Lecture Nine: Macroeconomics

1
Lecture Nine Macroeconomics

• From Says Law to Emergent Properties

2
Macroeconomics is

• Micro considers
• Behaviour of individuals firms
• Behaviour of markets
• Macro considers
• The behaviour of the whole economy
• And special markets
• Labour
• Money
• And key variables
• Rate of employment, growth, inflation
• In the beginning (before Keynes or Walras or even
  Smith), in Macro there was
• Quite a lot of debate!

3
Mercantilists on Macro

• Mercantilism in part justified tariffs, etc., on
  basis that it would increase employment
• 5. The frugal expending likewise of our own
  natural wealth might advance much yearly to be
  exported unto strangers and if in our rayment we
  will be prodigal, yet let this be done with our
  own materials and manufactures,
• where the excess of the rich may be the
  employment of the poor, whose labours would be
  more profitable for the Commonwealth,
• if they were done to the use of strangers.
• (Thomas Mun, Englands Treasure by Forraign
  Trade. or The Ballance of our Forraign Trade is
  The Rule of our Treasure)
• i.e., an excess of exports over imports will
  increase employment

4
Physiocrats (Quesnay)

• The Tableau Economique
• First ever input-output model of whole economy
• First systematic attempt to think about
  relationship between productivity and output at
  level of whole economy
• Basic ideas
• Objective of production to generate a net
  surplus over inputs
• Agriculture seen as only source of surplus
• Converts free energy of sun into plants, animals
• Manufacturing just transforms free gift no added
  value
• Three classes
• Farmers the productive class
• Manufacturing workers/firms the sterile class
• Feudal lords/clerics the proprietor class

5
Physiocrats (Quesnay)

• But manufactures needed to generate rural net
  product
• interdependence (multiplier, input-output
  concepts)
• Agriculture generates a surplus
• 1 unit of output requires lt 1 unit of input
• Sow 1 kilo of wheat as seed, get 10 kilos of
  wheat as crop
• Manufacturing simply converts form
• 1 unit of input, 1 unit of output (but in
  different form)
• Surplus key to wealth Wealth can be increased if
  gap between inputs and output in agriculture can
  be increased.

6
Physiocrats (Quesnay)

• An example in modern terms
• Old technology with 100 hectares of land
• 1 hectare land 7/10 bushels wheat 1/10 kilo
  steel produces 1 bushel wheat
• 0 hectare land 1/10 bushel wheat 9/10 kilo
  steel produces 1 kilo steel
• 70 wheat 10 steel -gt 100 wheat
• 10 wheat 90 steel -gt 100 steel
• Net output 20 bushels wheat, 0 kilos steel

7
Physiocrats (Quesnay)

• New technology with 100 hectares of land
• 1/10th less bushels of wheat used
• 1 hectare land 6/10 bushels wheat 1/10 kilo
  steel produces 1 bushel wheat
• 0 hectare land 1/10 bushel wheat 9/10 kilo
  steel produces 1 kilo steel
• 60 wheat 10 steel -gt 100 wheat
• 10 wheat 90 steel -gt 100 steel
• Net output 30 bushels wheat, 0 kilos steel
• Benefits of improved technology
• 16 reduction in inputs (from 7/10ths 6/10ths
  bushels)
• 50 increase in net product (from 20 to 30
  bushels)
• Means more wealth for proprietors, more
  employment making for workers making carriages

8
From Physiocrats to Smith

• Smiths rejected Physiocratic idea that
  agriculture the only source of wealth
• Artificers and manufacturers, in particular,
  whose industry, in the common apprehension of
  men, increases so much the value of the rude
  produce of land, are in this system represented
  as a class of people altogether barren and
  unproductive (Wealth of Nations Ch. 9)
• But input-output surplus concepts lost as well
• Smith much less concerned about macroeconomic
  issues
• The big macroeconomic debate amongst classical
  economists was Malthus vs Ricardo

9
Ricardo vs Malthus

• Malthus asserted that
• Aggregate demand could be less than supply
• A general glut
• Technological progress could lead to unemployment
• Ricardo confident that aggregate demand would
  always be sufficient
• Mr. Malthus asks
• how is it possible to suppose that the increased
  quantity of commodities, obtained by the
  increased number of productive labourers should
  find purchasers,
• without such a fall of price as would probably
  sink their value below the cost of production,
  or, at least, very greatly diminish both the
  power and the will to save?

10
Ricardo vs Malthus

• To which I Ricardo answer that
• the power and the will to save will be very
  greatly diminished, for that must depend upon the
  share of the produce allotted to the farmer or
  manufacturer.
• But with respect to the other question
• where would the commodities find purchasers?
• If they were suited to the wants of those who
  would have the power to purchase them, they could
  not fail to find purchasers, and that without any
  fall of price.
• Ricardo, Notes on Malthus' "Principles of
  Political Economy (pp. 160-161)
• Ricardo accepted there could be gluts of
  individual commodities, but not an overall
  excess of supply over demand

11
Ricardo vs Malthus

• Mistakes may be made, and commodities not suited
  to the demand may be producedof these there may
  be a glut
• they may not sell at their usual price
• but then this is owing to the mistake, and not to
  the want of demand for productions.
• For every thing produced there must be a
  proprietor.
• Either it is the master, the landlord, or the
  labourer.
• Whoever is possessed of a commodity is
  necessarily a demander,
• either he wishes to consume the commodity
  himself, and then no purchaser is wanted
• or he wishes to sell it, and purchase some other
  thing with the money

