John Maynard Keynes Presentation by Russell Baker, Caitlin Buckvold, Zachary Hanson, and Max Shaugnessy April 10, 2012

John Maynard Keynes

Presentation by Russell Baker, Caitlin Buckvold, Zachary Hanson, and Max Shaugnessy

April 10, 2012

Presentation Outline• Section I

o Historical context, Keynes’ early life, career path

• Section IIo Major Works – Economic Consequences of the Peace, Treatise on

Moneyo General Theory of Employment, Interest and Moneyo Academic Influences

• Section IIIo Critiques of Keynesianism and modern applications

Section IWhat factors influenced Keynes’ General Theory?

John Maynard Keynes

“Ideas shape the course of history.”

Early Life

Life: June 5, 1883 – April 21, 1946• Born and raised in England

Family:• Father – Robert Neville Keynes• Mother – Florence Ada Keynes• Brother – Geoffrey Keynes.

Knighted for work on blood transfusion, married granddaughter of Charles Darwin

• Sister – Margaret Keynes. Married Noble Prize winning Physiologist

Florence Ada Keynes• Social Reformer and

Mayor of Cambridge

• Ran numerous charities:o Provided pensions for elderly

living in povertyo Provided services for

“deserving” pooro Reintegrated inmates back

into society

• Loving mother, devoted to Keynes

John Neville Keynes• Economist and

Lecturer in Moral Sciences at Cambridge University

• “Positive Economy”• “Normative Economy”• “Art of Economics”

• Loving father, devoted to Keynes

Keynes’ Life

• Studied at Eton and King’s College, Cambridgeo In 1904, earned B.A. in

Mathematics

• President of the Cambridge Liberal Clubo Promoted redistribution of wealtho Favored government

involvement in the economy

• Member of Cambridge Apostleso Creepy, secret-societyo Debating forum for members

that included many prominent mathematicians and philosophers

Education

Keynes’ Life

• Clerk for India Office, 1906-1908

• Lecturer and Researcher on probability theory at Cambridge, 1909-1913o Published a series of articles

on the Indian economyo First book: Indian Currency

and Finance, 1913

• Treasury, 1915o One of the negotiators for

terms of Versailles Peace Treaty

1906-1915

World War I• Treaty of Versailles

o Britain, France, and USA responsible for negotiating terms of treaty with Germany

o Keynes working behind the scenes

• Terms of Treatyo Astronomical reparationso Crippled German economy

• Keynes’ Beliefso Reparations should be minimalo Need to protect German

citizens from starvation

Unemployment in Great Britain (1900-1950)

Unemployment rates had an enormous amount of influence on Keynes’ arguments

1900

1902

1904

1906

1908

1910

1912

1914

1916

1918

1920

1922

1924

1926

1928

1930

1932

1934

1936

1938

1940

1942

1944

1946

1948

1950

0

5

10

15

20

25

Unem

plo

ym

ent

Rate

(%

)

Keynes’ Life

• Treatise on Probability, 1921o First, large mathematical work

by Keynes

• Becomes an investor and currency speculatoro Very wealthy by the end of the

1920s

• Advocates against the Gold Standardo Believes that, to decrease

unemployment, Churchill should devalue the British Sterling

• Continues to work as a lecturer at Cambridge University

1920-1930

Great Depression

• Keynes loses most of his fortune after the Great Depression

• A Treatise on Money, 1930o Describes why

unemployment persists at such high levels

• Critical of British austerity measures during Depression, advocates for increased government spending

Keynes’ Life

• Britain abandons Gold Standard, 1931

• Keynes re-earns fortune through sales of the General Theory and currency speculation

• Keynes’ health begins to fail

• Economic Adviser to the British Government

1930s

http://youtu.be/U1S9F3agsUA

http://youtu.be/U1S9F3agsUA

The General Theory of

Employment, Interest and

Money

• Keynes’ Masterpiece

• Hugely influential across

the world

• Foundation of

Keynesianism

Keynes’ Life

• Keynes negotiates with USA to secure loans to Britain during wartime

• Argues that the taxes should be increased and a mandatory savings rate established to pay for the Waro Avoid inflation after War’s end

• Keynes, now a Baron, takes a seat in the House of Lords among the Liberal Party

• Advocates new monetary system after the War

1940s, World War II

Bretton Woods

• Established IMF and pre-cursor to the World Bank (International Bank for Reconstruction and Development)

• Establishes a world monetary system of fixed exchange rates tied to the US dollar

What factors influenced Keynes’ General Theory?

1. Family2. Education at

Cambridge3. Government Service4. World War I5. Great Depression

“[With Bretton Woods]… we

have shown that a concourse

of forty-four nations are

actually able to work

together at a constructive

task in amity and unbroken

concord. Few believed it

possible. If we can continue

in a larger task as we have

begun in this limited task,

there is hope for the world.”

- John Maynard Keynes

Section IIKeynes’ Major Works

The Economic Consequences of the Peace

“If we aim deliberately at

the impoverishment…

nothing can then delay for

very long that final war

between the forces of

Reaction and the despairing

convulsions of Revolution,

before which the horrors of

the late German war will

fade into nothing.”



