1. Keynes
Keynesians,
New Keynesian

2. John Maynard Keynes (1883-1946)
 Born in 1883 in Cambridge, England
 Son of John Neville Keynes
 Neville was a professor of Economics and Logic at Cambridge
Univ., and wrote on Economic Methodology
 Won a scholarship to Eton
 Boy Genius
 Won prizes for his work in the classics, mathematics, history,
English essays
 Wrote papers on contemporary social problems, participated
in crew and debate, acted, read everything
 Became an expert in medieval latin poetry
 Part of Eton’s social elite
 Won a scholarship to King’s College, Cambridge

3. Keynes’ Tract
 Relates money supply variability and
uncertainty to inflation and deflation.
 Variability of prices is a major cause of
business cycles.
 Wages and other costs of production
adjust more slowly than prices.
 Therefore price variability affects profits
and therefore investment.
 Investment cycles cause business cycles.

4. Keynes’ Treatise on Money
 Early elements of the General Theory.
 Expectations are quasi-rational?
 Swings in investment, based on changes in
profits, generate business cycles.
 Saving is passive.
 Introduces a stock-flow analysis.
 Written following Britain’s return to the gold
standard at parity in 1925.
 Argued that under a fixed gold standard, there
is no opportunity for independent domestic
policy.

5. The General Theory
“ I believe myself to be writing a book on
economic theory which will largely
revolutionize—not, I suppose, at once
but in the course of the next ten years—
the way the world thinks about economic
problems.”
-- John Maynard Keynes

6. The General Theory
1. If the consumer is an economic optimizer,
he/she must be unable to buy the goods they
planned to buy because of some kind of
constraint—risk, convention, social institutions,
cash, or ...?
a) According to the classical model, the consumer has
insatiable wants.
b) The consumer sells his/her labor in exchange for
enough income to buy the goods.
c) The money value of the incomes received must be
equal to the value of the output produced.
d) So how can unsold goods pile up in warehouses,
causing firms to lay off workers?

7. The General Theory (2)
2. Say’s Law cannot hold. (“Supply
creates its own demand.”)
a) If spending constraints are in effect,
then there will be a difference
between (unlimited) demand and
“effective demand”.
b) Actual (effective) demand will usually
be “deficient” to purchase total
output.

8. The General Theory (3)
3. Microeconomics and macroeconomics do not
operate on the same basis. One cannot assume
that what is true for the economic agent at the
level of the individual consumer or firm is true
in aggregate. This amounts to the fallacy of
composition.
 In microeconomics, relative price effects dominate.
This is not true in macroeconomics. In
macroeconomics, income effects dominate, making
income more important in determining aggregate
economic behavior.

9. The General Theory (4)
4. Therefore, consumption depends
primarily upon income, not
interest rates.
 C ≠ C(r), but rather C = C(Y)
 “People don’t change their standard of living
simply because the interest rate changes a
few points.”

10. The General Theory (5)
5. Saving occurs as the result of a habit,
convention, or social norm. People on average
set aside a certain percentage of their
income. Saving is not a function of interest
rates.
 S ≠ S(r), but rather S = S(Y)
5. Investment is related to interest rates, but
also to businesspeople’s expectations for the
future.
 That is, I = I(r,E).

11. The General Theory (6)
7. If S = S(Y) and I = I(r,E), then there is no
coordinating variable to bring supply and demand
together in the loanable funds (capital) market.
 There is no reason to assume that supply equals demand
in this market.
 There is no reason to believe that there will be adequate
funds available to provide adequate investment demand.
 Since AD = C + I + G + NX, if investment demand is
deficient, then AD < AS, and inventories may pile up,
with unemployment a natural outcome.
 Without the coordinating variable, this will be the normal
outcome, with AD = AS only happening accidentally.

