Who are you

Keynesian
Monetarist
New classicalist
New Keynesian
Post Keynesian

Finding macroeconomics confusing?

Finding macroeconomics confusing?

Outline of the lecture

Introduction
Chapter 2: Keynes v. the old classical school
Chapter 7: The New Keynesian school
Chapter 8. The Post Keynesian school

Olivier Blanchard

Macroeconomics is not an exact science but an applied one where ideas,

theories, and models are constantly evaluated against the facts,
and often modified or rejected Macroeconomics is thus the result of
a sustained process of construction, of an interaction between ideas
and events. What macroeconomists believe today is the result of an
evolutionary process in which they have eliminated those ideas that
failed and kept those that appear to explain reality well.

Events and ideas (1)

Pre-Keynesian classical economics:
The case against discretionary policies
The Great Depression (1930s)
Keynesian economics, neoclassical synthesis
Inflation (late 1960s and 1970s)
Milton Friedman and monetarism
Stagflation (1970s)
Post-Keynesian re-interpretation of Keynes
Supply-side economics and Reaganomics

Events and ideas (2)

The great embarrassment: microfoundations
New classical economics
New Keynesian economics
Two major groupings:
Keynesians/New-Keynesians/Post Keynesians:
economies are unstable; macroeconomic policy
helps
Classicals/neoclassicals/monetarists/supplysiders/New classicals: economies relatively
stable; macroeconomic policy destabilises

Supply creates demand (Says law)

Money does grow on trees

Demand creates supply

Money does not grow on trees

What the classical economist saw

The determination of output

Real wage

Production function
Law of diminishing returns

Competitive labour
market
Demand for labour
Negatively related to
the real
wage rate
Supply of labour
Positively related to the

Says Law
Supply creates its own
demand
A product
is no sooner created, than it, from that
instant, affords a market for other products to the
full extent of its own value ... The mere
circumstances of the creation of one product
immediately open a vent for other products. (Say,
1821)
Could we suddenly double the productive powers
of a country, we should double the supply of
commodities in every market: but we should, by the
same stroke, double the purchasing power. (J.S.
Mill)
Money does grow on trees

Strong version of Says Law

Output produced
is at the level of
full employment

Real wage

There are no
unexploited
opportunities
There are no
R100 notes on the
pavement

100
Production
creates
income
creates
spending

100

100
Production
creates
income
creates
spending

100

100
Production
creates
income
creates
spending

80

100

100
Production
creates
income
creates
spending

80
20

100

100
Production
creates
income
creates
spending

80
20

20

100

100
Production
creates
income
creates
spending

80
20

20

Unemployment is possible but not

involuntary unemployment

The quantity theory

MV = PY
M - Money supply
V - Velocity
P - Price level
Y - Output

With V and Y fixed and a causality from M to P

an increase in M leads to an increase in P

What happens if the money supply increases?

In the money market a disequilibrium is created Ms > Md

The demand for goods increases
Since Y is at the level of full employment the price level rises
Increase in the price level decreases the real wage
Decrease in real wage causes an excess demand on the labour market
Nominal wages increase to restore the equilibrium

Money is neutral

Unemployment in the classical model

Real
wage

Lt

What about the impact of unions?

Structural and
frictional
Unemployment

What cause changes in the level of output?

Real wage

Change in technology
Change in productivity
Change in labour supply
Change in capital

Business cycles and stabilisation policy (1)

Business cycle: pattern of recovery and contraction in economic activity around long-term trend

Stabilisation policy: policies to smooth the business

cycle
The classical view:
Market economies are inherently stable
Fluctuations reflect exogenous forces (such as
policy mistakes)
Policy intervention should be avoided market
forces would sort out economic problems

The great depression

Wages fell
Prices fell
Output fell
Unemployment increased

What Keynes saw

Principle of effective demand

In a closed economy with spare capacity the level of output
(and hence employment) is determined by aggregate planned
expenditure: C + I

When employment increases, aggregate real income is increased. The

psychology of the community is such that when real income is increased
aggregate consumption is increased, but not by so much as income.
JM Keynes

Hence employers would make a loss if the whole of the increased

employment were to be devoted to satisfying the increased demand for
immediate consumption.
JM Keynes
100

100

80
20

... To justify any given amount of employment there must be an

amount of current investment sufficient to absorb the excess of
total output what the community chooses to consume when
employment is at a given level.