12
Ricardo vs Malthus

• Ricardos analysis based on Says Law supply
  IS demand
• Only reason someone produces something is
• to sell it
• and buy something of equivalent value
• Hence supply is simultaneously demand (maybe with
  a little lag)
• Whoever has commodities has the power to
  consume, and as it suits mankind to divide their
  employments, individuals will produce one
  commodity with a view to purchase another
• Ricardo accepted arguments of Jean Baptiste Say
  here
• M. Say has, however, most satisfactorily shown,
  that there is no amount of capital which may not
  be employed in a country, because demand is only
  limited by production. (Principles, Ch. 21)

13
Says Law

• Says Law best put by Say himself
• Every producer asks for money in exchange for
  his products, only for the purpose of employing
  that money again immediately in the purchase of
  another product
• for we do not consume money, and it is not sought
  after in ordinary cases to conceal it
• thus, when a producer desires to exchange his
  product for money,
• he may be considered as already asking for the
  merchandise which he proposes to buy with this
  money.
• It is thus that the producers, though they have
  all of them the air of demanding money for their
  goods, do in reality demand merchandise for their
  merchandise.
• (Say, Catechism of Political Economy)

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Says Law

• Crises caused by disproportionality only
• Excess supply in one market, excess demand in
  others
• General gluts or general slumps impossible
• Argument
• Money only an intermediary in barter
• People sell only to buy again (increase in
  utility the object)
• Each persons supply is matched to his/her demand
• Sum of all supply thus cannot exceed sum of all
  demand (no general gluts) but

15
Says Law

• Slumps in one market can occur if supply of X
  exceeds demand for X at price producers of X
  want however
• Unless government regulations, monopolies
  intervene
• Price of X falls, demand for X rises
  equilibrium
• Basic logic micro in nature
• Hypothesis about behaviour of each individual in
  market system (micro)
• Aggregate hypothesis to overall economy (macro)
• Argument also essential real rather than
  monetary

16
Ricardo Say the Odd Couple

• Ricardo accepted Say on macro
• But differed on theory of value and price

Effort is the source of value

• The value of a commodity depends on the
  relative quantity of labour which is necessary
  for its production
• (Ricardo)

No it aint! Utility is

• What do you understand by the word Products ?
• all those things to which men have consented to
  give a value.
• How is value given to a thing ?
• By giving it utility
• (Say)

• Says Law dominated classical macroeconomics
  (even though neoclassical in origin) until

17
Marx Debunks Say

• Marxs circuits of capital CMC
• Of the part of the revenue in one branch of
  production (which produces consumable
  commodities) which is consumed in the revenue of
  another branch of production,
• it can be said that the demand is equal to its
  own supply (in so far as production is kept in
  the right proportion).
• It is the same as if each branch itself consumed
  that part of its revenue.
• Here there is only a formal metamorphosis of the
  commodity C-M-C' Linen-money-wheat. (Marx
  Theories of Surplus Value, 1861 p. 233)
• Supply implies demand aggregate balance the rule

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Marx Debunks Say

• But there is also MCM
• The circuit C-M-C starts with one commodity, and
  finishes with another, which falls out of
  circulation and into consumption.
• Consumption, the satisfaction of wants, in one
  word, use-value, is the end and aim.
• The circuit M-C-M, on the contrary, commences
  with money and ends with money.
• Its leading motive, and the goal that attracts
  it, is therefore mere exchange-value. (Marx,
  Capital I 1867, p. 148)
• Demand in MCM can evaporate if expectations of
  profit collapse

19
Marx Debunks Say

• Aggregate demand is thus sum of two circuits
• CMC
• Says Law applies
• MCM
• Says Law doesnt apply
• Aggregate demand can therefore differ from
  aggregate supply
• Marxs logical advance here lost in decline of
  classical school and rise of neoclassical
• Neoclassical school adopts Says Law as Walrass
  Law
• Sum of all excess demands is zero
• No possibility of generalised slump
• Dominates macroeconomic thinking before Great
  Depression

20
Pre-Keynesian Macro

• Conventional neoclassical macroeconomic theory
  less elaborate than Walrass General
  Equilibrium model
• Assumed fixed capital stock in short run,
  variable labor supply, etc., rather than
  everything variable as in Walras
• Example Hickss typical classical theory
  (outlined in Hicks 1936, Mr Keynes and the
  Classics)
• 2 industries Investment goods X consumption
  goods Y
• 2 factors of production labor (variable)
  capital (fixed in short run)
• Given capital stock in both industries

21
Hickss typical classical theory

• Output a function of employment Nx Ny
• Xfx(Nx) Yfy(Ny) where f has diminishing
  marginal productivity
• Prices equal marginal costs marginal product of
  labour times wage rate (since labour is only
  variable input)
• Marginal cost is increase in labor input (dNx
  dNy) for each increment to output (dx dy)
• Pxw.dNx/dx Pyw.dNy/dy
• Income value of output price times quantity
• I Ix Iy w.(dNx/dx) .x w.(dNy/dy) .y

22
Hickss typical classical theory

• Quantity of Money M a given, and fixed relation
  between M and income I (transactions demand for
  money only money a veil over barter)
• M k.I (k constant velocity of money)
• Demand for investment goods a function of
  interest rate
• IxC(i)
• Supply of savingsa function of interest rate
• IxS(i)
• Higher savings meanshigher investment (a
  familiar argument?)

