Unit3

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ECONOMIC POLICY
Part I
Unit 3
J.M. Keynes’ “General Theory” and its
influence on the XX century policy debate
•
Classical
and
neo-classical
(pre-keynesian)
economists maintained that market mechanisms,
provided that free competition held, were able to
ensure an optimal allocation of resources and full
employment
•
In the Walras-Pareto general equilibrium models,
prices adjust very rapidly (actually instantaneously).
Both the markets for productive services and for
consumer commodities are in equilibrium
L. Walras (1834-1910): governments should avoid to
intervene in the economic system. The only role of
government is to guarantee the legal framework for free
competition. In particular, it should:
i) guarantee the enforcement of contracts and the security
of private property
ii) dismantle monopolies (natural monopolies should be
nationalized)
Discretionary monetary and fiscal policies are not even
contemplated
More generally, in the neoclassical (pre-keynesian) models
full employment was taken for granted
According to the “Say’s Law”, supply created its own
demand
Household’s income was either spent ( C ) or saved ( S )
• Y=C+S
Furthermore, whatever was saved by households, was
invested in productive projects:
• S=I
Excess supply or insufficient demand were ruled out by
definition. In the classical/neoclassical world nothing is
hoarded or lies idle
During the 1930s, however, the classical/neoclassical
model appeared unable to explain the Great
Depression, characterized by an unprecedented
worldwide downturn of economic activity and prices
and by high and persistent unemployment
Keynes’ General Theory of Employment, Interest and
Money (1936): a remarkable, albeit controversial,
effort to explain and counteract this unprecedented
economic recession
In Keynes’ words:
“The composition of this book has been for the author a
long struggle of escape […] from habitual modes of
thought and expression […] The difficulty lies not in the
new ideas, but in escaping from the old ones, which
ramify into every corner of our mind” (K., 1936, p. viii)
The General Theory includes two parts:
Part I (chapters 1-18) is a fixed price model. By adopting a
partial equilibrium approach, Keynes analyses in
sequence the following markets:
•
the labour market (chapter 2)
•
the goods market (chapters 3-10)
•
the capital market (chapters 11-12
•
the money market (chapters 13-17)
Part II (chapters 19-21): Keynes generalizes the previous
model by assuming flexibility of wages and prices
•
The labour market
Keynes summarizes the classical theory of employment
which was based on two postulates:
•
•
the real wage is equal to the marginal productivity of
labour;
the utility of wage is equal to the marginal disutility of
labour
Let’s draw a Cartesian coordinate plane (vertical axis W/P
and horizontal axis N). Assuming that:
i) the marginal productivity of labour is decreasing;
ii) the marginal disutility of labour is increasing,
the Classical economists were able to draw Nd (labour
demand) and Ns (labour supply) as, respectively, a
downward sloping and an upward sloping curve
Equilibrium real wage and employment were uniquely
defined by the interaction of Nd and Ns
In the Classical analysis unemployment was basically
“voluntary”. This was due “to the refusal or inability of
a unit of labour, as a result of legislation or social
practice or of […] collective bargaining or of slow
response to change or of mere human obstinacy, to
accept a reward corresponding to the value of the
product attributable to its marginal productivity” (K.,
1936, p. 6)
The Classical model was also compatible with “frictional”
unemployment.
It did not include, on the contrary, “unvolontary”
unemployment.
In his analysis Keynes maintained that only the first
postulate was correct: the supply of labour, on the
contrary, was indeterminate:
Reasons:
i) Labour contracts are stipulated for money wages (W)
rather than for real wage (W/P)
ii) If W  production costs  P : “there may exist no
expedient by which labour as a whole can reduce its
real wage to a given figure by making revised money
bargains with the entrepreneurs” (Keynes, 1936, p.
13)
As a consequence, in Keynes’ view the labour market was
indeterminate: the level of employment was a function
of the aggregate demand
The goods market and the capital market
• As mentioned before, in the classical and neoclassical
models aggregate supply creates by definition its own
demand: the goods market is always in equilibrium
(“Say’s law”)
Keynes maintained on the contrary that aggregate demand
could be insufficient and that this was indeed case
during the Great Depression
In the General Theory he analyzed separately
i) consumption; ii) investment
i) Consumption: is a function of the disposable income and
in the aggregate is fairly stable
ii) Investment: according to Keynes (and to I. Fisher), an
investment decision (e.g. buying a machine) depends
on the present value of the flow of profits a firm can
expect from that particular investment, compared with
its cost
Investment depends therefore on the current interest rates,
and on the expectations of the future
Crucial point: according to Keynes the “basis of knowledge
on which estimates of perspective yields have to be
made” are extreme precarious:
“we have to admit that our basis of knowledge for
estimating the yield ten years hence of a railway, a
copper mine, a textile factory, an Atlantic liner […]
amounts to little and sometimes to nothing” (K., 1936,
pp. 149-50)
The role of the “animal spirits”:
“In former times […] investment depended on a sufficient
supply of individuals of […] constructive impulses who
embarked on business as a way of life, not really
relying on a precise calculation of perspective profit.