JM Keynes
100

100

80
20

20

equilibrium there is no inducement to either expand or contract output.

those factors which determine the rate of investment which

most unreliable, ...
What determines investment spending?

100

100

80
20

100

100

80
20

Broke the link between

savings and investment

100

100

80
20

Broke the link between

savings and investment

Principle of effective demand:

In a closed economy with spare capacity the level
of output (and hence employment) is determined
by aggregate planned expenditure: C + I

Investment spending
Expected profitability of investment
Interest rate
How does a change in investment spending influence
output?

Multiplier effect

Determining the level of employment

What happens when

investment spending changes?

Keynesian labour market

In assuming that the wage bargain determines
the real wage the classical school have slipped
in an illicit assumption.
There may exist no expedient by which labour as a
whole can reduce it real wage by making revised
money bargains with the entrepreneurs.
JM Keynes
The demand for goods determines the demand
for labour
Given the amount of labour demanded, the
wage is determined
The unemployed have no power to affect
change
Involuntary unemployment is possible

The role of fiscal policy

Money is not neutral

An increase in the money supply leads to a decrease

in the interest rate which leads to an increase in investment spending
If the economy is in a liquidity trap the increase in
the money supply fails to decrease the interest rate.

Business cycles and stabilisation policy (2)

The Keynesian view:
Market economies are inherently unstable
(due to volatile investment spending)
Policy intervention is essential to smooth
cyclical fluctuations

Labour market

The demand for goods determines the demand for labour

The amount of labour demanded determines the wage rate
The unemployed have no power to affect change
Involuntary unemployment is possible

Involuntary unemployment
In the event of a small rise in the price of wage-goods relative to the money- wage,
both the aggregate supply of labour willing to work for the current money-wage and
aggregate demand for it at that wage would be greater than the existing volume of
employment

A decrease in the money wage rate

or an increase in the price level
(or both) can result in a decrease
in real wages

IS-LM model

AS-AD model

Phillips curve

The Phillips curve illustrated the possibility of a trade-off

between inflation and unemployment

Classical view
Says Law: (aggregate) supply creates its own (aggregate) demand
Says Law holds for a barter economy
Says Law also holds for a money economy since money is seen purely as a
medium of exchange, not as a store of value
Weak version of Says Law: production automatically generates income as
payment to the factor inputs which is equivalent to purchase all the output produced
Strong version of Says Law: In addition, the output produced is the full employment
level of output
Thus the strong version of Says Law implies that there is no barrier in a free
market economy with perfectly flexible wages and prices to achieving full employment
Income is either consumed (C) or saved (S) and saving is always spent elsewhere
in the economy
Flexible interest rate (r) ensures that the desired amount of saving always equals
the desired amount of investment spending (loanable funds theory of r)
Y = C(r) + S(r) and E = C(r) + I(r). Since Y = E, then S(r) = I(r)
Neutrality of money: changes in demand for or the supply of money do not
affect real output, employment and relative prices

Keynesian view
Says Law a special case, only holds when aggregate demand (AD) = aggregate
supply (AS)
Principle of Effective Demand: output and employment determined by aggregate
desired spending
If AD AS, it is mainly quantity and not price adjustments that restore equilibrium
AD = E = C + I
C and S are passive, are a function of Y more than they are of r
Money serves as a store of value as well as a medium of exchange
Liquidity preference: in times of uncertainty money may be hoarded
(this implies non-neutrality of money)
Thus S will not necessarily be spent elsewhere, irrespective of changes in r
If S > I, it is mainly via decreases in output, employment and income (Y) that
equilibrium S = I is restored
The effect of autonomous changes in C or I on Y is magnified by the multiplier

Involuntary unemployment
Classical explanation:
No aggregate demand deficiency in terms of Says Law
Labour market: full employment equilibrium is maintained by flexible
real wages
Demand for labour by profit maximising firms: determined by workers
marginal productivity of labour
Supply of labour by utility maximising worker: determined by individual
choice or trade-off between work and leisure
Thus in perfectly competitive markets involuntary unemployment cannot
persist all observed unemployment is either voluntary or frictional
Involuntary unemployment can only persist in uncompetitive or regulated
labour markets
Keynesian explanation:
Aggregate demand deficiencies lead to lower output and employment
(reversal of Says Law)
If AD < AS, then involuntary unemployment is likely to occur and to persist
Downward rigidity of nominal (money) wages prevent labour market from clearing
Real wage can be reduced by increasing AD and allowing the price level to increase

