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Principles Of Economics
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Chapter 13
Keynes and Keynesian
Macroeconomic Policy
►
©
April 5, 2007
J. Patrick Gunning
What Is Macroeconomic Policy
►
Macroeconomic problems:
 1. How to promote economic growth.
 2. How to maintain an acceptable level of
unemployment.
 3. How to maintain an acceptable level of
inflation.
► Macroeconomic
policy refers to government
policy that attempts to “solve these
problems.”
Birth Of The Idea Of Macro Policy
► The
unemployment of the great depression.
► Followed by WWII.
► In 1946, would the depression and its
unemployment return?
► The Employment Act of 1946 was passed.
A Shift Of Faith
► The
act gave the executive branch of the
U.S. government the power and
responsibility to try to carry out
macroeconomic policy.
► The Employment Act signified that, for
many citizens, a faith in unrestricted free
enterprise had been replaced by a faith in
government guidance of free enterprise.
Types Of Macroeconomic Policies
Since 1946
► 1.
Keynesian economics (1946-1970s).
► 2. Monetarism (began to influence policies
beginning in the 1970s).
► 3. Supply-side economics (mid-1970s to
1990s).
Two Parts of This Chapter
► 1.
► 2.
The Economics of Keynes.
Keynesian economics: the
macroeconomic policy proposed by
economists who roughly followed the
economics of Keynes.
New Topic: The Economics Of
Keynes
► Keynes:
famous economist at Cambridge
University in England.
► Wrote The General Theory Of Employment,
Interest And Money (1936).
► Difficult-to-read book about unemployment
and output in a recession.
First Point: Keynes’s Hypotheses About
Real Output And Business Cycles
► Keynes
made two important points:
► 1. Real output may not reach its potential because
there may be less than the optimal amount of
entrepreneurship.
► 2. Business cycles are likely to be more severe
than neoclassical economists believed because:
 A. Entrepreneurs' investment is unstable.
 B. Wages are rigid.
 C. Lenders may speculate on the rate of interest.
Real Output Less Than Its Potential
► Real
output gap: a gap between the actual real
output and potential real output.
► Keynes believed that there would be a real output
gap due to risk averseness.
► Risk averse: the characteristic of a person who is
less willing to choose a prospect for gain with an
uncertain payoff than to choose on one with a
certain payoff. Risk averseness is measured by
comparing the expected payoff of each prospect.
Risk Averseness
►
Consider two prospects for gain:
 A: a 100 % probability of receiving $100.
 B: a 50 % probability of receiving $200.
 B is more risky because the probability of receiving it is lower.
►
Which would you prefer?
 If you prefer A, you are risk averse.
 If you prefer B, you are a risk preferrer.
 If you are indifferent, you are risk neutral.
►
Risk premium: the amount of money that a person
demands in order to compensate him for accepting an
alternative that is more risky than other.
 An example.
Second Point: The Business Cycle Is
Likely To Be More Severe Than We Think
► Three
► 1.
reasons:
Entrepreneurs’ errors.
► 2. Rigid Wages.
► 3. Speculation by Lenders (the liquidity
trap).
1. Entrepreneur Errors
► Entrepreneurial
investment may exaggerate the
amplitude of the business cycle because
entrepreneurs may exhibit “follow the leader”
over-optimism or over pessimism.
► Entrepreneurs are subject to mass psychology.
► They may jump on the bandwagon and follow the
crowd instead of making decisions based on a
sound assessment of revenues and costs.
2. Rigid Wages
► Keynes:
the presence of rigid wages cause
unemployment to be higher during a business
cycle than one might think on the basis of demand
and supply analysis.
► Workers may be happy to accept increases in pay
during an expansion but unwilling to accept
decreases during a contraction.
► Union leaders may resist an employer’s proposal
to decrease wages.
► The employer may have no option but to lay off
workers, causing unemployment.
3. Speculation By Lenders
► The
hypothesis: speculation by lenders may
stop complete coordination in markets for
loanable funds.
How Coordination Occurs
► Review
of a normal adjustment to a
decrease in demand for loanable funds.
► Suppliers reduce the interest rate and the
quantity of loanable funds.
► See figure 13-1.
Figure 13-1
Lender Psychology May Block
Coordination In The Loan Market
► If
you were a lender and expected the
loanable funds rate to rise on one-year
loans, you may not want to lend.
► If every lender was like you, no lending
would occur.
► Consider figure 13-2.
Figure 13-2
Rate Cannot Fall Below 2%
► Suppose
that once the rate fell to 2%,
everyone expects it to rise in the near
future.
► Then it could not fall to 1% even though
the supply of loanable funds curve shows
that some lenders would be willing to lend
at 1%. Because lenders speculate on the
rate of interest, at 2% the supply of
loanable funds would go to zero.