12. The General Theory (7)
8. Investment is a large and long-term
commitment, and is based on weakly
supported expectations about the future.
This makes investment very different from
consumption. Investment decisions will be
erratic and emotional, and the risks
associated with investment are very high.
As a result, business decision makers will
tend to under-invest, further worsening the
problem of deficient investment.

13. The General Theory (8)
9. It may be a natural outcome of the
organization and institutions of
modern economies that prices and
wages may not be fully flexible. This
would result in markets (like the labor
and goods markets) being unable to
clear, leading to unemployment and
aggregate supply exceeding demand.

14. The General Theory (9)
10. Money plays a key role in the economy. The
use of money leads to uncertainty, and makes
“piercing the veil” impossible. A money
economy is fundamentally different from a
barter economy. The classical dichotomy
cannot hold.
 Interest rates are established in the money market.
 People may rationally hoard money, holding money
for purposes other then making transactions.
11. Equilibrium is not AD = AS. It is a state that
persists.

15. Consumption
7000
6000
Consumption
5000
4000
3000
2000
1000
0
0 2000 4000 6000 8000 10000
Real GDP
U.S. Annual Data, 1929 - 2001

16. Consumption Function
c = mpc = ∆ C/∆ Yd = marginal propensity to consume
C
C = C0 + mpc x Yd
∆C Or
∆ Yd C = C0 + cYd
C0
Yd

17. Original Aggregate
Expenditure Model
Z=AS
Nominal Value
of Output (Py)
C e
D = AD
E*
There is a limit to the
profitable expansion of
output. If Say’s Law held,
there could be no obstacle
to full employ-ment. Output
could profitably be
increased until excess labor
was absorbed. Thus, this is
N*
a refutation of Say’s Law.
Law
Nf

18. o
Real GDP exceeds 45 line
(trillions of 1992 dollars/year)
Aggregate planned expenditure
planned expenditure
10.0
Total Expenditure
C+I+G
8.0
f
d e
6.0
4.0
b c Equilibrium
expenditure
a Planned
C0 expenditure
exceeds
G real GDP
I
0 2 4 6 8 10
Real GDP (trillions of 1992 dollars per year)

19. Policy
Planned
Expenditures
E1
E0
∆G
Y0 Yf Y

20. Alvin Hansen (1887-1975)
 Background
 Taught at Brown Univ., Univ. of Minnesota, and
finally Harvard (1937)
 Famous students
 Wrote a paper pointing out a math error in
Keynes’ Treatise on Money; not enthusiastic
about the General Theory at first.
 Business Cycle Theory (1927)
 1941, Fiscal Policy and Business Cycles
 Extended Keynes’ Policy Recommendations
 Supported Keynes’ analysis of the 1930s
 A Guide to Keynes (1953)

21. Hansen (2)
 Hicks-Hansen Synthesis (IS-LM)
r LM
r*
IS
y* y

22. Hansen (3)
 Hicks (1939) had pointed out problems with
Keynes’ theory, utilizing his own IS-LM
apparatus. Hicks and Hansen worked out the
indeterminacy of the interest rate and other
problems.
 Extensive revision of Keynes’ aggregate
expenditure model.
 1937-38, Advisory Council on Social Security
 Economic advisor to Federal Reserve Board
 Participated at Bretton Woods
 Involved in the Full Employment Act and the
creation of the Council of Economic Advisors

23. Hansen (4)
 Stagnation Thesis
 1938, Full Recovery or Stagnation
 Inadequacy of investment of keep pace,
making it impossible for the economy
to naturally maintain full employment
 Advocated (gov’t) compensatory
finance to compensate for inadequate
private sector investment

24. Abba P. Lerner (1903-1982)
 Background
 Taught by John R. Hicks, Lionel
Robbins, von Hayek
 Socialist at London School
 Focus on policy recommendations,
including functional finance.

