Who are you

KeynesianMonetarist

New classicalist

New Keynesian

Post Keynesian

Finding macroeconomics confusing?

Finding macroeconomics confusing?

Outline of the lecture

Introduction

Chapter 2: Keynes v. the “old classical” school

Chapter 7: The New Keynesian school

Chapter 8. The Post Keynesian school

Macroeconomics is not an exact science but an applied one where ideas, theories, and models are constantly evaluated against the facts, and often modified or rejected …Macroeconomics is thus the result of a sustained process of construction, of an interaction between ideas and events. What macroeconomists believe today is the result of an evolutionary process in which they have eliminated those ideas that failed and kept those that appear to explain reality well.

Olivier Blanchard

Events and ideas (1)

Pre-Keynesian classical economics:The case against discretionary policies

The Great Depression (1930s) Keynesian economics, neoclassical synthesis

Inflation (late 1960s and 1970s) Milton Friedman and monetarism

Stagflation (1970s) Post-Keynesian re-interpretation of KeynesSupply-side economics and Reaganomics

Events and ideas (2)

The great embarrassment: microfoundations New classical economicsNew Keynesian economics

Two major groupings:Keynesians/New-Keynesians/Post Keynesians:

economies are unstable; macroeconomic policy helps

Classicals/neoclassicals/monetarists/supply-siders/New classicals: economies relatively stable; macroeconomic policy destabilises

Supply creates demand (Say’s law) Money does grow on trees

Demand creates supply Money does not grow on trees

What the classical economist saw

The determination of output

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Competitive labour market

Demand for labour Negatively related to the real wage rate Supply of labour Positively related to the real wage rate

Production function Law of diminishing returns

Say’s Law Supply creates its own demand

“A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value ... The mere circumstances of the creation of one product immediately open a vent for other products.” (Say, 1821)

“Could we suddenly double the productive powers of a country, we should double the supply of commodities in every market: but we should, by the same stroke, double the purchasing power.” (J.S. Mill)

Money does grow on trees

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Strong version of Say’s Law

Output produced is at the level of full employment

There are no unexploited opportunities

There are no R100 notes on the pavement

Production creates income creates spending

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Production creates income creates spending

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Production creates income creates spending

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Production creates income creates spending

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Production creates income creates spending

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Production creates income creates spending

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Unemployment is possible but not involuntary unemployment

The quantity theory

MV = PY

M - Money supplyV - VelocityP - Price level Y - Output

With V and Y fixed and a causality from M to Pan increase in M leads to an increase in P

What happens if the money supply increases?

In the money market a disequilibrium is created Ms > Md

The demand for goods increases

Since Y is at the level of full employment the price level rises

Increase in the price level decreases the real wage

Decrease in real wage causes an excess demand on the labour market

Nominal wages increase to restore the equilibrium

Money is neutral

Unemployment in the classical model

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Structural and frictional Unemployment

What about the impact of unions?

What cause changes in the level of output?

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Business cycles and stabilisation policy (1)

Business cycle: pattern of recovery and contrac-tion in economic activity around long-term trend

Stabilisation policy: policies to smooth the business cycleThe classical view:Market economies are inherently stableFluctuations reflect exogenous forces (such as

policy mistakes)Policy intervention should be avoided – market

forces would sort out economic problems

The great depression

Wages fellPrices fellOutput fellUnemployment increased

What Keynes saw

Principle of effective demandIn a closed economy with spare capacity the level of output (and hence employment) is determined by aggregate planned expenditure: C + I

“When employment increases, aggregate real income is increased. The psychology of the community is such that when real income is increased aggregate consumption is increased, but not by so much as income.” JM Keynes

“Hence employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption.” JM Keynes

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... To justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output what the community chooses to consume when employment is at a given level.

JM Keynes

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At equilibrium there is no inducement to either expand or contract output.

It is those factors which determine the rate of investment which are most unreliable, ...

What determines investment spending?