Determines Nx
23
Hickss typical classical theory

• Causal chain
• M determines I (total output)
• i determines Ix (output of investment goods)
• Ix determines Nx (given w)
• I-Ix determines Iy (output of consumption goods
  is a residual)
• Iy determines Ny (given w)
• Lower money wage means higher employment
• Lower wage means lower prices
• Unchanged money I means higher income relative to
  prices, so higher sales
• Higher sales mean increased employment (and lower
  real wage due to diminishing marginal product)

24
Neoclassical Macro

• Asserted unemployment due to excessive wages,
  until...

The Great Depression
Arguably began with Stock Market Crash
Just one week before
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The economists were saying

• Stock prices have reached what looks like a
  permanently high plateau.
• I do not feel that there will soon, if ever, be a
  fifty or sixty point break below present levels,
  such as Mr. Babson has predicted.
• I expect to see the stock market a good deal
  higher than it is today within a few months.
  (Irving Fisher, October 15 1929)
• In the next few years, Irving Fisher lost12
  million dollars!
• Thats 102 million in 2000 prices
• Crash occurred on October 23rd 1929

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A 120 Point Break in just 15 Days...
Crash continued for another 3 years
27
The Great Wall Street Crash
and thats the index the SP of 1948 had many
stocks which didnt exist in 1929, while many of
the 1929 entrants had gone bankrupt
SP 500 from 32 at its zenith
25 years to recover
To below 5at its nadir
in less than 3 years
Not only theStockmarketcrashed
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The Great Depression
WW II
29
The Great Depression
To 25 in 3 years
WW II Brings Sustained Recovery
From effectively zero...
30
Keyness Revolution

• A (partial) rejection of (neo)classical economics
• Kept marginal product theory of factor returns
  but
• Rejected theory of investment, money, savings
• Key innovation proper treatment of uncertainty
• Investment
• in certain world, would be determined by interest
  rate
• in uncertain world, motivated by expectations of
  profit
• Expectations of profit volatile based on flimsy
  foundations
• Expect current state of affairs to continue
• Trust current prices, etc., as correct
• Trust mass sentiment

31
Keyness Revolution Investment Savings

• Investment (determined by expectations, output,
  capital stock) determines income via multiplier
• If(E,Y,K) (E component highly volatile)
• Yf(I)
• Consumption a function of income
• Ca c.Y (stable relationship)
• YCICS (ex-post Investment ex-post Savings)
• Savings a residual function of income
• SY-C
• Investment determines Savings
• Attempt to increase Savings (by reducing MPC) may
  reduce investment hence output

32
Keyness Revolution Money

• Neoclassical theory
• money a veil over barter
• transactions motive only for holding money
• Keynes
• Money ultimate source of liquidity in uncertain
  world
• Not only transactions, but also speculative,
  precautionary finance motives for holding money
  (latter not in General Theory, but 1937 papers)
• Rate of interest the return for foregoing
  liquidity
• Liquidity preference highly volatile because
  based on expectations (as is Investment)

33
Keyness Revolution Critique Says Law

• Expenditure has 2 components
• D1, related to current output (consumption)
• D2, not related to current output (investment)
• Says Law (rejected by Keynes) requires
• either D20 or
• Increased savings causes increased D2
• But
• Decision to invest based on expectations of
  profit in uncertain future
• Increased savings means decreased consumption now
• May lead to lower expectations and less
  investment
• Argument inspired by Marxs CMC/MCM, but
  Marx not citedprobably for political reasons

34
Keyness Revolution Critique Says Law

• One of the rare occasions in which Keynes
  praised Marx occurred in a 1933 draft of the
  General Theory. Here Keynes credits Marx with the
• pregnant observation that the nature of
  production in the actual world is not CMC',
  i.e.. of exchanging commodity (or effort) for
  money in order to obtain another commodity (or
  effort). That may be the standpoint of the
  private consumer.
• But it is not the attitude of business, which is
  a case of MCM' , i.e.. of parting with money
  for commodity (or effort) in order to obtain more
  money (1971, Vol. 29, p. 81, Keynes's emphasis).
• Dillard 1984 Keynes and Marx a centennial
  appraisal Journal of Post Keynesian Economics p.
  424
• So Keyness published critique of Says Law not
  as clear as Marxs

35
In a nutshell...

• The theory can be summed up by saying that,
  given the psychology of the public, the level of
  output and employment as a whole depends on the
  amount of investment...
• More comprehensively, aggregate output depends on
  the propensity to hoard, on the policy of the
  monetary authority as it affects the quantity of
  money, on the state of confidence concerning the
  prospective yield of capital-assets, on the
  propensity to spend and on the social factors
  which influence the level of the money-wage.
• But of these several factors it is those which
  determine the rate of investment which are most
  unreliable, since it is they which are influenced
  by our views of the future about which we know so
  little.
• Keynes, 1937, The General Theory, p. 221

36
Keynes and Investment under Uncertainty

• 1937 papers mark a shift from marginal concepts
  to two price levels
• In most of the General Theory, Keynes argued that
  investment was motivated by relationship between
  marginal efficiency of investment schedule (MEI)
  interest rate
• In Chapter 17 of General Theory, The General
  Theory of Employment and Alternative theories
  of the rate of interest (1937), spoke in terms
  of two price levels
• investment motivated by the desire to produce
  those assets of which the normal supply-price is
  less than the demand price (Keynes 1936 228)
• Demand price determined by prospective yields,
  depreciation and liquidity preference.
• Supply price determined by costs of production

37
Keynes and Investment under Uncertainty

• Two price level analysis becomes more dominant
  subsequent to General Theory
• The scale of production of capital assets
  depends, of course, on the relation between
  their costs of production and the prices which
  they are expected to realise in the market.
  (Keynes 1937a 217)
• MEI analysis akin to view that uncertainty can be
  reduced to the same calculable status as that of
  certainty itself via a Benthamite calculus,
• whereas the kind of uncertainty that matters in
  investment is that about which there is no
  scientific basis on which to form any calculable
  probability whatever. We simply do not know.
  (Keynes 1937a 213, 214)

38
What is uncertainty?

• Very hard to grasp, even though essential aspect
  of our world we do not know the future
• But we have worked out how to calculate risk
• Most of Keyness examples were about how
  uncertainty is not risk
• Negative exampleswhat uncertainty is notrather
  than what it is
• By "uncertain" knowledge, let me explain, 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 nor is the prospect of a
  Victory bond being drawn.

