Keynesian Economics Part 2 Investment and Output

In my last post on Keynesian economics I outlined a simple example that I think captures the core of Keynes’s economics. It will help to understand this post if you read that one first.

Keynes’s key insight was that an attempt to save by an individual does not always lead to an increase in aggregate saving. I showed how using a simple example in the last post, but we can also generalize the problem. Imagine that each consumer consumes only a fraction of their income (it does not have to be the same across individuals, but I will assume it is for simplicity). Then total consumption spending is given by

    \[C = bY\]

Where C is consumption, Y is income (and total output), and b is the fraction of income spent on consumption (the marginal propensity to consume).

Let’s say that the only spending in the economy is consumption spending. You might already be able to see that we have a problem. Total spending must always equal total income in the economy so that

    \[Y = C = bY\]

Which can only be true if Y=0, so the economy breaks down. Perhaps this scenario is easiest to see if we imagine the case where there is one worker and one firm. The worker works for the firm and gets paid Y. He then decides to buy bY of the output he just produced. The firm realizes he made too much stuff, so he cuts back on production. But this means he reduces his demand for the worker’s labor and cuts his hours. But now the worker makes less so he spends even less and the process continues until no production is carried out at all. The only way we could sustain production through consumption alone would be if nobody wanted to save at all.

If consumption spending isn’t enough to keep firm production positive, we need some demand from another source. One source could be other firms in the form of investment. If we fix income at Y and assume again households only want to consume bY, it is still possible that firms can make up the additional spending by investing (1-b)Y. Keynes argued that there is no reason to expect that investment would always exactly fill gap. If desired investment by firms is less than the difference between consumption and income, they won’t be able to sell all of their product and will cut back on production. We can see that if we write out our equation again, now with investment, it becomes

    \[Y = C + I = bY + I\]

And solving for Y gives

    \[Y = \frac{I}{1-b}\]

So the level of investment determines the level of income. It was through this logic that Keynes concluded that it was the “animal spirits” of firms that determined the state of the economy. It’s possible that the level of investment exactly corresponds to the full employment level of output of an economy, but there is nothing that guarantees that it will.

There are still a few subtleties we need to consider. The first is the role of interest rates. In the classical view of the economy, when people try to save more, they increase the supply of loanable funds, which pushes down interest rates (think of banks having excess money to lend and the only way they can get rid of it is by lowering the interest rate). That lower interest rate then makes previously unprofitable investment projects become profitable and investment rises. If the interest rate falls enough, it’s possible that the increase in investment would be enough to offset the decrease in consumption.

Keynes didn’t deny this possibility. However, he argued (I think correctly), that interest rates are certainly not the only, and likely not even the primary, factor that goes into a firms investment decision. If a firm expects demand to be low due to a recession, there is no interest rate where it will be profitable for them to make that investment. And, as we saw in the last post, by failing to make those investments, firms’ expectations become self-fulfilling and their pessimism is proven correct. Interest rate adjustments alone therefore cannot save us from a Keynesian recession.

Another potential question comes from the assumptions of the Keynesian consumption function. It is obviously unrealistic to assume that each household wants to consume the same constant fraction of their income. People like Milton Friedman have argued that what people really care about when making consumption decisions is their permanent income. If my income falls today, but I expect it to return to its previous level tomorrow, I will borrow in the bad times to keep a constant level of consumption. I think this criticism is valid, but I don’t think it stops Keynes’s story. As long as aggregate consumption is less than total output (which it almost certainly will be), we still need investment to fill the gap. We still rely on expectations of firms to be correct regarding their future demand.

By focusing on the case where investment was exactly enough to move the economy to full employment, Keynes argued that “classical” economists implicitly restricted the economy to a special case. Keynes set out to correct that theory by proposing a “general theory” where investment fluctuated unpredictably and could (and often is) less than the level that would sustain full employment. I think this contribution is extremely valuable and unfortunately often overlooked. Even modern “New Keynesian” models bear little resemblance to the economy Keynes described. Models with money at all are rare and ones that allow the type of monetary disequilibrium in Keynes’s theory are all but nonexistent.

What has been emphasized instead have been the policy implications of Keynes’s work. In my next post I will provide an argument that Keynesian policies do not solve the problem Keynes described.

 

Please Don’t Audit the Fed

Source: Wikimedia Commons

Rand Paul, following in his father’s footsteps, has re-introduced a plan to audit the Fed. Trump supports the plan and even Bernie Sanders voted for it the last time the bill was put up before congress. I have no idea why. There might be an argument for ending the Fed entirely. Larry White gives a good summary of the argument in this video. I’ve written about the American Free Banking System, which worked reasonably well in the absence of a central bank (although the evidence is mixed). And maybe ending the Fed is the ultimate goal of Fed audit supporters and this bill is just a symbolic victory. But it really does essentially nothing useful and could potentially have detrimental effects.

In the press release linked above, Thomas Massie says “Behind closed doors, the Fed crafts monetary policy that will continue to devalue our currency, slow economic growth, and make life harder for the poor and middle class. It is time to force the Federal Reserve to operate by the same standards of transparency and accountability to the taxpayers that we should demand of all government agencies.” Even besides the fact that there is no serious economic analysis I know of that says the Fed makes life harder for the poor and middle class, this statement is complete nonsense.

