Download Power Point Slides Fifteen: Worldly Philosophers Ch. 9

JOHN MAYNARD KEYNES:
1883 TO 1946
Descended from a knight who had crossed the English
Channel with William the Conqueror, Keynes was the son
of a Cambridge University economist. Educated at Eton
and Cambridge, he demonstrated from his early years a
dazzling, wide-ranging intellect, along with an
arrogance and what seemed to some a dismissive elitism.
His establishment habits (including the signature homburg
normally associated with a City of London stockbroker)
and his pride in being a member of what he called the
"educated bourgeoisie" were combined with chronic
social and intellectual rebellion, orneriness, and the
lifestyle of a Bloomsbury bohemian and aesthete. His
daunting mathematical dexterity was complemented by
a considerable literary grace, whether the subject was
the subtleties of economic thought or his obsession with
the hands of statesmen. He celebrated "vigilant
observation" of the real world as one of the
requirements of a good economist, and he loved to pore
through statistics. His best ideas, he liked to say, came
"from messing about with figures and seeing what they
must mean." Nevertheless, he could not resist endlessly
toying with ideas, and he compulsively sought to spin out
all-encompassing theories and generalizations from
particulars.
http://www.pbs.org/wgbh/commandingheights/shar
ed/minitext/prof_johnmaynardkeynes.html
KEYNES BIO
HTTP://WWW.ECONLIB.ORG/LIBRARY/ENC/BIOS/KEYNES.HTML
Keynes was born in Cambridge and attended King’s College, Cambridge, where he earned his
degree in mathematics in 1905. He remained there for another year to study under ALFRED
MARSHALL and ARTHUR PIGOU, whose scholarship on the quantity theory of money led to Keynes’s Tract
on Monetary Reform many years later. After leaving Cambridge, Keynes took a position with the civil
service in Britain. While there, he collected the material for his first book in economics, Indian Currency
and Finance, in which he described the workings of India’s monetary system. He returned to
Cambridge in 1908 as a lecturer, then took a leave of absence to work for the British Treasury. He
worked his way up quickly through the bureaucracy and by 1919 was the Treasury’s principal
representative at the peace conference at Versailles. He resigned because he thought the Treaty of
Versailles was overly burdensome for the Germans.
After resigning, he returned to Cambridge to resume teaching. A prominent journalist and speaker,
Keynes was one of the famous Bloomsbury Group of literary greats, which also included Virginia
Woolf and Bertrand Russell. At the 1944 Bretton Woods Conference, where the International
Monetary Fund was established, Keynes was one of the architects of the postwar system of fixed
exchange rates (see FOREIGN EXCHANGE). In 1925 he married the Russian ballet dancer Lydia
Lopokova. He was made a lord in 1942. Keynes died on April 21, 1946, survived by his father, John
Neville Keynes, also a renowned economist in his day.
MEMBER OF THE "BLOOMSBURY GROUP”
HTTP://WWW.ECON.UNT.EDU/~DMOLINA/ECON4510.HTM
That glittering group of bohemian thinkers and doers who
revolted against the manners and morals of Victorian
England included the great economist john Maynard
Keynes; Virginia Woolf and her husband, Leonard, a
famed British civil servant; The novelist E.M.
Forester; And any number of poets, philosophers,
artists and titled eccentrics. They flaunted
convention, scoffed at religion, and had mad affairs
with one another, writing down every word in diaries
and letters in the secure belief history would want to
know.
QUOTES BY KEYNES:
HTTP://WWW.ECON.UNT.EDU/~DMOLINA/ECON4510.HTM
I do not know which makes a man more conservative -to know nothing but the present, or nothing but the
past.
The day isn't far off when the economic problem
will take the back seat where it belongs, and the
heart and head will be occupied or reoccupied, by
our real problems of life and of human relations, of
creation and behavior and religion.
It is ideas, not vested interests, which are
dangerous for good or evil.
QUOTES BY KEYNES (CONT):
HTTP://WWW.ECON.UNT.EDU/~DMOLINA/ECON4510.HTM
The difficulty lies, not in the new ideas, but in
escaping from the old ones which ramify . . . into every
corner of our minds.
Most men love money and security more, and creation and
construction less, as they get older.
QUOTES BY KEYNES (CONT):
HTTP://WWW.ECON.UNT.EDU/~DMOLINA/ECON4510.HTM
Keynes was on the staff of the British delegation
that negotiated peace after World War I, but he
regarded the terms as the seeds of disaster,
resigned in protest, and wrote his criticisms in The
Economic Consequences of the Peace (1919),
"...bursting" (as Schumpeter wrote) "into
international fame when men of equal insight but
less courage and men of equal courage but less
insight kept silent."
