Subject: History of economic thought

Lecturer: Dr.Jafar F. Jafarov

Lecture date: 2020

Lecture 8.Keynesianism and its evolution

Plan

1. Theoretical Setting of Keynes 's Analysis

2. Keynesian Versus Classical Economic Theories
3. Keynesian Economics and Fiscal Policy & Monetary Policy
4. Keynes 's Defense of the Marginal Productivity Theory of Distribution

Literature

1. Grant Brue. The History of Economic Thought, Seventh Edition.International

Student Edition. 2017
2. Yukihiro Ikeda, Annalisa Rosselli. Routledge Studies in the History of
Economics.War in the History of economic thought. 2017
3. Alessandro Roncaglia. The Wealth of Ideas: A History of Economic Thought.
2016 by Cambridge University Press

1. Theoretical Setting of Keynes 's Analysis

Keynesian economics is a theory that says the government should increase

demand to boost growth. Keynesians believe consumer demand is the primary driving
force in an economy. As a result, the theory supports expansionary fiscal policy. Its
main tools are government spending on infrastructure, unemployment benefits, and
education. A drawback is that overdoing Keynesian policies increases inflation.
The British economist John Maynard Keynes developed this theory in the 1930s.
The Great Depression had defied all prior attempts to end it. President Franklin D.
Roosevelt used Keynesian economics to build his famous New Deal program. In his first
100 days in office, FDR increased the debt by $4 billion to create 16 new agencies and
laws. For example, the Works Progress Administration put 8.5 million people to work.
The Civil Works Administration created 4 million new construction jobs.
Keynes described his premise in “The General Theory of Employment, Interest,
and Money.” Published in February 1936, it was revolutionary. First, it argued that
government spending was a critical factor driving aggregate demand. That meant an
increase in spending would increase demand.
Second, Keynes argued that government spending was necessary to maintain
full employment.
Keynes advocated deficit spending during the contractionary phase of the
business cycle. But in recent years, politicians have used it even during the
expansionary phase. President Bush's deficit spending in 2006 and 2007 increased the
debt. It also helped create a boom that led to the 2007 financial crisis. President Trump
is increasing the debt during stable economic growth. That will also lead to a boom-and-
bust cycle.

Keynesian Economics
 Government spending on infrastructure, unemployment benefits, and education
will increase consumer demand.
 Government spending is necessary to maintain full employment.

Classical Economics
 Increasing business growth will boost the economy.
 Government should play a limited role and target companies, not consumers.

2. Keynesian Versus Classical Economic Theories

Classical economic theory promotes laissez-faire policy. It says the free market
allows the laws of supply and demand to self-regulate the business cycle. It argues that
unfettered capitalism will create a productive market on its own. It will enable private
entities to own the factors of production. These four factors are entrepreneurship,
capital goods, natural resources, and labor. In this theory, business owners use the
most efficient practices to maximize profit.
Classical economic theory advocates for a limited government. It should have a
balanced budget and incur little debt. Government spending is dangerous because it
crowds out private investment. But that only happens when the economy is not in a
recession. In that case, government borrowing will compete with corporate bonds. The
result is higher interest rates, which make borrowing more expensive. If deficit spending
only occurs during a recession, it will not raise interest rates. For that reason, it also
won't crowd out private investment.

Criticism
Supply-side economists say that increasing business growth, not consumer
demand, will boost the economy. They agree the government has a role to play, but
fiscal policy should target companies. They rely on tax cuts and deregulation.
Proponents of trickle-down economics say that all fiscal policy should benefit the
wealthy. Since the wealthy are business owners, benefits to them will trickle down to
everyone.
Monetarists claim that monetary policy is the real driver of the business cycle.
Monetarists like Milton Friedman blame the Depression on high-interest rates. They
believe expansion of the money supply will end recessions and boost growth.
Socialists criticize Keynesianism because it doesn't go far enough. They believe
the government should take a more active role to protect the common welfare. This
means owning some factors of production. Most socialist governments own the nation's
energy, health care, and education services.
Even more critical are communists. They believe the people, as represented by
the government, should own everything. The government completely controls the
economy.

