It is given by equilibrium between supply and
demand on the money market
• Different role of interest – not as a reward for
postponed consumption, but reward for giving
up the possibility to hold liquid assets (money)
Why people demand money?
Three different reason to demand money
1. Transaction demand (see QTM): people demand
money to cover their transactions – increasing
function of income
2. Precautionary demand (not much importance):
people demand money to have enough cash increasing function of income
3. Speculative demand (principle difference from
Fisher’s version of QTM): people decide whether
hold money (that provides zero interest) or any type
of interest bearing asset (for simplicity called bond)
–
Here, in speculative money demand, nominal interest i (see
remark above)
Note: there is an inverse relation between interest and
price of bond: the larger is interest, the lower is the
price and vice versa (see any basic textbook on
Finance or Macroeconomics)
Liquidity preference
• Speculative demand – decreasing function of interest
• Primarily, people hold liquidity (money). They give up
this possibility (i.e. transfer their wealth into interest
bearing bonds), only when it brings additional yield:
– In general, the higher the interest, the higher the yield,
hence higher interest  lower demand for money
(and higher demand for bonds)
– Keynes: uncertainty and risk - if interest expected to
increase, than price of bond very low and people
prefer to hold money (why to hold bonds when their
price will fall?)
Demand for money
,
• Keynes labeled total demand for money as liquidity
preference
• Particular case: at very low rates of interest nobody
wants to invest into bonds (everybody expects the
interest to increase, so price of bond to decrease) and
people hold only money (money demand is infinitely
interest elastic – graphically horizontal)
• Demand for money:
D
M
 L(Y, i)
P
L(Y1 , i)
i
L(Y2 , i)
Y1  Y2
LY  0 , Li  0
M/P
VII.2 Equilibrium in the
Keynesian system
VII.2.1 Goods market and
effective demand
Effective demand and supply
determination
• Aggregate demand AD:
– consumption mainly given by disposable income, but has important
autonomous component; relatively stable
– investment, determined by expected return, very volatile, “animal
spirits”
– governmental expenditures exogenous
• Refusal of Say’s law:
– effective demand ≡ AD, supported by purchasing power (money),
i.e. the demand, the agents really want to spend money for
– such (effective) AD does not have to be equal to AD that would be
necessary to “buy out” the full employment output
– opposite causality compared to Say’s law: demand determines
supply (and production, employment)
Quantitative adjustment
• If consumption depends on disposable income only
• If investment depends less on interest, but mainly on exogenous
factors (expectations, uncertainty, etc.)
• If government expenditures exogenous
then
• Prices are not a decisive factor in determining supply and demand
on aggregate level
• In equilibrating processes, producers generate output according
effective AD
– adjustment of quantities, not of prices
– quantities, i.e. output, consumption, savings, investments, etc. adjust,
not prices
• Another essential novelty compared to classical model where
– Output determined on labor market that adjusted to wage (price of labor)
– Composition of demand determined by interest (price of money)
Equilibrium on goods market
• Equilibrium condition Y=AD, so
 