The classical view:

Market economies are inherently stable
Fluctuations reflect exogenous forces
(such as policy mistakes)
Policy intervention should be avoided
market forces would sort out economic
problems

The classical view:

Market economies are
inherently stable
Fluctuations reflect
exogenous forces (such
as policy mistakes

The Keynesian view:

Market economies are
inherently unstable
Policy intervention is
essential to smooth
cyclical fluctuations

Macro dimension of current fiscal policy

Effects of fiscal policy on the level and stability of
aggregate demand
... by expanding governments contribution to the
economy, the fiscus is able to support economic
activity at a time when global and domestic demand
is faltering. This complements the role of monetary
policy in supporting macroeconomic stability,
reducing the impact of the downturn on households
and mitigating its depth and duration. The publicsector infrastructure programme also supports
aggregate demand and boosts vital job-generating
sectors of the economy, while raising long-term
growth potential.

There is no disagreement that we need action by our government, a

recovery plan that will help to jumpstart the economy."
PRESIDENT-ELECT BARACK OBAMA, JANUARY 9 , 2009

With all due respect Mr. President, that is not true.

Notwithstanding reports that all economists are now Keynesians and that
we all support a big increase in the burden of government, we do not
believe that more government spending is a way to improve economic
performance. More government spending by Hoover and Roosevelt did
not pull the United States economy out of the Great Depression in the
1930s. More government spending did not solve Japan's "lost decade" in
the 1990s. As such, it is a triumph of hope over experience to believe that
more government spending will help the U.S. today. To improve the
economy, policy makers should focus on reforms that remove
impediments to work, saving, investment and production. Lower tax rates
and a reduction in the burden of government are the best ways of using
fiscal policy to boost growth.

Short-run and long-run Phillips curves

In the mean time Milton Friedman was up

to something!

MV = PY
In the short run M influences both
P and Y but in the long run only P

Strict monetary policy rule

New classical economics

Robert Lucas

Rational behaviour
Rational expectations
Market clearing

To assume rational expectations is to assume that agents'

expectations are correct on average. In other words, although the
future is not fully predictable, agents' expectations are assumed
not to be systematically biased.

Policy is ineffective if:

Policy changes are correctly anticipated
Expectations are formed rationally
Markets clear

The government can effect the economy, but it

cannot stabilise the economy
Apply policy rules
Be credible

Chapter 7

The new Keynesian school

Keynesian in spirit
A market system does not automatically ensure
full
employment
Effective demand is important
Money is not neutral
Absence of continuous market clearing
This is due to wage and/or price stickiness
explained in terms of rational (maximising
behaviour) including, in some new Keynesian
models, rational expectations
Attempts to explain
Micro foundations for wage and price rigidities
rooted in
maximising behaviour
The absence of continuous market clearing in

Reason for stickiness

Nominal rigidity
Nominal wage long term wage contracts
Nominal price imperfect competition, cost of price
adjustment
Real rigidity
Something is preventing the real wage from adjusting
Labour market
Implicit contracts- Invisible handshake
Efficiency wage
Adverse selection model
Labour turnover model
Shirking model
Fairness model
Insider-outsider

New Keynesians and the business cycle

Chapter 7.8

Originates from the demand and supply side

Frictions and imperfections amplify the shock
Two traditions
Nominal rigidities
Money is non-neutral in the short run
but neutral in the long run
Coordination failure
Cutting prices will benefit all firms
(Figure 7.8)

Price and wage flexibility

Wage and price rigidity is not
the main problem
Financial market
imperfections
Vulnerability
to bankruptcy

Firms

Prefer to cut
production

Risk averse
Credit rationing
(Figure 7.9)

New Keynesian economics

Fluctuations are irregular and unpredictable
Uncertainty in respect of future economic problems

Coarse tuning: Do not support fine tuning neither

fixed policy rules
Not sure whether it should be fiscal or monetary policy
Money is not neutral

