Principles
of Economics: MACROECONOMICS Phil Martinez
Lecture Notes
J.M. Keynes
JOHN MAYNARD
KEYNES
Principles
of Economics: MACROECONOMICS Phil Martinez
JOHN MAYNARD
KEYNES
I. THE GREAT DEPRESSIONA. SCOPEAffected all Capitalist economies, worldwide.
The worst affected were the most developed nations - the US and Britain.
Latin America & Japan were less affected due to less integration w/ US/Europe.
USSR was not affected - it was a state-planned economy & not integrated w/ West.
B. DEPTH (all data is for the US)Output (GNP or Q) fell approx. 33%
Employment (N) fell approx. 25%
Wages (w) fell approx. 40%
Investment (I) fell significantly (see GNP as a proxy)
Interest rates (r) fell to about 1%; & were < 0 in some areas for short periods.
C. THE CLASSICAL EXPLANATION OF THE GREAT DEPRESSION- It's a necessary process of internal self-adjustment in response to external disruption.
- There is nothing to be done about it. The gov't. should do nothing except balance the budget.
- Recall Say's Law: "Supply will call forth its own Demand".
The reasoning:
1) In a recession there is an excess of goods supplied to the market:
if qS > qD, then P will fall. Consumers respond to the lower price and buy-up excess Q at lower P.
2) In a recession there is an oversupply of unemployed labor:
if NS > ND, then wages (w) falls. Employers respond by re-hiring UN at lower w.
3) In a recession there is an oversupply of unemployed capital (K):
if KS > KD, then r falls. Investors/borrowers respond and re-invest/borrow at lower r.Therefore, the economy automatically self-recovers.
D. KEYNES' EXPLANATION OF THE GREAT DEPRESSION- Due to the impact of negative investor expectations and loss of consumer buying power (i.e. loss of income due to high UN) the U.S economy was stuck in an economic collapse (depression). The economy had come to rest at an equilibrium output level far below its full-potential output level.
- It could not self-adjust out of this depressed equilibrium. Interest rates were extraordinarily low yet Investment was not stimulated. Wages were extraordinarily low yet employment was not recovering. Prices for goods were extremely low, yet consumption was not responding.
- This left only the government (or international free trade) as possible stimulators of the economy. Since countries were closing-off trade in order to keep jobs within their economies, the government must deficit spend to stimulate demand and put money in the hands of spending households.
M A Y 1 9 3 2, The Atlantic Monthly
The World's Economic Outlook by John Maynard Keynes
…This is the point at which, on the precedent of previous slumps, we might hope for the beginning of recovery. I am not confident, however, that on this occasion the cheap-money phase will be sufficient by itself to bring about an adequate recovery of new investment. It may still be the case that the lender, with his confidence shattered by his experiences, will continue to ask for new enterprise rates of interest, which the borrower cannot expect to earn. Indeed, this was already the case in the moderately-cheap-money phase which preceded the financial crisis of last autumn.
If this proves to be so, there will be no means of escape from prolonged perhaps interminable depression except by direct state intervention to promote and subsidize new investment.
Formerly there was no expenditure out of proceeds of borrowing that it was thought proper for the State to incur except for war. In the past, therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war.
At any rate, I predict with an assured confidence that the only way out is for us to discover some object which is admitted even by the deadheads to be a legitimate excuse for largely increasing the expenditure of someone on something! …
II. KEYNES' CRITIQUE OF CLASSICAL ECONOMICS (SAY'S LAW)
1) Classical theory is based upon models and mathematics borrowed from physics and engineering and re-interpreted for economics, NOT on empirical observation of actual economies. Thus, Classical theory concludes that economic processes are necessarily automatic and complete when they are not .
Keynes on Classical Economic Theory's lack of Empiricism:
The classical theorists resemble Euclidean geometers in a non-Euclidean world, who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight -- as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry.
John Maynard Keynes, 1936 The General Theory, page 16.
Too large a proportion of recent "mathematical" economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.
John Maynard Keynes (1936)
The General Theory, page 298.
2) Prices may not completely adjust.
- "Sticky prices"…. firms resist lowering P; e.g. menu costs- "Sticky wages"…e.g. employees resist lowering their wages; employers prefer to lay a few people off rather than cutting everyone's wages.
- Consumers, employers, investors, borrowers may not re-act to the change in prices due to poor expectations about the state and future of the economy.
3) The market is inherently unstable due to the importance and volatility of investor expectations. Investors can rapidly de-stabilize an economy due to rapidly changing speculation and expectations of the future. Furthermore,investors may not re-invest even if interest rates collapse if expectations are poor.
(The stock market prices of the late 1990's are an example of volatile, speculative, and irrational expectations resulting in unsustainable values.)
Keynes On The Long Run:
This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
John Maynard Keynes, 1924,A Tract on Monetary Reform, Chapter III
4) The market can generate sub-optimal equilibria.
5) The government must intervene to stabilize the market in order to save the capitalist system from internally generates instability. In particular, must use
fiscal and monetary policies to keep:
(i) employment high;(ii)the economy growing;
(iii) inflation under control.
III. KEYNES' CONCLUSIONS ABOUT THE MACROECONOMY
1) The economy is driven by Demand - Effective Demand - not by Supply.
(In other words, Say's Law is backward.)
Effective Demand: people must have the money to buy what they need/desire for their demand intentions to be economicaly effective.Effective Demand = the desire to buy something + the ability to buy it
> This is a Demand-Side Theory.
2) Since the adjustment process is not guaranteed to succeed, a market economy can get STUCK in a depression (or period of high inflation). Self-adjustment may not be fully successful if effective demand is depressed. THE ECONOMY CAN REACH AN EQUILIBRIUM BELOW FULL EMPLOYMENT (FULL POTENTIAL) OUTPUT.
Full, or even approximately full, employment is of rare and short-lived occurrence. . . . and an intermediate situation which is neither desperate nor satisfactory is our normal lot.
John Maynard Keynes (1936) The General Theory, page 250.3) Therefore, the government MUST intervene to stimulate demand (consumer purchases, employment, investment, borrowing) in order to STIMULATE the economy out of a depression or in order to STABILIZE the volatility of investment in the economy.
Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative. . . .
The authoritarian state systems of to-day seem to solve the problem of unemployment at the expense of efficiency and of freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated -- and, in my opinion, inevitably associated -- with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.
John Maynard Keynes (1936)The General Theory, pp. 380-1.
NOTE: Despite criticism of Keynesianism as being socialist-oriented, Keynes's actual view was that government involvement in the economy was necessary to save Capitalism from the social upheaval that would result from prolonged Depressions or dramatic fluctuations caused by volatile expectations. This position is well stated in the preceding quotation.
The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.
John Maynard Keynes, (1936)The General Theory, page 372
FEAR THE BOOM AND THE BUST!
http://www.youtube.com/watch?v=d0nERTFo-Sk
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