39
Keynes on Uncertainty

• Or, again, the expectation of life is only
  slightly uncertain.
• Even the weather is only moderately uncertain.
• The sense in which I am using the term is that in
  which
• the prospect of a European war is uncertain,
• or the price of copper and the rate of interest
  twenty years hence,
• or the obsolescence of a new invention, or the
  position of private wealth-owners in the social
  system in 1970.
• About these matters there is no scientific basis
  on which to form any calculable probability
  whatever. We simply do not know.
• Nevertheless, the necessity for action and for
  decision compels us as practical men to do our
  best to overlook this awkward fact and to behave
  exactly as we should if we had behind us a good
  Benthamite calculation of a series of prospective
  advantages and disadvantages, each multiplied by
  its appropriate probability, waiting to be
  summed.

40
What is uncertainty?

• Imagine you are very attracted to a particular
  person
• This person has accepted invitations from 1 in 5
  of the people who have asked him/her out
• Does this mean you have a 20 chance of success?
• Of course not
• Each experience of sexual attraction is unique
• What someone has done in the past with other
  people is no guide to what he/she will do with
  you in the future
• His/her response is not risky it is uncertain.
• Ditto to
• individual investments
• success/failure of past instances give no guide
  to present odds

41
How to cope with relationship uncertainty?

• We try to find out beforehand
• ask friendseliminate the uncertainty
• We do nothing
• paralysed into inaction
• We ask regardless
• compel ourselves into action
• We follow conventions
• follow the herd of the social conventions of
  our society
• play the game hope for the best
• So what about investors?

42
Keynes and Investment under Uncertainty

• In the midst of incalculable uncertainty,
  investors form fragile expectations about the
  future
• These are crystallised in the prices they place
  upon capital asset
• These prices are therefore subject to sudden and
  violent change
• with equally sudden and violent consequences for
  the propensity to invest
• Seen in this light, the marginal efficiency of
  capital is simply the ratio of the yield from an
  asset to its current demand price, and therefore
  there is a different marginal efficiency of
  capital for every different level of asset
  prices (Keynes 1937a 222)

43
Keynes on Uncertainty and Expectations

• Three aspects to expectations formation under
  true uncertainty
• Presumption that the present is a much more
  serviceable guide to the future than a candid
  examination of past experience would show it to
  have been hitherto
• Belief that the existing state of opinion as
  expressed in prices and the character of existing
  output is based on a correct summing up of future
  prospects
• Reliance on mass sentiment we endeavour to fall
  back on the judgment of the rest of the world
  which is perhaps better informed. (Keynes 1936
  214)
• Fragile basis for expectations formation thus
  affects prices of financial assets

44
Keynes on Finance Markets

• Conventional theory says prices on finance
  markets reflect net present value capitalisation
  of expected yields of assets
• But, says Keynes, far from being dominated by
  rational calculation, valuations of finance
  markets reflect fundamental uncertainty and are
  driven by whim
• all sorts of considerations enter into the
  market valuation which are in no way relevant to
  the prospective yield (1936 152)
• ignorance
• day to day instability
• waves of optimism and pessimism
• the third degree

45
Keynes on Finance Markets

• Ignorance due to dispersion of share ownership
  (shades of Telstra?)
• As a result of the gradual increase in the
  proportion of equity ... owned by persons who ...
  have no special knowledge ... of the business...
  the element of real knowledge in the valuation of
  investments ... has seriously declined (1936
  153)
• Anyone here got T2 shares?
• Impact of day to day fluctuations
• fluctuations in the profits of existing
  investments, which are obviously of an ephemeral
  and non-significant character, tend to have an
  altogether excessive, and even an absurd,
  influence on the market (1936 153-54)

46
Keynes on Finance Markets

• Waves of optimism and pessimism
• In abnormal times in particular, when the
  hypothesis of an indefinite continuance of the
  existing state of affairs is less plausible than
  usual ... the market will be subject to waves of
  optimistic and pessimistic sentiment, which are
  unreasoning and yet in a sense legitimate where
  no solid basis exists for a reasonable
  calculation. (1936 154)
• The Third Degree
• Professional investors further destabilise the
  market by attempting to anticipate its short term
  movements and react more quickly
• As Geoff Harcourt once remarked, Keynes writes
  like an angel. The next few slides are in
  Keyness own words.

