TEST 1 - Center for the History of Political Economy

History of Modern Macroeconomics Lecture 3.2. The Great Depression: Keynes and His Critics (the 1930s) Kevin D. Hoover Department of Economics Department of Philosophy Center for the History of Political Economy Duke University

Center for the History of Political Economy Summer School June 2012

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John Maynard Keynes (1883-1946)

Center for the History of Political Economy Summer School June 2012

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Keynes is the Most Influential Economist of the 20th Century (by articles in JSTOR)

Economist Keynes

Name in Title

Name in Article

1,428

30,249

Friedman

130

17,828

Samuelson

110

14,524

Lucas

44

9,535

Prescott

10

4,846

Center for the History of Political Economy Summer School June 2012

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Keynes’s Paternity: Natural and Academic

John Neville Keynes (1852-1949)

Alfred Marshall (1842-1924)

Center for the History of Political Economy Summer School June 2012

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Some Bloomsburies

Duncan Grant 1885-1978 (Self-portrait)

Virginia Woolf 1882-1941

Lytton Strachey 1880-1932 (by Dora Carrington)

E.M. Forster 1882-1941

Center for the History of Political Economy Summer School June 2012

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Keynes and the Arts

Center for the History of Political Economy Summer School June 2012

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Maynard and Lydia

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Keynes’s Books circa 1930

1919

1921

1930

1923 Center for the History of Political Economy Summer School June 2012

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If the books seem dry . . . Maynard and Lydia again

Center for the History of Political Economy Summer School June 2012

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A Doctrinaire Quantity Theorist and the Urgency of the Present Now “in the long run’ [the neutrality of money] is probably true. If, after the American Civil War, the American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that . . . p would be just 10 per cent greater than [it] actually [is] and that the present values of k [and y] would be entirely unaffected. But 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. Keynes, A Tract on Monetary Reform

Center for the History of Political Economy Summer School June 2012

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Malthus as a Precursor to Keynes Theoretical writers are too apt, in their calculations, to overlook these intervals [i.e., trade cycles]; but eight or ten years, recurring not unfrequently, are serious spaces in human life. They amount to a serious sum of happiness or misery, according as they are prosperous or adverse, and leave the country in a very different state at their termination. T. Robert Malthus, Principles of Political Economy Center for the History of Political Economy Summer School June 2012

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Perfectionist and Imperfectionists Accounts of the Business Cycle  

Ricardo-Malthus debate as a prelude Say’s Law:    

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Supply creates its own demand Capital always finds productive uses No natural barriers to full employment No general gluts

Imperfectionist: Labor resistance (implicit or explicit) to real wage cuts the source of unemployment Perfectionist (Keynes): unemployment in the nature of the economy Center for the History of Political Economy Summer School June 2012

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The General Theory of Employment Interest and Money (1936) 

“Monetary theory of production”

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Perfectionist account of the business cycle

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Real output not prices the central theoretical focus

Center for the History of Political Economy Summer School June 2012

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“Mr. Keynes and the Classics”: The Most Influential Interpretation of the General Theory

Sir John Hicks (1904-1989)

IS-LM Model

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The IS-LM (originally IS-LL) Model – 1  Aggregate Supply: classical except for sticky nominal wages  Aggregate Demand: IS  Consumption Function C = C(Y) 0 < C < 1  Investment Function I = I(r) I < 0  Accounting Identity/Equilibrium Condition Y = C + I or S = I  The IS Curve: Y – C(Y) – I(r) = 0 Center for the History of Political Economy Summer School June 2012

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The IS-LM (originally IS-LL) Model – 1

 Aggregate Demand: LM  Money Supply MS M  Money Demand or Liquidity Preference: D M = L(Y, r) L/Y > 0, L/r < 00  /Equilibrium Condition S D M =M  The LM (or LL) Curve: M  L(Y , r )  0 Center for the History of Political Economy Summer School June 2012

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Hick’s IS-LM Interpretation of Keynes r IS Curve2

LM Curve

IS Curve1

Effect of Monetary Expansion

Flat section = absolute liquidity preference Y Center for the History of Political Economy Summer School June 2012

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Keynes: Heterogeneity 

Relative social position in labor markets and aggregate supply

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Coordination failure (ex ante and ex post)

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Fallacies of composition

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Monetary economy Center for the History of Political Economy Summer School June 2012

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Uncertainty and Rationality – 1 

Risk vs. Uncertainty (Treatise on Probability) “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 of 1970. About these matters there is no scientific basis on which to form any calculable probabilities whatever. We simply do not know.” [Keynes 1937, pp. 113-14; Collected Works, vol. 14.] Center for the History of Political Economy Summer School June 2012

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Uncertainty and Rationality – 2 

Conventions as a solution to uncertainty “a convention . . . assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change . . .” Keynes General Theory, p. 152

Center for the History of Political Economy Summer School June 2012

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Uncertainty and Rationality – 3 

Room for psychology and temperament (“animal spirits”) but not irrationality: “. . . it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motives on whim or sentiment or chance.” Keynes, General Theory, p. 163

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Rationality requires decision Center for the History of Political Economy Summer School June 2012

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Implications of Uncertainty

r

IS Curve

r LM Curve IS Curve

LM Curve Tranquil periods slide up and down IS curve

Tranquil periods slide up and down LM curve

Periods of reassessment IS curve shifts bodily

Y

Center for the History of Political Economy Summer School June 2012

Periods of reassessment IS curve shifts bodily

Y

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The Trade Cycle 

Investment major source of fluctuations 

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marginal efficiency naturally falls as boom progresses large shifts from reassessments of future profits – dimmed animal spirits firms hesitate to cut wages wage cuts reduce income and have adverse multiplier effects

Center for the History of Political Economy Summer School June 2012

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Policy to Fight a Slump 

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Government expenditure (especially public works) can replace investment = socialization of investment Indirect effect on expected future profits and firms confidence (animal spirits) dominate

Center for the History of Political Economy Summer School June 2012

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Policy to Maintain a Boom 

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Predictable and consistent monetary and fiscal policy supports conventional response to uncertainty “In estimating the prospects of investment, we must have regard . . . to the nerves and hysteria of those upon whose spontaneous activity it largely depends.” Keynes, General Theory, p. 162 Center for the History of Political Economy Summer School June 2012

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The Central Message (or Central Innovation) of The General Theory 

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Perfectionist account of the failure of real wage changes to clear the labor market Distinction between aggregate supply and demand The multiplier Liquidity preference The liquidity trap Activitist (fiscal) policy Focus on uncertainty Center for the History of Political Economy Summer School June 2012

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Thanks  The End Center for the History of Political Economy Summer School June 2012

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