MORE KEYNES QUOTES
Paul Samuelson, the Nobel laureate from the
Massachusetts Institute of Technology, recalled that
John Maynard Keynes once was challenged for
altering his position on some economic issue. “When
my information changes,” he remembered that
Keynes had said, “I change my mind. What do you
do?”
http://quoteinvestigator.com/2011/07/22/keyne
s-change-mind/
MORE KEYNES QUOTES
Letter to George Bernard Shaw: "I believe myself to be writing a book on economic
theory which will largely revolutionize - not, I suppose, at once but in the course of the
next ten years - the way the world thinks about economic problems.“
To Henry Clay: "I find myself more and more relying for a solution of our problems on
the invisible hand which I tried to eject from economic thinking twenty years ago.“
http://www.maynardkeynes.org/keynes-quotes.html
Economic Consequences of the Peace
http://www.econlib.org/library/Enc/bios/Keynes.html
Keynes became a celebrity before becoming one of the most respected economists of the
century when his eloquent book The Economic Consequences of the Peace was published in
1919. Keynes wrote it to object to the punitive reparations payments imposed on Germany by
the Allied countries after World War I. The amounts demanded by the Allies were so large, he
wrote, that a Germany that tried to pay them would stay perpetually poor and, therefore,
politically unstable. We now know that Keynes was right. Besides its excellent economic analysis
of reparations, Keynes’s book contains an insightful analysis of the Council of Four (Georges
Clemenceau of France, Prime Minister David Lloyd George of Britain, President Woodrow Wilson
of the United States, and Vittorio Orlando of Italy).
Keynes wrote: “The Council of Four paid no attention to these issues [which included making
Germany and Austro-Hungary into good neighbors], being preoccupied with others—
Clemenceau to crush the economic life of his enemy, Lloyd George to do a deal and bring home
something which would pass muster for a week, the President to do nothing that was not just
and right” (chap. 6, para. 2).
Keynes and Monetarism
http://www.econlib.org/library/Enc/bios/Keynes.html
In the 1920s Keynes was a believer in the quantity theory of money (today called MONETARISM). His
writings on the topic were essentially built on the principles he had learned from his mentors,
Marshall and Pigou. In 1923 he wrote Tract on Monetary Reform, and later he published Treatise on
Money,both on MONETARY POLICY. His major policy view was that the way to stabilize the economy is
to stabilize the price level, and that to do that the government’s central bank must lower INTEREST
RATES when prices tend to rise and raise them when prices tend to fall.
One should note... Monetarism is associated with the work of Milton Friedman
Keynes’s General Theory
http://www.econlib.org/library/Enc/bios/Keynes.html
Keynes’s General Theory revolutionized the way economists think about economics. It was
pathbreaking in several ways, in particular because it introduced the notion of aggregate
demand as the sum of consumption, INVESTMENT, and government spending; and because it
showed (or purported to show) that full employment could be maintained only with the help of
government spending. Economists still argue about what Keynes thought caused high
unemployment. Some think he attributed it to wages that take a long time to fall. But Keynes
actually wanted wages not to fall, and in fact advocated in the General Theory that wages be
kept stable. A general cut in wages, he argued, would decrease income, consumption, and
aggregate demand. This would offset any benefits to output that the lower price of labor might
have contributed.
Why shouldn’t government, thought Keynes, fill the shoes of business by investing in public
works and hiring the unemployed? The General Theory advocated deficit spending during
economic downturns to maintain full employment. Keynes’s conclusion initially met with
opposition. At the time, balanced budgets were standard practice with the government.
General Theory
http://www.econ.unt.edu/~dmolina/econ4510.htm
Keynes became editor of the Economic Journal,
certainly one of the most important of journals
of professional work and research in economics
then as now. After the disaster of the Great
Depression, Keynes was the leading figure in a
group of (mostly) younger and very creative
economists who attempted to understand and
explain the disaster. Borrowing freely from
their ideas, Keynes published The General Theory
of Employment, Interest and Money,
General Theory (cont)
http://www.econ.unt.edu/~dmolina/econ4510.htm
The General Theory, as it is known, also
founded modern macroeconomics, and virtually
all of the work in that field emerges from
Keynes' work, if not positively as extensions
and adaptations then negatively as criticism
or the extension of criticism of it.
Keynes and Free Markets
http://www.econlib.org/library/Enc/bios/Keynes.html
Contrary to some of his critics’ assertions, Keynes was a relatively strong advocate of free
markets. It was Keynes, not ADAM SMITH, who said, “There is no objection to be raised against the
classical analysis of the manner in which private self-interest will determine what in particular is
produced, in what proportions the factors of production will be combined to produce it, and
how the value of the final product will be distributed between them.”