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20 Broke the link between savings and investment

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20 Broke the link between savings and investment

Principle of effective demand: In a closed economy with spare capacity the level of output (and hence employment) is determined by aggregate planned expenditure: C + I

Investment spending

Expected profitability of investment Interest rate

How does a change in investment spending influence output?

Multiplier effect

Determining the level of employment

What happens when investment spending changes?

Keynesian labour market

The demand for goods determines the demand for labourGiven the amount of labour demanded, the wage is determinedThe unemployed have no power to affect changeInvoluntary unemployment is possible

In assuming that the wage bargain determines the real wage the classical school have slipped in an illicit assumption.

There may exist no expedient by which labour as a whole can reduce it real wage by making revised money bargains with the entrepreneurs. JM Keynes

The role of fiscal policy

An increase in the money supply leads to a decrease in the interest rate which leads to an increase in investment spending

If the economy is in a liquidity trap the increase inthe money supply fails to decrease the interest rate.

Money is not neutral

Business cycles and stabilisation policy (2)

The Keynesian view:Market economies are inherently unstable

(due to volatile investment spending)Policy intervention is essential to smooth cyclical fluctuations

Labour market

The demand for goods determines the demand for labourThe amount of labour demanded determines the wage rateThe unemployed have no power to affect changeInvoluntary unemployment is possible

Involuntary unemployment

In the event of a small rise in the price of wage-goods relative to the money- wage, both the aggregate supply of labour willing to work for the current money-wage and aggregate demand for it at that wage would be greater than the existing volume ofemployment

A decrease in the money wage rate or an increase in the price level (or both) can result in a decrease in real wages

IS-LM model AS-AD model

Phillips curve

The Phillips curve illustrated the possibility of a trade-offbetween inflation and unemployment

Classical view• Say’s Law: (aggregate) supply creates its own (aggregate) demand• Say’s Law holds for a barter economy• Say’s Law also holds for a money economy since money is seen purely as a medium of exchange, not as a store of value• Weak version of Say’s Law: production automatically generates income as payment to the factor inputs which is equivalent to purchase all the output produced• Strong version of Say’s Law: In addition, the output produced is the full employment level of output • Thus the strong version of Say’s Law implies that there is no barrier in a free market economy with perfectly flexible wages and prices to achieving full employment• Income is either consumed (C) or saved (S) and saving is always spent elsewhere in the economy • Flexible interest rate (r) ensures that the desired amount of saving always equals the desired amount of investment spending (“loanable funds” theory of r)• Y = C(r) + S(r) and E = C(r) + I(r). Since Y = E, then S(r) = I(r)• Neutrality of money: changes in demand for or the supply of money do not affect real output, employment and relative prices

Keynesian view

• Say’s Law a special case, only holds when aggregate demand (AD) = aggregate supply (AS) • Principle of Effective Demand: output and employment determined by aggregate desired spending• If AD ≠ AS, it is mainly quantity and not price adjustments that restore equilibrium• AD = E = C + I• C and S are passive, are a function of Y more than they are of r• Money serves as a store of value as well as a medium of exchange• Liquidity preference: in times of uncertainty money may be hoarded (this implies non-neutrality of money)• Thus S will not necessarily be spent elsewhere, irrespective of changes in r• If S > I, it is mainly via decreases in output, employment and income (Y) that equilibrium S = I is restored• The effect of autonomous changes in C or I on Y is magnified by the multiplier

Involuntary unemployment

Classical explanation:• No aggregate demand deficiency in terms of Say’s Law• Labour market: full employment equilibrium is maintained by flexible real wages• Demand for labour by profit maximising firms: determined by workers’ marginal productivity of labour• Supply of labour by utility maximising worker: determined by individual choice or trade-off between work and leisure• Thus in perfectly competitive markets involuntary unemployment cannot persist – all observed unemployment is either voluntary or frictional• Involuntary unemployment can only persist in uncompetitive or regulated labour markets