Skip Keynes Quotes
47
Keynes on Finance Markets

• It might have been supposed that competition
  between expert professionals ... would correct
  the vagaries of the ignorant individual...
  However,... these persons are, in fact, largely
  concerned, not with making superior long-term
  forecasts of the probable yield of an investment
  over its whole life, but with foreseeing changes
  in the conventional basis of valuation a short
  time ahead of the general public... For it is not
  sensible to pay 25 for an investment of which you
  believe the prospective yield to justify a value
  of 30, if you also believe that the market will
  value it at 20 three months hence. (1936 154-55)

48
Keynes on Finance Markets

• Of the maxims of orthodox finance none, surely,
  is more anti-social than the fetish of liquidity,
  the doctrine that it is a positive virtue on the
  part of investment institutions to concentrate
  their resources upon the holding of liquid
  securities. It forgets that there is no such
  thing as liquidity of investment for the
  community as a whole. The social object of
  skilled investment should be to defeat the dark
  forces of time and ignorance which envelop our
  future. The actual, private object of most
  skilled investment today is to beat the gun, as
  the Americans so well express it, to outwit the
  crowd, and to pass the bad, or depreciating,
  half-crown to the other fellow. (1936 155)

49
Keynes on Finance Markets

• professional investment may be likened to those
  newspaper competitions in which the competitors
  have to pick out the six prettiest faces from a
  hundred photographs, the prize being awarded to
  the competitor whose choice most nearly
  corresponds to the average preferences of the
  competitors as a whole ... It is not a case of
  choosing those which, to the best of one's
  judgment, are really the prettiest, nor even
  those which average opinion genuinely thinks the
  prettiest. We have reached the third degree where
  we devote our intelligences to anticipating what
  average opinion expects the average opinion to
  be. And there are some, I believe, who practise
  the fourth, fifth and higher degrees. (1936 156)

50
Keynes on Finance Markets

• If the reader interjects that there must surely
  be large profits to be gained from the other
  players in the long run by a skilled individual
  who, unperturbed by the prevailing pastime,
  continues to purchase investment on the best
  genuine long-term expectations he can frame, he
  must be answered, first of all, that there are,
  indeed, such serious-minded individuals and that
  it makes a vast difference to an investment
  market whether or not they predominate in their
  influence over the game-players. But we must also
  add that there are several factors which
  jeopardise the predominance of such individuals
  in modern investment markets.

51
Keynes on Finance Markets

• Investment based on genuine long-term
  expectation is so difficult today as to be
  scarcely practicable. He who attempts it must
  surely lead much more laborious days and run
  greater risks than he who tries to guess better
  than the crowd how the crowd will behave and,
  given equal intelligence, he may make more
  disastrous mistakes. There is no clear evidence
  from experience that the investment policy which
  is socially advantageous coincides with that
  which is most profitable. It needs more
  intelligence to defeat the forces of time and
  ignorance than to beat the gun.

52
Keynes on Finance Markets

• Moreover, life is not long enough--human nature
  desires quick results, there is a peculiar zest
  in making money quickly, and remoter gains are
  discounted by the average man at a very high
  rate. The game of professional investment is
  tolerably boring and over-exacting to anyone who
  is entirely exempt from the gambling instinct
  whilst he who has it must pay to this propensity
  the appropriate toll.
• Furthermore, an investor who proposes to ignore
  near-term market fluctuations needs greater
  resources for safety and must not operate on so
  large a scale, if at all, with borrowed money...

53
Keynes on Finance Markets

• Finally it is the long-term investor ... who
  will in practice come in for most criticism,
  wherever investment funds are managed by
  committees or banks. For it is in the essence of
  his behaviour that he should be eccentric,
  unconventional and rash in the eyes of average
  opinion. If he is successful, that will only
  confirm the general belief in his rashness and
  if in the short run he is unsuccessful, which is
  very likely, he will not receive much mercy.
  Worldly wisdom teaches us that it is better for
  reputation to fail conventionally than to succeed
  unconventionally. (Keynes 1936 156-58)
• At the same time as Keynes was writing the
  General Theory, Irving Fisher put forward the
  very similar Debt Deflation Theory of Great
  Depressions

54
Fisher on Depression

• Fishers reputation destroyed by prediction of no
  crash
• afterwards, developed theory to explain it
• The Debt Deflation Theory of Great Depressions
• Neoclassical theory assumed equilibrium
• but real world equilibrium short-lived since New
  disturbances are, humanly speaking, sure to
  occur, so that, in actual fact, any variable is
  almost always above or below the ideal
  equilibrium (1933 339)
• As a result, any real world variable is likely to
  be over or under its equilibrium levelincluding
  confidence speculation
• But two key problems are debt and prices

55
Debt Deflation Theory of Great Depressions

• The two dominant factors which cause
  depressions are over-indebtedness to start with
  and deflation following soon after
• Thus over-investment and over-speculation are
  often important but they would have far less
  serious results were they not conducted with
  borrowed money.
• That is, over-indebtedness may lend importance to
  over-investment or to over-speculation. The same
  is true as to over-confidence.
• I fancy that over-confidence seldom does any
  great harm except when, as, and if, it beguiles
  its victims into debt. (Fisher 1933 341)
• When overconfidence leads to overindebtedness, a
  chain reaction ensues

56
Debt Deflation Theory of Great Depressions

• (1) Debt liquidation leads to distress selling
  and to
• (2) Contraction of deposit currency, as bank
  loans are paid off, and to a slowing down of
  velocity of circulation. This contraction of
  deposits and of their velocity, precipitated by
  distress selling, causes
• (3) A fall in the level of prices, in other
  words, a swelling of the dollar. Assuming, as
  above stated, that this fall of prices is not
  interfered with by reflation or otherwise, there
  must be
• (4) A still greater fall in the net worths of
  business, precipitating bankruptcies and

57
Debt Deflation Theory of Great Depressions

• (5) A like fall in profits, which in a
  "capitalistic," that is, a private-profit
  society, leads the concerns which are running at
  a loss to make
• (6) A reduction in output, in trade and in
  employment of labor. These losses, bankruptcies,
  and unemployment, lead to
• (7) Pessimism and loss of confidence, which in
  turn lead to
• (8) Hoarding and slowing down still more the
  velocity of circulation. The above eight changes
  cause
• (9) Complicated disturbances in the rates of
  interest, in particular, a fall in the nominal,
  or money, rates and a rise in the real, or
  commodity, rates of interest. (1933 342)