Keynes believed that once full employment had been achieved by FISCAL POLICY measures, the
market mechanism could then operate freely. “Thus,” continued Keynes, “apart from the
necessity of central controls to bring about an adjustment between the propensity to consume
and the inducement to invest, there is no more reason to socialise economic life than there was
before”
 Earlier economists who focused on long-run issues
 Markets were self-regulating through the “invisible hand”
 Say’s Law: Supply Creates its Own Demand
 The economy would always return to its potential output and target rate of unemployment in
the long run
 Advocated a laissez-faire economic policy
 Classical Economists believe people are perfectly rational and markets are quickly corrected.
10-15
 Imagine a wheat farmer who sees declining prices for wheat in the market. What
are his/her options?
 The farmer can reduce his/her production of wheat. Lower prices signal to producers that
there is less demand for what the producer is offering.
 But it is likely he/she will also increase his production of another commodity (like corn,
etc…)
 Because the farmer has output, a decline in prices – caused by a decline in aggregate
demand – is not likely to have a long-term impact on the economy.
 Hence, it is reasonable to assume that the macro-economy is self-adjusting.
 Imagine an automobile manufacturer who sees declining prices in the automobile
market. What are her/his options?
 The auto manufacturer can reduce his/her production of cars. Lower prices signal to
producers that there is less demand for what the producer is offering.
 Does the auto manufacturer have another option? Since an automobile factory cannot be
easily changed so that other goods can be produced, it seems likely that the auto
manufacturer has any other options.
 And that means a decline in prices – caused by a decline in aggregate demand – will
have a longer impact on a manufacturing based economy
 Hence, it is reasonable to assume that the macro-economy is not self-adjusting.
Like Marshall, Keynes understood that time
matters
In the long-run, Keynes thought the economy
could return to full employment on its own.
but “in the long-run we are dead”
In the short-run, the economy could remain
below full employment. And the short-run
could last years.
The Essence of Keynesian Economics
◦ First outlined in 1936 by John Maynard Keynes
◦ Problems of the Depression required a short-run, rather than long-run, focus
◦Keynes famously said: “In the long run,
we’re all dead”
◦ Adjustments to equilibrium for a single market (micro issue) and the aggregate economy (macro
issue) are different
◦ Keynesians argued that, in times of recession, spending is a public good that benefits everyone
◦ THIS SLIDE AND THE FOLLOWING SLIDES ARE THE STANDARD TEXTBOOK PRESENTATION
OF THE KEYNESIAN MODEL (from David Colander’s Macroeconomics, 9th edition)
10-19
Key Insight of the Keynesian AS/AD
Model
Short-run equilibrium output may differ from long-run potential output assuming a fixed price level
◦ Equilibrium output is the level of output toward which the economy gravitates in the short run because of the cumulative
cycles of declining or increasing production
◦ Potential output is the highest amount of output an economy can sustainably produce using existing production processes
and resources
Market forces may not be strong enough to correct deviations from potential output
McGraw-Hill/Irwin
20
Key Insight of the Keynesian AS/AD
Model
Paradox of thrift
◦ In the long run, saving leads to investment and growth
◦ In the short run, saving may lead to a decrease in spending, output, and employment
◦ Thomas Malthus noted this in the early 19th century
Aggregate demand management, which is government’s attempt to control the aggregate level of spending,
may be necessary
Keynesian economists advocated an activist demand management policy
McGraw-Hill/Irwin
21
The Components of the AS/AD Model
Aggregate Demand Curve (AD)
• Is a curve that shows how a change in the price level will change aggregate expenditures on all goods and services in
an economy
Short-Run Aggregate Supply Curve (SAS)
• Is a curve that specifies how a shift in the aggregate demand curve affects the price level and real output in the short
run, other things constant
Long-Run Aggregate Supply Curve (LAS)
• Is a curve that shows the long-run relationship between output and the price level
McGraw-Hill/Irwin
22
Shifts in the AD Curve
A shift in the AD curve means that at every price level, total expenditures have changed.