Does the Fed need to be more transparent? I have a hard time seeing how it possibly could be. The Fed already posts on its website more information than anyone other than an academic economist could possibly want to know. Transcripts from their meetings, their economic forecasts, justifications for interest rate changes – it’s all there in broad daylight for anybody to read. As David Wessel points out in an excellent Q&A on auditing the Fed, the Government Accountability Office (GAO) already knows everything important about most of the assets held by the Fed.

The only possible change that could come as a result of auditing the Fed is more influence by congress over Federal Reserve decisions. That’s terrifying. Whatever your opinion of the Fed, it’s impossible to deny that it’s run by incredibly smart people who have dedicated their lives to understanding monetary policy. That doesn’t make them infallible. I’m all for taking power away from experts, for decentralizing and allowing markets to control money. But if we’re going to allow a group of individuals to decide the policy, at least let them be people who have some idea what they’re talking about. You might not love Janet Yellen, or Ben Bernanke, or Alan Greenspan, but I can’t imagine anyone would prefer monetary policy to be run by congress. Think about the arguments over raising the debt ceiling. Do we want that every time the Fed tries to make a decision? I certainly don’t.

I can absolutely criticize monetary policy. The Fed has come in below its 2% inflation target consistently for about 10 years now even though unemployment had been far from the natural rate. Maybe an NGDP target would be an improvement over the current dual mandate. And maybe we don’t need a central bank at all. I’m not opposed to monetary reform. But I can’t get behind a bill that only appears to make conducting monetary policy more political.

Why Nominal GDP Targeting?

Nominal GDP (in logs) and approximate 6% trend since 1982
Nominal GDP (in logs) and approximate 6% trend since 1982

Probably the best example that blogging can have a significant influence on economic thinking has been Scott Sumner’s advocacy of nominal GDP (NGDP) targeting at his blog The Money Illusion (and more recently EconLog). Scott has almost singlehandedly transformed NGDP targeting from an obscure idea to one that is widely known and increasingly supported. Before getting to Scott’s proposals, let me give a very brief history of monetary policy in the United States over the last 30 years.

From 1979-1982, the influence of Milton Friedman led the Federal Reserve to attempt a policy of constant monetary growth. In other words, rather than attempt to react to economic fluctuations, the central bank would simply increase the money supply by the same rate each year. Friedman’s so called “k-percent” rule failed to promote economic stability, but the principle behind it continued to influence policy. In particular, it ushered in an era of rules rather than discretion. Under Alan Greenspan, the Fed adjusted policy to changes in inflation and output in a formulaic fashion. Studying these policies, John Taylor developed a simple mathematical equation (now called the “Taylor Rule”) that accurately predicted Fed behavior based on the Fed’s responses to macro variables. The stability of the economy from 1982-2007 led to the period being called “the Great Moderation” and Greenspan dubbed “the Maestro.” Monetary policy appeared to have been solved. Of course, everybody knows what happened next.

On Milton Friedman’s 90th birthday, former Federal Reserve chairman Ben Bernanke gave a speech where, on the topic of the Great Depression, he said to Friedman, “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” According to Scott Sumner, however, that’s exactly what happened. Many explanations have been given for the Great Recession, but Scott believes most of the blame can be placed on the Fed for failing to keep nominal GDP on trend.

To defend his NGDP targeting proposal, Scott outlines a simple “musical chairs” model of unemployment. He describes that model here and here. Essentially the idea is that the total number of jobs in the economy can be approximated by dividing NGDP by the average wage (which would be exactly true if we replace NGDP by labor income, but they are highly correlated). If NGDP falls and wages are slow to adjust, the total number of jobs must decrease, leaving some workers unemployed (like taking away chairs in musical chairs). Roger Farmer has demonstrated a close connection between NGDP/W and unemployment in the data, which appears to support this intuition

NGDP_Unemployment
Source: Farmer (2012) – The stock market crash of 2008 caused the Great Recession: Theory and evidence

We can also think about the differences in a central bank’s response to shocks under inflation and NGDP targeting. Imagine a negative supply shock (for example an oil shock) hits the economy. In a simple AS-AD model, this shock would be expected to increase prices and reduce output. Under an inflation targeting policy regime, the central bank would only see the higher prices and tighten monetary policy, deepening the drop in output even more. However, since output and inflation move in opposite directions, the change in NGDP (which is just the price level times output), would be much lower, meaning the central bank would respond less to a supply shock. Conversely, a negative demand shock would cause both prices and output to drop leading to a loosening of policy under both inflation and NGDP targeting. In other words, the central bank would respond strongly to demand shocks, while allowing the market to deal with the effects of supply shocks. Since a supply shock actually reduces the productive capacity of an economy, we should not expect a central bank to be able to effectively combat supply shocks. An NGDP target ensures that they will not try to.

Nick Rowe offers another simple defense of NGDP targeting. He shows that Canadian inflation data gives no indication of any changes occurring in 2008. Following a 2% inflation target, it looks like the central bank did everything it should to keep the economy on track

CanadaCPI

Looking at a graph of NGDP makes the recession much more obvious. Had the central bank instead been following a policy of targeting NGDP, they would have needed to be much more active to stay on target. Nick therefore calls inflation “the dog that didn’t bark.” Since inflation failed to warn us a recession was imminent, perhaps NGDP is a better indicator of monetary tightness.

CanadaNGDP

Of course, we also need to think about whether a central bank would even be able to hit its NGDP target if it decided to adopt one. Scott has a very interesting idea on the best way to stay on target. I will soon have another post detailing that proposal.