Keynes and the failure of self-correction Macroeconomic Analysis Miguel Lebre de Freitas 1. The Classical view

The term ‘classical’ refers to work done by a group of economists in the 18th and 19th centuries who advocated the Laissez-faire

Adam Smith Thomas Malthus David Ricardo (1723-1790) (1766-1834) (1772-1823) Adam Smith (1723-1790)

• Scottish, Graduated from Glasgow at the age of 17 • Father of Economics • Developed much of the theory about free markets, that we regard as standard now.

 Market forces ensure the production of the right goods and services.  This happens because producers want to make profits.  Under laissez-faire, public well-being would increase from competition.

Invisible Hand: •Competition (and free entry) would mean that producers would try to outsell each other and this would bring prices down to their lowest possible levels (making minimal profit). • This would end up benefiting the consumer without government intervention. • Classical economists trusted the self correction forces of the economy Private vices, public benefits

• Self-seeking individuals will interact in mutually beneficial ways without being coordinated from above. • Interference with this self-seeking will pervert the balance. • Vice can be disguised, and yet is necessary in the attainment of collective goods – For instance, pride is a vice, and yet without pride there would be no fashion industry, as individuals would lack the motivation to buy new and expensive clothes. • Private vices result in public benefits like industry, employment and economic flourishing. Bernard Mandeville (1670—1733) Jean-Baptiste SAY (1776-1832)

French businessman that introduced the work of Adam Smith to Europe.

• Say can take credit for the way in which we tend to divide the factor of production into Land (all natural resources, Labor (all human resources, and Capital (man-made resources to aid production) • However, he is best known for his “LAW OF MARKETS” or Say’s Law, which states: “Supply creates it’s own demand.” The great depression

The Great Depression was an intellectual failure for the economists working on business cycle theory—as was then called.

– Output fell by 30 percent and unemployment rose to 20 percent. – People wanted to work but could not find jobs at any wage. – The lengthy duration of the Great Depression undermined the classical view. – After the Depression, most people believed government should have a role in regulating the economy. – The classical laissez-faire looked factually wrong and immoral. Keynes and the failure of self- correction

Keynes asked: •“If supply creates its own demand, why are we having a worldwide depression?” (1883-1946) The publication of Keynes’s General [Graduate of Cambridge -studied Theory of Employment, Interest, and Classics and Math] Money, in 1936, launches macroeconomics as a discipline. Agenda 1. The classical view – Self-correction – Say’s Law – Quantity theory 2. Keynes: wages are sticky – Involuntary unemployment 3. Keynes effect – The is a monetary variable – Say’s Law in reverse 4. The Great depression – – Paradox of thrift – Fiscal policy Simple (static) model

• Production function Q zF N  FN  0 FNN  0

– Particular case: Q zN FNN  0

• Savings and

   – Private Savings: SP S P  rQT,    

– Government Savings: SG  TG 

  E  – Investment: I Irz,    Labour demand

• Firms maximize profits:

– Demand for labour:

W zF N   w WP N P

– Particular case:

W d 1 W  z  N FN   P Pz 

N Equilibrium

Equilibrium: Q C  I G    Or, in alternative:   E  SP  rQT,,   TG   Irz     

Q Households Firms C S tY P I Financial System G S T g

GovernmentI  K   K Market for loanable funds

There are two possible candidates to clear the market for goods and SSrQT(,  ) TG P   services: r • income (Q), • interest rate (r)

The variable that actually adjusts is a matter of disagreement between the classical and the Keynesian E views. I Irz , ,...

S,I Macroeconomics Prior to the Great Depression

“Classical economists” stressed the importance of production and paid little heed to the demand side

Two key assumptions: • Competitive markets • Flexible prices

Thus: • The real wage clears the labour market: w* : N S  N d – Same for other markets

** • Output will be at full employment: Q zFN  Equilibrium in the labour market

• Wages and prices flexible

• Real wages adjust to ensure full employment w WP N S

Q** zFN 

* W  0    P  d 1 W  N FN   Pz 

0 N * N Market for loanable funds

Given output, SSrQ(,*  T ) TG P 0   the real interest r rate adjusts to clear the market for loanable r* funds •Today we label it as the “natural interest rate” I  I r,...

