Keynesian economics and macroeconomic theory

Keynesian economics is an economic theory based on the ideas of John Maynard Keynes (Jackson 29). First published in 1936, Keynes's theory suggests that general trends may overwhelm the micro-level behavior of individuals. He stated," This book is chiefly addressed to my fellow economists ... I myself held with conviction for many years the theories which I now attack, and I am not, I think, ignorant of their strong points" (Keynes). Keynes asserted the importance of the aggregate demand for goods as the driving factor, especially in downturns. From this he argued that government policies could be used to promote demand at a macro level, to fight high unemployment and deflation of the sort seen during the 1930s. Keynes thought that the economy was the most important issue of the time as evidenced by his statement, "The ideas of economists . . . are more powerful than is commonly understood. Indeed the world is ruled by little else" (Keynes). To further defend this point, he stated, "It is better that a man should tyrannize over his bank balance than over his fellow-citizens and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative" (Keynes). A central conclusion of Keynesian economics is that there is no strong automatic tendency for output and employment to move toward full employment levels. This conflicts with classical economics, which assumes a general tendency towards equilibrium in a restrained money creation economy (Banguero 25).

John Maynard Keynes was one who perceived increasing cracks in the assumptions and theories that held sway at that time. He believed that his book on economic theory would "largely revolutionize not, I suppose, at once but in the course of the next ten years change the way the world thinks about economic problems" (Keynes). Keynes questioned two of the pillars of economic theory dominant: the need for a solid basis for money, generally a gold standard, and the theory, expressed as Say's Law which stated that decreases in demand would only cause price declines, rather than affecting real output and employment (Banguero 26). In his political views, Keynes was not revolutionary, but pro-business and pro-entrepreneur. He often argued that "... The importance of money essentially flows from its being a link between the present and the future" (Keynes).

Several principles are central to Keynesianism (Kant 109). The first principle suggests that aggregate demand is influenced by a host of economic decisions and sometimes behaves erratically. The public decisions include those on monetary and fiscal policy. A few economists, however, believe in what is called debt neutrality, the doctrine that substitutions of government borrowing for taxes have no effects on total demand. Keynes once stated, "The avoidance of taxes is the only intellectual pursuit that still carries any reward" (Keynes).

Next, changes in aggregate demand have their greatest short-run impact on real output and employment, not on prices. Keynesians believe the short run lasts long enough to matter, a principle Keynes coined as "short-run expectations." Keynes's once stated, "In the long run, we are all dead" to make the point (Keynes).

The third principle of Keynesian economics is the belief that anticipated monetary policy can produce real effects on output and employment only if some prices are rigid. Otherwise, an injection of new money would change all prices by the same percentage. Keynesian models generally typically assume or try to explain rigid prices or wages. Rationalizing rigid prices is hard to do because, according to standard microeconomic theory, real supplies and demands do not change if all nominal prices rise or fall proportionally (Banguero 26).

Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending, i.e. consumption, investment, or government expenditures, cause output to fluctuate (Jackson 32). If government spending increases, for example, and all other components of spending remain constant, then output will increase. Keynesian models of economic activity also include a "multiplier effect" (Keynes). That is, output increases by a multiple of the original change in spending that caused it. For example, a $10 billion increase in government spending could cause total output to rise by $15 billion (a multiplier of 1.5) or by $5 billion (a multiplier of 0.5). Contrary to many widespread beliefs, Keynesian analysis does not require that the multiplier exceed 1.0. For Keynesian economics to work, however, the multiplier must be greater than 0 (Kant 115).

The fourth principle of Keynesian economics is that prices and, especially wages, respond slowly to changes in supply and demand, resulting in shortages and surpluses, especially of labor. Even though monetarists are more confident than Keynesians in the ability of markets to adjust to changes in supply and demand, many monetarists accept the Keynesian position on this matter. Milton Friedman, for example, the most prominent monetarist, has written: "Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages" (Friedman 58). In current dialect, that would certainly be called a Keynesian position.

Keynesians do not think that the typical level of unemployment is ideal, partly because unemployment is subject to the impulse of aggregate demand, and partly because they believe that prices adjust only gradually. Keynesians typically see unemployment as both too high on average and too variable, although they know that rigorous theoretical justification for these positions is hard to come by. Keynesians also feel certain that periods of recession or depression are economic maladies, not efficient market responses to unattractive opportunities.

Many Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems (Banguero 29). This does not mean that Keynesians advocate what used to be called fine-tuning, or adjusting government spending, taxes, and the money supply every few months to keep the economy at full employment. Almost all economists, including most Keynesians, now believe that the government cannot know enough soon enough to fine-tune successfully. Three "lags" (Keynes) make it unlikely that fine-tuning will work (Jackson 27).

First, there is a lag between the time that a change in policy is required and the time that the government recognizes this. Second, there is a lag between when the government recognizes that a change in policy is required and when it takes action. In the United States, this lag is often very long for fiscal policy because Congress and the administration must first agree on most changes in spending and taxes. The third lag comes between the time that policy is changed and when the changes affect the economy. Many Keynesians still believe that more modest goals for stabilization policy are not only defensible, but also sensible.

