KEYNESIAN ECONOMICS

ECON 434 | Spring 2011

How do we explain this?

Or this?

Economic impact

  1929 1933

Banks in operation 25,568 14,771 

Prime interest rate 5.03% 0.63%

Volume of stocks sold (NYSE) 1.1 B 0.65 B

Privately earned income $45.5B $23.9B

Personal and corporate savings $15.3B $2.3B

Impact on consumer spending

  1929 1933

Food $19.5 $11.5

Housing $11.5 $  7.5

Clothing $11.2 $  5.4

Automobiles $  2.6 $  0.8

Medical care $  2.9 $  1.9

Philanthropy $  1.2 $  0.8

Value of shares on the NYSE $89.0 $19.0

Does this hold?

Q

P

LRAS (Ɛ = 0)

D0

D1

John Maynard Keynes (1883-1946)

One of the most (if not the most) influential economists of all time.

Most of modern macroeconomics is based on his The General Theory of Employment, Interest, and Money (1936)

Keynesian theory (in very brief) Demand creates its own supply Unemployment can happen in the short

run (it can be a semi-permanent situation, absent some external force to reduce it; read: the government)

Governments can revive the economy through changes in fiscal policy (government spending)

Keynesian theory

Keynesian theorists and classical macroeconomists would be most likely to agree about how this economy will adjust if:

(a) Aggregate Demand declines from AD1 to AD0.

(b) classical full employment requires output Q1.

(c) the recessionary gap equals the GDP gap.

(d) severe stagflation occurs at point a.

(e) Aggregate Demand increases from AD1 to AD2.

Keynesian theory

Keynesian theorists and classical macroeconomists would be most likely to agree about how this economy will adjust if:

(a) Aggregate Demand declines from AD1 to AD0.

(b) classical full employment requires output Q1.

(c) the recessionary gap equals the GDP gap.

(d) severe stagflation occurs at point a.

(e) Aggregate Demand increases from AD1 to AD2.

Keynesian theory

For Keynes: Ensuring adequate AD is the most important for ensuring full employment Expansion of productive capacity and price-level

stability are secondary goals (pursued after the achievement of full employment).

AD alone determines output and employment in the midst of a depression because AS in this range would be relatively flat.

Assumes that idle productive capacity allows production and income to stretch to accommodate growth in AD without causing inflationary pressure

Aggregate expenditures

GDP = C + I + G + (X – M) C: consumption

Autonomous consumption: unrelated to income Induced consumption: occurs only because people

have income to spend Marginal propensity to consume: the relative change in

consumption induced by a small change in disposable income (ΔC/ΔY)

I: investment G: government spending X: exports M: imports

Investment

While consumption is the most stable component of GDP, investment is the least stable.

According to Keynesian theory, the volatility of investment (due, in part, to “animal spirits”) is the root cause of most business cycles Greenspan: Irrational exuberance

Keynesian macroequilibrium occurs when saving and investment are equal

Investment is only mildly influenced by interest rates but very sensitive to even minor changes in the expectations of business. Pessimism causes investment to plummet, while optimism

causes sudden surges in investment

Macroequilibrium

Savings

Investment

National income

Savings, investment

S > i: Undesired inventory accumulates; firms reduce production

I > s: Inventories shrink; firms boost production

The multiplier

The multiplier effect occurs when one person’s spending becomes someone else’s income, and some of the second person’s income is subsequently spent, becoming the third person’s income, and so on. 1/(1 – mpc)

The paradox of thrift

What happens if we try to save more? Classical analysis: Saving promotes investment and

growth Keynes: Attempts to save more may cause income

to fall so much that actual saving shrinks Consumption falls when households try to save more.

Firms will counter declining sales and swelling inventories by cutting production, employment, and investment.

Saving is the natural reaction to hard times; if a growing number of households start saving, the momentum for a recession can build

The paradox of thrift, however, is probably irrelevant in an economy operating at full steam

Fiscal policy debates

Policy change Keynesians Supply side

Tax rates raised Generates more revenue for govt. In a recession, higher tax rates may also worsen the economic conditions and actually reduce tax revenue b/c high taxes dampen consumer spending

Reduces AS because of incentive effects. Disincentives from high tax rates may cut AS so much that revenues fall (see the Laffer curve)

Government purchases raised

Raises AD and income both directly and via a multiplier effect

Reduces AS because people have fewer incentives to produce and generate income if the government does more for them

Functions of money

Medium of exchange Money is used to execute transactions

Measure of value (standard unit of account) Used as a common denominator to rank relative prices

Store of value Held as an asset because it is less risky or because they

view the transaction costs of conversion to other assets as too high (*Keynesian notion)

Standard of deferred payment Allows for intertemporal contracts (i.e., money is good

for more than immediate purchases [the classical view])

Demand for money

Transaction demand People want money so they can spend it

Precautionary demand People want money because they know that unanticipated

spending is required at times Keynesian invention; classical economists would agree

with this, however, because it assumes money is closely related to income

Asset demand Major Keynesian invention that clashes with classical

theory People hold money because (a) they expect the prices of

stocks and bonds to fall in the near future, (b) are reluctant to hold only assets that tend to swing widely in value, and (c) believe that transaction costs are higher than any expected returns from investment in stocks/bonds.

Cost of holding money

Quantity of money demanded

Quantity of money demanded

1/PNominal interest rate

Classical view: Cost of a dollar is what you could buy with it

Keynesian view: Cost of a dollar is the interest you sacrifice by not making a different financial investment

Keynesian monetary theory

Velocity of money is NOT constant Full employment is NOT the natural state of a

market economy Asset demand for money: Rising uncertainty

(not income) is a major reason for the growth of money demanded.

The liquidity trap: At very low interest rates, growth of the money supply yields neither extra spending nor declines in interest rates; extra money is absorbed through hoarding into idle cash balances (put it under your mattress)

Some material taken from Economics, Byrns and Stone, 6th edition