VIII Keynesian revolution – economic policies

Legacy for economic policy• Keynesian theory suffered significant setbacks, BUT• Two Keynesian conclusions survived till today:1. Capitalist economy, if left to market forces, can operate

for a long time with substantial involuntary unemployment

For practical purpose, it is not important whether the economy might converge towards full employment equilibrium, if this happens with long delay

2. Insufficient demand is the principal culprit of depression situation, hence fiscal and/monetary demand stimulation are the principle tools of short term economic policies

It is the role of the Government to perform this demand stimulating policies

VIII.1 Fiscal and monetary stimulation of aggregate demand

Keynes’ policy prescriptions• His principal focus – the depression situation• Aggregate demand requires stimulation• Subsequent simplifications: fiscal and monetary

multipliers in the framework of ISLM model– Easy illustration of the basic idea, bellow we will do the same

• Keynes himself – much wider considerations:– Concern about autonomous components of consumption and –

especially – investments (famous quote on “socialization of investment”)

– Understanding the role of expectations– Concern about the political forces and the role of trade unions

• All this quite often quoted by his disciples, but almost nothing survived as to the practical recommendations– Entire victory of simplified, “hydraulic” ISLM interpretation

Policy innovations (1)

• Fiscal and monetary policies• Preference of fiscal policies

– Monetary policy less efficient due to almost flat LM curve and interest-inelastic investment

• Sharp departure from pre-1930 policy taboos:– Accepts budget deficits– Refuses the crowding-out effect – remember LIV: fiscal

stimulation via increase of government spending is crowding-out the either personal consumption of private investment

• Here his views were shared by many economists, but widely opposed by British Treasury (Finance Ministry) – the “Treasury view” problem

Policy innovations (2)

• Refused wage cuts as a remedy for depression– Both on political and economic ground– Political power of trade unions and social tension during the

depression– In the US, real wages were falling during most of 1930’s, without

any practical impact– Similar situation observed in many other countries (except Britain,

due to overvalued currency)

• Fiscal multiplier and its effect on growth and employment• The policy role of the governments: the theory provides

the tools to increase the product (and employment) by stimulating aggregate demand– Government is the only “agent” on the market, capable to perform

this role

VIII.2 ISLM illustration

ISLM vs. complete model

• The complete model multipliers (as we did for Classical model in LIV) – see Sargent’s textbook in Literature– Requires more theoretical discussion on

specification of consumption and investment function – beyond the scope her

• Instead – ISLM illustration– Keep in mind that it is a simplification

VIII.2.1 Fiscal policy in ISLM

• Changes of governmental expenditures

• Changes in tax rates

• Transfers to population (not included in the simple model here)

• Time aspect

Increase of governmental expenditures

• Initial equilibrium in• Increase: → higher AD

– Shift of IS (when each level of interest corresponds to higher level of Y) → at given interest, point A represents new equilibrium on goods market

– However, in A, disequilibrium on money market (off LM curve), EDM → interest → I → AD → Y

• New equilibrium in 2E

1EΔG

r

Y

1IS

LM

1E

1Y

1r2IS

A

AY2Y

2E2r

Multiplier of governmental expenditures

• Differentiation of both equations:

, hence

• Substituting in the first equation for dr from second equation and after arrangement we have

• By assumptions

and

dY = CY-T 1 - TY dY + Irdr + dG

0 = LYdY + L rdr dr=- LY L r dY

dY = 1

1-CY-T 1-TY +Ir

LY

L r

dG dG

0 < CY-T 1 - TY <1 a Ir

LY

L r

> 0

αβ1

Crowding out effect (1)

• In ISLM model, multiplier of governmental expenditures is lower than the same multiplier for the goods market only (when interest is given)

• Full model (and in reality) – higher governmental expenditures are partially offset by decrease of investment (due to the increase of interest) - G crowds out private investment

• Formally: impact of the term Ir

LY

L r

Crowding out effect (2)

• Keynes (short term): increase in governmental expenditures will have higher impact on product when– Interest elasticity of demand for money is high (LM curve

almost horizontal)– And/or interest elasticity of investment is low (IS curve very

steep)– Hence

• Classical model (long term): vertical LM ↔ increase of governmental expenditures fully crowds out private investment L r 0

rr Land/or 0I

Tax policies• Simplification: • Tax multiplier (derived equally as above)

• Policy induced change: impact of the tax change enabled first through the change of disposable income, than impact on consumption, AD and product (income); only than multiplier applies.

