Tag: Monetary Policy

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

   

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

   

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

   

And solving for Y gives

   

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.