3. Keynesian Economics and Fiscal Policy

The multiplier effect is one of the chief components of Keynesian countercyclical
fiscal policy. According to Keynes's theory of fiscal stimulus, an injection of government
spending eventually leads to added business activity and even more spending. This
theory proposes that spending boosts aggregate output and generates more income. If
workers are willing to spend their extra income, the resulting growth in the gross
domestic product( GDP) could be even greater than the initial stimulus amount.
 The magnitude of the Keynesian multiplier is directly related to the marginal
propensity to consume. Its concept is simple. Spending from one consumer becomes
income for another worker. That worker's income can then be spent and the cycle
continues. Keynes and his followers believed individuals should save less and spend
more, raising their marginal propensity to consume to effect full employment and
economic growth.
In this way, one dollar spent in fiscal stimulus eventually creates more than one
dollar in growth. This appeared to be a coup for government economists, who could
provide justification for politically popular spending projects on a national scale.
This theory was the dominant paradigm in academic economics for decades.
Eventually, other economists, such as Milton Friedman and Murray Rothbard, showed
that the Keynesian model misrepresented the relationship between savings, investment,
and economic growth. Many economists still rely on multiplier-generated models,
although most acknowledge that fiscal stimulus is far less effective than the original
multiplier model suggests.
The fiscal multiplier commonly associated with the Keynesian theory is one of
two broad multipliers in macroeconomics. The other multiplier is known as the money
multiplier. This multiplier refers to the money-creation process that results from a
system of fractional reserve banking. The money multiplier is less controversial than its
Keynesian fiscal counterpart.

Keynesian Multiplier
The Keynesian multiplier represents how much demand each dollar of
government spending generates. For example, a multiplier of two creates $2 of gross
domestic product for every $1 of spending. Most economists agree that the Keynesian
multiplier is one. Every $1 the government spends adds $1 to economic growth. Since
government spending is a component of GDP, it has to have at least this much impact.
The Keynesian multiplier also applies to decreases in spending. The International
Monetary Fund estimated that a cut in government spending during a contraction has a
multiplier of 1.5 or more. Governments who insist on austerity measures during a
recession remove $1.50 from GDP for every $1 cut.

Keynesian Economics and Monetary Policy

Keynesian economics focuses on demand-side solutions to recessionary periods.
The intervention of government in economic processes is an important part of the
Keynesian arsenal for battling unemployment, underemployment, and low economic
demand. The emphasis on direct government intervention in the economy places
Keynesian theorists at odds with those who argue for limited government involvement in
the markets. Lowering interest rates is one way governments can meaningfully
intervene in economic systems, thereby generating active economic demand.
Keynesian theorists argue that economies do not stabilize themselves very quickly and
require active intervention that boosts short-term demand in the economy. Wages and
employment, they argue, are slower to respond to the needs of the market and require
governmental intervention to stay on track.
Prices also do not react quickly, and only gradually change when monetary policy
interventions are made. This slow change in prices, then, makes it possible to use
money supply as a tool and change interest rates to encourage borrowing and lending.
Short-term demand increases initiated by interest rate cuts reinvigorate the economic
system and restore employment and demand for services. The new economic activity
then feeds continued growth and employment. Without intervention, Keynesian theorists
believe, this cycle is disrupted and market growth becomes more unstable and prone to
excessive fluctuation. Keeping interest rates low is an attempt to stimulate the economic
cycle by encouraging businesses and individuals to borrow more money. When
borrowing is encouraged, businesses and individuals often increase their spending. This
new spending stimulates the economy. Lowering interest rates, however, does not
always lead directly to economic improvement.
Keynesian economists focus on lower interest rates as a solution to economic
woes, but they generally try to avoid the zero-bound problem. As interest rates
approach zero, stimulating the economy by lowering interest rates becomes less
effective because it reduces the incentive to invest rather than simply hold money in
cash or close substitutes like short term Treasuries. Interest rate manipulation may no
longer be enough to generate new economic activity if it cannot spur investment, and
the attempt at generating economic recovery may stall completely. This is know as a
liquidity trap.
Japan's Lost Decade during the 1990s is believed by many to be an example of
this liquidity trap. During this period, Japan's interest rates remained close to zero but
failed to stimulate the economy.
When lowering interest rates fails to deliver results, Keynesian economists argue
that other strategies must be employed, primarily fiscal policy. Other interventionist
policies include direct control of the labor supply, changing tax rates to increase or
decrease the money supply indirectly, changing monetary policy, or placing controls on
the supply of goods and services until employment and demand are restored.

New Keynesian Theory

In the 1970s, rational expectations theorists argued against the Keynesian
theory. They said that taxpayers would anticipate the debt caused by deficit spending.
Consumers would save today to pay off the future debt. Deficit spending would spur
savings, not increase demand or economic growth.
The rational expectations theory inspired the New Keynesians. They said that
monetary policy is more potent than fiscal policy. If done right, expansionary monetary
policy would negate the need for deficit spending. Central banks don't need politicians’
help to manage the economy. They would merely adjust the money supply.

