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Home , Aggregate demand, Demand shock, Fiscal policy, John Maynard Keynes, Monetary policy, Stimulus (economics)

An Introduction to Keynes &

Fiscal "Construction teams still work around the clock in 's largest city...In a telling shift, however, construction workers are putting up fewer of the office and apartment buildings that had sprouted like weeds in the boom years...Instead they are working on municipal projects...part of China's enormous spending program aimed at preventing the from weakening too seriously." -- NYT April 3, 1999

Overview

Clearly something needed to be done as the economy continued its slide into Depression, but if we were to see any substantial shifts in macroeconomic policy, we first needed to see a shift in the prevailing economic theory. Until the Classical model could be successfully challenged, the guidelines for policy officials would be maintenance of the standard and a .

John Maynard Keynes provided the theoretical basis for a reconsideration of macroeconomic policy in his 1936 book, The General Theory. The centerpiece of the Classical view had been Crowding-out, and it was to be replaced by the Keynesian . The essence of the multiplier is captured in the following quotes. First we have the historian Gerald Johnson's description of how the panic in 1929 produced a wave that rippled through the economy.i

When the panic of 1929 suddenly wiped out the whole of many and sharply reduced the values of others, a great number of people who had thought themselves rich, or at least well off, found themselves with much less than they had thought they had, or with nothing at all. By [the] millions they quit buying anything except what they had to save to stay alive. This drop in spending threw the stores into trouble, and they quit ordering [new products] and discharged clerks. When orders stopped the factories shut down, and factory workers had no jobs.

More recently, Dave Barry provided a humorous take on the multiplier.

Some of you... may have decided that, this year, you're going to celebrate it the old- fashioned way, with your family sitting around stringing cranberries and exchanging humble, handmade gifts, like on "The Waltons". Well, you can forget it. If everybody pulled that king of subversive stunt, the economy would collapse overnight. The would have to intervene: it would form a cabinet-level Department of Holiday Gift-Giving, which would spend billions and billions of dollars to buy Barbie dolls and electronic games, which it would drop on the populace from Air Force jets, killing and maiming thousands. So, for the good of the nation, you should go along with the Holiday Program. This means you should get a large sum of and go to a mall.ii

On a more serious note, when China was faced with a dramatic drop in for its in the slowdown in the later 1990s, its policy makers clearly were Keynesians as they shifted demand from exports to government.

Construction teams still work around the clock in China's largest city...In a telling shift, however, construction workers are putting up fewer of the office and apartment buildings that had sprouted like weeds in the boom years...Instead they are working on municipal projects...part of China's enormous spending program aimed at preventing the economy from weakening too seriously.iii

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They did the same in response to the collapse in demand in the Great of 2008.

China on Sunday night announced an aggressive $586 billion economic package, the largest in the country's history, at a time when it is struggling with increasing social unrest due to factory closings and rising .

In a wide-ranging plan that are comparing to the , the government said it would ease restrictions, expand social services and launch an infrastructure spending program that would include the construction of new railways, roads and airports.iv

Keynes' ideas were simple and based on the premise that the prevailing Classical theory, while maybe adequate as a guide to the long run, was not valuable to policy makers who could not afford to operate in that time frame. Keynes said as much when he suggested, "In the long run we are all dead." To Keynes, the demanded a reassessment of the assumptions of the Classical model. Where Classical economists focused on flexible , Keynes focused on inflexible prices. Where Classical economists focused attention exclusively on and the long run, Keynes focused on and the short-run. Where Classical economists assumed markets worked efficiently and would quickly eliminate any imbalances, Keynes recognized that markets sometimes move too slowly to eliminate imbalances.

In the labor where the imbalance between would be unemployment, Classical economists believed unemployment would simply "disappear" like imbalances in any market. Unemployment is simply a surplus, and we know from our analysis of supply and demand that a surplus would push the market lower and eliminate the surplus. Keynes believed in the power of markets, but he thought the labor market was different and could get "stuck" and unemployment would not disappear. Keynes believed wages would not adjust downward quickly because people take their pay personally and they would resist, at least initially, any pay cuts. Just think about how you would react to your boss announcing a 10% cut in wages effective on Monday: either you take the 10% cut or you are fired. Would you simply agree to the cut, or would you fight the cut and accept unemployment? Keynes thought many would fight the cut and the result would be persistent unemployment.

