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RH351
Rhetoric of Economic Thought
Transparencies
Set 6
Keynes, Keynesianism, and
modern macroeconomics
Economic analysis – key contributors, 20th century
1900
2000
1950
Alfred Marshall (1842 – 1924)
John Maynard Keynes (1883 – 1946)
Keynes
Thorstein Veblen (1857 – 1929)
Joseph Schumpeter (1883 – 1950)
Friedrich A. von Hayek (1899 – 1992)
Hayek
Ronald Coase (1910 – )
Milton Friedman (1912 – )
Paul Samuelson (1915 – )
Samuelson
Kenneth Arrow (1921 – )
Friedman
Gary Becker (1930 – )
Robert Lucas (1937 – )
Lucas
John Maynard Keynes, 1883 – 1946
Biographical Details
1883
Early life
1906 / 1909
1914 – 1918
1918
1919
1921
1923
1924 – 1925
1926
1930
1930 – 1935
1936
1939 – 1943
1944
1946
Marx dies, Keynes born
Eaton / Cambridge – Studies under Marshall
British civil service / back to Cambridge
The Great War – At the Treasury, financing the war
Versailles Peace Conference
The Economic Consequences of the Peace
Treatise on Probability
Tract on Monetary Reform
Gold Standard debate in U.K.
"Currency Policy and Unemployment" (1923)
"Monetary Reform" (1924)
"The Gold Standard Act" (1925)
The Economic Consequences of Mr. Churchill (1925)
The End of Laissez-Faire
A Treatise on Money
Responses to “The Great Slump”
General Theory of Employment, Interest, and Money
WWII, back at the Treasury
Bretton Woods
Keynes dies / Keynesianism is born
G. E. Moore’s Principia Ethica (1903)
“…
o
ur causal knowledge is utterly insufficient to tell us
what different effects will probably result from two different
actions, except within a comparatively short space of time
… Our utter ignorance of the far future gives us no
justification for saying that it is even probably right to
choose the greater good within the region over which a
probable forecast may extend … It does in fact appear to be
the case that, in most cases, whatever action we now adopt,
‘it will be all the same a hundred years hence,’ … we can
only hope to discover which, among a few alternatives, will
generally produce the greatest balance of good in the
immediate future.”
Chapter V, “Ethics in Relation to Conduct”, sections 93 and 94
Keynes’ road to The General Theory
But this long run is a misleading guide to current affairs. In the
long run we are all dead. Economist set themselves too easy, too
useless a task if in tempestuous seasons they can only tell us that
when the storm is long past the ocean is flat again.
Tract on Monetary Reform (1923)
I abandon laissez-faire – not enthusiastically . . . . but because,
whether we like it or not, the conditions of its success have
disappeared …
Our problem is to work out a social organization which shall be
as efficient as possible without offending our notions of a
satisfactory way of life.
The End of Laissez Faire (1926)
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.
Letter to G.B. Shaw (1935)
Keynes, The General Theory
-- Aggregate Demand
The idea that we can safely neglect the aggregate
demand function is fundamental to the Ricardian
economics ...
The celebrated optimum of traditional economic
theory, which has led to economists being looked
upon as Candide's ... is also to be traced, I think, to
their having neglected to take account of the drag on
prosperity which can be exercised by an insufficiency
of effective demand ...
It may well be that the classical theory represents
the way in which we should like our Economy to
behave. But to assume that it actually does so is to
assume our difficulties away.
The General Theory (pp. 32 – 34)
Keynes, The General Theory
-- The Propensity to Consume
The fundamental psychological law, upon which we
are entitled to depend with great confidence both a
priori from our knowledge of human nature and from
the detailed facts of experience, is that men are
disposed, as a rule and on the average, to increase
their consumption as their income increases, but not
by as much as the increase in their income. That is
to say, if Cw is the amount of consumption and Yw is
income (both measured in wage-units) Cw has the
same sign as Yw but is smaller in amount, i.e.
dC w
dYw
is
positive and less than unity.
The General Theory (p. 96)
Keynes, The General Theory
-- Investment
There will be an inducement to push the rate of
new investment to the point which forces the supplyprice of each type of capital asset to a figure which,
taken in conjunction with its prospective yield, brings
the marginal efficiency of capital in general to
approximate equality with the rate of interest. That
is to say, the physical conditions of supply in the
capital goods industries, the state of confidence
concerning the prospective yield, the psychological
attitude to liquidity and the quantity of money ...
determine, between them, the rate of new
investment.
The General Theory (p. 248)
Keynes, The General Theory
-- Animal Spirits
Even apart from the instability due to speculation, there
is the instability due to the characteristic of human nature
that a large proportion of our positive activities depend on
spontaneous optimism rather than mathematical
expectations, whether moral or hedonistic or economic.