Y  CY  T   I i - πe  G or SY  T   Ii - π e   BD
• Solution  equilibrium output
• Quantitative adjustment – during the equilibrating
processes, quantities, not prices, adjust
– AD>AS  real investment higher than planned
 decrease of production
– AD<AS  vice-versa
• Graphical illustration: Paul Samuelson
– Required simplification: price entirely fixed
Paul A. Samuelson
•
•
•
•
•
1915 – 2009
MIT
Neoclassical synthesis
Teacher, professor
Textbook – Economics,
invented “Keynesian
cross” (see next slide)
• Foundation of Economic
Analysis (1947)
• Linear Programming and
Economic Analysis
• Nobel Price Award 1970
Y,AD
unintended
investment > 0
unintended
investment < 0
AD
E
45 o
Y1
Y0
Y2
S T
Y
S,I
E
Y1 Y0
I+BD
Y2
Y
VII.2.2 Money market
Interest and equilibrium on the
money market
• Nominal supply of money exogenous, controlled by
Central Bank
• Supply of real money:
MS P
• Equilibrium and interest determination:
MS
 L(Y, i)
P
– Interest too high ↔ excess supply of money → people buy bonds
(higher demand for bonds) → price of bond → i
– Interest too low ↔ excess demand for money → people sell
bonds (higher supply of bonds) → price of bonds  → i 
• Implication – by changing the supply of nominal money,
Central Bank can influence the level of interest
i
i1
i0
MS
P
E
i2
L(Y, i)
M0
P
M
P
Interest and money market
• Equilibrium on money market – supply of
money equals demand
• Principal difference from classical model:
interest is determined on money market and
results from
– Liquidity preference
– Supply of money by central authorities
• Reminder: classical model – interest is a
result of society’s thrift (savings) and
investment demand
Consequences for labor market
• If output determined on the goods market, than
employment corresponds to that level of output
• It does not have to be a full employment output –
such an output is only a special case → main
reason why Keynes called his book “General
Theory”
• If workers do not react to real wage → supply of
labor is missing in the Keynesian model and
nominal wage becomes (in particular moment of
time) and exogenous variable
• Equilibrium as a state of rest ↔ equilibrium with
involuntary unemployment
VII.3 Complete Keynesian model
VII.3.1 The model
• Market with goods and services
Y  C I G
Y  FK, N
demand and equilibrium,
assuming AD=AS
supply
• Labor market
N  N D W P 
demand
• Financial markets (money market)
M P  L(Y, i)
demand and equilibrium,
assuming MD=MS
• Components of aggregate demand
C  CY - TY
I  I(i - π e )
consumption function
investment function
Technical features
• 6 equations and 6 endogenous variables:
Y, C, I, N, P, i
– Important: price P is flexible!
• 5 exogenous variables: K, M, G, W, πe
• Equilibrium as a state of rest
• Demand equals supply on 2 markets: goods
and services and money
• Labor market
– Nominal wage W in particular moment is given
(exogenous)
– Supply schedule is missing!
• The model is completely interdependent, no
dichotomy, money is not a veil
VII.3.2 ISLM
ISLM – important comment
• Textbook interpretation (”orthodox” interpretation of
Keynes):
– Both prices and wages are fixed
– There are spare capacities in the economy, namely the more labor
can be hired without impact on the increase of wages and prices
– In simple interpretation of ISLM: no need to distinguish between
nominal and real interest rates (i and r), as price P is considered
fixed (i.e. πe=0); bellow we use r (but could use i as well)
• Fixed price: simplification of AD x AS relation in Keynesian
model as well
– Right-angled AS curve (see next slide)
• Less standard derivation bellow: starting from full model,
linearizing, collapsing into just two equations and getting
simultaneous solution
• For usual explanation of ISLM, see any textbook on
macroeconomics, with graphical interpretation
– Review: Appendix to this Lecture
P
AD1
AS
AD 2
P1
Y1
Y2
Yf
Y
John R. Hicks
•
•
•
•
•
1904-1989
LSE, Oxford
Value and Capital
Austrian school
Theories of economic
growth
• Nobel price (1972)
• ISLM model: “Mr.
Keynes and the
Classics”,
Econometrica, 1937
Linearization of the model
Taking total differentials of all equations
1
dY  dC  dI  dG
2
dY  FN dN  FK dK
3
dN 
4
dM dP M
- .  L Y dY  L r dr
P P P
(5)
(6)
FN  dW dP 
- 

FNN  W P 
dC  CY-T 1- TY dY
dI  Ir dr
IS curve
Substitute (5) and (6) above into (1) to get
1
where