Reduce bargaining power of unions

Improving the position of the unemployed

New Keynesians and inflation

Low and stable inflation is good for the economy
Inflation has real economic cost
Distorts the distribution of income
Influence market efficiency
Investment decisions negatively
Damages the well being of the poorest groups
Inflation targeting
Inflation targeting is a strategy for conducting monetary policy pioneered in
the early 1990s by a number of developed and developing countries. The
introduction of this strategy meant that these countries have come to recognize
the potential benefits of price stability. It is therefore common to find that
many central bank legislations have price stability as their principal goal of
monetary policy.
Primary long run goal of monetary policy is therefore price stability

Why inflation targeting

Inflation has serious economic consequences
Fine tuning does not work
It is a framework and not a rule
Gives constrained discretion to central banks
The main argument for the adoption of targets is the notion that to conquer
inflation, and thereafter to preserve price stability, requires policy credibility
and credibility, in turn, requires consistency, commitment, and transparency,
which cannot be without the accountability that arises from the adoption
of the explicit targets
Bleher and Leone (2002):1)

CPIX for South Africa

14

12

10

.
.
.
.
.
.
.
.
.

16

0
38657 38718 38777 38838 38899 38961 39022 39083 39142 39203 39264 39326 39387 39448 39508 39569 39630 39692
38626 38687 38749 38808 38869 38930 38991 39052 39114 39173 39234 39295 39356 39417 39479 39539 39600 39661 39722

Target
Interest rate

Chapter 8

The Post Keynesian School

Paul Davidson

Post Keynesians
Major works of Paul Davidson
"A Clarification of the Ricardian Rent Share", 1959, Canadian J of Econ and Political Science.
"Increasing Employment, Diminishing Returns, Relative Shares, and Ricardo", 1960, Canadian J of
Econ and Political Science, 1960.
Theories of Aggregate Income Distribution, 1960.
"More on the Aggregate Supply Function," 1962, EJ.
Employment and Income Multipliers and the Price Level," 1962, AER
"Public Policy Problems of the Domestic Crude Oil Industry", 1963, AER.
"Modigliani on the Interaction of Real and Monetary Phenomena", with E. Smolensky, 1964, REStat.
Aggregate Supply and Demand Analysis with E. Smolensky, 1964.
"Keynes's Finance Motive", 1965, Oxford EP.
"The Importance of the Demand for Finance", 1967, Oxford EP.
"A Keynesian View of Patinkin's Theory of Employment", 1967, EJ.
"The Valuation of Public Goods," 1968, in Garnsey and Hibbs, editors, Social Sciences and the
Environment.
"Money, Portfolio Balance, Capital Accumulation, and Economic Growth," 1968, Econometrica.
"The Demand and Supply of Securities and Economic Growth and its implications for the KaldorPasinetti vs. Samuelson-Modigliani controversy", 1968, AER.
"A Keynesian View of the Relationship Between Accumulation, Money and the Money Wage Rate",
1969, EJ.
"Money and the Real World", 1972, EJ
"A Keynesian View of Friedman's Theoretical Framework for Monetary Analysis," 1972, JPE.
Money and the Real World, 1972.
"Money as Cause and Effect", with S. Weintraub, 1973, EJ.
"Market Disequilibrium Adjustments: Marshall Revisited," 1974, Econ Inquiry.