Most, probably, of our decisions to do something positive,
the full consequences of which will be drawn out over
many days to come, can only be taken as the result of
animal spirits - a spontaneous urge to action rather than
inaction, and not as the outcome of a weighted average of
quantitative benefits multiplied by quantitative
probabilities.
... if the animal spirits are dimmed and the spontaneous
optimism falters, leaving us to depend on nothing but a
mathematical expectation, enterprise will fade and die;
The General Theory (p. 161)
Hayek and Keynes on free markets and social justice
Our problem is to work out a social organization
which shall be as efficient as possible without
offending our notions of a satisfactory way of life.
The End of Laissez-Faire (1926)
John Maynard Keynes
1883 – 1946
We must face the fact that the preservation of
individual freedom is incompatible with a full
satisfaction of our views of distributive justice
Individualism, True and False (1945)
Friedrich Hayek
1889 – 1992
The evolution of “textbook” economics
Early 1800s: Political Economy
Mill, The Wealth of Nations (1776)
Ricardo, Principles of Political Economy (1817)
1850: Political Economy
Mill, Principals of Political Economy (1848)
1900: Economics
Marshall, Principals of Economics (1890)
Keynes’s
General Theory
1950: Economics
Samuelson, Economics, An Introductory Analysis (1948)
Part 1: Basic Economic Concepts and National Income
Part 2: Determination of National Income and its Fluctuations
Part 3: The Composition and Pricing of National Output
Macroconomics
Microconomics
Keynes or Keynesianism?
The Employment Act of 1946:
The Congress hereby declares that it is the continuing policy and
responsibility of the Federal Government to use all practicable means
consistent with its needs and obligations and other essential considerations
of national policy … to promote maximum employment, production, and
purchasing power.
What is at stake in our economic decisions today is not some
grand warfare of rival ideologies which will sweep the country
with passion, but the practical management of a modern
economy. What we need is not labels and cliches but more
basic discussion of the sophisticated and technical questions
involved in keeping a great economic machinery moving ahead.
John F. Kennedy, 1962
We’re all Keynesians now.
Richard Nixon, 1971
The Income-Expenditure Model – the “Keynesian Cross”
$
TOTAL SPENDING
C+I
C
EQUILIBRIUM POINT
l
45°
0
NNP
NET NATIONAL PRODUCT
Samuelson, 1961 (5TH ed.)
Hicks and the birth of IS – LM analysis
“Against a given quantity of money, the first equation, M = L(I,i) gives us a relation between Income (I) and the rate of
interest (i). This can be drawn out as a curve (LL) which will slope upwards, since an increase in income tends to raise
the demand for money, and an increase in the rate of interest tends to lower it … The curve IS can … be drawn showing
the relation between Income and interest which must be maintained in order to make saving equal to investment.
“Income and the rate of interest are now determined together at P, the point of intersection of the curves LL and IS. They
are determined together; just as price and output are determined together in the modern theory of demand and supply.”
J. R. Hicks, “Mr. Keynes and the ‘Classics’; A Suggested Interpretation.” Econometrica 5 (April 1937): 147 – 159.
“Hick’s graphical approach, called the IS-LM approach, is still used widely today because of its great intuitive appeal.”
Robert E. Hall and John B. Taylor, Macroeconomics: Theory, Performance, and Policy, 2nd ed. (1986).
i
INTEREST RATE (R)
IS
LM
L
P
L
I
IS
GNP(Y)
0
Hicks, 1937
Hall & Taylor, 1986
The algebra of the basic IS-LM model
IS Curve
LM Curve
(Equilibrium in the goods market)
(Equilibrium in the assets market)
Output = Expenditure
Y C  I G
Y  a  b(Y  T )  c  dr   G
Y  a  bY  bT  c  dr  G
dr  a  c  G  bT  (1  b)Y
 a  c  G  bT   (1  b) 
r

Y


d

  d 
r
1-b
< 0, because 0 ≤
≤1
Y
d
Demand for
“Real Balances” =
M
P
f(Output, Interest Rate)
+
= L(Y , r ), e.g.,
M
P
= kY - hr
M  kYP  hrP
1M k
r=+ Y
h P h
r k
= > 0, becauseh, k > 0
Y h
Fiscal and Monetary policy with IS – LM analysis
Typical “Keynesian” View
Typical “Monetarist” View
If d is “large”, IS is flat
If h is “small”, LM is steep
F Monetary policy is relatively strong
INTEREST
RATE
If d is “small”, IS is steep
If h is “large”, LM is flat
F Fiscal policy is relatively strong
INTEREST
RATE
(i)
(i)
LM
LM’
Illustrating equal magnitude
Shifts of IS and LM
LM
IS
LM’
IS’
IS
GNP(Y)
For equal magnitude changes in fiscal or monetary policy,
monetary policy is relatively more effective in influencing output.