(7) dY   Ir dr  dG


1 - C Y -T 1 - TY 
(7) is combination of all Y and r that satisfy equilibrium on
the goods market – IS curve (investment = savings); in a
(Y,r)-plane IS is decreasing (has negative slope):
dr
1
|IS 
0
dY
I r
If in (7) we assume dY=0 and allow G vary, than
dr
1
- 0
dG
Ir
i.e. with increased G, IS shifts “up and right”; and vice versa
LM curve (2)
dr
1 1
 . 0
dM L r P
i.e. with increasing M, LM shifts to the right, and vice
versa, decreasing M shifts LM to the left;
respectively
dr
1 1
- .
0
dW
L r P.W
i.e. with increasing nominal wage W, LM shifts to the
left, and vice versa, decreasing W shifts LM to the
right
LM curve (1)
From (3) single out dP/P and substitute into (4) to get
 
1  dM M dW  FNN M
(8) dr 
- .
  2 . - L Y dY 

L r  P P W  FN P
 
(8) is combination of all Y and r that satisfy equilibrium on
money market – LM curve (liquidity/money); in a (Y,r)-plane
LM is increasing (has positive slope):
dr
1
|LM 
dY
Lr
 FNN M

 2 . - L Y   0
 FN P

If in (8) we put dY=0 and allow M to vary (keeping dW=0),
respectively allow W vary (keeping dM=0), we get (see next
slide):
Equilibrium as ISLM
• (7) and (8) are 2 equations in 2 unknowns, Y and r
• Solution: values of output and interest (and by
substitution of other 4 endogenous variables) that
– Ensure the equilibrium on goods and money
markets
– On the labor market allow for equilibrium (as
state of the rest), where demand of labor does not
have to be equal to labor supply
r
LM
IS
r0
Y0
Y
VII.3.3 Graphical interpretation of the
full model
• Full model: we distinguish between i and r again
(πe≠0)
• Equilibrium output determined by effective
demand (ISLM)
• This level of output determines the employment
(on demand for labor schedule)
• Demand for labor determines real wage and when
nominal wage is given, then this determines price
P, consistent with equilibrium on money market
(with LM curve)
• Equilibrium (state of rest) with involuntary
unemployment
LM
i
NS
W/P
(W/P)0
i0
IS
Y0
ND
N0
Y
N
Y
Y
F
Y0
Y0
45°
Y0
Y
N0
N
VII.4 Underemployment
equilibrium?
VII.4.1 “Keynes effect”
• The model above
– In the instantaneous moment of time, model allows for
underemployment equilibrium – see above
– Crucial assumption: exogenously given nominal wage
– In reality, when we allow wage to change in time, even
Keynesian model does not stay in underemployment
equilibrium
• Adjustment mechanism described by Keynes himself before
General Theory in Treatise on Money (1930) – so-called “Keynes
effect”
• Excess supply of labor → W↓ → production costs ↓ → P ↓ →
real money (M/P)↑ → excess supply of money, people bid bonds,
i↓ and LM shifts to the right (see next slide), at the same time I↑
→ AD↑ → Y↑ → N↑
• Higher AD moderates decrease of price level, so nominal wage
falls faster than price (unbalanced deflation) → real wage falls
• The model converges towards full employment equilibrium,
underemployment equilibrium does not exists (see next slide)
LM0
i
NS
W/P
LM1
W0/P0
i0
W1/P1
IS
i1
Y0
Y1
ND
N0
Y
N1
N
Y
Y
F
Y1
Y1
Y0
Y0
45°
Y0
Y1
Y
N0
N1
N
VII.4.2 Underemployment equilibrium
• Given the reality of Great Depression, Keynes was seeking
for an explanation of long-lasting underemployment
equilibrium
• In the longer-run, nominal wage could not have been
considered as fixed
• When – with flexible wages - his model converges to full
employment equilibrium, he needed additional
assumptions to allow for a theoretical possibility of stable
underemployment equilibrium
• He, indeed, claims that two cases arise when
underemployment equilibrium exists:
– Liquidity trap
– Interest-inelastic investment function
VII.4.2.1 Liquidity trap
• When interest so low, that demand for money
becomes infinitely interest elastic
(horizontal), then
– Absolute liquidity preference (nobody wants to
purchase additional bonds)
– Interest does not react to changes in supply of
nominal money  liquidity trap
• LM curve becomes for some low value of
interest also horizontal
• Never observed in reality, in some situation,
some economies close (Great Depression,
Japan in the 1990s, today?)
Keynes effect locked
• When interest very low, only increase expected,
i.e. only fall of bond prices expected as well →
• Even when amount of real money increases,
people do not bid for bond, but keep additional
idle balance as cash →
• Fall of nominal wages and prices (both decrease
proportionally - balanced deflation) does not lead
to fall of interest, increase of investment, AD,
output and employment
• Economy remains at state of rest with involuntary
unemployment
• Graphical illustration – next slide
LM0
i
NS
W/P
LM1
(W/P)0
i0
IS
Y0
ND
N0
Y
N
Y
Y
F
Y0
Y0
45°
Y0
Y
N0
N
VII.4.2.2 Interest-inelastic
investment function