S,I Illustration of the Say’s Law • What happens if population expands?

w WP N S  N * • The real wage falls • Employment w* 0 0 increases • Output expands * 1 w1 ** Q  zFN  N N d

* * N 0 N0 N1 Market for loanable funds

The fall in the real interest rate ensures the * SSrQP (,0  T )  TG increase in r * SSrQP (,1  T )  TG : • Savings decline

0 • Investment r* 0 1 increases * r1 * I  I r,... I  C  Q

S,I Crowding out Government expenditures crowd out private spending If government expenditures * SSrQP (,  T )  TG1  increase, savings r * SSrQP (,  T )  TG0  will decline, causing the interest rate to increase 1 * r1 0 G  I C  0 * r0 I  I r,... Composition of demand has changed S,I Savings are good for growth If the desire for savings increase, the interest rate will fall Investment will increase 0 * SSrQP (,  T )  TG r 1 * SSrQP (,  T )  TG I C  0 Current output is unaffected, but 0 * future output r0 1 will expand * r1 I  I r,...

S,I Irwin Fisher (1867-1947) Classical dichotomy

“Real variables are independent of the • Quantity theory of money ” md  kQ AS P • Money market equilibrium M S 1  kQ P1 P

M1 • AS: Q Q* P0 P  0 kQ M P  0 kQ “Money only produces 0 Q * Q nominal effects” Summary: the classical view Jean-Baptiste SAY (1776-1832) 1 - Say’s law: “Supply creates its own demand”. Real interest rates ensures S=I. Hence, aggregate demand is determined by income.

2 – Classical dichotomy : “Real variables are independent of the price level” Irwin Fisher formulated the quantity theory of money in terms of the Irwin Fisher "equation of exchange: MV=PQ (1867-1947) • Only relative prices matter • The equilibrium price level is determined by the and demand.

Classical economists believed that competitive markets and flexible prices would ensure that the economy would naturally gravitate toward Arthur Pigou full employment. No need for stabilization. (1877-1959) At most, government could promote wage flexibility • The sole classical economist concerned with high unemployment was Pigou: in 1913, he claimed that policy should be directed to promote wage flexibility, so as to ease the automatic adjustment, Keynes and the failure of self-correction

• The price mechanism is not fast enough • The economy may reach an equilibrium which is not full employment – Potential output is driven by technology and resources – But firms produce only the quantity of goods John Maynard they believe consumers, investors, KEYNES governments, and foreigners are planning to (1883-1946) buy. – When inventories rise, production declines • “ Effective demand determines output” Key ingredients: 1. Wage and price – Say’s Law holds in Reverse stickiness 2. The theory of liquidity preference Sticky wages • Demand contraction (animal spirits) d  • Sticky nominal wages Q zFN WP  • Workers are rationed but firms are not • (Classical unemployment) w WP S * ASW( ,) z N  N P AD0 AD1

W  1   P 1  P0 0 * W  0 1   P P0  1 N d

0 N N * N 0 Q Q * Keynesian supply curve

Q zN • Keynesian unemployment W • “Effective” labour demand z  (firms are rationed too) P

N S P ASW( ,) z W d N1 P N d z P Wz 1 0 1 0

AD0

AD1

0 N N * 0 Q Q * Q Liquidity preference

d • Money demand m  mi,Q i  r  – Driven by transaction purposes – But money velocity can be i destabilized by changes in the opportunity cost of holding money (bond yields). 1 • Sticky Prices i1 1' – Interest rate adjusts to clear 0 the money market i0 – Interest rate is a “monetary variable” d m(, iQ0 ) d m(, iQ1 ) M/P 0 m1 m0 Endogenous Q • Assume

S S(, r Q  T ) S i r r P1 G

S SP(, r Q0  T ) S G • If the interest rate is determined in 1 the money market, r 1 0 which variable will adjust to clear the I  I r,... market for goods and services?