IS’
GNP(Y)
For equal magnitude changes in fiscal or monetary policy,
fiscal policy is relatively more effective in influencing output.
The Phillips Curve

w
Phillips, A. W., “The Relationship Between
Unemployment and the Rate of Change of
Money Wage Rates in the United Kingdom,”
Economica 25 (November 1958).
Samuelson, Paul A., and Robert M. Solow,
"Analytical Aspects of Anti-Inflation Policy."
American Economic Review 50:2 (1960): 17794.
5.5%
Unemployment Rate
Friedman on the Phillips Curve
Phillips’ analysis of the relation between unemployment and
wage change is deservedly celebrated as an important and
original contribution. But, unfortunately, it contains a basic
defect – the failure to distinguish between nominal wages and
real wages …Phillips wrote his article for a world in which
everyone anticipated that nominal prices would be stable and
in which that anticipation remained unshaken and immutable
whatever happened to actual prices and wages.
Milton Friedman
(1912 – )
… the Phillips Curve can be expected to be reasonably stable and well defined for
any period for which the average rate of change of prices, and hence the
anticipated rate, has been relatively stable. For such periods, nominal and real
wages move together … The higher the average rate of price change, the higher
will tend to be the level of the curve…
To state this conclusion differently, there is always a temporary trade-off between
inflation and unemployment; there is no permanent trade-off. The temporary
trade-off comes not from inflation per se, but from unanticipated inflation.
“The Role of Monetary Policy,” American Economic Review 58:1 (March 1968), 1 – 17.
The “expectations augmented” Phillips Curve
Friedman, Milton, “The Role of Monetary
Policy,” American Economic Review 58:1
(March 1968), 1 – 17.
Inflation
Phelps, Edmund, "Phillips Curves,
Expectations of Inflation and Optimal
Unemployment over Time,“ Economica 34
(August 1967).
U*
Unemployment Rate
The 1970s crisis in macroeconomic policy
The present situation cannot last… it will either
degenerate into hyper-inflation and radical change;
or institutions will adjust to a situation of chronic
inflation; or government will adopt policies that will
produce a low rate of inflation and less government
intervention into the fixing of prices.”
Milton Friedman
As an advice-giving profession, we’ve made a real
mess of things.
Robert Lucas
Schools of thought in mid-20th century macroeconomics
Keynesianism is the view that
Monetarism is the view that
economies are inherently unstable,
that they may in fact settle at less-than
full employment equilibrium, that
Aggregate Demand is the primary
determinant of output and
employment, and that authorities can
intervene in an economy to stabilize
it. Keynesians generally express a
preference for fiscal policy as a
stabilizing tool.
economies are inherently stable, that
the quantity of money has a major
influence on economic activity and
the price level, and that the objectives
of monetary policy are best achieved
by targeting the rate of growth of the
money supply. Monetarists generally
express a preference for monetary
policy as a stabilizing tool relative to
prices only, being generally skeptical
of attempts to manage output.
Keynes
Samuelson
Friedman
Greenspan
Schools of thought in late-20th century macroeconomics
New Keynesianism is the view
New Classicalism is the view that
that market failures and
microeconomic coordination failures
give rise to macroeconomic
instabilities that frequently cause
economies to settle at less-than full
employment equilibrium, that both
aggregate demand and aggregate
supply are important determinants of
output and employment, and that
authorities can intervene with fiscal
and monetary policy tools to stabilize
an economy
economies are inherently stable, that
fiscal and monetary interventions
tend to be destabilizing, and that
cyclical fluctuations are caused by
either real shocks to the economy or
unanticipated policy shocks. New
classicals generally express a
preference for microeconomic
policies aimed at fostering aggregate
supply, and a predictable monetary
policy to maintain price stability.
Bernanke
Mankiw
Prescott
Lucas
Saltwater macroeconomics
Freshwater macroeconomics
• Minnesota
• Cal Berkeley
• Stanford
Based on David M. Kreps, “Economics – The Current Position” (1997)
Rochester
• Chicago
•
Carnegie - Mellon
• Harvard / MIT
•
• Yale
Princeton
• •Penn
The Keynesian “revolution”
Beyond all this stretched the ‘Keynesian Revolution’ – the logic and practice of
managing economies so as to maintain full employment and avoid depressions like
that of 1929 – 33. In the form Keynes left it, his Revolution was never wholly
accepted; and the debate about its value and relevance, and its author’s place in the
pantheon of thought and statesmanship, continues.
Robert Skidelsky, John Maynard Keynes, Volume III, Fighting for Freedom, 1937 – 1946 (2000)
Now, after more than three decades in the wilderness, Keynesian-style fiscal policy
seems to be staging a comeback.
“A stimulating notion,” The Economist, February 16, 2008.