Jim’s Notes

Keynesian Theories

Why Keynesian Theory? Context, Environment, and Concerns with Classical Theory

Context and Environment in which Keynes Writes

Great Depression

The Classical Theory says the economy corrects itself in the long-run.
But after seven years of continuing depression, in 1923 John Maynard Keynes counters with the observation that ‘in the long-run we are all dead’.

Global Economy Stumbles

Versailles Treaty and Inflations

Failed Gold Standard

Tariff Wars

Declining International Trade

Financial bubbles and banking crises

Rise of Fascism and Communism

Fears capitalism won’t survive

Explain Data/Events Classical Theory Can’t Explain such as Great Depression

Is market capitalism inherently unstable?

Can depressions continue forever? Are depressions inevitable?

Role of government in a highly industrialized economy with large corporations, unions, and monopolistic industries

Any alternative to state socialism?

Can ‘democratic’ governments restore full-employment in a modern industrial economies?

Introduce role of uncertainty about the future and imperfect expectations

Keynesian Assumptions and Insights

Markets are NOT necessarily efficient or competitive

Wages and Prices are ‘sticky’

Monopolistic firms reduce output not prices

‘Efficiency’ wages

Expectations (not just current prices) –> Plans –> Consumption spending, savings plans, investment spending, and liquidity preferences

C (consumer spending) based on expectations for future:

Job security
Price levels
Interest rates
Life expectancy
Wealth, not just income

I: Investment spending based on commitments fixed in the past and expected economic conditions in future

Expected future interest rates and ability to refinance
Expectations of future sales, capacity, profits, conditions
NOTE: Not the current level of income!

Expectations can be proven wrong

Unexpected and unknowable events:
Future resource costs
Technological change
Changes in tax structure
Other destabilizing events
Recent growth rates

Say’s Law won’t always hold

A liquidity preference (desire to hold cash and not spend it) exists and varies independently of interest rates.

Liquidity preference is a desire to convert more or less of current income (S, a flow) into cash assets (a stock)

Since S and I are both determined by more than just interest rates, changes in interest rates won’t necessarily cause the quantity of S supplied to equal the quantity of I demanded

I does NOT necessarily equal S

‘Animal spirits’

Capital markets prices can be irrational for periods of time

mob behavior can create irrational pricing in capital markets and/or change liquidity preference (Capital Markets Can Be Irrational and Not Efficient at Times)

Money Supply is Expandable

Money supply (credit) in the economy is partly endogenously determined and is not dependent on a supply of some physical good like gold.

Government (often through central banks) can expand money supply and expand supply of safe, risk-free financial assets

Countercyclical Fiscal Policy:

G: Government Spending and budget balance is autonomous and can offset

Budget controlled of public officials – government can run a deficit if desired. No budget constraint is binding.

Governments can run persistent though not unlimited deficits – the so-called ‘government budget constraint’ is not hard and not create crowding out

Private corporations, especially monopolistic ones, are not necessarily more efficient at all types of production than government.

Public goods and infrastructure must be funded by government.

Assumptions Compared: Keynesian vs. Classical


Say’s Law
Rational utility- and profit-maximizers (rational expectations)
Current income/prices drive C and I
Competitive markets and flexible prices
Interest rates determine S and I
SRAS/LRAS matter


Sticky prices
Monopolistic markets
Expectations drive C and I
I =/= S.
AD matters

A Simple Keynesian Model

How Gaps and Problems Happen

Mechanism: Shifts in AD

Changes in Expectations and Policies –> changes and shifts in AD (C, I, and G) –> create gaps
Increasing pessimism, fear, and defaults create Recessionary gaps
Increasing optimism, over-excitement, and over-leverage create Inflationary gaps
Sticky prices and monopolistic markets prevent the Classical correction mechanism

Using Circular Flow

No R.O.W.
not really a necessary assumption, but a simplifing assumption for this course now. Adding R.O.W. doesn’t really change the conclusions.

Simple numerical example of counter-cyclical policy

Using AD-AS model

Keynesian Recommendations:

Concept: Policy should stabilize AD and manage/smooth out the macroeconomic business cycle

NOT socialism or government running actual businesses or industries.

Monetary policy:

Active central bank actions to manage interest rates

To Slow an overheating economy: higher rates –> discourage I and encourage S –> slows AD
To Stimulate a slow economy: lower rates –> encourage more I and discourage S (more C) –> increase AD


‘Pushing on string’: Central banks can only change base interest rates, they can’t force businesses or consumers to borrow and spend.
Zero lower bound: if interest rates are already lower, then they can’t go negative (at least not easily) and the central bank can’t stimulate

Fiscal Policy to Manage AD to stabilize a private economy prone to

Counter-cyclical fiscal policy

Change G and T to offset changes in C and I

Simple numerical example of counter-cyclical policy

Automatic Stabilizers and Banking-Financial System Regulation

Idea: reduce fear, uncertainty, and excessive mania

Improve Confidence and Expectations

Laws and government programs that automatically ‘kick-in’ as the economy either slows too much or overheats. Automatic stabilizers, once created, do not require a current political repsonse to deal with changing macroeconomic conditions.

Using Circular Flow

No R.O.W.

not really a necessary assumption, but a simplifing assumption for this course now. Adding R.O.W. doesn’t really change the conclusions.

Using AD-AS model

Fiscal Policy – What It Is

Government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables

Federal Budget, Expenditures and Tax Revenues

G+Gtransfer > T –> budget deficit

G+Gtransfer < T –> budget surplus

G+Gtransfer = T –> balanced budget

Discretionary policy requires an act of Legislature (Congress) and the President

Stimulus effect:

Raise G, lower T

Increase deficit (or reduce the surplus)

Contractionary effect:

lower G, raise T

Increase surplus (or reduce deficit)

Types of Fiscal Policy

Tax Oriented

Spending Oriented

Two categories

Automatic stabilizers
Discretionary fiscal policy

Automatic Stabilizers

Automatic Stabilizers automatically increase deficits when economy slows and reduce deficits/create surpluses when economy grows faster


Disaster safety nets
Unemployment insurance
Social Security
Banking deposit insurance
Securities regulation

Automatic stabilizers have been a tremendous success. They are largely responsible for making sure that recessions have been relatively short and mild in the post-World War II era.

Keynesian Results

Keynesian Conclusion:

Modern capitalist economy with sophisticated financial markets:

necessarily unstable cyclically
can get ‘stuck’ in long recession/depression with very high unemployment
will NOT automatically correct itself without policy changes.

Government should use policies (monetary, fiscal, and regulatory) to stabilize the macroeconomy (via AD)

Keynesian Successes

Ended Great Depression

Mild and short recessions between 1940’s until 2007

‘Fine tuning’ appeared to work: 1950’s and 1960’s

Short, mild, infrequent recessions

Widespread use of Keynesian policies coincided with 30 year ‘golden age’ when U.S. and world real GDP growth was strongest

Keynesian Fiscal Policies largely prevented recurrences of severe depressions following major financial crises in 1990’s (Asia and Japan) and 2008 (US, Europe, China, others)

Keynesian Failures

Stagflation of 1970’s

Political difficulties in use:

Difficult to ‘fine-tune’
Political capture of spending flows: ‘military Keynesianism’
Rising deficits and debt, both private and public
Rarely is ‘contractionary’ fiscal policy used, even if needed
Tendency to use fiscal stimulus policy, even if the problem is Aggregate Supply shock.