58
Debt Deflation Theory of Great Depressions

• Fisher thus concurs with ancient charge against
  usury, that it maketh many bankrotts (Jones
  1989 55)
• Bankruptcy an individual problem in feudal system
• in capitalist economy, chain reaction can drag
  the economy into crisis
• Theory nonequilibrium in nature
• we may tentatively assume that, ordinarily and
  within wide limits, all, or almost all, economic
  variables tend, in a general way, towards a
  stable equilibrium
• but though assumed stable, equilibrium is
• so delicately poised that, after departure from
  it beyond certain limits, instability ensues
  (Fisher 1933 339).

59
Debt Deflation Theory of Great Depressions

• Two classes of far from equilibrium events
  explained
• Great Depressions,
• when overindebtedness coincides with deflation
• the more debtors pay, the more they owe. The
  more the economic boat tips, the more it tends to
  tip. It is not tending to right itself, but is
  capsizing (Fisher 1933 344).
• Cycles, when one occurs without the other
• with only overindebtedness or deflation,
• economic growth eventually corrects situation it
• is then more analogous to stable equilibrium
  the more the boat rocks the more it will tend to
  right itself. In that case, we have a truer
  example of a cycle (Fisher 1933 344-345)

60
Debt Deflation Theory of Great Depressions

• Fishers new theory ignored
• Old theory made basis of modern finance theory
• Debt deflation theory revived in modern form by
  Minsky (a future lecture)
• Fishers macroeconomic contribution (which
  emphasised the need for reflation and 100
  money during the Depression) overshadowed by
  Keyness General Theory
• Many similarities and synergies in Keynes and
  Fisher, but different countries meant one largely
  unaware of others work

Skip Keynes Quotes
61
Keynes and Debt-deflation

• Some consideration of debt-deflation in General
  Theory when discussing reduction in money wages
  (the neoclassical proposal for ending the Great
  Depression--see last lecture)
• Since a special reduction of money-wages is
  always advantageous to an individual entrepreneur
  ... a general reduction ... may break through a
  vicious circle of unduly pessimistic estimates of
  the marginal efficiency of capital... On the
  other hand, the depressing influence on
  entrepreneurs of their greater burden of debt may
  partially offset any cheerful reactions from the
  reductions of wages. Indeed if the fall of wages
  and prices goes far, the embarrassment of those
  entrepreneurs who are heavily indebted may soon
  reach the point of insolvency--with severe
  adverse effects on investment. (Keynes 1936 264)

62
Keynes and Debt-deflation

• The method of increasing the quantity of money
  in terms of wage-units by decreasing the
  wage-unit increases proportionately the burden of
  debt whereas the method of producing the same
  result by increasing the quantity of money whilst
  leaving the wage-unit unchanged has the opposite
  effect. Having regard to the excessive burden of
  many types of debt, it can only be an
  inexperienced person who would prefer the
  former. (1936 268-69)
• Thus 2 reasons for favouring reflation/inflation
  as means to end Great Depression
• accepted neoclassical argument that real wage had
  to fall for employment to rise (next slide)
• impact of rising price level on debt far safer
  than that of a falling price level.

63
Keynes on Wages

• Since accepted marginal product theory, accepted
  that real wages had to fall for employment to
  rise

Increased output
Output

• But argued
• cutting money wage would cut pricesno effect on
  real wage
• solution to depression was reflation, not
  deflation
• increase output, real wages will fall

Employment
real wage
Marginal Product of Labour
Nf
Nu
Reduces real wage
64
Keynes on Policy

• Reflate domestic economy to escape Depression
• Government deficit funding of public works
• Multiplier impact on output, employment
• Boost to investor expectations
• Maintain low interest rates
• International Balance of Payments system to avoid
  beggar my neighbour currency devaluations
• Central world monetary authority
• Fixed exchange rates, IMF approval for variation
• Trade deficit economies must deflate economies to
  reduce imports
• Trade surplus economies must reflate to boost
  imports

65
Keynesian Policy in Practice

• Domestic policy recommendations became the norm
• Budget deficits to increase employment during
  slumps (but surpluses rarely achieved during
  booms for political reasons)
• Low interest rates
• International recommendations only half followed
  in Bretton-Woods agreement
• Fixed exchange rates, IMF, etc. (US as standard)
• Pressure on deficit countries to deflate but
• No pressure on trade surplus countries to reduce
  surplus (USA then major creditortrade
  surplusnation)

66
The interpretation of Keynes

• General Theory highly influential, but read by
  few economists (let alone economic journalists!)
• Most relied upon summaries and textbook
  interpretations
• GT itself not precise plenty of room for
  interpretation
• Key interpretation Hicks 1936, Mr Keynes the
  Classics IS-LM rendition of Keynes
• Hicks sets out typical classical theory
• Mk.I (money supply output), IxC(i)
  (investment demand), IxS(i) (savings supply)
• Argues that Keyness innovation is the
  proposition that the demand for money should obey
  marginal analysis

67
A marginal interpretation of Keynes

• On grounds of pure value theory, it is evident
  that the direct sacrifice made by a person who
  holds a stock of money is a sacrifice of
  interest
• and it is hard to believe that the marginal
  principle does not operate at all in this field
  Hicks, 1936
• Proposes that
• ML(i) (demand for money a decreasing function of
  interest rate) is Liquidity Preference
• this Keyness main innovation
• Multiplier Ix S(I) comparatively
  insignificant