Keynesian explanation:• Aggregate demand deficiencies lead to lower output and employment (reversal of Say’s Law)• If AD < AS, then involuntary unemployment is likely to occur and to persist• Downward rigidity of nominal (money) wages prevent labour market from clearing• Real wage can be reduced by increasing AD and allowing the price level to increase

The classical view:Market economies are inherently stableFluctuations reflect exogenous forces (such as policy mistakes)Policy intervention should be avoided – market forces would sort out economic problems

The classical view:Market economies are inherently stableFluctuations reflect exogenous forces (such as policy mistakesPolicy intervention should be avoided – market forces would sort out economic problems

The Keynesian view:Market economies are inherently unstablePolicy intervention is essential to smooth cyclical fluctuations

Macro dimension of current fiscal policy

Effects of fiscal policy on the level and stability of aggregate demand

“... by expanding government’s contribution to the economy, the fiscus is able to support economic activity at a time when global and domestic demand is faltering. This complements the role of monetary policy in supporting macroeconomic stability, reducing the impact of the downturn on households and mitigating its depth and duration. The public-sector infrastructure programme also supports aggregate demand and boosts vital job-generating sectors of the economy, while raising long-term growth potential.”

National Budget Review 2009

There is no disagreement that we need action by our government, a recovery plan that will help to jumpstart the economy."

— PRESIDENT-ELECT BARACK OBAMA, JANUARY 9 , 2009

With all due respect Mr. President, that is not true.

Notwithstanding reports that all economists are now Keynesians and that we all support a big increase in the burden of government, we do not believe that more government spending is a way to improve economic performance. More government spending by Hoover and Roosevelt did not pull the United States economy out of the Great Depression in the 1930s. More government spending did not solve Japan's "lost decade" in the 1990s. As such, it is a triumph of hope over experience to believe that more government spending will help the U.S. today. To improve the economy, policy makers should focus on reforms that remove impediments to work, saving, investment and production. Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth.

Short-run and long-run Phillips curves

In the mean time Milton Friedman was upto something!

MV = PYIn the short run M influences both

P and Y but in the long run only P

Strict monetary policy rule

New classical economics

Rational behaviourRational expectationsMarket clearing

To assume rational expectations is to assume that agents' expectations are correct on average. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased.

Robert Lucas

The government can effect the economy, but it cannot stabilise the economyApply policy rules Be credible

Policy is ineffective if:

Policy changes are correctly anticipatedExpectations are formed rationallyMarkets clear

Chapter 7 The new Keynesian school

Keynesian in spirit A market system does not automatically ensure full employment Effective demand is important Money is not neutral

Absence of continuous market clearingThis is due to wage and/or price stickiness explained in terms of rational (maximising behaviour) including, in some new Keynesian models, rational expectations

Attempts to explain Micro foundations for wage and price rigidities rooted in maximising behaviour The absence of continuous market clearing in terms of rational behaviour

Reason for stickinessNominal rigidityNominal wage – long term wage contractsNominal price – imperfect competition, cost of priceadjustment

Real rigiditySomething is preventing the real wage from adjusting

Labour marketImplicit contracts- Invisible handshakeEfficiency wage Adverse selection modelLabour turnover modelShirking modelFairness modelInsider-outsider

New Keynesians and the business cycle Chapter 7.8

Originates from the demand and supply sideFrictions and imperfections amplify the shock

Two traditions

Nominal rigidities Price and wage flexibility

Money is non-neutral in the short runbut neutral in the long runCoordination failure Cutting prices will benefit all firms(Figure 7.8)

Wage and price rigidity is not the main problem

FirmsRisk averse

Financial market imperfections

Vulnerability to bankruptcy

Prefer to cut production

Credit rationing

(Figure 7.9)

New Keynesian economicsFluctuations are irregular and unpredictable Uncertainty in respect of future economic problems

Coarse tuning: Do not support fine tuning neither fixed policy rulesNot sure whether it should be fiscal or monetary policyMoney is not neutral