• Franceo Wanted to set back German

progress 50 years

• United Stateso Woodrow Wilson left Washington

“enjoying a prestige and moral influence unequalled in history”

o In fact, weak-minded and not knowledgeable of European conditions

• The French succeeded in achieving many of their demands

Versailles Conference

Overview


• Treaty of Versailles, 1919, crippled German economy

• Keynes’ proposals overlooked, considered controversial

• Wrote The Economic Consequences of Peace in two months the following Summer of 1919

• The Economic Consequences of Peace was largely a critique of the Treaty of Versailles

The Treaty of Versailles

Overview


• Europe cannot prosper without an equitable, integrated economic system

• The Allies violated the Fourteen Points: a commitment fairness regarding reparations, territorial adjustments, and economic matters


Criticism


• Reparations were severe, exaggerated, and questionable

• Inflation hit Europe hard, with Germany experiencing hyperinflation

• Keynes attributed the hyperinflation to governments being too short-sighted to secure loans or taxes from resources they acquired, (and instead) have printed notes for the balance”


Aftermath


• Keynes claimed the Treaty did not include a rehabilitation plan to the European economy

• Three key problems1. Decline in Europe’s internal

productivity2. Breakdown of transportation

and infrastructure3. Inability to import goods and

supplies from overseas

Europe after the War


• Keynes suggested a plan to help remedy the situation:

1. Revising the treaty and reparations

2. Abandonment of inter-ally Indebtedness

3. An international loan4. European relations with

Russia

Solving Europe’s Problems


• The Economic Consequences of Peace became an immediate bestseller on both sides of the Atlantic

• Solidified Keynes’ reputation as a leading economist

• Public perceived Germany was being treated unfairly, resulting in public support for appeasement

• Keynes predicted the next war would begin twenty years from 1919

Success and Influence

A Treatise on Money

A Treatise on Money

• Published in 1930, written during the beginning stages of the Great Depression

• A Treatise on Money professed his views on money, interest, and monetary policy

• Many of his views were borrowed from his mentors, Alfred Marshall and Arthur Pigou

Background

A Treatise on Money

• Keynes’ introduced his theory that where saving exceeds investment, recession will occur

• Keynes suggested that in order to stabilize the economy, the price level must first be stabilized

• Government Central Bank lower interest rates when prices rise, raise interest rates when prices fall

• Many of his ideas are further developed in his future work, General Theory

Monetary Policy

Classical Theory Keynes

A Treatise on Money

• Critically acclaimed as a hard to read, and many of the concepts were a work-in-progress

• Hayek wrote three reviews and critiques on A Treatise on Money

• Their debates / critiques largely revolved around discrepancies in terminology, especially as it pertained to saving and investment models

• Both were promising economists aspiring to develop economic models / theory

Reception

A Treatise on Money

• A Treatise on Money served as a prequel to his greatest masterpiece – The General Theory of Employment, Interest, and Money.

• Many fundamental concepts within General Theory were more polished ideas from A Treatise on Money

Legacy

The General Theory of

Employment, Interest and

Money

“It is astonishing what

foolish things one can

temporarily believe if one

thinks too long alone,

particularly in economics”


The General Theory on

Employment, Money and

InterestBook I

• The General Theory was written during the Great Depression, published in 1936

• Keynes introduces the book with the radical claim that The General Theory is meant to contrast his arguments with those of classical theory of economics

• Keynes claims that classical economics are applicable to only special cases, which “happen not to be those of the economic society in which we actually live”

Introduction



InterestBook I

• Classical theory of employment says the labor market is determined by supply & demand, where unemployment strictly caused by either frictional unemployment or voluntary unemployment

• Doesn’t explain Great Depressiono People must simply work for less?

• Classical Theory – supply creates its own demand. If there are people willing to work, jobs will be created to use themo Unemployed is a result of refusal to work

Introduction



InterestBook I

1. The real wage is equal to the marginal disutility of the existing employment;

2. There is no such thing as involuntary unemployment in the strict sense; and

3. Supply creates its own demand (Say’s Law)

The Classical Assumptions



InterestBook I

1. Workers and unions will protest nominal wage reductions, but not real wage reductions under the classical schoolo Inflation a better solution than wage

cuts?

2. If wages decrease, cost of production decreases, then prices decrease real wages stay the same

• Keynes uses this example to criticize fundamental assumptions of classical economics

A Critique of Classical

Labor Model



InterestBook I

• People earn money, then spend some of it – not all of it, resulting in “insufficient effective demand”

• Businesses hire based off how much they expect to sell o Spending determines employment, supporting

the idea of unemployment

• The existence of “insufficient effective demand” will often result in less-than optimal unemployment levels, despite that marginal product of labor > marginal disutility of employment

Effective Demand



InterestBook I

• These two fundamental concepts left Keynes baffled as to how classical Ricardian economics is considered “complete” and “victorious”

• “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.”