68
Keynes according to Hicks

• Mr Keynes begins with three equations,
• ML(i), IxC(i), IxS(I)
• in contrast to (neo)classical theory ... the
  demand for money is conceived as depending upon
  the rate of interest (Liquidity Preference).
• On the other hand, any possible influence of the
  rate of interest on the amount saved out of a
  given income is neglected.
• Although it means that the third equation becomes
  the multiplier equation, which performs such
  queer tricks, nevertheless this second amendment
  is a mere simplification, and ultimately
  insignificant.
• (ML(i) is money demand money supply M is
  assumed to be exogenous)

69
Keynes according to Hicks

• In this model
• Money demand/supply determines i

Ms
i

• i determines Ix
• Ix determines I via the multiplier
• Increase Ms-gtincrease I
• Increase propensity to invest, or to consume-gt
  increase I

Md
70
Keynes special theory, according to Hicks
Ms
i
Investment
Money marketdetermines int. rate
i
interest ratedetermines Investment
Md (liquidity preference)
Ixf(i)
Ix
M
I (output)
I (output)
Output determines employment
InvestmentdeterminesOutput
Ix
N (employment)
If(Ix)The multiplier
71
Keynes special theory, according to Hicks
Ms
i
Investment
Money marketdetermines int. rate
i
interest ratedetermines Investment
Increasing Ms increases N
Md (liquidity preference)
Ixf(i)
Ix
M
I (output)
I (output)
Output determines employment
InvestmentdeterminesOutput
Ix
N (employment)
Employment grows more than output because of
diminishing marginal product
If(Ix)The multiplier
72
Keynes special theory, according to Hicks
Ms
i
Investment
Money marketdetermines int. rate
i
interest ratedetermines Investment
Reducing LP increases N
Md (liquidity preference)
Ixf(i)
Ix
M
I (output)
I (output)
Output determines employment
InvestmentdeterminesOutput
Ix
N (employment)
If(Ix)The multiplier
Employment grows more than outputbecause of
diminishing marginal product
73
Keynes general theory, according to Hicks

• something appreciably more orthodox OREF 31
• The dependence of the demand for money on
  interest does not ... do more than qualify the
  old dependence on income. However much stress we
  lay upon the 'speculative motive', the
  'transactions motive' must always come in as
  well.
• Hickss version of Keyness GT
• ML(I,i), IxC(i), IxS(I).
• vs Hickss version of typical classical theory
• Mk.I, IxC(i), IxS(i)

74
Keynes general theory, according to Hicks

• The LL (LM) curve
• Fixed Ms Md fn of i Md fn of I

The LM curve
Exogenous Ms
i
i
Md1 (I2)
Md1 (I1)
I
I2
I1
M
75
Keynes general theory, according to Hicks
I (income)
I (income)
IxS(I)
The IS curve Investment demand a fn of i
IxC(i) Savings supply a fn of Income IxS(I)
Savings a function of income
S
I (income)
i
Investment a function of interest rate
i
The IS curve
Multiplier
IxC(i)
I(output)
Ix (Investment)
76
Keynes general theory, according to Hicks

• The product IS-LM analysis

i
LL (now LM)
IS
I (output)
77
Keynes general theory, according to Hicks

• Keynes as a marginalist neoclassical, according
  to Hicks
• Income and the rate of interest are now
  determined together ... just as price and output
  are determined together in the modern theory of
  demand and supply.
• Indeed, Mr Keynes's innovation is closely
  parallel, in this respect, to the innovation of
  the marginalists.
• Integrating Keynes and the Classics
• Slope of LM curve
• almost horizontal for low levels of I
• almost vertical for high levels of I

78
Keynes general theory, according to Hicks

• In Keynesian region, rightward shift of IS
  curve (by fiscal policy, etc.) mainly boosts
  income
• In Classical region, rightward shift of IS
  curve (by fiscal policy, etc.) mainly boosts
  interest rate
• the General Theory of Employment is the
  Economics of Depression, Classical is Economics
  of full employment

i
LM
Classical region
IS
Keynesian region
I (output)
79
Nice theory, but is it Keynes?

• Whatever Happened to Uncertainty Expectations?
• Hicks Ixf(i) Investment demand a function of
  the rate of interest (and income in more general
  model)
• Keynes Our knowledge of the factors which will
  govern the yield of an investment some years
  hence is usually very slight and often
  negligible OREF 4
• It would be foolish, in forming our
  expectations, to attach great weight to matters
  which are very uncertain... therefore, we are
  guided ... by the facts about which we feel
  somewhat confident, .... the facts of the
  existing situation enter disproportionately,
  into the formation of our long-term
  expectations
• Why not Ixf(i,I,E) where E is expectations?

80
Nice theory, but is it Keynes?

• Keynesian Economics as practised
• Keynes minus uncertainty expectations
• Keynes without uncertainty is something like
  Hamlet without the Prince. (Minsky, John Maynard
  Keynes, 1975, p. 57)
• Evolved towards the Neoclassical synthesis
• IS-LM macro grafted onto neoclassical micro
• Key architects Hicks Samuelson
• Revival of neoclassical economics as Keynes
  criticised for having bad microfoundations
• Protest group of economists (Post-Keynesians)
  try to develop uncertainty-based interpretation
  of Keynes in opposition to dominant neoclassical
  synthesis view
• Curiously, one protester was John Hicks!