Finally, many Keynesians are more concerned about combating unemployment than about conquering inflation. They have concluded from the evidence that the costs of low inflation are small. Contrarily, Keynes once stated, "By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens" (Keynes). Views on the relative importance of unemployment and inflation heavily influence the policy advice that economists give and that policymakers accept. Keynesians typically advocate more aggressively expansionist policies than non-Keynesians. Keynesians' belief in aggressive government action to stabilize the economy is based on value judgments and on the beliefs that (a) macroeconomic fluctuations significantly reduce economic well-being, (b) the government is knowledgeable and capable enough to improve upon the free market, and (c) unemployment is a more important problem than inflation (Kant 124).

Keynesian theory was much denigrated in academic circles from the mid-1970's until the mid-1980's. However, it has staged a strong comeback since then because Keynesian economics was better able to explain the economic events of the 1970's and 1980's than its principal intellectual competitor, new classical economics. New classical economic theory emphasizes the ability of a market economy to cure recessions by downward adjustments in wages and prices. The new classical economists of the mid-1970's attributed economic downturns to people's misperceptions about what was happening to relative prices. Misperceptions would arise, they argued, if people did not know the current price level or inflation rate. Therefore, economic downturns, by the new classical view, should be mild and brief. During the 1980's, most of the world's industrial economies endured deep and long recessions.

According to new classical theory, a correctly perceived decrease in the growth of the money supply should have only small effects, if any, on real output (Ingham 81). An offshoot of new classical theory formulated by Harvard's Robert Barro is the idea of debt neutrality. Barro argues that inflation, unemployment, real GNP, and real national saving should not be affected by whether the government finances it's spending with high taxes and low deficits or with low taxes and high deficits (Kant 108). Because people are rational, he argues, they will correctly perceive that low taxes and high deficits today must mean higher future taxes for them. Barro argues that people will cut consumption and increase their saving by one dollar for each dollar increase in future tax liabilities. Thus, a rise in private saving should offset any increase in the government's deficit. Naive Keynesian analysis, by contrast, sees an increased deficit, with government spending held constant, as an increase in aggregate demand. If the stimulus to demand is nullified by contractionary monetary policy, real interest rates should rise strongly. There is no reason, in the Keynesian view, to expect the private saving rate to rise.

Massive U.S. tax cuts occurred between 1981 and 1984. However, the private saving rate did not rise. With fiscal stimulus offset by monetary contraction, real GNP growth was largely unaffected; it grew at about the same rate as it had in the recent past (Banguero 25). Again, this all seems more consistent with Keynesian than with new classical theory.

After Keynes, Keynesian analysis was combined with classical economics to produce what is generally termed "the neoclassical synthesis" (Ingham 87), which dominates mainstream macroeconomic thought. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as classical or neoclassical theory predicted.

In the years following World War II, Keynes's policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis. In this era of new liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation.

It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt to understand and control economic activity. This model, the IS-LM model is nearly as influential as Keynes' original analysis in determining actual policy and economics education (Jackson 30). The model relates aggregate demand and employment to three exogenous quantities. These qualities are the amount of money in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory.

The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve (Banguero 29). This curve indicated that increased employment, and decreased unemployment, implied increased inflation. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output and employment, and then use the Phillips curve to predict an increase in inflation.

The strength of the Keynesian economics influence can be seen by the wave of conservative economists, which began in the late 1940s beginning with Milton Friedman. Instead of rejecting macro-measurements and macro-models of the economy, they embraced the techniques of treating the entire economy as having a supply and demand equilibrium. However, unlike the Keynesians, they argued that "crowding out" (Friedman 65) effects would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was largely ignored by early Keynesians. This monetarism had an ideological appeal since monetary policy does not imply as much government intervention the economy. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and inspired a wave of revisions to Keynesian theory.

Through the 1950s, moderate degrees of government demand lead industrial development and use of fiscal and monetary counter-cyclical policies continued. In the 1960s, this reached a peak where it seemed to many Keynesians that prosperity was now permanent. However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction. This stagflation meant that both expansionary and contractionary policies had to be applied simultaneously, which was clearly impossible. This dilemma led to the rise of ideas based upon more classical analysis, including monetarism, supply-side economics, and new classical economics. This produced a policy bind and the collapse of the Keynesian consensus on the economy (Navarro 552). Samuelson and Nordhaus wrote, "In the early stages of the Keynesian revolution, macroeconomists emphasized fiscal policy as the most powerful and balanced remedy for demand management. Gradually, shortcomings of fiscal policy became apparent. The shortcomings stem from timing, politics, macroeconomic theory, and the deficit itself" (Samuelson and Nordhaus 268).

In the 1990s, the 'uncoupling' of money supply and inflation caused an increasing questioning of the original form of monetarism. The repeated failures of projections for economic recovery in Japan and the United States based on neo-classical synthesis models have encouraged the recent revival in Keynesian ideas, with particular emphasis on giving the Keynesian macroeconomic analysis theoretically sound foundations in microeconomics (Navarro 557). These theories have been called new Keynesian economics (Ingham 89).

The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust (Banguero 22). New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices 'clear' markets, balance supply and demand, by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with "sticky" (Friedman 154) wages and prices . New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity (Richardson and McKie 271).