Reduce bargaining power of unions Improving the position of the unemployed

New Keynesians and inflation Low and stable inflation is good for the economyInflation has real economic cost Distorts the distribution of income Influence market efficiency Investment decisions negatively Damages the well being of the poorest groups

Inflation targeting

Inflation targeting is a strategy for conducting monetary policy pioneered in the early 1990’s by a number of developed and developing countries. The introduction of this strategy meant that these countries have come to recognize the potential benefits of price stability. It is therefore common to find that many central bank legislations have price stability as their principal goal of monetary policy.Primary long run goal of monetary policy is therefore price stability

Why inflation targeting

Inflation has serious economic consequences

Fine tuning does not work

It is a framework and not a rule

Gives constrained discretion to central banks

The main argument for the adoption of targets is the notion that to conquer inflation, and thereafter to preserve price stability, requires policy credibility and credibility, in turn, requires consistency, commitment, and transparency, which cannot be without the accountability that arises from the adoption of the explicit targets

Bleher and Leone (2002):1)

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Chapter 8 The Post Keynesian School Paul Davidson

Post KeynesiansMajor works of Paul Davidson "A Clarification of the Ricardian Rent Share", 1959, Canadian J of Econ and Political Science. "Increasing Employment, Diminishing Returns, Relative Shares, and Ricardo", 1960, Canadian J of Econ and Political Science, 1960. Theories of Aggregate Income Distribution, 1960. "More on the Aggregate Supply Function," 1962, EJ. Employment and Income Multipliers and the Price Level," 1962, AER "Public Policy Problems of the Domestic Crude Oil Industry", 1963, AER. "Modigliani on the Interaction of Real and Monetary Phenomena", with E. Smolensky, 1964, REStat. Aggregate Supply and Demand Analysis with E. Smolensky, 1964. "Keynes's Finance Motive", 1965, Oxford EP. "The Importance of the Demand for Finance", 1967, Oxford EP. "A Keynesian View of Patinkin's Theory of Employment", 1967, EJ. "The Valuation of Public Goods," 1968, in Garnsey and Hibbs, editors, Social Sciences and the Environment. "Money, Portfolio Balance, Capital Accumulation, and Economic Growth," 1968, Econometrica. "The Demand and Supply of Securities and Economic Growth and its implications for the Kaldor-Pasinetti vs. Samuelson-Modigliani controversy", 1968, AER. "A Keynesian View of the Relationship Between Accumulation, Money and the Money Wage Rate", 1969, EJ. "Money and the Real World", 1972, EJ "A Keynesian View of Friedman's Theoretical Framework for Monetary Analysis," 1972, JPE. Money and the Real World, 1972. "Money as Cause and Effect", with S. Weintraub, 1973, EJ. "Market Disequilibrium Adjustments: Marshall Revisited," 1974, Econ Inquiry.