81
IS-LM An Explanation

• In 1979/80, Hicks commented that
• The IS-LM diagram, which is widely, though not
  universally, accepted as a convenient synopsis of
  Keynesian theory, is a thing for which I cannot
  deny that I have some responsibility. (Hicks
  1979/80)
• saw two key problems with IS-LM as an
  interpretation of Keynes
• 2nd problem was time-period of model
• Hickss used a week,
• Keynes used a short-period, a term with
  connotations derived from Marshall we shall not
  go far wrong if we think of it as a year (Hicks
  1980).

82
IS-LM An Explanation

• Not unreasonable to hold expectations constant
  for a weekand therefore ignore them.
• But keeping expectations constant over a year in
  an IS-LM model does not make sense, because
• for the purpose of generating an LM curve, which
  is to represent liquidity preference, it will not
  do without amendment. For there is no sense in
  liquidity, unless expectations are uncertain.
  (Hicks Explanation)
• I.e., why hold money for precautions/speculation,
  if expectations were constant?
• Cant validly derive LM curve, because
  transactions are only reason for holding money
  when expectations constant

83
IS-LM An Explanation

• If expectations constant, then cant be out of
  equilibrium
• if out of equilibrium, expectations must change!
• I accordingly conclude that the only way in
  which IS-LM analysis usefully survivesas
  anything more than a classroom gadget, to be
  superseded, later on, by something betteris in
  application to a particular kind of causal
  analysis, where the use of equilibrium methods,
  even a drastic use of equilibrium methods, is not
  inappropriate
• When one turns to questions of policy, looking
  towards the future instead of the past, the use
  of equilibrium methods is still more suspect. For
  one cannot prescribe policy without considering
  at least the possibility that policy may be
  changed. There can be no change of policy if
  everything is to go on as expectedif the economy
  is to remain in what (however approximately) may
  be regarded as its existing equilibrium. (Hicks
  Explanation)

84
Keynesian Theory in Practice

• Despite Hicks disavowal of his own model, the
  interpretation of Keynes was dominated by IS-LM,
  and Aggregate Demand-Aggregate Supply (AS-AD)
  analysis
• Emphasis upon fiscal policy
• No attention to issue of expectations
• Policy focus post-Depression, WWII
• Full employment primary
• Australian 1945 White Paper on Employment
• "maintain such a pressure of demand on resources
  that for the economy as a whole there will be a
  tendency towards a shortage of men instead of a
  shortage of jobs"
• Price stability secondary

85
Keynesian Theory in Practice

• Although we have defined the boundary of the
  full-employment zone in terms of registered
  unemployment of 1.0 to 1.5 per cent of the work
  force, this is by no means to say that Australia
  should be content with this degree of
  unemployment. It should be possible to maintain
  employment at a higher level than this and avoid
  the difficulties arising from shortages and
  bottlenecks Vernon Committee, 1966
• The scorecard
• Recovery from Great Depression
• Years of high stable growth, low inflation
• Ending with rising inflation during Vietnam War
  Years, and severe collapse in 1973 (before OPEC!)

86
Breakdown of Keynesianism Philips Curve

• 1958 study identifies relationship between
  unemployment rate of change of money wages
• Consonant with Keynes on real wages and
  employment
• Inc. output gt decrease real wages gt prices must
  rise
• Inflation-unemployment trade-off perceived as
  core of Keynesian policy
• 1960s--accelerating inflation. Breakdown of
  Philips Curve opens door to Friedmans monetarism

87
The Phillips Curve

• 3 factors which might influence rate of change of
  money wages
• Level of unemployment (highly nonlinear
  relationship)
• Rate of change of unemployment
• Rate of change of retail prices operating
  through cost of living adjustments in wage rates
  when retail prices are forced up by a very rapid
  rise in import prices or agricultural
  products. Economica 1958 p. 283-4
• Cost-based perspective on prices
• Developed curve from UK wage change/unemployment
  statistics from 1861-1913
• Only 1st of 3 causal factors shown in curve

88
The Phillips Curve

• Found a clear tendency for
• inverse relation between U and rate of change of
  money wages (Dwm)
• Dwm above curve when U falling, and v.v
• Fitted exponential curve to data

89
The Phillips Curve
Deviations from trend because of
Fitted through average wage change U for
0-2,2-3,3-4, 4-5,5-7,7-11 unemployment
Wage-price spiral due to wars falling U
Rising unemployment
90
The Phillips Curve fitted to 1913-1948 data
Rapid rise in U 13 fall in M prices cost of
living agreements
War-induced rise in M prices
91
The Phillips Curve 49-57 data with time lag
Close fit of 50s UK data to curve
Import price rise
92
The Phillips Curve

• Conclusion Phillips extrapolates from money
  wages to price inflation
• Ignoring years in which import prices initiate
  a wage-price spiral, which seems to occur very
  rarely except as a result of war, and assuming an
  increase in productivity of 2 p.a., for a
  stable level of product prices unemployment
  would be 2.5. For stable wage rates about
  5.5 p. 299
• An inflation-unemployment trade-off?
• But Phillips main purpose for developing it was
  to provide an input for his dynamic models in
  which unemployment, output, etc., varied
  cyclically.

93
The Phillips Model

• RECOMMENDATIONS for stabilising aggregate
  production and employment have usually been
  derived from the analysis of multiplier models,
  using the method of comparative statics.
• This type of analysis does not provide a very
  firm basis for policy recommendations, for two
  reasons.
• First, the time path of income, production and
  employment during the process of adjustment is
  not revealed. It is quite possible that certain
  types of policy may give rise to undesired
  fluctuations, or even cause a previously stable
  system to become unstable, although the final
  equili