Criticism of Classical

Economics



InterestBook IV

• Prospective yield: value of expected returns – cost of inputs and maintenance

• Supply price: cost of manufacturer making new machine (replacement cost)

Marginal Efficiency of Capital

=prospective yield – supply

price

Marginal Efficiency of

Capital



InterestBook IV

• Increasing investment in capital has two effects:o Decreases prospective yield in the

long runo Increases supply price in short run

Overall diminishing the marginal efficiency

• Investment-demand schedule: how much investment must increase to lower ME to a given level

• Investment will be pushed until ME (general) = market interest rate


Capital



InterestBook IV

• Changes in value of money affect expected yield

Expect inflation yield increases attracting more investment

And vice versa

• No way to predict long-term expected yields

• “Beat the gun” in stock markets

• Instability due to “animal spirits”


Capital



InterestBook VI

• Interest rates are the price people demand for parting with their money

• Depends on:o liquidity preference (desire to hold

cash)o money supply

• Driven by bond market speculationo expected increase in r hold cash

now, buy bonds later

• People believe saving lowers interest rates when really it lowers demand and increases unemployment

Interest Rates

Increase MS

Decreases r

Increases investment

Increases employme

nt

Increases prices

Increases liquidity

preference



InterestBook IV

• Central bank can lower short-term rates by printing money buying short-term government debto US did this in Great Depression

• To extend this to long-term rates, government should buy long-term bonds

• Larger amount of cash they seek to create by purchasing bonds/debt, greater the fall of r

• Monetary policy seen as experimental will not delivery long-term reduction of ro it will only increase “precautionary

motive” of holding cash

Controlling the Interest

Rate



InterestBook IV

• Liquidity traps

• Rates fall so low that everyone prefers holding cash and authority loses control over the rates

• Hyperinflation – no one wants to hold cash

• Crises – can’t get people to want to reasonably part with their cash

Problems with Controlling

the Interest Rate



InterestBook IV

• For full employment, government keeps r down by printing money

• More profitable to invest in things with lower yields

• ME zero (remember: ME = yield – supply cost)

• No one would invest in anything anymore

• Accumulation but no growth

• The rentier disappears

Problems with Controlling

the Interest Rate



InterestBook V

Changes in money-wages

The employment function

The theory of prices



InterestBook V

• Classical argument: A reduction in wages stimulates demand (due to reduced production costs)

• Keynes’ rebuttal: This could only be true if aggregate demand is fixed

Money-wages, Chapter 19



InterestBook V

• The profits realized by entrepreneurs as a result of lower production costs will be disappointing, and employment will fall back to its previous figure

Keynes’ Analysis

Why the classical money-

wage theory doesn’t work



InterestBook V

• The reduction of money-wages will have no lasting tendency to increase employment! Therefore…



InterestBook V

• Propensity to consume

• Schedule of marginal efficiencies of capital; (Expected income = Price of capital asset)

• Rate of interest

Why?

• Demand

• Investment

Then which factors are

related to increasing

employment?



InterestBook V

• A flexible money policy is preferred because it is easier to implement

• Flexible wage policies would be unjust, wasteful, and disastrous

• If labor was in a position to affect change, then Trade Unions would rule monetary policy

Flexible Wage Policy v.

Flexible Money Policy

Which is preferred?



InterestBook V

• Short run:o Stable priceso Stable employment

• Long run:o Prices fall slowly as a

result of better technology, while wages remain stable

oOR, wages rise slowly as prices stay stable

Rigid Wage Policies

Why does Keynes believe

wages should be somewhat

rigid?



InterestBook V

• Quantity Theory of Money is not 100% righto Emphasis on money

demand

• Recent mathematical models are “mere concoctions”

• Deceptive simplicity to assume A B.

The Theory of Prices

Chapter 21



InterestBook V

• The long-run relationship between the national income and the quantity of money will depend on liquidity preferenceso Psychology of the public

• The very long-run course of prices has always been upward

Theory of Prices: A

Generalization

Section IIIModern application of Keynes & its critics

“We’re all Keynesian

s now”

• First coined by Milton Friedman in 1965

• Later repeated by Richard Nixon in 1971

• “I guess everyone is a Keynesian in a foxhole”

– Robert Lucas

• Popular phrase following the financial crisis and subsequent bailouts

“We’re All Keynesians Now”

What do modern economists think of

Keynes?

• “How Did Paul Krugman Get It So Wrong?” by John Cochrane

• “How Did Economists Get It So Wrong?” by Paul Krugman

Saltwater v. Freshwater

• Efficient markets hypothesis

• Robert Barro’s Ricardian Equivalence

• The solution is not to “rehabilitate an eighty year old book”

• Irrational market behavior, animal spirits

• Boost consumption & effective demand

• Return to Keynes. Fiscal stimulus, re-regulate finance

Conclusion

Documents

John Maynard Keynes Presentation by Russell Baker, Caitlin Buckvold, Zachary Hanson, and Max Shaugnessy April 10, 2012