Download VIII Keynesianism – economic policies

VIII Keynesian revolution –
economic policies
Legacy for economic policy
• Keynesian theory suffered significant setbacks, BUT
• Two Keynesian conclusions survived till today:
1. Capitalist economy, if left to market forces, can operate
for a long time with substantial involuntary
unemployment
For practical purpose, it is not important whether the economy
might converge towards full employment equilibrium, if this
happens with long delay
2. Insufficient demand is the principal culprit of depression
situation, hence fiscal and/monetary demand stimulation
are the principle tools of short term economic policies
It is the role of the Government to perform this demand
stimulating policies
VIII.1 Fiscal and monetary
stimulation of aggregate demand
Keynes’ policy prescriptions
• His principal focus – the depression situation
• Aggregate demand requires stimulation
• Subsequent simplifications: fiscal and monetary
multipliers in the framework of ISLM model
– Easy illustration of the basic idea, bellow we will do the same
• Keynes himself – much wider considerations:
– Concern about autonomous components of consumption and –
especially – investments (famous quote on “socialization of
investment”)
– Understanding the role of expectations
– Concern about the political forces and the role of trade unions
• All this quite often quoted by his disciples, but almost
nothing survived as to the practical recommendations
– Entire victory of simplified, “hydraulic” ISLM interpretation
Policy innovations (1)
• Fiscal and monetary policies
• Preference of fiscal policies
– Monetary policy less efficient due to almost flat LM
curve and interest-inelastic investment
• Sharp departure from pre-1930 policy taboos:
– Accepts budget deficits
– Refuses the crowding-out effect – remember LIV: fiscal
stimulation via increase of government spending is
crowding-out the either personal consumption of private
investment
• Here his views were shared by many economists, but widely
opposed by British Treasury (Finance Ministry) – the “Treasury
view” problem
Policy innovations (2)
• Refused wage cuts as a remedy for depression
– Both on political and economic ground
– Political power of trade unions and social tension during the
depression
– In the US, real wages were falling during most of 1930’s, without
any practical impact
– Similar situation observed in many other countries (except Britain,
due to overvalued currency)
• Fiscal multiplier and its effect on growth and employment
• The policy role of the governments: the theory provides the
tools to increase the product (and employment) by
stimulating aggregate demand
– Government is the only “agent” on the market, capable to perform
this role
VIII.2 ISLM illustration
ISLM vs. complete model
• The complete model multipliers (as we did
for Classical model in LIV) – see Sargent’s
textbook in Literature
– Requires more theoretical discussion on
specification of consumption and investment
function – beyond the scope her
• Instead – ISLM illustration
– Keep in mind that it is a simplification
VIII.2.1 Fiscal policy in ISLM
• Changes of governmental
expenditures
• Changes in tax rates
• Transfers to population (not included in
the simple model here)
• Time aspect
Increase of governmental
expenditures
• Initial equilibrium in E1
• Increase: ΔG → higher AD
– Shift of IS (when each level of interest corresponds
to higher level of Y) → at given interest, point A
represents new equilibrium on goods market
– However, in A, disequilibrium on money market (off
LM curve), EDM → interest  → I → AD  → Y 
• New equilibrium in E 2
LM
r
r2
r1
E2
E1
A
IS2
IS1
Y1
Y2
YA
Y
Multiplier of governmental
expenditures
• Differentiation of both equations:
dY = CY-T 1 - TY  dY + Ir dr + dG
0 = L YdY + L r dr
, hence
dr=- L Y L r dY
• Substituting in the first equation for dr from second
equation and after arrangement we have
dY =
1
L
1-C Y-T 1-TY +Ir Y
Lr
• By assumptions
and
dG   dG
LY
0 < C Y-T 1 - TY <1 a Ir
>0
Lr
1 β  α
Crowding out effect (1)
• In ISLM model, multiplier of governmental
expenditures is lower than the same multiplier
for the goods market only (when interest is
given)
• Full model (and in reality) – higher
governmental expenditures are partially offset
by decrease of investment (due to the increase
of interest) - G crowds out private investment
• Formally: impact of the term
LY
Ir
Lr
Crowding out effect (2)
• Keynes (short term): increase in governmental
expenditures will have higher impact on product when
– Interest elasticity of demand for money is high (LM curve
almost horizontal)
– And/or interest elasticity of investment is low (IS curve very
steep)
– Hence
Ir  0 and/or Lr  
• Classical model (long term): vertical LM ↔ increase of
governmental expenditures fully crowds out private
investment L r  0 
Tax policies
• Simplification:
TY = tY, 0 <t<1
• Tax multiplier (derived equally as above)
dY =
-CY-T Y
1-C Y-T 1-t  + Ir
LY
Lr
dt = - CY-T Ydt
.
