THE ORTHODOX KEYNESIAN SCHOOL MACROECONOMICS
2/8/2011
mirza asjad baig
1
INTRODUCTION
ss system did allow for a restoration of full employment Keyness equilibrium via price flexibility. (Modiglianis ,1944). it was generally accepted that neoclassical oclassical micro microeconomics and macroeconomics could sit alongside Keynesian each other.(Samuelson ,1955) The classical/neoclassical model remained relevant microeconomic issues and the long-run analysis of growth.
for
omics provi provid ded the most most useful Orthodox Keyne ynesian macroeconomics framework for analyzing short-run aggregate phenomena.
2/8/2011
mirza asjad baig
2
MAIN PURPOSE
FIRST
To review one highly influential orthodox Keynesian interpretation of Keyness (1936) General Theory, namely the Hicksian ISLM model for a closed economy.
SECOND
To consider the eff ectiveness of fiscal and monetary policy for stabilization purposes when the model is extended t o an open economy.
THIRD
To discuss the original Phillips curve analysis and comment on the importance of the Phillips curve to orthodox Keynesian analysis.
FOURTH
To summarize the central propositions of orthodox Keynesian economics 2/8/2011
mirza asjad baig
3
ISSUES
Two recurrent and interrelated issues arise throughout this and subsequent chapters, concerning:
1. The controversy over the self-equilibrating properties of the economy. 2. The role for interventionist government policies.
2/8/2011
mirza asjad baig
4
The Orthodox Keynesian School
The e conomy is inherently unstable and is subject to erratic shocks. the economy can take a long time to return to the neighborhood of full employment after being subjected to some disturbance. The aggregate level of output and employment is essentially determined by aggregate demand. The eff ects of fiscal polic y measures are considered to be more direct, predictable and faster acting on aggregate demand than those of monetary policy
2/8/2011
mirza asjad baig
5
IS IS LM LM MODEL macroeconomic model that graphically represents two intersecting curves, called the IS and LM curves.
A
The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand for this model).
The liquidity pref erence/money supply equilibrium (LM) curve represents the amount of money available for investing (supply for this model). M / P = L(i ,Y )
2/8/2011
mirza asjad baig
6
THE SHORT RUN EQUILIBRIUM IN A CLOSED ECONOMY
The IS curve summarizes all combinations o f income and interest rates that clear the market for goods a nd services. The LM curve summarizes all combinations of income and interest rates that clear the money market.
2/8/2011
mirza asjad baig
7
THE SHORT RUN EQUILIBRIUM IN A CLOSED ECONOMY
Anywhere other than the intersection, which we label i0 and Y0 , we would expect there to be changes in Y or i that restore either goods market or money market equilibrium.
Generally, we believe that the money market adjusts very quickly so the economy will rarely be o the LM curve. H owever, it will not stay o the IS curve for very long either as rms can adjust production to bring it in line with demand. Consider a point like A. Even though the money market is in equilibrium, the goods market is not (we are o the IS curve). At that low interest rate, Y is too low to cl ear the goods market so rms increase productio n and Y rises. As Y rises, i has to rise as well i n order to maintain money market equilibrium so the e conomy moves towards the intersection point. Now consider a point like B. Once again, the money market is in equilibrium but the goods market is not (we are o the IS curve). At that high interest rate, Y is too high to clear the goods market so rms decrease production and Y falls. As Y falls, i has to fall as w ell in order to maintain money market equilibrium so the economy moves towards the intersection point.
2/8/2011
mirza asjad baig
8
USING THE ISIS-LM MODEL TO ANALYZE FISCAL POLICY We can use the IS-LM model to look at the impact of scal policy:
government decisions on taxation and spending. Economists ref er to increases in government purchases or cuts in taxes as expansionary scal policy. C uts in government purchases and increases in taxes are ref erred to as contractionary scal policy.
2/8/2011
mirza asjad baig
9
USING THE IS IS--LM MODEL TO ANALYZE MONETARY POLICY
We can also use the IS-LM model to think about monetary policy decisions. When
the Fed pursues an expansionary monetary policy, i.e. it increases the money supply, we showed that this would cause the LM curve to shift to the right. From the graph below we see that this causes GDP to rise and interest rates to fall in the economy.
The opposite would be true for contractionary monetary policy. The decrease in money supply causes interest rates to rise in order to restore money market equilibrium. On the goods market side, the higher interest rates result in decreased investment spending, which in turn lowers Y.
2/8/2011
mirza asjad baig
10
UNDEREMPLOYMENT EQUILIBRIUM IN THE KEYNESIAN MODEL
Excess supply of labour W production costs P real money (M/P) excess supply of money, people bid bonds, r and LM shifts to the right (see next slide), at the same time I AD Y N Higher AD moderates decrease of price level, so nominal wage falls faster than price (unbalanced deflation) real wage falls. The model converges towards full employment equilibrium, underemployment equilibrium does not exists.