Five important shift factors are:
• Foreign income
• Exchange rates
• Distribution of income
• Expectations
• Monetary and fiscal policy
Deliberate shifting of the AD curve is what most policy makers mean by macro policy
McGraw-Hill/Irwin
23
Shifts in the AD Curve
Price level
The AD curve shifts out by more
than the initial change in
expenditures
Initial effect Multiplier
effect
• Exports increase by 100
P0
• The multiplier magnifies this shift
Total effect
200
100
AD0
300
McGraw-Hill/Irwin
AD1
AD curve shifts to the right by a
multiple of 100, in this case by
300
Real output
24
The Slope of the Short-Run Aggregate Supply (SAS) Curve
◦ The SAS curve is upward sloping because of:
◦ [from http://www.unc.edu/depts/econ/byrns_web/Economicae/asupplyc.html]
• This short-run positive relationship occurs primarily because production costs (e.g., wages) are "sticky"
relative to output prices when demand changes.
• Increases to Aggregate Demand cause movements up along the Aggregate Supply curve in which prices rise
more quickly than wages, so higher profit per unit induces more output.
• Declines in Aggregate Demand reverse these movements along the Aggregate Supply curve---prices fall more
quickly than costs, so profits decline and firms reduce production.
McGraw-Hill/Irwin
25
Shifts in the SAS Curve
Price level
SAS1
SAS0
SAS2
Shifts in the SAS are caused by changes in:
• Input prices
• Productivity
• Import prices
• Excise and sales taxes
When production costs increase, the SAS
curve shifts up
Real output
McGraw-Hill/Irwin
26
The Long-Run Aggregate Supply Curve
The long-run aggregate supply (LAS) curve shows the long-run relationship between output and the price
level
The position of the LAS curve depends on potential output which is the amount of goods and services an
economy can produce when both capital and labor are fully employed
The LAS curve is vertical because potential output is unaffected by the price level
McGraw-Hill/Irwin
27
The LAS Curve
Price level
LAS
◦Potential output is assumed to be in the middle of a
range bounded by high and low levels of potential
output
C
A
B
Overutilized
resources
Underutilized
resources
Low-level
potential output
McGraw-Hill/Irwin
SAS
• When resources are over-utilized
(point C), factor prices may be bid
up and the SAS shifts up
• When resources are under-utilized
(point A), factor prices may
decrease and SAS shifts down
Real output
High-level
potential output
28
◦Increases in the LAS are caused by increases in:
Price level
LAS0
LAS1
LAS2
◦
Capital
◦
Resources
◦
Growth-compatible institutions
◦
Technology
◦
Entrepreneurship/Innovation
which of these factors lead to
persistent growth?
Real output
McGraw-Hill/Irwin
29
Short-Run Equilibrium in the AD/AS Model
Price level
◦Short-run equilibrium is where the SAS and
AD curves intersect and point E is short-run
equilibrium
F
P1
P0
SAS
E
AD1
AD0
Y0
McGraw-Hill/Irwin
Y1
A shift in the aggregate demand
curve to the right changes
equilibrium from E to F, increasing
output from Y0 to Y1 and increasing
price level from P0 to P1
Real output
30
Short-Run Equilibrium in the AD/AS Model
Price level
SAS1
P2
SAS0
G
E
P0
A shift up in the short-run
aggregate supply curve changes
equilibrium from E to G, decreasing
output from Y0 to Y2 and increasing
price level from P0 to P2
AD
Y2
McGraw-Hill/Irwin
Y0
Real output
31
Long-Run Equilibrium in the AD/AS Model
Price level
◦Long-run equilibrium is where the LAS and
AD curves intersect
LAS
P1
H
P0
E
A shift in the aggregate demand
curve changes equilibrium from E
to H, increasing the price level
from P0 to P1 but leaving output
unchanged
AD1
AD0
YP
McGraw-Hill/Irwin
Real output
32
Application:
A Recessionary Gap in the AD/AS Model
Price level
LAS
SAS1
P1
A
SAS0
E
P0
Gap
Y1
McGraw-Hill/Irwin
AD0
YP
• A recessionary gap is the
amount by
which equilibrium output is below potential
output
• At point A, some resources are
unemployed and the recessionary
gap is YP – Y1
Eventually wages and prices
decrease and SAS shifts down to
return the economy to a long and
short-run equilibrium at E
Real output
33
Application:
An Inflationary Gap in the AD/AS Model
Price level
• An inflationary gap is the
amount by
which equilibrium output is above potential
output
LAS
SAS0
E
P0
B
P2
Gap
YP
McGraw-Hill/Irwin
SAS2
AD0
Y2
• At point B, resources are being used
beyond their potential and the
inflationary gap is Y2 – YP
Eventually wages and prices increase
and SAS shifts to return the economy
to a long and short-run equilibrium at
E
Real output
34
Aggregate Demand Policy
A primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal
policy shifts the AD curve
◦ Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates
◦ Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the
economy
McGraw-Hill/Irwin
35
Application:
Expansionary Fiscal Policy in the AD/AS Model
Price level
• If the economy is at point A, there is a
recessionary gap equal to YP – Y0