• When investment reacts very slowly to large
changes in interest then even a fall to zero
level interest does not have to generate
aggregate demand strong enough to allow
for full employment equilibrium output
• At least theoretically, the economy can stay
at state of rest with zero interest and output
with involuntary unemployment
• Graphically: IS curve very steep, full
employment output would require ISLM
intersection at negative interest rate
i
LM0
IS
LM1
(W/P)0
(W/P)1
i0
i1
NS
W/P
(W/P)F
ND
Y1
Y0
YF
N0
Y
N1
NF
N
Y
Y
F
Y1
YF
Y1
Y0
YF
Y0
45°
Y0 Y1 YF
Y
N0 N1 NF
N
VII.5 No “General” Theory
Underemployment equilibrium
• Given the explanation so far, under realistic
assumptions, i.e. flexible prices and nominal
wages (perhaps sluggish), the existence of
underemployment equilibrium in Keynesian
model is possible if only and only either the
assumption of liquidity trap and/or of extremely
interest inelastic investment function applies
• However, even this conclusion turned out to be
wrong
Pigou’s vengeance
• Arthur Cecil Pigou (see LIV), in 1943,
published an article where he proved that if
we make the consumption function slightly
more complex, introducing the wealth, the
strict Keynesian underemployment
equilibrium can not exist
• Pigou effect: falling prices increase real
wealth and consumption and aggregate
demand
• Increase of AD → shift of IS curve to the right
→ the economy converges to full employment
equilibrium even at either liquidity trap or with
very interest inelastic investment function
Criticism of Pigou effect
• If dynamic expectation introduced
• If we search for the time-length of the effect
• If we discuss how to define exactly the net wealth that
determines the consumption behavior of an individual
then Pigou effect does not have an practical impact
However: if we take the Keynesian theory, as presented in
General Theory, it is an unequivocal truth that
underemployment equilibrium can exist only with fixed
nominal wages. This was the end of the title „General
Theory“
… but it was not the end of Keynes
VII.5 Conclusions
Incomplete theory
• Greatest contribution: Keynes
opened entirely new avenues in
theoretical thinking
• Fallacy:
– his theory is not a general theory –
equilibrium with excess labor supply
depends on assumption of rigid
nominal wage
– his conclusions are fit for economies in
deep depressions (depend on the
assumption of liquidity trap and low
interest elasticity of investment)
Keynesian revolution
• Departure from existing economic
thinking (classical model)
• Pioneering:
– Equilibrium with unemployment
• equilibrium when DS
– New explanation of long-term unemployment
– New sort of economic policies – see next
Lecture
– New discipline - macroeconomics
– Closer to real data – System of national
accounts
Literature to Ch. VII
• Snowdon, B., Vane, H.: Modern
Macroeconomics, Edvard Elgar, 2005, Ch.1-3
(and the literature given here – General
Theory, Hicks, Pigou, etc.)
• Sargent, T., Macroeconomic Theory,
Academic Press 1987 (2nd ed.), Ch. 2
• Heijdra, B.J., van der Ploeg, F.: Foundations
of Modern Macroeconomics, Oxford
University Press, 2000, Ch. 1
• ISLM model – any intermediate textbook on
macroeconomics
Appendix: ISLM model
• “Historical” simplification (unfortunate)
• Simultaneous equilibrium on two markets, of
goods and money, prices fixed
• John Hicks: Mr. Keynes and the “Classics”
(1937)
• ISLM model is presented here only for the sake
of completeness
• However, it is assumed that students will
understand ISLM very well from standard
course of macroeconomics
The widespread interpretation
• Involuntary unemployment  production with
less than full utilization of resources
• Simplification: fixed prices (including nominal
wages)
– Interpretation: with high unemployment the firms
can increase production (higher workers) without
increasing wages (i.e. costs and prices)
• „right-angled“ aggregate supply (see main
text of this Lecture)
• Keynes never fully confirmed this approach
A.1 Goods market and IS
curve
Output multiplier
• For a moment, assume interest r fixed
• Equilibrium on the goods market:
Y  C Y  TY  Ir   G
• Differentiating equilibrium condition and
after arrangement (with dr = 0)
dY 
1
1  CY  T 1  TY 
dG   dG
• Multiplier of a change in exogenous variable
(G)
 =1 1-CY-T 1-TY 
Y,AD
AD  CY  T  Ir   G1
E1
AD  CY  T   Ir   G 0
E0
45 
S,I
Y0
Y1
E1
E0
Y0
SY  T  T
Y
Ir   G1
Ir   G 0
Y1
Y
Construction of IS curve
• Equilibrium on the goods market:
Y  C Y  TY  Ir   G
• One equation for two unknowns
• Graphically: set (locus) of points (Y,r),
maintaining goods market in
equilibrium
• Differentiating this equilibrium condition
and after arrangement the slope of IS is
given by
dr 1  C Y-T 1  TY  1