• Effect less certain – the reaction of consumers to a tax change might modify MPC

T Y = tY, 0 <t<1

.

dY = -CY-TY

1-CY-T 1-t + Ir LY

L r

dt = - CY-TYdt

Balanced budget multiplier

• Keynes – allowed for budget deficit• Reality – budget balance is always watched• Question: what is the multiplier in case of equal

change in governmental expenditure and amount of taxes, i.e.

and after arrangement• Balanced budget multiplier is equal one.

dG = d T Y dY = CY-TdY - CY-TdG + dG

dY dG = 1

VIII.2.2 Monetary policy in ISLM

• Original equilibrium in E1

• Increase of money supply• At given Y, excess supply of money → higher

demand for bonds, higher price of bonds and lower interest → shift of LM to the right, new equilibrium on money market at point A

• However, disequilibrium at goods market (EDG) → low interest increases investment, AD and product. Higher product increases demand for money → increase of interest → overall equilibrium at E2

MS>0

r

Y

IS

1LM

1E

1Y

1r

2LM

AAr

2E

2Y

2r

Multiplier of monetary policy

• Again, differentiation of both equilibrium conditions, hence

• After arrangements

dY =

Ir

L r

1 - CY-T 1-TY + Ir

LY

L r

dM

S

P=

Ir

L r

dM

S

P>0

0PdMbut 0dG S

Efficiency of monetary policy

• The higher efficiency (impact on product growth) of monetary policy,– The lesser interest elasticity of demand for money (the

steeper is demand for money and LM curve as well)– The higher is interest elasticity of investment (the flatter is IS

curve

• If (flat LM) , than multiplier of monetary policy is equal to zero and monetary policy is entirely ineffective → liquidity trap

rL

VIII.2.3 Some crucial differences with Classical model

• Equilibrium at less than full employment– and demand does not have to equal supply on

some markets

• Quantitative adjustment, wages and prices adjust slowly

• Money in not neutral– It is not a veil

• Demand stimulation is not completely crowded out

VIII.3 Lessons for the policy

Basics• Capitalist economy must be steered towards

full employment output by policies, performed by the governments, stimulating aggregate demand

• Monetary policies less efficient → crucial role of fiscal policies– Multiplier effect

• When output at less than full employment level, then wages and prices adjust slowly– Downward wage rigidity as general concept

• At full employment out put level – classical model applies again

Keynes’ wrong predictions (1)

• Estimate if numerical value of fiscal multiplier– Expectations up to value of 3, in reality just above 1

• Inherent stagnation of the capitalist economy, APC falls with growing income– Not proved by the data (Kuznets)

• High interest elasticity of money demand (reason for liquidity trap) or low interest elasticity of investment– Not validated by the data

Keynes’ wrong predictions (2)

• Expectation about the return of recession after the end of WWII– Lack of aggregate demand, either because of lack

of consumer demand (low income and/or falling APC) or investment demand (after the war economy stops to generate government military demand)

• Completely refuted by the post-WWII economic development– Till today discussion of this was result of the

application of Keynesian recommendations of not– See next Lectures, but: after WWII, it was mainly

the effect of private investment that filled the gap between AD and AS

VIII.4 Conclusions

Lasting impact on economic policy

• After Keynes: for more than 3 decades, a prevailing view was that the governments must intervene to steer capitalist economy towards production at full employment– This remained accepted by many (not only economists),

even by those who criticize Keynes or understand his fallacies

• After 1970 – a reversal in prevailing views (see chapters later)

• Today:– his model is considered as one stage in the

development of macroeconomics– new Keynesian economics (see later)

Literature to Ch. VIII

Again, the literature to this Lecture is immense, bellow are 3 recommendations

• ISLM model as policy instrument – any intermediate textbook on macroeconomics

• Snowdon, B., Vane, H.: Modern Macroeconomics, Edvard Elgar, 2005, namely Chapter 3 (and the literature given here)

• Blaugh, M.: Economic Theory in Retrospect, CUP 1997 (5th edition), Chapter 16, namely parts 16.1-16.5 and 16.19-16.23