Oil: Its Time Allocation and Project Independence," with L.H. Falk and H. Lee, 1974, BPEA. "Post-Keynesian Monetary Theory and Inflation", 1977, in Weintraub, editor, Modern Economic Thought. "A Discussion of Leijonhufvud's Social Consequences of Inflation", 1977, in Harcourt, editor, Microfoundations of Macroeconomics. "The Carter Energy Proposal", 1977, Challenge. "Money and General Equilibrium," 1977, Economie Appliquee. "Why Money Matters: Some Lessons of the Past Half Century of Monetary Theory", 1978, JPKE. "The United States Internal Revenue Service: The Fourteenth Member of OPEC?", 1979, JPKE. "Post Keynesian Approach to the Theory of Natural Resources", 1979, Challenge. "Monetary Policy, Regulation and International Adjustments," with M.A. Miles, 1979, Economies et Societies. "Oil Conservation: Theory vs. Policy", 1979, JPKE "What Is the Energy Crisis?", 1979, Challenge "Keynes's Paradigm: A Theoretical Framework for Monetary Analysis", with J.A. Kregel, 1980, in Nell, editor, Growth, Property and Profits. "The Dual Faceted Nature of the Keynesian Revolution: The Role of Money and Money Wages in Determining Unemployment and Production Flow Prices," 1980, JPKE. "Keynes's Theory of Employment, Expectations and Indexing", 1980, Revista de Economia Latinoamericana "Post Keynesian Economics: Solving the Crisis in Economic Theory", 1981, in Bell and Kristol, editors, The Crisis in Economic Theory. "Can VAT Resolve the Shortage of Savings (SOS) Distress?", 1981, JPKE. "Alfred Marshall is Alive and Well in Post Keynesian Economics", 1981, IHS Journal. "A Critical Analysis of the Monetarist-Rational Expectations Supply Side (Incentive) Economics Approach to Accumulation During a Period of Inflationary Expectations," 1981, Kredit und Kapital. International Money and the Real World, 1982. "Rational Expectations: A Fallacious Foundation for Studying Crucial Decision-Making Processes", 1982, JPKE "Monetarism and Reagonomics", 1983, in Weintraub and Goodstein, editors, Reagonomics in the Stagflation Economy. "The Dubious Labor Market Analysis in Meltzer's Restatement of Keynes's Theory," 1983, JEL. "The Marginal Product Curve Is Not The Demand Curve For Labor and Lucas' Labor Supply Function Is Not the Supply Curve for Labor", 1983, JPKE. "An Appraisal of Weintraub's Work", 1983, Eastern EJ. "Reviving Keynes's Revolution", 1984, JPKE. "The Conventional Wisdom on Deficits Is Wrong", 1984, Challenge. "Incomes Policy as a Social Institution", 1985, in Maital and Lipnowski, editors, Macroeconomic Conflict and Social Institutions. "Policies For Prices And Incomes", 1985, in Barrere, editor, Keynes Today. "Financial Markets and Williamson's Theory of Governance: Efficiency vs. Concentration vs. Power", with G.S. Davidson, 1984, Quarterly Review of Economics and Business.

"Liquidity and Not Increasing Returns Is The Ultimate Source of Unemployment Equilibrium", 1985, JPKE. "Can Effective Demand and the Movement Towards Income Equality Be Maintained in the Face of Robotics ?", 1985, JPKE. "Sidney Weintraub - An Economist of the Real World", 1985, JPKE. "A Post Keynesian View of Theories and Causes of High Real Interest Rates", 1986, Thames Papers in Political Economy. "Finance, Funding, Savings, and Investment", 1986, JPKE. "The Simple Macroeconomics of a Nonergodic Monetary Economy vs. a Share Economy: Is Weitzman's macroeconomics too simple?", 1986, JPKE. "Financial Markets, Investment, and Employment", 1988, in Matzner et al, editors, Barriers to Full Employment. "Sensible Expectations and the Long-Run Non-Neutrality of Money", 1987, JPKE. "A Modest Set of Proposals for Remedying The International Debt Problem", 1987, JPKE. "Weitzman's Share Economy And The Aggregate Supply Function", 1988, in Hamouda and Smithin, editors, Keynes and Public Policy After Fifty Years. "Endogenous Money, The Production Process, And Inflation Analysis", 1988, Economie Apliquee "A Technical Definition of Uncertainty and the Long Run Non- Neutrality of Money", 1988, Cambridge JE. Economics for a Civilized Society, with G. Davidson, 1988. "Keynes and Money" 1989, in Hill, editor, Keynes, Money, and Monetarism "Prices and Income Policy: An Essay in Honor of Sidney Weintraub", 1989, in Barrere, editor, Money, Credit, and Prices in Keynesian Perspective. "Patinkin's Interpretation of Keynes and the Keynesian Cross", 1989, HOPE. "Only in America: Neither The Homeless Nor The Yachtless Are Economic Problems", 1989, JPKE. "The Economics of Ignorance Or Ignorance of Economics?", 1989, Critical Review "Shackle and Keynes vs. Rational Expectations Theory on the Role of Time, Liquidity, and Financial Markets" 1990, in S. Frowen, editor, Unkowledge and Choice in Economics "Liquidity Proposals for a New Bretton Woods Plan", 1990, in Barrere, Keynesian Economic Policies. "On Thirlwall's Law", 1990, Revista de Economia Politica Collected Writings of Paul Davidson, 2 vols, 1990-1. Controversies in Post Keynesian Economics, 1991. " A Post Keynesian Positive Contribution To `Theory'", 1991, JPKE "Is Probability Theory Relevant For Choice Under Uncertainty?: A Post Keynesian Perspective", 1991, JEP. "What Kind of International Payments System Would Keynes Have Recommended for the Twenty-First Century?" 1991, in Davidson and Kregel, editors, Economic Problems of the 1990s. "Money: Cause or Effect? Exogenous or Endogenous?", 1992, in Nell and Semmler, editors, Nicholas Kaldor and Mainstream Economics "Eichner's Approach to Money and Macroeconomics", 1992, in Milberg, editor, The Megacorp and Macrodynamics. "Reforming The World's Money", 1992, JPKE. "The Elephant and the Butterfly; or Hysteresis and Post Keynesian Economics", 1993, JPKE.