The good news is the existence of these unemployed workers and excess capacity with those idle factories meant could expand without putting any upward pressure on wages or prices because neither workers nor firms had any bargaining power. Where the Classical economists say any increase in Aggregate Demand (AD) generates higher prices, Keynes expected workers would be “thrilled” to work at the existing if there was any work for them and would be “thrilled” to sell additional at existing prices. In Keynes’ depressed world, an increase in AD would increase output rather than prices.

Keynes also questioned the assumption of flexible rates and suggested interest rates could get stuck at non- rates. In difficult economic times, if firms had laid off workers and had machines sitting idle, a drop in interest rates would not prompt firms to buy new machinery or build new factories as suggested by the Classical economists. You would also see respond to the tougher, more uncertain economic times by increasing their . When you are worried about having a job next week, you are more for that “rainy day.” In this environment, even if the central pushed interest rates down to zero, we may find unwilling to lend money to consumers and businesses or these consumers and businesses unwilling to borrow to finance their spending. The result is that a decline in interest rates would not generate the aggregate demand needed to put the unemployed back to work. This is precisely what we saw in 2008-2009 as the US economy slipped into a deep recession and banks became more restrictive with their lending, something we examine more closely in the final unit.

There is not much good news here, but there is some. In the depressed economy of the Great Depression in the 1930s – and also the in the early –idle resources mean that any increase in aggregate demand will not necessarily push prices higher. If the government decides it needs to increase

2 it’s spending to offset the decrease in spending by consumers and producers, then this will not cause by pushing wages and prices higher. It also means that if the government needs to borrow money to finance its spending, this increased borrowing will not drive up interest rates. In this environment the economy’s problem is pretty simple – there is not enough aggregate demand to keep workers working – and thus Keynes focused attention on aggregate demand and the need for the government to respond to shifts in aggregate demand with the appropriate monetary or fiscal .

This situation, where output can expand without any upward pressure on wages and prices is represented in the AS-AD diagram below. The AS curve is horizontal because workers will be happy to work more hours for the same wage and firms will be happy to sell more of their "stuff" at the same prices. This very different view of the supply-side of the economy had a dramatic effect on the macro policy prescriptions. As Keynes saw it, if the private sector could not be relied upon to provide adequate demand, then the government could step in as the "demander of last resort" and borrow funds to purchase and services.

Diagram 1 The Keynesian AS - AD Model

In theory the government could get the economy moving again by stimulating aggregate demand, and it could do that with either – pushing money into the system to drive down interest rates to “encourage” and households to borrow that money to buy “stuff,” or it could simply buy “stuff” on its own. Instead of enticing you to buy a new car with low interest rates the government could simply buy a new road or reduce your and hope you spent the on stuff. Of these possibilities, Keynes believed in a situation as extreme as the Great Depression, the best solution was , so now we will turn our attention to that. We begin with a brief overview of government finances and then look at the key Keynesian concept – the multiplier.

Fiscal Policy: In Theory and Practice

When Keynes turned his attention to the output market he focused on spending. An important point overlooked in the Classical view is that is a primary determinant of spending by households; if people had more income they would buy more . Keynes recognized this and the relationship between income and consumption spending became a key piece of the complete macro model. The concept Keynes introduced to capture the link between income and consumption is the marginal propensity to consume (MPC), defined as the change in consumption created by a change in income. If the marginal propensity to consume was .8, then consumption spending would increases by $80 for every $100 increase in income, or if you lost your job and your income dropped by $1,000, then your consumption spending would fall by $800.

Keynes also questioned the traditional view of money and showed monetary policy could theoretically, but not empirically, affect the . At this time, however, we will postpone this discussion of money's role in the economy until the 1970s.

