John Maynard Keynes - History of Economic Thought - Lecture Slides, Slides of Economics

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John Maynard Keynes

John Maynard Keynes (1883-1946)

• The General Theory of

Employment, Interest and

Money (1936)

• A Treatise on Money (1930)

Wage Rigidity

• Keynes argued that wages might not be driven

down by the unemployed.

– Wages in some cases are fixed by long-term

contracts.

– Moreover, workers suffer ‘wage illusion’.

• That is, they would refuse to accept wage cuts but

happily accept price increases even though both these

changes reduce the purchasing power of the wage (or,

the real wage).

Futility of Wage Reductions

• Moreover, Keynes made an informal argument

that even if the wage fell, there was no guarantee

that the unemployed would be hired.

• If wages fell, the workers would be poorer and would cut back on their shopping.
• This would lead to a fall in the prices of goods.
• As a result, businesses would not find it viable to hire

more workers;

• although wages have fallen, the lower prices of manufactured goods would still make it hard to hire workers.

The Multiplier

• But apart from the direct effects of expansionary fiscal policy on employment, there would also be a chain of indirect effects.
• If one set of unemployed workers get hired, they would have some extra money in their pockets.
• Therefore, they would go shopping.
• This would induce businesses to hire some more of the unemployed.
• These workers would, therefore, have some extra shopping money and their shopping would similarly create more jobs.
• And so on and on the process would go, creating more and more jobs.
• As a result of this chain effect—called the multiplier—a $10 million increase in government spending would end up adding to GDP by not $10 million but by a multiple of $10 million. - Keynes borrowed this idea from his contemporaries, Richard Kahn and Ralph Hawtrey.

Thrift makes the multiplier smaller

• The indirect multiplier effect of fiscal policy was shown

to depend on the attitudes of consumers.

• The less thrifty they were the bigger would be the

number of additional jobs created by expansionary fiscal policy.

• If workers are free spenders by nature, then any group

of newly hired workers would go on a spending binge and this would create a large number of additional jobs for the unemployed.

• If workers are thrifty by nature, their shopping would

be pretty tame and only a small number of additional jobs would be created.

Speculative Demand for Money

• The classical theory of the demand for money had said that people carry cash in their wallets only because cash is needed for shopping (that is, only for transactions purposes ). - After all, the classical economists argued, as cash does not earn interest, you would be better off using your money to buy stocks and bonds so that your wealth would grow.
• Keynes argued that people should carry cash for the sensible management of their wealth as well as for transactions purposes.
• Suppose you are convinced that the interest rate on long-term bonds would soon go up.
• It would not be a good idea to use all of your savings to buy bonds. You should hold on to some cash. - That way, when the interest rates do go up, you would have some ready cash with which to buy those high interest bonds.
• Therefore, Keynes argued, sensible wealth management required that people hang on to some cash even if they don’t need it for shopping.

The Demand for Money

• Moreover, Keynes’s liquidity preference idea implied that

the demand for money would be inversely related to the

interest rate.

• If interest rates are currently very high, then it is likely that they will soon fall.
• Therefore, it would not make sense to carry cash; it would better to spend all your savings to buy the bonds and lock in the current high interest rates.
• On the other hand, if interest rates are currently low, then they would be likely to rise soon.
• This gives people a good reason to hang on to cash and be ready to snap up the bonds when interest rates rise.
• Therefore, the demand for money would be high when

interest rates are low.

Monetary Policy

• The neoclassical theory of investment had argued that

investment increases when interest rates fall and vice versa.

• Therefore, if the central bank increased the money

supply by printing more money and lending it to borrowers, the interest rate on borrowed money would decrease.

• This in turn would increase investment spending by

businesses.

• This would increase the production of capital

equipment for businesses and, thereby, reduce unemployment.

Stabilization Policy

• Thus, we see that Keynes had proposed two

cures for unemployment:

– expansionary fiscal policy, and

– expansionary monetary policy.

• However, of these two cures, Keynes preferred

expansionary fiscal policy and had doubts

about the effectiveness of monetary policy.

Founder of Macroeconomics

• Keynes is regarded as the pioneer of

macroeconomic theory and policy

On the cover of Time , December 31, 1965, nearly two decades after his death!