25. Paul Samuelson (1915- )
 1970, 1st American Nobel in Economics
 Textbook, Economics
 PhD, Harvard
 Phillips Curve with Solow
wage Consumer
inflation price
inflation
u u
Phillips’ curve Samuelson-Solow Curve

26. Samuelson (2)
 Contributions
 Comparative statics
 Revealed preference theory
 Efficient markets hypothesis
 Product and factor mobility
 Public goods theory
 Methodological innovations
 Use of mathematics
• Called economics “full of inherited contradictions,
overlaps, and fallacies.”
• Dissertation Foundations of Economic Analysis,
published in 1947.

27. Samuelson (Accelerator)
 The desired capital stock is proportional to the
level of output:
K td = αYt
 Investment is the process of moving from the
current level of capital to a desired level:
I n,t = K td − K t −1
 We assume that whatever the capital stock
ended up being last period was the level of
capital that businesses actually wanted:
K t −1 = K td−1 = αYt −1

28. Accelerator (2)
 This allows us to rewrite:
I n,t = K td − K t −1
 As
I n,t = K td − K t −1 = αYt − αYt −1 = α (Yt − Yt −1 )
I n,t = α∆Yt
 Thus investment is related to the rate of
change in output.
 If the economy is growing rapidly, then investment
grows rapidly.
 If the economy is not growing, then investment
slows, and net investment (after depreciation) may
actually be negative.

29. Post Keynesians
 Sraffa, Robinson, Pasinetti, Weintraub, Davidson
 Neo-Ricardian view of production, value, and
distribution
 Oligopolistic corporations. markup pricing
 Endogenous money
 Cyclical instability
 Incomes policy
 Class struggle for income shares, markup pricing
necessitate a permanent incomes policy

30. New Keynesians
 Fischer, Taylor, Howitt, and many others
 Rational expectations, general
equilibrium, microfoundations
 Offer theoretical support at the firm profit
maximization level for Keynesian features
in the economy
 Contracting models
 Menu/transactions costs
 Efficiency wages
 Insider-Outsider theory

31. New Keynesian Theory

32. New Classical View
of Keynesian Economics
 “Failure on a grand scale.”
 Made up of ad hoc assumptions, not built on a
strong foundation of rational agents.
 Must assume rational, optimizing agents.
 Must assume that markets clear.
 Keynesians do not explicitly handle expectations,
and expectations have been shown to be
critically important.
 Have not given explicit structural explanations of
wage stickiness.
 How can you explain persistence in business
cycles?
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33. New Keynesian Economics
 Most economists believe that short-run
fluctuations in output and employment
represent deviations from the natural
rate,
and that these deviations occur because
wages and prices are sticky.
 New Keynesian research attempts to
explain the stickiness of wages and prices
by examining the microeconomics of price
adjustment.
slide 33

34. Small menu costs and
aggregate-demand externalities
 There are externalities to price adjustment:
A price reduction by one firm causes the
overall price level to fall (albeit slightly).
This raises real money balances and increases
aggregate demand, which benefits other firms.
 Menu costs are the costs of changing prices
(e.g., costs of printing new menus or mailing
new catalogs)
 In the presence of menu costs, sticky prices
may be optimal for the firms setting them
even though they are undesirable for the
slide 34

35. Recessions as coordination failure
 In recessions, output is low, workers
are unemployed, and factories sit
idle.
 If all firms and workers would
reduce their prices, then economy
would return to full employment.
 But, no individual firm or worker
would be willing to cut his price
without knowing that others will cut
slide 35

36. New Keynesian Response
(1)
 Persistence:
 There have been and are persistent and
substantial deviations from full
employment. There is nothing to the
persistence question.
• Unemployment in Great Britain was greater
than or equal to 10% from 1923-1939.
• U.S. Great Depression, unemployment was
greater than or equal to 14% for 10 years.
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37. New Keynesian Response
(2)
 Extreme Informational Assumptions
 NK’s accept that adaptive expectations
are ad hoc and unrealistic
 Unconstrained REH implies
unrealistically sophisticated agents
 Bounded rationality
 Structural impediments
37