The logic of Keynes' analysis is presented in traditional texts either graphically or algebraically. We will not look at the traditional algebraic and graphical versions of the model, but rather focus on developing an

3 understanding of the multiplier process by following the spending trail created by an increase in spending on public works financed by borrowing. We begin the story in the market where the government must come to borrow money to pay for the roads project. The government has no problems finding a bank to lend it the funds at current interest rates and so it now uses the funds to place orders for the work. To produce the additional "stuff" demanded by the government, businesses recall workers, and because there is a pool of unemployed workers, labor has no bargaining power and the increased demand would not affect wage rates. You could see this in Roosevelt's speech in 1937 at the dedication of the post office building in Poughkeepsie, N.Y. where he speaks about the use of artists to improve the design of new public buildings.

And during these past four or five years, partly because of the situation of unemployment in the Nation, we have been able to bring into the Government many, many people who otherwise might have been out doing private work. To them much credit is due for the improvement of the architecture of all the Federal buildings in every county and every state of the United States.

Once these workers are hired and receive their paychecks, they will buy goods and services with their new income. In Keynes' terminology, the "primary expenditure" on the roads, generated "primary employment" in road building. This in turn generates "secondary employment" in the production of goods and services so the final change in expenditures / employment would be some multiple of the initial expenditure. The additional demand - increased consumption spending on homes, cars, food, clothing - would translate into increased production of those goods and services because the businesses, with idle factories and workers, had no power to raise price. The nature of the AS curve has important implications for macroeconomic policy. In the Classical model the AS curve was vertical so the only policies that would expand the economy - meaning more output (GDP) - would be polices that focused on the supply-side of the economy and shifted out the AS curve. Keynes took the opposite approach and focused exclusively on the demand side of the economy. If the economy was stuck in a recession, then the government simply needed to increase aggregate demand (shift the AD curve outward) to increase output and employment. More importantly, any initial increase in aggregate demand would eventually be transformed by the multiplier process into some multiple expansions in aggregate demand.

This sounded great in theory, but the change in US policies was anything but smooth and continuous. It turned out President Roosevelt did not quickly buy into the new Keynesian theory. For every few steps forward, Roosevelt took one step backward. He took a step forward on May, 22 1932, when he promoted an activist position: "The country needs and, unless I mistake its temper, the country , bold, persistent experimentation." By July 20, 1932 Roosevelt stepped backward and promoted a balanced budget: "Government, like any family, can for a year spend a little more than it earns. But you and I know that a continuance of that habit means the poorhouse."

At the center of Keynes' "solution" was an increase in aggregate demand that would have a multiplier effect on the economy. The magnitude of the final output and employment effect of a change in spending depends upon the share of the additional income spent on local production - the marginal propensity to consume. The multiplier is defined as the change in income (ΔY) resulting from a $1 change in aggregate demand (ΔAD), and the formula for the multiplier is:

(1) Multiplier = ΔY/ΔAD

ΔY = change in income ΔAD = change in aggregate demand MPC = marginal propensity to consume

It is also true that the multiplier depends on the marginal propensity to consume, and the relationship is specified in equations (2) and (3). (2) Multiplier = 1/(1-MPC)

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(3) Y/ΔAD = 1/(1-MPC)

These equations should be added to your short list of important equations because they will be the basis of a number of potential questions. In fact there can be 4 types of questions because the equations contains 4 unknowns (Multiplier, MPC, DΔY, ΔAD). You can expect that with information on any three of the variables you can use some simple algebra to solve for the value of a last unknown. Three examples are given below.

1. If individuals spend 80 percent of their income on locally produced goods and services (MPC = .8), and a $100M increase in (ΔAD = 100) is proposed, what would be the expected change in income (ΔY). You have been given info on ΔAD and ΔY so you simply plug the knowns into equation (2) and you get a final change in aggregate output.

ΔY/ΔG = 1/(1-MPC) ΔY/$100 = 1/(1-.8) = 1/.2 = 5 ΔY = 5*$100 = $500 The change in income is $500M.

2. If you know a change in spending of $500 will produce a change in total output of $1,500, what is the multiplier? You have been given info on ΔAD and ΔY so you simply plug the knowns into equation (1) and you get a value for the multiplier.