S,I Role of inventories

 If I

• Keynes disputed the classical view that the interest rate would equilibrate savings and investment: – The interest rate is determined in the money market (the theory of “liquidity preference”) Hence: The amount people wish to save at full employment levels of income may not equal the level of investment planned by businesses – If S = S(Q), it is output Q that adjusts to equal savings and investment Simultaneous determination

• Savings and Investment (IS)      E  SP  rQT,,   TG    Irz      • Money demand and Supply (LM) M S  mi,Q  P • Aggregate supply

d  Q zFN WP  • Assume i r The Keynes Effect

- Or Transmission Mechanism. “In normal times the central bank has the power to influence aggregate demand”

• Key ingredients 1. Wage/Price stickiness 2. The theory of liquidity preference

• Hence, • When money expands, the interest rate declines, boosting consumption and investment (Keynes effect) • The aggregate demand is negatively sloped Aggregate Demand

• Slope • When the P increases, M/P declines • This causes the interest P rate to increase • This causes S(Q)>I 1 • Or C+I+G>Q P 1 • Thus, Q must fall to 0 balance the market for goods and services P0

AD0

0 Q1 Q0 Q Aggregate Demand

• When the M expands, • Shift M/P increases • This causes the interest rate to fall P • This causes S(Q)Q 0 1 • Thus, Q must increase P0 to balance the market for goods and services AD1

AD0

Q 0 Q0 Q1 The Great Depression

• The transmission mechanism (“Keynes effect”) fails  Monetary policy is impotent Keynes  Aggregate demand becomes vertical

Two reasons 1. Unresponsive demand 2. Liquidity trap Unsresponsive demand

Both S and I are interest-inelastic: •Aggregate savings are primarily a function of income and not very responsive to the interest rate (fallacy of composition) •Investment is mostly influenced by the state of business expectations (“animal spirits”)

    E  SQTP    TG    Iz     

•Even if the central bank manages to influence the interest rate, private demand will not respond •The AD curve is vertical The fallacy of composition

• One shall not assume that what is true for the individual level holds in the aggregate. • At the microeconomic level, relative price effects are important determinants of individual decisions. • At the macro-level, much of relative price effects cancel out. • At the macro-level income is more important in determining aggregate economic behavior than prices. • As a corollary, savings depend more on income than on the interest rate Liquidity trap

When the interest rate is very low people do not buy bonds. 1.Bonds are less liquid than i money 2.Bonds prices may fall. Money in excess will be hoarded. …The AD curve is vertical

i d m (i,Q)

 M   M  M/P 0      P  0  P 1 Destabilizing deflation

Pigou: - The fall in prices should make the real value of people money holdings to increase (real balance effect) causing consumption (IS) to expand Arthur Pigou - Deflation will drive the economy out of the liquidity trap (1877-1959) However: M=5% of wealth (too small)

Keynes: Deflation is destabilizing -Expectations effect: deflation implies postponement of consumption -Redistributive effect: unexpected deflation redistribute income from debtors (who consume) to creditors (who save) …Deflation will further depress the effective demand

Evidence: 1923-33: inflation =-24%, and aggregate demand contracted abruptly The multiplier Assume the marginal propensity to save is constant

SP  asQT  

The IS/AD curve becomes

 E  asQT    TG   Iz    Implying 1 Q 1 Q a 1 sTGIz   E    s   G s The Paradox of thrift

• What happens when the marginal propensity to save increases?