• Policy
induced change: impact of the tax change
enabled first through the change of disposable
income, than impact on consumption, AD and
product (income); only than multiplier applies.
• Effect less certain – the reaction of consumers to
a tax change might modify MPC
Balanced budget multiplier
• Keynes – allowed for budget deficit
• Reality – budget balance is always watched
• Question: what is the multiplier in case of equal
change in governmental expenditure and
amount of taxes, i.e.
dG = d  TY
dY = C Y-TdY - C Y-TdG + dG
and after arrangement
• Balanced budget multiplier is equal one.
dY dG = 1
VIII.2.2 Monetary policy in ISLM
• Original equilibrium in E1
S
• Increase of money supply M >0
• At given Y, excess supply of money → higher
demand for bonds, higher price of bonds and
lower interest → shift of LM to the right, new
equilibrium on money market at point A
• However, disequilibrium at goods market (EDG)
→ low interest increases investment, AD and
product. Higher product increases demand for
money → increase of interest → overall
equilibrium at E2
LM 1
r
LM 2
r1
r2
rA
E1
E2
A
Y1
IS
Y2
Y
Multiplier of monetary policy
• Again, differentiation of both equilibrium
conditions, hence
dG  0 but dM P  0
S
• After arrangements
Ir
Lr
S
S
dM
Ir dM
dY =

= 
>0
LY
P
L
P
r
1 - CY-T 1-TY  + Ir
Lr
Efficiency of monetary policy
• The higher efficiency (impact on product growth) of
monetary policy,
– The lesser interest elasticity of demand for money (the
steeper is demand for money and LM curve as well)
– The higher is interest elasticity of investment (the flatter is IS
curve
• If L r   (flat LM) , than multiplier of monetary policy
is equal to zero and monetary policy is entirely
ineffective → liquidity trap
VIII.2.3 Some crucial differences
with Classical model
• Equilibrium at less than full employment
– and demand does not have to equal supply on
some markets
• Quantitative adjustment, wages and prices
adjust slowly
• Money in not neutral
– It is not a veil
• Demand stimulation is not completely
crowded out
VIII.3 Lessons for the policy
Basics
• Capitalist economy must be steered towards
full employment output by policies, performed
by the governments, stimulating aggregate
demand
• Monetary policies less efficient → crucial role
of fiscal policies
– Multiplier effect
• When output at less than full employment
level, then wages and prices adjust slowly
– Downward wage rigidity as general concept
• At full employment out put level – classical
model applies again
Keynes’ wrong predictions
(1)
• Estimate if numerical value of fiscal multiplier
– Expectations up to value of 3, in reality just above 1
• Inherent stagnation of the capitalist economy,
APC falls with growing income
– Not proved by the data (Kuznets)
• High interest elasticity of money demand
(reason for liquidity trap) or low interest
elasticity of investment
– Not validated by the data
Keynes’ wrong predictions
(2)
• Expectation about the return of recession
after the end of WWII
– Lack of aggregate demand, either because of lack
of consumer demand (low income and/or falling
APC) or investment demand (after the war economy
stops to generate government military demand)
• Completely refuted by the post-WWII
economic development
– Till today discussion of this was result of the
application of Keynesian recommendations of not
– See next Lectures, but: after WWII, it was mainly
the effect of private investment that filled the gap
between AD and AS
VIII.4 Conclusions
Lasting impact on economic policy
• After Keynes: for more than 3 decades, a
prevailing view was that the governments must
intervene to steer capitalist economy towards
production at full employment
– This remained accepted by many (not only economists),
even by those who criticize Keynes or understand his
fallacies
• After 1970 – a reversal in prevailing views (see
chapters later)
• Today:
– his model is considered as one stage in the
development of macroeconomics
– new Keynesian economics (see later)
Literature to Ch. VIII
Again, the literature to this Lecture is immense,
bellow are 3 recommendations
• ISLM model as policy instrument – any
intermediate textbook on macroeconomics
• Snowdon, B., Vane, H.: Modern
Macroeconomics, Edvard Elgar, 2005, namely
Chapter 3 (and the literature given here)
• Blaugh, M.: Economic Theory in Retrospect,
CUP 1997 (5th edition), Chapter 16, namely
parts 16.1-16.5 and 16.19-16.23