Multiplier = ΔY/ΔG Multiplier = $1,500/$500 = 3 The multiplier is 3.

3. If you know that the multiplier is 4 and you want to increase total output by $1,500, what is the necessary increase in spending? You simply need to plug the known information into equation (3), rearrange the terms, and solve for the unknown.

ΔY/ΔG = Multiplier $1,500/ΔG = 4 $1,500/4 = ΔG = $375

You can see how this relationship is valuable to policy makers attempting to achieve some target level of economic activity. Expansionary fiscal policy (#G) would, by definition increase aggregate demand (#AD). If we assume the increased demand is accommodated by increased supply, which it would be in a depressed economy, then income will rise (#Y) which will increase consumption spending (#C). But the second round increase in consumption will now set off a third round of expansion since this increase in aggregate demand will lead to a further increase in output. The result is that the initial increase in spending / or tax cut will produce a multiplied effect on output. And, if business conditions are bad when the policy is undertaken, the increase in income may actually increase demand - a crowding-in phenomenon.

The rest, as they say, is history. In the early 1930s, Franklin D. Roosevelt pushed through a wide array of programs called the New Deal that were consistent with the philosophy espoused by Keynes. When Roosevelt reaffirmed his commitment to a balanced budget in his 1936 campaign and cut government spending while allowing tax to increase as the economy grew, it was obvious he had not been sold completely on Keynes' idea.v And he paid the price as the economy spiraled downward in 1937, but things turned around by 1939 as the New York World's Fair opened with optimism evident in the theme "A World of Tomorrow." It was not until the 1940s when WW II provided an "extreme" aggregate that

5 the economy was truly lifted out of the Depression. What remained to be seen was whether this anti- depression policy would catch on and whether it could be used as an anti-recession policy. This was a policy debate that was still a few decades off, although in the post WW II era the Keynesians quickly took the high ground in the academic debates.

The concept of the multiplier, however, remains alive and well and you will run across it often. One place you often hear about it is in discussions of local or state level where the emphasis is on attracting a to the state with the expectation that the jobs this company creates, maybe Fidelity's move to RI or BMW's move to SC, would create additional jobs in some supporting industries. A more recent example at the national level was a study estimating the economic impact of the Iraq War.vi An interesting feature of that analysis is that the short-run and long run effects are quite different. In the short run (5 years) the increased military spending has a positive, multiplier effect on GDP and employment, but by 10 years has emerged as resources have been diverted from consumption and investment. model that is a feature of most introductory economics books.

6 1930s Keynes i And those ideas were still around at the opening of the 21st century on the other side of the world as China's economy slowed and policy makers adopted some traditional Keynesian tactics. "Construction teams still work around the clock in China's largest city...In a telling shift, however, construction workers are putting up fewer of the office and apartment buildings that had sprouted like weeds in the boom years...Instead they are working on municipal projects...part of China's enormous spending program aimed at preventing the economy from weakening too seriously." ii Dave Barry, "Christmas Shopping: A Survivor's Guide" iii SETH FAISON , “INTERNATIONAL BUSINESS; China Manages to Keep Its Economy Humming,” NYT, April 3, 1999 iv Ariana Eunjung Cha and Maureen Fan, “China Unveils $586 Billion Stimulus Plan,” Washington Post Foreign Service, Monday, November 10, 2008 v It was clear, Roosevelt was not yet converted to the new economics of , a taste of which can be seen in the abstract of a conversation between Keynes and A. P. Chew from the Agriculture Department in 1936. In that abstract it is evident Keynes sees a continuation of the Depression as a threat to ("It is problematical if capitalism can stand another shock like the last one. Certainly, it cannot stand a succession of shocks without social means of alleviating the effects"); government intervention is essential for a continued recovery ("The recovery in very large measure is a result of what the administration has done, and further government action is desirable to keep in existence the instrumentalities that have demonstrated their value"); and the secret to the recovery is a growth in aggregate demand ("The problem of foreign , while important, is not the primary economic problem."). vi Dean Baker, "The Economic Impact of the Iraq War and Higher Military Spending," Center for Research, May 2007

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