S asQT'   TG S, I

S asQT   TG 1 I Iz E  0 • What if investment falls 0 in response? Q' Q 1 a Q a 1 sTGIz   E   s   The paradox of thrift

In a leveraged economy the attempt of people to save may make things worse • Saving can be seen as good when it leads to more investment. This would need, however, a falling interest rate (classical model). • In the Keynesian framework, the variable that balances savings and investment is income. • Paradox of thrift: an increase in savings leads to a decrease in expenditures and in output, deepening the recession. – In the end, total savings will be unchanged, as they have to match the exogenous investment – In case investment declined in response, things will get even worse The Accelerator Theory

• The ACCELERATOR THEORY suggests that a net investment depends on the rate of change of output. • If there is a fall in consumer confidence, output will fall through the multiplier. • This will, in turn, will cause Sir Roy HARROD (1900-1978) investment to decline, through the accelerator. • Then, because of the fall in investment, the multiplier takes over again. • The interaction of the multiplier and accelerator will amplify cyclical fluctuations. Effective labour demand

W w  d P AD1 AD0 N P N S 1 1‘ 0 W w  P0 P1 1 W 1‘ w*  P1 0 P0 N d

0 Q Q * 0 N N * N Effective labour demand

d AD1 ASW( ,) z W d N0 P N1 AD0 P

d 1 0 N P Wz z 1 0

0 Q Q * Q 0 N N * N Fiscal policy

• Changes in expectations AD’ AD’’ P (“animal spirits”) may tilt the economy do a depression P 0 0 • The price mechanism will not be fast enough to ensure 1 P1 self correction If the private sector is not AS prepared to spend, then the government should do it instead. 0 Q Q * Summary: Two fronts

Keynes attacked the classical view in three fronts: 1- Problems in aggregate supply: - Wages and other costs of production adjust more slowly than prices. - With sticky wages, the fall in prices will cause an increase in real wages, aggravating involuntary unemployment and the fall in investment (Empirical problem here: real wages do not increase during recessions…) 2- Problems in effective (aggregate) demand Keynes contended that during the Great Depression the monetary policy was ineffective: - Unresponsive investment ( “animal spirits”) - Liquidity trap: the interest rate is so low that people don’t buy bonds: they save in the form of cash (monetary expansion no longer lowers the interest rate).

Government expenditures have a stabilizing role Keynes contributions

• In the process of deriving effective demand, Keynes introduced many of the building blocks of modern macroeconomics: – The relation of consumption and savings to income – Liquidity preference: the supply of money determines the interest rate (“Keynes effect”). – The importance of expectations in affecting consumption and investment; and the idea that animal spirits are a major factor behind shifts in demand and output. – The multiplier (expenditure shocks are magnified).

Keynes distinguished:. •Equilibrium income – the level of income toward which the economy gravitates in the short run. •Potential income – the level of income that the economy technically is capable of producing. Comment by Paul Samuelson

“It is a badly written book, poorly organized; any layman who, beguiled by the author’s previous reputation, bought the book was cheated of his 5 shillings. It is not well suited for classroom use. It is arrogant, bad-tempered, polemical, and not overly-generous in its acknowledgements... In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding on its relations to its predecessors. Flashes of insight and intuition intersperse tedious algebra. An awkward definition gives way to an unforgettable cadenza. When it is finally mastered, we find its analysis to be obvious and at the same time new. In short, it is the work of genius.” The Neoclassical Synthesis - Post-war economic conditions, with full employment and rising inflation, revealed that constant price levels was not a general case. - The neo-classical synthesis was an attempt to qualify the Keynes ideas and merge them with those of early economists.

The neoclassical synthesis refers to a large consensus that emerged in the early 1950s. Contributions: •IS-LM (Hicks, Hansen) •Theories of consumption (Modigliani, Friedman) •Theories of Investment (Tobin, Jorgensen) Samuelson •Money demand (Tobin) •Phillips curve: empirical regularity found by A. W. Paul Samuelson Phillips in 1958, and popularized by Samuelson and wrote the first Solow in 1960 (the 3%-5% rule) modern economics •Large macroeconomic models (Lawrence Klein textbook developed the first U.S. macroeconomic model in the early 1950s. The model was an extended IS relation, with 16 equations).

The neoclassical synthesis was to remain the dominant view for another 20 years