0
dY
Ir
I r
S,I
S+T
E1
Ir1   G
E0
Ir0   G
Y0
Y
Y1
r
r0
E0
E1
r1
IS
Y0
Y1
Y
IS curve (1)
• Differentiation of equilibrium condition =
movement along IS
• Slope of IS given by
– Multiplier

– Interest elasticity of investment
• Low interest elasticity I r  0 means
almost vertical IS dr dY  
• Keynes – low interest elasticity of
investment, hence small change of
investment, AD and product due to changes
in r
IS curve (2)
• Points off IS curve - disequilibrium:
– “to the right and above”: – high interest, low
investment and low AD  excess aggregate
supply
– “to the left and bellow” – low interest, high
investment and high AD  excess aggregate
demand
• Shift of IS  changes in exogenous
variables
A.2 Money market and LM curve
• Equilibrium on money market
MS
 LY, r 
P
• Again, one equation for two unknowns
• Graphically: set (locus) of points (Y,r),
maintaining money market in
equilibrium
• Differentiation the equilibrium
condition and arrangements give the
slope of LM
dr
L
dY

Y
Lr
0
r
r
S
M
P
r1
E1
r0
E0
LM
E1
r1
LY1, r 
r0
E0
LY0 , r 
M
 
 P 0
M
P
Y0
Y1 Y
LM curve (1)
• Differentiation of equilibrium condition =
movement along LM
• Slope of LM given by
– Income elasticity of demand for money
– Interest elasticity of demand for money
• If interest elasticity of demand very high Lr  
then LM curve almost horizontal:
dr dY  0
 liquidity trap
LM curve (2)
• Points off LM curve – disequilibrium
– “to the left and above” – high interest, people
interested in bonds (not in money)  excess
supply of money
– “to the right and bellow” – low interest,
people not interested in bond (but in money)
 excess demand
• Shift of LMS curve  changes in
exogenous variables
A.3 Equilibrium in ISLM
• Solution of the system of 2 equations in
2 unknowns
Y  C Y  TY  Ir   G
MS
 LY, r 
P
• Graphical solution, adjustment
processes
r
ESG
ESM
LM
ESG
EDM
EDG
ESM
EDG
EDM
IS
Y