Keynes’s Idea In Terms Of Liquidity
► Liquidity:
the character of an asset based on
the extent to which it can be easily
exchanged for goods. Money is the most
liquid asset.
► When the interest rate falls to 2%, lenders
want more liquid assets than the one-year
loans.
Liquidity Trap
► Liquidity
trap: the hypothesis that below
some rate of interest, lenders would make
no loans because they expect that the rate
would rise.
► The loanable funds market in figure 13-2 is
in a trap because below a certain rate of
interest, lending would cease.
Keynes Assumption About The
Loanable Funds Market
► Keynes
did not assume, as we have done,
that there are many loanable funds
markets, each with a different length and
starting time.
► The liquidity trap hypothesis did not
consider the short-term loan market.
Keynes’s Corrective Policy
► To
assure that business firms remain
profitable during a recession.
► This can be done by stabilizing aggregate
spending.
New Topic: Keynesian Economics
► The
Employment Act of 1946 led the president to
form a Council of Economic Advisors.
► Keynes died in 1946.
► Members of the Council, interpreters of Keynes,
and their colleagues developed a set of principles
for carrying out macroeconomic policies.
► Around 1950, these principles were included in the
first textbooks that distinguished macroeconomics
as a separate field of study.
Macroeconomics And Microeconomics
As Defined In The Textbooks
► Macroeconomics:
the study of “the economy
as a whole” and the policies that could be
used to guide it.
► Microeconomics: the study of markets and
prices.
Macroeconomic Equilibrium
► Keynesian
macroeconomic model: a model
of aggregate demand and aggregate supply
of Keynesian real output produced during a
period of time.
► Macroeconomic equilibrium: the price level
and level of Keynesian real output at which
aggregate demand equals aggregate supply.
Aggregate Demand
► Aggregate
spending: spending on Keynesian
real output.
 Keynesian real output: final products produced
during a period of time, including services. It
does not refer to unfinished products or to used
goods.
► Aggregate
demand (curve): the amount of
spending on Keynesian real output that we
assume would occur at different price levels.
Components Of Keynesian
Spending
► The
class divisions of and the names assigned to
the classes are based roughly on who spends on
the final products.
 1. Consumption spending (C): spending by households
on finished goods and on services.
 2. Investment spending (I): spending by business on
newly-produced capital goods, increases in business
inventories of finished products, and spending by
households on new houses (Households spend on this.
It is an exception.)
 3. Government spending (G): spending by governments.
Graph of Aggregate Demand Curve
Why Aggregate Spending Might Be
Higher At Lower Price Levels
► 1.
Consumer spending might be higher
because households are likely to feel that
they can afford to buy more goods at lower
prices.
► 2. Businesses investment spending is likely
to be higher because when the price level is
low, interest rates are also low.
Aggregate Demand Curve vs.
Ordinary Demand Curve
► The
ordinary demand curve for a consumer good
refers to the marginal consumer’s evaluation of an
additional unit.
► The ordinary derived demand curve for a resource
refers to the marginal entrepreneur’s belief about
the additional revenue he can earn from
employing one more unit.
► The aggregate demand is unrelated to these. It is
the total real output on which spending is
assumed to occur at different levels of prices.
More spending is assumed to occur at lower price
levels.
Aggregate Supply
► Aggregate
supply: the amounts of different
finished goods and services produced during a
period of time. The goods and services are
produced by business firms and by government
agencies.
► Aggregate supply (curve): the amount of
Keynesian real output that is produced by
producers of products at different price levels plus
the real amount of government production.
Graph of Aggregate Supply Curve
Why Aggregate Supply Might Be
Higher At Higher Price Levels
► Possibility
1: firms produce a larger output
at higher price levels than they produce at
lower price levels.
► Possibility 2: firms charge higher prices for
higher quantities of goods, perhaps because
they must do so in order to hire more
resources.
Aggregate Supply Curve vs.
Ordinary Supply Curve
► The
ordinary supply curve is a marginal cost
curve.
► It represents the cost to the marginal
entrepreneur of producing the next unit.
► It also represents the utility foregone when
resources are not used to help cause other
goods to be produced and consumed.
Model Of Macroeconomic
Equilibrium: Figure 13-3
Explanation of Figure 13-3
► Macroeconomic
equilibrium (figure 13-3): the
combination of price level and real output at which
aggregate demand equals aggregate supply, i.e.,
where the aggregate demand curve and the
aggregate supply curve cross. Firms would not
want to produce a larger quantity than qe.
Adjustment In Price Level And Real Output
If The Macroeconomy Is Out Of Equilibrium
► At
p1 in figure 13-3, producers would produce
goods that they cannot sell. At such a price level,
consumers would feel too poor to buy all the
consumer goods that have been produced. The
price level would tend to fall leading businesses to
cut back production.
► At p2 in figure 13-3, producers will have produced
a lower real output than the spending that
consumers, businesses, and the government want
to do. The price level would tend to rise leading
business investment to increase, thereby
increasing real output.