LAS
P1
• The appropriate fiscal policy is to
increase government spending and/or
decrease taxes
E
A
P0
Gap
Y0
McGraw-Hill/Irwin
YP
AD0
AD1
AD shifts to the right and output
returns to potential output YP and
prices
increase to P1
Real output
36
Application:
Contractionary Fiscal Policy in the AD/AS Model
Price level
LAS
• If the economy is point B, there is an
inflationary gap Y2 – YP
B
P2
P1
E
Gap
YP
McGraw-Hill/Irwin
• The appropriate fiscal policy is to
decrease government spending and/or
increase taxes
AD2
Y2
AD0
AD shifts to the left, output returns to
potential output YP and inflation is
prevented
Real output
37
Limitations of Fiscal Policy

Implementing fiscal policy through changing taxes and government spending is a slow legislative
process
• There is no guarantee that government will do what economists say is necessary

Potential output (the level of output that the economy is capable of producing without
generating inflation) is difficult to estimate
•
McGraw-Hill/Irwin
We do have ways to get a rough idea of where it is
38
Limitations of Fiscal Policy

There are two ways to think about the effectiveness of fiscal policy: in the model and in reality

The effectiveness of fiscal policy depends on the government’s ability to perceive and to react appropriately
to a problem

Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate
expenditures that would create a business cycle

Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or
potential level of income
McGraw-Hill/Irwin
39
Other Contributions
http://www.econ.unt.edu/~dmolina/econ4510.htm
• Fiscal Policy and the Multiplier Effect
• Liquidity Trap
• He was also the British representative in
1944 at Brenton Wood Conference that set
up the International Monetary Fund and
the World Bank.
Nixon and Keynesian Economics
• New York Times Article (January 6, 1971)
• Nixon Reportedly Says He Is Now a Keynesian
• WASHINGTON, Jan. 6, 1971 (Reuters) -- President Nixon has described
himself as "now a Keynesian in economics," according to Howard K.
Smith of the American Broadcasting Company, one of the four
television commentators who interviewed the President on a
television show Monday night.
Bartlett, Friedman, and Keynes
• Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and
served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit
and the Burden: Tax Reform – Why We Need It and What It Will Take.”
• As it happens, (Milton) Friedman had said in 1965 that “we’re all Keynesians now” in the Dec. 31
issue of Time magazine. He later complained that his quote had been taken out of context. His full
statement was, “In one sense, we are all Keynesians now; in another, nobody is any longer a
Keynesian.” Friedman said the second half of his quote was as important as the first half.
• I think Milton Friedman was right that in a sense we are all Keynesians and not Keynesians at the
same time. What I think he meant is that no one advocates Keynesian stimulus at all times, but
that there are times, like now, when it is desperately needed. At other times we may need to be
monetarists, institutionalists or whatever. We should avoid dogmatic attachment to any particular
school of economic thought and use proper analysis to figure out the nature of our economic
problem at that particular moment and the proper policy to deal with it.
• http://economix.blogs.nytimes.com/2013/05/14/keynes-and-keynesianism/?_r=0
Mankiw, W. Bush, and Keynes
• Who is Gregory Mankiw, the 44-year-old Harvard professor nominated this week as U.S. President George W. Bush's new
chairman of his Council of Economic Advisers?The key facts seem to be these. He is highly intelligent, wide-ranging in his
economic expertise, and an excellent writer. He is a "New Keynesian" and named his dog Keynes. (This we see as very
important.) His mentors have been bright and prominent economists, such as Larry Summers, former treasury secretary,
and Alan Blinder, formerly of the Federal Reserve. From his early 20s, Mankiw has been close to the powerful. "Choose
your mentors well," is advice he himself gives in an essay on his life. In his research, he has kind words for Bush's great
friend, President Bill Clinton, while, on Federal Reserve Chairman Alan Greenspan, Mankiw's words are as opaque as those
of the (perhaps) great helmsman himself.
• Bush would appear to have turned to Mankiw for a number of reasons. One reason is that Mankiw's "new Keynesian"
approach to economic policy-making may make him a good fit with Bush's current policies. New Keynesians believe in
using fiscal policy flexibly to help smooth trends in growth. Thus, at a time of recession, new Keynesians would be
comfortable with a widening government deficit if the deficit spending helped to alleviate the downturn in the economy.
That has been Bush's policy.
http://www.upi.com/Business_News/2003/02/28/Commentary-Bushs-new-Keynesian-Mankiw/UPI34101046472891/#ixzz2kfmZwTDy