2/8/2011
mirza asjad baig
11
THE GENERAL CASE WITH THE KE Y NES EFFECT
2/8/2011
mirza asjad baig
12
UNDEREMPLOYMENT EQUILIBRIUM Given the reality of great depression, Keynes was seeking for an explanation of long-lasting underemployment equilibrium. In the longer-run, nominal wage could not have been considered as fixed. When with flexible wages - his model converges to full employment equilibrium, he needed additional assumptions to allow for a theoretical possibility of stable underemployment equilibrium. He, indeed, claims that two cas es arise when underemployment equilibrium exists:
Liquidity trap Interest-inelastic investment function
2/8/2011
mirza asjad baig
13
LIQUIDITY TRAP
When interest so low, that d emand for money becomes infinitely
interest elastic (horizontal), then Absolute liquidity pref erence (nobody wants to purchase additional bonds). Interest does not react to changes in supply of nominal money liquidity trap. LM curve becomes for some low value of interest also horizontal Never observed in reality, in some situation, some economies close(Great Depression, Japan in the1990s)
2/8/2011
mirza asjad baig
14
KEYNES EFFECT LOCKED
When interest very low, only increase expected, i.e. only fall
of bond prices expected as well Even when amount of real money increases, p eople do not bid for bond, but keep additional idle balance as cash Fall of nominal wages and prices (both decrease proportionally balanced deflation) does not lead to fall of i nterest, increase of investment, AD, output and employment. Economy remains at state of rest with involuntary unemployment
2/8/2011
mirza asjad baig
15
LIQUIDITY TRAP
2/8/2011
mirza asjad baig
16
INTEREST--INELASTIC INVESTMENT FUNCTION INTEREST
When investment reacts very slowly to large changes in interest then even
a fall to zero level interest does not have to generate aggregate demand strong enough to allow for full employment equilibrium output. At least theoretically, the economy can stay at state of rest with zero interest and output with involuntary unemployment. Graphicall y: IS curve very steep, full employment output would require ISLM intersection at negative interest rate.
2/8/2011
mirza asjad baig
17
THE INTERESTINTEREST -INELASTIC INVESTMENT CASE
2/8/2011
mirza asjad baig
18
THE CENTRAL PROPOSITIONS OF ORTHODOX KEYNESIAN ECONOMICS F irst Proposition: Modern
industrial capitalist economies are subject to an
endemic flaw in that they are prone to costly recessions, sometimes severe,
which are primarily caused by a deficiency of aggregate (eff ective) demand. Recessions should be viewed as undesirable departures from full employment equilibrium that are generally caused by demand shocks from a vari ety of
possible sources, both real and monetary. Second Proposition: Orthodox K eynesians believe that an economy can be in
either of two regimes. In the Keynesian regime aggregate economic activity
is demand-constrained. In the classical regime output is supply constrained and in this situation supply creates its own demand (Say s Law).
2/8/2011
mirza asjad baig
19
THE CENTRAL PROPOSITIONS OF ORTHODOX KEYNESIAN ECONOMICS
Third Proposition: Unemployment of labour is a major feature of the K eynesian
regime and a major part of that unemployment is involuntary in that it consists of people without work who are prepared to work at wages that employed workers of comparable skills are currently e arning (see for example, Solow, 1980; Blinder, 1988). market economy is subject to fluctuations in aggregate output, Proposition: A unemployment and prices, which need t o be corrected, can be corrected, and therefore should be corrected (Modigliani, 1977, 1986). The discretionary and coordinated use of both fiscal and monetary policy has an important role to play in stabilizing the economy. These macroeconomic instruments should be dedicated to real economic goals such as real output and employment. F ourth
Proposition: In modern industrial economies prices and wages are not perf ectly flexible and therefore changes in aggregate demand, a nticipated or unanticipated, will have their greatest impact in the short run on real output and employment rather than on n ominal variables F ifth
2/8/2011
mirza asjad baig
20
THE CENTRAL PROPOSITIONS OF ORTHODOX KEYNESIAN ECONOMICS
Sixth Proposition:Business cycles represent fluctuations in output, which are undesirable deviations below the full employment equilibrium trend path of output. B usiness cycles are n ot symmetrical fluctuations around the trend. Seventh Proposition: T he policy makers who control fiscal and monetary policy face a non-linear trade-off between inflation and unemployment in the short run. Eighth Proposition: More controversial and less unanimous, some K eynesians,
including Tobin, did on occasions support the temporary use of incomes policies (Guideposts) as an additional policy instrument necessary to obtain the simultaneous achievement of full employment and price stability (Solow, 1966; Tobin, 1977). Ninth Proposition: K eynesian macroeconomics is concerned with the shortrun problems of instability and does not pretend to apply to the long-run issues of growth and development. The separation of short-run demand fluctuations from long-run supply trends is a key f eature of the neoclassical synthesis.
2/8/2011
mirza asjad baig
21
PHILLIPS CURVE
The Phillips curve represents the relationship between the rate of INFLATION and the UNEMPLOYMENT rate. Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.
2/8/2011
mirza asjad baig
22
