“Economics of Keynes”

1. “Economics of Keynes” Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

2. Neoclassical Synthesis By Mid-1960s the economics profession was dominated by a synthesis of orthodox IS-LM Keynesian and classical long-run Growth economics with a smattering of monetarist ideas thrown in Keynesian economics was seen as a special case of a more general model Keynes status as a theorist had been minimized

3. The Economics of Keynes Clower, “The Keynesian Counter-Revolution: A Theoretical Appraisal,” The Theory of Interest Rates, Hahn and Brechling, ed. (1965) Leijonhufvud, “Keynes and the Keynesians: A Suggested Interpretation,” AER (May 1967) Leijonhufvud, On Keynesian Economics and the Economics of Keynes (1968) Clower and Leijonhufvud, “The Coordination of Economic Activities: A Keynesian Perspective,” AER (May 1975)

4. Coordination Issues Unemployment and “effective demand failures” are disequilibrium situations arising from coordination failures Keynes’ revolution was directed at Walrasian General Equilibrium analysis

5. The Walrasian System • “Auctioneer” • Searches for the price vector P that clears all markets • No trades at non-equilibrium prices • Economic agents • Price-takers, quantity-makers • Stock-flow liquidity • All goods equally liquid at equilibrium P, so all asset values can be equally realized

6. The Walrasian System • Two-good system (L and G) • Auctioneer initially sets prices at (W/P)1 and P1; suppose values s.t. in L there is a notional D < S, ESL and in G there is a notional D > S, EDG. • Auctioneer adjusts (W/P) down and P up until equilibrium is established. • In equilibrium, effective and notional demand and supplies are the same.

7. The Walrasian System The Auctioneer takes account of notional desires to buy and sell by noting the excess demands and supplies and turns them into effective messages by only permitting trades at equilibrium

8. The Clower-Leijonhufvudian SystemWhat Keynes Really Meant

9. The CL “Keynesian” System Keynes’ mission was to kill off the Auctioneer myth and raise the issue of information and coordination problemsof real economies

10. The CL “Keynesian” System • Without a Walrasian Auctioneer • Economic agents are price-makers • Trades can take place at non-equilibrium prices • buyers and sellers can be constrained in carrying out some plans • some goods are more liquid than others, since not allassets’ full market values can be realized

11. “Money buys goods and goods buy money; but goods do not buy goods.”

12. The CL “Keynesian” System In non-clearing markets without an auctioneer, one has to make a distinction between notional (unconstrained) and effective (constrained) demands and supplies.

13. Dual-Decision Hypothesis Plans to buy and sell are not realized simultaneously; the decision to sell is not automatically transformed into a decision to buy; the sale must be realized before a purchase is made. The Dual Decision Hypothesis Planned (notional) purchases are not made unless planned sales have been realized (made effective).

14. Dual-Decision Hypothesis Only signals transmitted areeffective messages backed by means of payment (money). Effective demands can diverge from Notional demands.

15. The CL “Keynesian” System • Two-good system (L and G) • Suppose (W/P)1 > (W/P)e so that there exists an ESL. • Some labor sellers are constrained in their demand for goods. • Effective DG < notional DG. • There is no incentive to raise P and encourage production. If P doesn’t increase, (W/P) doesn’t fall! • Unemployment but not equilibrium.

16. “Price-incentives may be effective in all markets and all prices may be “flexible” and a market system may still go hay-wire in its groping for the coordinated solution.” - Leijonhufvud, “Effective Demand Failures,” p. 111-112 • Though prices are flexible, prices do not change, even though notional excess demands and supplies exist, because the desires are not made effective. • Prices may be “right,” but transacted amounts persistently differ from desired rates of sales and purchases. • Prices that were “right” may move away from their equilibrium values, generating price signals that are false and make coordination failure worse.

17. The CL “Keynesian” System • Keynes recognized the difficulties of finding P • Keynes saw Q adjustments as occurring before and faster than P adjustments • (reversing Walrasian adjustments)

18. The CL “Keynesian” System • IS-LM gets Keynes wrong • Key elements of IS-LM not in Keynes • Rigid wages, liquidity trap, interest-inelastic investment • Keynes aggregates bonds and capital goods • IS-LM aggregates consumption goods and capital goods

19. The CL “Keynesian” System • C& L Claim: IS-LM gets Keynes wrong • Two Key problems 1. Offer of L by unemployed ineffective because does not constitute an effective demand for goods; Workers are unwilling to be paid in goods in a money economy. 2. Temporal problem that an increase in saving does not send a signal to produce more in the future… “future demands are not effective demands.”

20. The CL “Keynesian” System • Is Clower and Leijonhufvud’s Keynes in Keynes? • Keynes long struggle was to escape Marshall, not Walras. • Walrasian model was developed post-Keynes. • Important to understanding Neoclassical Synthesis debate, but perhaps not the Keynesian episode.

21. Second Thoughts • How applicable is Dual Decision Hypothesis version of Keynes to real economies? • Notion of corridor • Inside, price adjustments dominate quantity adjustments and we are in a classical world of self-equilibrating markets • Outside, quantity adjustments dominate price adjustments and in a Keynesian world of persistent disequilibrium

22. Second Thoughts • Keynes’ world • Pure flow model of realized sales determining current income which determine current expenditure • As soon as some market does not clear, the dominance of quantity adjustments causes multiplier repercussions

23. Second Thoughts • Real world • Modern economies are stock-flow economies • Stocks are buffers between physical and financial inflows and outflows • Money-stock of liquid assets • an important buffer that allows expenditures to be maintained when receipts fall • this is the reason for their existence

24. “Conclusions: (a) in such economies [stock-flow], we must expect the propagation of shocks impinging on flow to be heavily dampened – as long as the shocks are not of greater magnitude than anticipated by transactors in making their decisions on the levels of buffer stocks to maintain; (b) such economies are, therefore, much more “robust” than pure flow models would suggest – within “the corridor”; if disturbances are of unanticipatedly large magnitude, buffer stocks may be exhausted – at which point, the…”tight” income-constraint takes over.” - Leijonhufvud, “Effective Demand Failures,” p. 117