Demand And Supply Shocks
► Demand
shock: a shift in the aggregate demand
curve – households, firms or government want to
spend more or less than before at each price level.
 Cause? A change in confidence, perhaps due to a
change in housing prices or a change in the stock
market, a particularly cold winter, or a storm-prone
summer.
► Supply
shock: a shift in the aggregate supply
curve – firms want to supply more or less than
before at each price level.
 Cause? A disaster that affects energy supplies, a major
technological advance.
Effects Of A Demand Shock:
Figure 13-4
Effects Of A Supply Shock:
Figure 13-5
Two Kinds Of Macroeconomic Policy
► Fiscal
policy.
► Monetary
policy.
Fiscal Policy To Affect Equilibrium
Real Output
►Fiscal
policy: increases and decreases
in government spending and consumer
taxation.
►Expansionary fiscal policy: reducing
taxes and/or raising government
spending.
►Contractionary fiscal policy: raising
taxes and/or reducing government
spending.
Expansionary Fiscal Policy
► Keynesians
believed that this policy could maintain
real output and employment at high levels. It
could insure that firms would not make losses.
► They believed that it can prevent a contractionary
phase in the business cycle and, therefore,
prevent the unemployment rate from falling below
a target level.
► Reducing taxes raises consumer spending (C).
Both this and increased government spending (G)
raise aggregate demand.
Contractionary Fiscal Policy
► Keynesians
believed that this policy can
prevent or moderate the expansionary
phase of a business cycle and control
inflation.
► Raising taxes would reduce consumer
spending (C). Both this and a reduction in
government spending (G) would reduce
aggregate demand.
Popular Keynesian Beliefs About
Fiscal Policy
► 1.
Keynesians believed that expansionary
fiscal policy can prevent or moderate the
contraction phase of the business cycles
and, therefore, maintain real output at a
high level and reduce unemployment.
► 2. Keynesians believed that contractionary
fiscal policy can prevent or moderate the
expansionary phase of a business cycle and,
therefore, help control inflation.
Full Employment Equilibrium
► The
goal of Keynesian fiscal policy is full
employment equilibrium.
► Full employment equilibrium: a
macroeconomic equilibrium at which a
target level of unemployment is achieved –
also called full employment GDP (gross
domestic product).
► GDP, adjusted for inflation, is a statistical
measure of real output.
Three Models Of Full Employment
Equilibrium: Figure 13-6
Actions Needed To Achieve Full
Employment Equilibrium
► Left
panel: full employment economy – no
action necessary.
► Center panel: unemployment economy –
expansionary fiscal policy needed to achieve
full employment equilibrium.
► Right panel: inflation economy –
contractionary fiscal policy needed to
achieve full employment equilibrium.
Keynesian Views On Negative
Supply Shocks
► 1.
Expansionary fiscal policy can offset the
effects of negative demand shocks.
► 2.
Expansionary fiscal policy can offset the
effects of negative supply shocks.
Mediating The Effects Of
Negative Shocks
► Beginning
with a full employment equilibrium,
assume that there is a negative demand shock.
The center panel of figure 13-6 can be used to
represent the resulting unemployment economy.
To mediate the effects, the government could
raise aggregate demand.
► The same reasoning applies to a negative supply
that shifts a full employment economy to an
unemployment economy.
Monetary Policy To Help Achieve Full
Employment Price Stabilization
► Two
types of monetary policy:
 1. Expansionary monetary policy: central bank
policy that is intended to raise aggregate
spending by increasing business investment
spending (I).
 2. Contractionary monetary policy: central bank
policy that is intended to reduce aggregate
spending by reducing business investment
spending (I).
Keynesian Views On
Monetary Policy
► 1.
If the economy is an unemployment economy,
expansionary monetary policy can increase
investment demand and raise the equilibrium real
output to the full employment level.
► 2. If the economy is an inflation economy,
contractionary monetary policy can reduce
investment demand and reduce the equilibrium
real output to the full employment level, thereby
reducing the price level.
An Analogy: Bringing A
Pot To Its Boiling Point
► If
it overheats,
turn down the
heat.
► If
it is not hot
enough turn up
the heat.
Knowledge Needed to Achieve
Keynesian Goals
► The
problem of timing and placing the
Keynesian policy so that it exactly offsets
the demand or supply shock.
 Government agents must know when a shock is
likely to occur.
 Government agents must know the particular
industries that are effected, the nature of the
effects, and when they will occur.
Problems in a Democracy
► Fiscal
policy requires legislation which, in a
democracy, may take a long time to pass.
► Monetary policy is easier to put into effect.
However, its affects are much broader. It
cannot pinpoint specific industries.
► Improperly timed and placed fiscal or
monetary policy could have effects that are
just the opposite of those desired by the
Keynesians.