38. New Keynesian Economics
 Attempts to build Keynesian arguments
based upon rational expectations and
microeconomic foundations.
 Examples:
 Contracting models
 Sticky price models based upon transactions
cost or menu costs
 Efficiency wage models
38

39. New Keynesian Models (1)
 Sticky Prices
 Menu costs and other transactions costs:
• It costs to change prices.
 A firm might hold prices constant even if
demand fell if the firm faced a cost to the
price change.
• Costs: loss of customer good will
• Potential price war
• Menu costs
39

40. New Keynesian Models (2)
 Efficiency Wage Models
 Firms wish to buy worker effort, not their
“attendance”.
 Instead of Y = F(K,N), the firm really operates
according to Y = F(K,eN), where N is the
number of workers or worker-hours, and e is
the effort per worker.
 The firm does not seek to minimize the cost of
labor, but rather seeks to minimize the cost
per efficiency unit.
40

41. New Keynesian Models (3)
 Efficiency Wages, continued
 By paying the worker more than the equilibrium wage
for labor, the firm may reduce the cost per efficiency
unit by reducing the costs associated with:
• Paying supervisors (monitoring costs)
• Hiring replacement workers when the current workers
leave (turnover costs)
• Poor worker morale.
 This leads to:
• Shirking models,
• Turnover cost models, and
• Gift exchange models.
41

42. New Keynesian Models (4)
 Efficiency wage models identify a market
failure:
eN s
$ Ns
Ns > Nd
Nd
N, eN
42

43. New Keynesian Response
(5)
 Sticky Prices
 Menu costs and other transactions costs
 A firm might hold prices constant even
if demand fell if the firm faced a cost to
the price change.
• Costs: loss of customer good will
• Potential price war
• Menu costs
43

44. New Keynesian Response
(6)
 Insider-Outsider Models and
Hysteresis
 Hysteresis: present unemployment is
highly related to past unemployment.
 Past unemployment causes current
unemployment by turning insiders into
outsiders.
 Outsiders cannot exert downward force
on real wages.
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45. The Name
 The name “New Keynesian Theory” was
introduced by Michael Parkin (1982).
 One of the earliest uses of the term “new-
Keynesian Economics” was in an article by
Ball, Mankiw, and Romer (1988).
 “New” is used instead of “neo” to
distinguish from “Neoclassical Synthesis
Keynesian Economics” (a term used by
Samuelson and others), and also to show
it is the counter-argument to the New
Classical Economics.
45

46. Founding Researchers
“What is New Keynesian Economics”, Gordon
(1990)
 The foundations of New Keynesian
Economics are usually attributed to
Stanley Fischer, Edmund Phelps,
and John Taylor.
 The focus has been on
demonstrating the microfoundations
of price and wage stickiness.
46

47. Basic Principles (1)
 According to Gordon, sticky prices implies
that real GDP is a residual, and is not
determined by agents in the economy.
 If this is the case, then firms optimize by
setting prices, and accept quantities
(production levels) as given.
 In the neoclassical and new classical
theories, the firms are price takers and
optimize by setting quantities (production
levels).
47

48. Basic Principles (2)
 Price and wage stickiness emerges from microeconomics:
 Technology of transactions
 Heterogeneity of goods and factor inputs
 Imperfect competition
 Imperfect information
 Imperfect capital markets
 These core elements remove any incentive for individual
agents to focus on nominal demand in price-setting.
 New Keynesian Economics is about macroeconomic
externalities of individual decisions and coordination
failures inherent in free market economies.
 Note that Gordon omits any topics that are not at the
heart of the debate between the New Keynesian and New
Classical economists.
48