Oil: Its Time Allocation and Project Independence," with L.H. Falk and H. Lee, 1974, BPEA.
"Post-Keynesian Monetary Theory and Inflation", 1977, in Weintraub, editor, Modern Economic Thought.
"A Discussion of Leijonhufvud's Social Consequences of Inflation", 1977, in Harcourt, editor, Microfoundations of Macroeconomics.
"The Carter Energy Proposal", 1977, Challenge.
"Money and General Equilibrium," 1977, Economie Appliquee.
"Why Money Matters: Some Lessons of the Past Half Century of Monetary Theory", 1978, JPKE.
"The United States Internal Revenue Service: The Fourteenth Member of OPEC?", 1979, JPKE.
"Post Keynesian Approach to the Theory of Natural Resources", 1979, Challenge.
"Monetary Policy, Regulation and International Adjustments," with M.A. Miles, 1979, Economies et Societies.
"Oil Conservation: Theory vs. Policy", 1979, JPKE
"What Is the Energy Crisis?", 1979, Challenge
"Keynes's Paradigm: A Theoretical Framework for Monetary Analysis", with J.A. Kregel, 1980, in Nell, editor, Growth, Property and Profits.
"The Dual Faceted Nature of the Keynesian Revolution: The Role of Money and Money Wages in Determining Unemployment and
Production Flow Prices," 1980, JPKE.
"Keynes's Theory of Employment, Expectations and Indexing", 1980, Revista de Economia Latinoamericana
"Post Keynesian Economics: Solving the Crisis in Economic Theory", 1981, in Bell and Kristol, editors, The Crisis in Economic Theory.
"Can VAT Resolve the Shortage of Savings (SOS) Distress?", 1981, JPKE.
"Alfred Marshall is Alive and Well in Post Keynesian Economics", 1981, IHS Journal.
"A Critical Analysis of the Monetarist-Rational Expectations Supply Side (Incentive) Economics Approach to Accumulation During a Period
of Inflationary Expectations," 1981, Kredit und Kapital.
International Money and the Real World, 1982.
"Rational Expectations: A Fallacious Foundation for Studying Crucial Decision-Making Processes", 1982, JPKE
"Monetarism and Reagonomics", 1983, in Weintraub and Goodstein, editors, Reagonomics in the Stagflation Economy.
"The Dubious Labor Market Analysis in Meltzer's Restatement of Keynes's Theory," 1983, JEL.
"The Marginal Product Curve Is Not The Demand Curve For Labor and Lucas' Labor Supply Function Is Not the Supply Curve for Labor",
1983, JPKE.
"An Appraisal of Weintraub's Work", 1983, Eastern EJ.
"Reviving Keynes's Revolution", 1984, JPKE.
"The Conventional Wisdom on Deficits Is Wrong", 1984, Challenge.
"Incomes Policy as a Social Institution", 1985, in Maital and Lipnowski, editors, Macroeconomic Conflict and Social Institutions.
"Policies For Prices And Incomes", 1985, in Barrere, editor, Keynes Today.
"Financial Markets and Williamson's Theory of Governance: Efficiency vs. Concentration vs. Power", with G.S. Davidson, 1984, Quarterly
Review of Economics and Business.

"Liquidity and Not Increasing Returns Is The Ultimate Source of Unemployment Equilibrium", 1985, JPKE.
"Can Effective Demand and the Movement Towards Income Equality Be Maintained in the Face of Robotics ?", 1985, JPKE.
"Sidney Weintraub - An Economist of the Real World", 1985, JPKE.
"A Post Keynesian View of Theories and Causes of High Real Interest Rates", 1986, Thames Papers in Political Economy.
"Finance, Funding, Savings, and Investment", 1986, JPKE.
"The Simple Macroeconomics of a Nonergodic Monetary Economy vs. a Share Economy: Is Weitzman's macroeconomics too simple?", 1986,
JPKE.
"Financial Markets, Investment, and Employment", 1988, in Matzner et al, editors, Barriers to Full Employment.
"Sensible Expectations and the Long-Run Non-Neutrality of Money", 1987, JPKE.
"A Modest Set of Proposals for Remedying The International Debt Problem", 1987, JPKE.
"Weitzman's Share Economy And The Aggregate Supply Function", 1988, in Hamouda and Smithin, editors, Keynes and Public Policy After
Fifty Years.
"Endogenous Money, The Production Process, And Inflation Analysis", 1988, Economie Apliquee
"A Technical Definition of Uncertainty and the Long Run Non- Neutrality of Money", 1988, Cambridge JE.
Economics for a Civilized Society, with G. Davidson, 1988.
"Keynes and Money" 1989, in Hill, editor, Keynes, Money, and Monetarism
"Prices and Income Policy: An Essay in Honor of Sidney Weintraub", 1989, in Barrere, editor, Money, Credit, and Prices in Keynesian
Perspective.
"Patinkin's Interpretation of Keynes and the Keynesian Cross", 1989, HOPE.
"Only in America: Neither The Homeless Nor The Yachtless Are Economic Problems", 1989, JPKE.
"The Economics of Ignorance Or Ignorance of Economics?", 1989, Critical Review
"Shackle and Keynes vs. Rational Expectations Theory on the Role of Time, Liquidity, and Financial Markets" 1990, in S. Frowen, editor,
Unkowledge and Choice in Economics
"Liquidity Proposals for a New Bretton Woods Plan", 1990, in Barrere, Keynesian Economic Policies.
"On Thirlwall's Law", 1990, Revista de Economia Politica
Collected Writings of Paul Davidson, 2 vols, 1990-1.
Controversies in Post Keynesian Economics, 1991.
" A Post Keynesian Positive Contribution To `Theory'", 1991, JPKE
"Is Probability Theory Relevant For Choice Under Uncertainty?: A Post Keynesian Perspective", 1991, JEP.
"What Kind of International Payments System Would Keynes Have Recommended for the Twenty-First Century?" 1991, in Davidson and
Kregel, editors, Economic Problems of the 1990s.
"Money: Cause or Effect? Exogenous or Endogenous?", 1992, in Nell and Semmler, editors, Nicholas Kaldor and Mainstream Economics
"Eichner's Approach to Money and Macroeconomics", 1992, in Milberg, editor, The Megacorp and Macrodynamics.
"Reforming The World's Money", 1992, JPKE.
"The Elephant and the Butterfly; or Hysteresis and Post Keynesian Economics", 1993, JPKE.