4. Keynes 's Defense of the Marginal Productivity Theory of Distribution

Keynes basically agreed with the neoclassical marginal productivity theory of

distribution (in fact, as we will see, he agreed with nearly every tenet of neoclassical
theory except for the belief that aggregate demand would always equal aggregate
supply at the full-employment level of income). He began the General Theory by stating
that the neoclassical (or classical, as Keynes referred to it) "theory of employment" was
based "on two fundamental postulates," the first being that the "wage is equal to the
marginal product of labour." 14 In stating his disagreements with neoclassical
economics, Keynes was careful to reassure the reader that he agreed with this first
postulate-that laborers receive the value of their marginal product:
In emphasizing our point of departure from the classical system, we must not
overlook an important point of agreement. For we shall maintain the first postulate as
heretofore, subject only to the same qualifications as in the classical theory; and we
must pause, for a moment, to consider what this involves. It means that, with a given
organization , equipment and technique, real wages and the volume of output (and
hence of employment) are uniquely correlated, so that, in general, an increase in
employment can only occur to the accompaniment of a decline in the rate of real
wages. Thus I am not disputing this vital fact which the classical economists have
(rightly) asserted as indefeasible . . . . Thus if employment increases, then, in the short
period, the reward per unit of labour in terms of wage-goods must, in general, decline
and profits increase.
It would seem that Keynes had a theory of employment identical to that of his
neoclassical contemporaries and that his recommendation for increasing employment
would be identical to theirs, that is, to decrease wages and increase profits . It was and
it was not. Keynes was involved in a contradiction. As theneoclassicists did, Keynes
argued that to increase employment, wages had to be decreased and profits increased
(and many ignorant conservatives of the time considered Keynes a radical ! ) . If profit-
maximizing behavior motivated capitalists to hire laborers to the point where their w age
equaled the value of their marginal product (as Keynes and all the neoclassical
economists agreed), then lowering the real w age of workers was the only answer to
unemployment. Keynes wanted to agree with the neoclassicists and simultaneously to
disagree with them. He did this in a most unconvincing way. He argued that real wages
could be decreased in either of two ways. First, the money wage rate could be
decreased while the prices of wage goods remained constant or decreased more slowly
(which is what most neoclassical economists recommended). Second, the price of w
age goods could be increased while the money wage rate remained constant or
increased more slowly. Keynes argued that workers would never accept the first method
of reducing their real wages but would accept the second method more or less
peacefully.

Keynes 's Analysis of Capitalist Depressions

Throughout the remainder of the General Theory, Keynes consistently assumed that the
rate of utilization of the productive capacity of physical capital declined sharply in times
of depression, and the number of employed workers declined sharply as well. Keynes 's
theory was addressed to those obvious realities of depression in an insightful and
coherent manner. B ut because it is an equally obvious fact of capitalist depressions
that the real wages of workers did not increase when employment decreased, Keynes's
adherence to the marginal productivity theory that w ages were always equal to the
workers ' marginal productivity contradicted the rest of his theory. As we have frequently
pointed out in this book, the contradictions in a great thinker 's theory (and Keynes was
a logician of the first order) give the best insights into the thinker 's ideological
orientation. Keynes wished to furnish capitalist governments with theoretical insights
that would help to save capitalism. In doing so, it was necessary for him to abandon
some tenets of neoclassical theory. But, as we will see, he wanted to retain as much
neoclassical ideology as possible. So he adhered to both the marginal productivity
theory of distribution and the belief that the free market efficiently allocated resources
(once full employment was attained) , despite the fact that both these tenets of
neoclassical ideology were logically tied to the belief that the free market automatically
created a full employment, Pareto optimal situation.Even with theorists having the
extraordinary logical ability of Keynes, ideology very frequently wins out over logic.
Keyne’s rejected the notion that if a capitalist economy started from a situation of full
employment, then the rate of interest would automatically equate saving and investment
and thus keep aggregate demand equal to aggregate supply. His major departure s
from the doctrines that comprised the neoclassical theory of automaticity were twofold :
First, although he accepted the neoclassical notion that saving was influenced by the
rate of interest, he insisted that the level of aggregate income was a far more important
influence on the amount of saving than was the rate of interest. Second, he argued that
saving and investment did not determine the rate of interest. The interest rate was a
price that equalized the demand and supply of money-something quite different from
(although not unrelated to) investment and saving .