The affair was partly a lottery, though with the ultimate
result largely governed by whether the abilities and
character of the managers were above or below the
average”
“If human nature felt no temptation to take a chance, no
satisfaction (profit apart) in constructing a factory, a
railway, a mine or a farm, there might not be much
investment merely as a result of cold calculation” (K.,
1936, p. 150)
The unfortunate consequence, however, was that:
“economic prosperity is excessively dependent on a
political and social atmosphere which is
congenial to the average business man”
Therefore, the fear of a Labour government, or of a
New Deal can cause a collapse of investment
simply because upsets “the belicate balance of
spontaneous optimism”
On the whole, Keynes (during the 1930s) was not
optimistic on the future of “capitalism”
This pessimistic view was shared also by other
economists:
e.g.: J.A. Schumpeter, Capitalism, Socialism ans
Democracy, 1942 predicted that after the war
the market economies would have been
replaced by a “State socialism”
Anyway, if businessmen were reluctant to invest,
government had to take the lead by adopting deficit
spending policies aimed at improving the country’s
basic infrastructures
Unfortunately, this was rarely the case: indeed, Keynes
observed, “wars have been the only form of large-scale
loan expenditure which statesmen have thought
justifiable” (K., 1936, p. 130)
In Keynes’ view, any initiative aimed at employing idle
factors of productions is positive, even that of “digging
holes in the ground”
Limits of Keynes’ analysis: he adopts a short-run
perspective in which investment is as a key part of
demand
Keynes does not mention the role of investment in the
medium-long run
The money market
In the classical model, the only role of money was that of
medium of exchange
The demand for money was therefore the following:
•
Md = kPY
0k1
Keynes focused his analysis on the role of money as a
store of value: money indeed was by definition the
asset characterized by the highest degree of liquidity
The demand for money in terms of liquidity preference
During a depression people have an obvious incentive to
postpone investment and consumption decisions and to
scramble for liquidity. This tendency, however, has the
very unfortunate consequence of worsening the downturn
of economic activity
“Unemployment develops, that is to say, because people
want the moon: men cannot be employed when the object
of desire (i.e. money) is something which cannot be
produced and demand for which cannot be readily
chocked off”
In Keynes’ view the rate of interest is “the reward for
parting with liquidity for a specific period” (K., 1936,
p. 167)
The demand for money is a function of both income
(direct relation) and the interest rate (inverse
relation)
The money supply is exogenous (the amount of liquidity
is determined by the Central bank)
In Keynes view, the transmission mechanism of
monetary policy is basically indirect:
• provided that the demand for money is stable, an
increase in money supply (Ms) would cause a
reduction of the interest rate (i), an increase in
investment (assuming expectations as given) and
therefore an increase in aggregate demand
This mechanism, however, can become ineffective as a
consequence of two factors:
- high interest rate elasticity of the demand for money
(extreme case: the liquidity trap)
- adverse expectations in the business sectors.
In these circumstances monetary policy is totally ineffective:
in order to get out of the recession, governments have to
adopt expansionary fiscal policies
As already mentioned, in chapters 19-21 of his General
Theory Keynes generalizes his model by assuming
flexibility of prices
Hypothesis:
“so long as there is any unemployment […] an increase in
the quantity of money will have no effect whatever on
prices and employment will increase in exact proportion
to any increase in effective demand brought about by the
increase in the quantity of money” (K, ch. 21, p. 295)
- However:
“as soon as full employment is reached, prices will increase
in exact proportion to the increase in effective demand”
In Keynes view, therefore, aggregate supply is perfectly
elastic as long as Y  Y* ; then it becomes perfecly
inelastic
Concluding remarks: was Keynes a liberal?
In his General Theory: K.
advocates a (moderate)
redistribution of income and the necessity for the
governments to intervene in economic activity:
“It seems unlikely that the influence of banking policy on the
rate of interest will be sufficient to determine an
optimum rate of investment. Therefore a somewhat
comprehensive socialization of investment will prove
the only means of securing an approximation to full
employment” (ch. 24, p. 378)
However:
“there is no obvious case for a system of State socialism
which would embrace most of the economic life of the
community”
Quite the contrary, in Keynes view, a system based on
private initiative and responsibility was definitely more
efficient than a centralized system
“But above all [market economy] is the best safeguard of
personal liberty, in the sense that, compared with any
other system, it greatly widens the field for the exercise
of personal choice. It is also the best safeguard of the
variety of life […] the loss of which is the greatest of all
the losses of the homogeneous or totalitarian state”
Keynes’ General Theory marked a watershed in XX century
economic policy
However, the mainstream macroeconomic theory that
emerged in the early 1950s (and remained dominant till the
early 1970s) was actually a synthesis based on the ideas of
Keynes and earlier economists (the so called neoclassical
synthesis)
The neoclassical syntesis was the result of the work of such
authors as J. Hicks, A. Hansen, P. Samuelson, F.
Modigliani, D. Patinkin
•
.
The most influential formalization of Keynes’s ideas was the
IS-LM model, developed by John Hicks and Alvin
Hansen in the 1930s and early 1940s.
Policy discussions became organized around the slopes of
the IS and LM curves.
Another influential tool elaborated by the Keynesian
economists after WWII was the Phillips curve
The Phillips curve was “discovered” in 1958 as an empirical
relation between the rate of unemployment and the
rate of inflation
In 1960 the economists P. Samuelson and R. Solow
replicated Phillips exercise using U.S. data
They identified a stable, negative relation between u e π
(rate of inflation):
[1] πt =  α ut
This relation implied that the governments were able to
“choose” between different combinations of
unemployment rates and inflation rates
During the 1960s the Keynesian model and the Phillips
curve were severely criticized by Milton Friedman,
the leader of the monetarists

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