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Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to F. A. Hayek’s Capital-Based Macroeconomics Is government policy the source of macroeconomic instability? Roger W. Garrison 2011 EXPENDITURES C = a + bY INCOME Yfe CONSUMPTION C+I INVESTMENT The nature of the Keynesian-styled spiraling associated with recession, depression and inflation becomes more transparent with the production possibility frontier in play. W S Also, the PPF gives analytical legs to the views of Keynes’s opponents---to Milton Friedman’s Monetarism and F. A. Hayek’s D Capital-based Macroeconomics. N EXPENDITURES C = a + bY Yfe INCOME CONSUMPTION C+I INVESTMENT A waning of animal spirits causes investment to decrease and with it income and consumption. The economy falls inside its PPF. W S D N C = a + bY Yfe INCOME CONSUMPTION EXPENDITURES C+I INVESTMENT Note that if investment A further were towaning fall to zero, sendsthe theeconomy economywould settle into an income-expenditure deeper into the equilibrium PPF’s interior. with Y = C. Movements inside the frontier (and beyond Thus, the vertical intercept of the Keynesian demand constraint W it) trace out a linear relationship, showing is aligned withS the intersection of the consumption function and how consumption varies with investment. the 45o line. D The straight line that passes through these N points is the Keynesian demand constraint. C+I Y = C + I where, in equilibrium, Hence, C = a + b(C + I) C = a + bY So, C = a + bC + bI C – bC = a + bI CONSUMPTION EXPENDITURES C = a + bY (1–b)C = a + bI C = [a /(1-b)]+[b /(1-b)]I Yfe INCOME INVESTMENT Note that each of the four points that define the economy’s spiral path constitute an actual or potential Keynesian equilibrium. At each of those equilibrium points, Y = C + I. We also know that C = a + bY. But rather than use these two relationships to solve for the equilibrium level of income, let’s use them to determine the implied relationship between investment spending and consumption spending. EXPENDITURES C+I C = a + bY CONSUMPTION a b C = (1 – b) + (1 – b) I b 1–b a (1 – b) Yfe INCOME INVESTMENT For simplicity, let a = 0 and b = 0.90. Then C = a + bY becomes C = 0.90Y. C = a/1-b)+ b/1-b)I becomes C = 9I, which led Keynes to write: C = [a /(1-b)]+ [b /(1-b)]I “If, forformula example, the public are in the so habit of spending of their “The is not, of course, quite simple as in thisnine-tenths illustration…. But income consumption itorfollows entrepreneurs to of there is on always a formula, less ofthat this ifkind, relating thewere output This goods, ismore the Keynesian Demand Constraint. produce consumption goods at a cost more than nine timesofthe cost of consumption goods which it pays to produce to the output investment Keynes never wrote equation, hedispute. talk could the investment goods theyappears are producing, partbeyond ofbut their output goods…. This conclusion to methis tosome be quite Yet the hiswhich readers through it.theofsame not be sold at awhich price covered itsat cost production.” consequences follow from it are time unfamiliar and of the greatest possible importance.” Keynes denied that there are viable market forces that can move the economy along the Production Possibilities Frontier. CONSUMPTION Keynes argued that it is the instability of investment spending and, in particular, the waning of “animal spirits” that sends the economy spiralling into recession. By similar reasoning, Keynes realized, a waxing of animal spirits (known today as “over exuberance”), will set off an inflationary spiral. INVESTMENT Policymakers, in Keynes’s view, should prescribe fiscal and monetary policies aimed countering these destabilizing forces that are inherent in market economies. Friedman didn’t doubt that there are viable market forces that can move the economy along the Production Possibilities Frontier. But he considered those movements to be largely irrelevant to macroeconomic issues. CONSUMPTION Friedman argued that it is the central bank’s propensity to create money that accounts for inflationary spirals. By similar reasoning, Friedman realized, a shrinking (or collapse) of the money supply will cause the economy to spiral into recession (or depression). INVESTMENT Central banks, in Friedman’s view, should abstain from pro-actively managing the macroeconomy and, instead, should increase the money supply year-in and year-out at a rate that maintains long-run price-level stability. CONSUMPTION Hayek didn’t doubt that there are market forces that can move the economy along the Production Possibilities Frontier. And he considered these forces to be viable---but only if the central bank abstaines from manipulating interest rates. Hayek argued that an increase in saving, which finances more investment, will lead the economy clockwise along its production possibilities frontier. Similarly, a decrease in saving (and hence an increase in consumption) will lead the economy in a counter-clockwise direction. INVESTMENT In Hayek’s view, when the central bank lowers interest rates (without there being any increase in saving), it misleads the economy. Resources get misallocated during a policy driven boom, which eventually end in a bust. Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to F. A. Hayek’s Capital-Based Macroeconomics Is government policy the source of macroeconomic instability? Roger W. Garrison 2011