49. Demand-side contributions
 Credit rationing as a source of
fluctuations in commodity demand and as
a channel for monetary policy. (Blanchard
and Fischer, 1989)
 Feedback from price stickiness to
aggregate nominal demand. (Taylor,
Summers)
 How the monetary system interferes with
the coordination of intertemporal choices.
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50. What are Keynesians?
Greenwald and Stiglitz, JEP 1993
 The authors claim that Keynesians, new and old,
can be identified viz a viz members of other
schools by their belief in three propositions:
 An excess supply of labor may exist, sometimes for
prolonged periods, at the prevailing level of real wages.
 The aggregate level of economic activity fluctuates
widely—more widely than can be explained by short-
run changes in technology, tastes, or demographics.
 Money matters, at least most of the time, although
monetary policy may be ineffective at times.
 A lot of this boils down to the proposition that at
times quantities adjust rather than prices to
bring about cash-flow equilibria.
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51. Two Strands of NK
Research
1. Nominal price rigidities are the fundamental
ways in which real-world economies differ from
Walrasian Arrow-Debreu economies. Most of
the work here focuses on explaining sources of
rigidity.
 Because of these rigidities, the classical dichotomy
breaks down, and policy can be effective.
1. Even if prices and wages were perfectly
flexible, output would still be volatile. This
flexibility is not the central problem. In fact,
more flexibility might make things worse. This
approach focuses on market failures.
 Thus monetary policy has real effects even when
prices and wages are perfectly flexible.
51

52. Two Strands (Continued)
 The flex-price NK school argues that:
 Natural economic forces can magnify shocks
that seems small, and
 Sticky prices and wages may actually reduce
the magnitude of the fluctuations (as Keynes
argued).
 This makes this group less interested in
the source of the shocks (unlike the RBC
theorists), and more interested in the
mechanisms by which they propagate,
are magnified or diminished.
52

53. Three Ingredients
to the Flex-price Approach
1. Risk-averse Firms.
2. A credit allocation mechanism in which credit
allocating, risk-averse banks play a central
role.
3. New labor market theories, like insider-
outsider and efficiency-wage theories, play a
 1 and 2 explain the magnification of shocks in
role.
the economy.
 3 explains why the shocks may link to
unemployment.
53

54. Risk-aversiveness
 There are imperfections in the equity
market.
 With equity, firms share risk with the equity
holders.
 With debt, firms alone face the risk.
• If equity finance is not available to firms, firms will
naturally be risk-averse.
 Firms do not typically finance a large
percentage of their investment with debt.
Why?
• Equity sales signals future poor performance?
54

55. Risk-aversiveness (2)
 How can firms manage to sell equity at
all?
 Owners of firms are risk-averse and do not
always have perfect information about their
firms futures.
 Equity sales diversifies risk.
 Negatives to Investors
 Negative signal about future performance. The
worst, most over-valued firms are the most
willing to sell their shares.
 Principal-agent problem.
55

56. How does risk-aversiveness
affect the firm?
 The firm will be sensitive to any risky
undertaking.
 Production is a risky speculation.
 Firms are concerned about the consequences
of any actions they might take (instrument
uncertainty), and therefore the bigger the
action the bigger the perceived potential risk.
 Firms know more about the current situation
than they will about any potential situation.
Hence they will tend to avoid (big) changes.
 Firms will adopt a portfolio approach to risk
management.
56

57. Risk-averse firms
 If the demand curve shifts, the firm must
determine what to do. The risk-averse
firm may choose to adjust quantities
rather than prices as a response to risk.
 In a recession, the aggregate supply
curve may shift dramatically. The risk of
production increases dramatically as the
firms’ willingness to accept risk declines
dramatically.
 This may lead to magnified responses in
AS.
57

58. Another example
 A decrease in export prices reduces exporters’ net worth.
 The exporters reduce their output, as well as their demand
for factors.
 Prices fall in the factor sectors, affecting factor firms’
profitability and liquidity, and these firms’ purchases of
factors and capital.
 In response to the increased risk, firms reduce inventories
since holding inventory represents a risk. (This explains a
long-standing mystery about why inventories don’t smooth
output fluctuations.)
 This further reduces output.
 NOTE: There is no need to discuss stickiness of prices or
wages here!
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