Would Keynes Be a New Keynesian?", 1992, Eastern EJ.

"Asset Deflation and Financial Fragility" 1993, in Arestis, editor, Contemporary Issues in Money and Banking
editor, Can the Free Market Pick Winners?, 1993.
editor, Growth, Employment and Finance: Economic Reality and Economic Theory, with J.A. Kregel, 1994.
"The Asimakopulos View of Keynes's General Theory", 1994, in Harcourt and Roncaglia, editors, Investment and
Employment in Theory and Practice.
"Monetary Theory and Policy In A Global Context With A Large International Debt" 1994, in Frowen, editor, Monetary
Theory and Monetary Policy
Post Keynesian Macroeconomic Theory: a foundation for successful economic policies for the Twenty-first Century, 1994.
"What Are The Essential Characteristics of Post Keynesian Monetary Theory?", 1996, in G. Deleplace and E. J. Nell, editors,
Money in Motion.
"The General Theory in An Open Economy," 1996, in Harcourt and Riach, editors, A Second Edition of the General Theory.
"Reality and Economic Theory", 199?, JPKE
"Are Grains of Sand In The Wheels of International Finance Sufficient To Do The Job When Boulders Are Often Required?"
1997, EJ
Resources on Paul Davidson
Davidson's Homepage at Tennessee.
Bibliography of Davidson
Davidson's archive at PKT

Principle of effective demand

Entrepreneurial economy
Money using economy
Overturn three classical postulates:
Gross substitution axiom
Neutrality of money
Ergodic economic world

Says Law
Income = Spending on current goods
(consumption goods + investment goods)
Demand
Producible goods

Liquid assets
Non-producible
Non-substitutable

Demand
Producible goods

Liquid assets
Non-producible
Zero elasticity of production
Non-substitutable
Zero elasticity of substitution

Money matters
Neutrality of money changes in money supply only affects nominal variables

Is constrained by the finance ability of the banking system to create money

Increase in money supply finances producible goods resulting

in an increase in employment

Cooperative economy

Entrepreneur economy
Production is organised
by entrepreneurs

Contracts are made in

real terms
who hire the factors of production for money and look to their
recoupment by selling the output for money
There is no guarantee that all money paid out will be
spend on their products

Uncertainty
ergodic
There is a stable underlying structure, such
that we can develop theory that can be applied
time after time, consistently.
Non ergodic world
"Uncertainty" means that we simply do not
know what outcomes will occur

True Uncertainty
We live in a world of true uncertainty

I do not mean merely to distinguish what is known for certain from what is only probable
The game of roulette is not subject, in this sense to uncertainty The sense in which I am
using the term is that there is no scientific basis on which to form any calculable
probability whatever. We simply do not know (Keynes 1936)

Damn the torpedoes, full speed ahead

Post Keynesians
Says law is broken
Money does matter in the short and long run
Involuntary unemployment is possible in the long run
Involuntary unemployment is not only caused by rigid wages
Favour fiscal policy directed at investment and infrastructure