Would Keynes Be a New Keynesian?", 1992, Eastern EJ. "Asset Deflation and Financial Fragility" 1993, in Arestis, editor, Contemporary Issues in Money and Banking editor, Can the Free Market Pick Winners?, 1993. editor, Growth, Employment and Finance: Economic Reality and Economic Theory, with J.A. Kregel, 1994. "The Asimakopulos View of Keynes's General Theory", 1994, in Harcourt and Roncaglia, editors, Investment and Employment in Theory and Practice. "Monetary Theory and Policy In A Global Context With A Large International Debt" 1994, in Frowen, editor, Monetary Theory and Monetary Policy Post Keynesian Macroeconomic Theory: a foundation for successful economic policies for the Twenty-first Century , 1994. "What Are The Essential Characteristics of Post Keynesian Monetary Theory?", 1996, in G. Deleplace and E. J. Nell, editors, Money in Motion. "The General Theory in An Open Economy," 1996, in Harcourt and Riach, editors, A Second Edition of the General Theory. "Reality and Economic Theory", 199?, JPKE "Are Grains of Sand In The Wheels of International Finance Sufficient To Do The Job When Boulders Are Often Required?" 1997, EJ

Resources on Paul Davidson Davidson's Homepage at Tennessee. Bibliography of Davidson Davidson's archive at PKT  

Principle of effective demand

Entrepreneurial economy

Money using economy

Overturn three classical postulates:

• Gross substitution axiom• Neutrality of money• Ergodic economic world

Say’s LawIncome = Spending on current goods (consumption goods + investment goods)

Demand

Producible goods Liquid assets Non-producible Non-substitutable

Demand

Producible goods Liquid assets Non-producible Zero elasticity of production Non-substitutable Zero elasticity of substitution

Money mattersNeutrality of money – changes in money supply only affects nominal variables

Is constrained by the finance ability of the banking system to create money

Increase in money supply finances producible goods resulting in an increase in employment

Cooperative economy Entrepreneur economy

Contracts are made inreal terms

Production is organised by entrepreneurs

… who hire the factors of production for money and look to their recoupment by selling the output for money

There is no guarantee that all money paid out will bespend on their products

Uncertainty

ergodicThere is a stable underlying structure, such that we can develop theory that can be applied time after time, consistently. Non ergodic world"Uncertainty" means that we simply do not know what outcomes will occur

True Uncertainty

We live in a world of true uncertainty

‘… I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense to uncertainty … The sense in which I am using the term is that … there is no scientific basis on which to form any calculable probability whatever. We simply do not know’ (Keynes 1936)

Damn the torpedoes, full speed ahead

Post Keynesians

Say’s law is brokenMoney does matter in the short and long runInvoluntary unemployment is possible in the long runInvoluntary unemployment is not only caused by rigid wages

Favour fiscal policy directed at investment and infrastructure