Questions
1. Explain how the neoclassical synthesis misunderstood the real contribution of Keynes. The IS-LM framework is based on interpreting Keynesian theory as being based on fixed wages in the short run. Label this as Pseudo-Keynes or PK. Contrast what Keynes really said Real Keynes (RK) with what neoclassicals understood of Keynes or PK.
Answer: Ideas of Keynes were never understood by economists. Keynesian revolution never took place. Similarly, Keynesian policies were never implemented because it was some bad approximation of real policies of Keynes. Keynes said that I am not a Keynesian. Like Minsky many economists questioned the degree to which Keynesian theory and policy actually followed Keynes General Theory. All this can be attributed to neoclassical synthesis (a term introduced by Paul Samuelson). Sometimes called the Hicks-Hansen model or the famous ISLM model (this is misleadingly presented in mainstream macroeconomics course as Keynes’s model). Neoclassical synthesis gives short run to Keynes and it keeps the long run. In long run classical concepts prevail but in short run rigidity of prices leads to unemployment. This is sever misunderstanding of Keynes. According to Keynes negotiations take place in terms of nominal wages that eliminates the possibility of profit maximization. Supply and demand analysis fail in the labor market. But in classical synthesis all Keynesian ideas were rejected. Only idea that is said to be Keynesian (Keynes explicitly rejects this) is the rigidity of wages in the short run.
2. Explain how misunderstanding Keynes (PK) leads to the central importance of money illusion and how long it lasts in the debate on economic policy. Explain the short run versus long run Phillips curve -- the expectation augmented Phillips curve (EAPC) developed by Friedman
Answer: Keynes rejects utility maximization, profit maximization and supply and demand in labor market. But in Neo-Classical synthesis all of these Keynesian ideas were rejected. Only idea that was said to be Keynesian although Keynes explicitly rejects this in General Theory is that Keynes thought that wages are rigid, when wages are rigid its very easy to see that supply and demand equilibrium will not work. Negotiations take place in nominal wages because there is money illusion. People confuse nominal wage with the real wage. The don’t notice that prices are rising and so if you have money illusion than all Keynesian phenomena can be established. So, Keynes was reduced to the concept of money illusion.
The great debate which occurred in post-war period (1950-1970) was about the differences over parameters (interest rate elasticity of investment and income elasticity of money demand). Money has short run impact on interest rate because of money illusion. But how long this money illusion will last was the question that need to be answered. Keynesian said that it is easy to fool workers, money illusion can be created quickly and lasts for a long time. Monetarists were of the view that money illusion will quickly disappear and monetary policy will have long and variable lags and it will have harmful long run effects so we should not have this kind of policy. There was agreement between Keynesians and monetarists that wage rigidity leads to unemployment. The solution was to expand money supply. Increase in money supply will cause prices to rise and decline in real wages. Fixed nominal wages will fool workers in to working more and firms in to hiring more, raising output and restoring equilibrium. This will work temporarily and these policies will lead to inflation. Keynesian thought the policy makers faced an inflation-unemployment trade-off (Philips curve) and could choose preferred outcomes. It is not part of Keynesian theory but Keynes thought that money supply beyond a certain level will cause inflation and below it will lead to unemployment. So, the two were separated. According to Philips curve there are two things output gap and inflation. If output gap is zero or negative, there will be inflationary pressure because economy is trying to grow more than its capacity. With a reduction in output gap, inflationary pressure will also be reduced. There is a trade-off between these two things. Monetarists thought that the inflation choices would get built into the system, and cause harm to the efficiency of the system. They thought that Keynesian policies would accelerate inflation. The monetarist argued that if government attempted to reduce unemployment below the natural rate (sometimes called non-accelerating inflationary rate of unemployment or NAIRU), then as the inflation rate rose, workers would demand even higher money wages to achieve their desired real wage levels. Ultimately, this would result in a rising rate of inflation. Expectations augmented or expectations adjusted Phillips curve showed that there is no trade-off between inflation and unemployment in the long run. It allows for the effects of price changes on money wages. Thus they (monetarists) recommends tight fiscal policy and fixed rule of money growth (Friedman’s rule). So, you need to have inflation because without inflation real wage adjustment cannot be done easily. This was macro debate up until 1970’s.
3. Explain how stagflation in the 70's supported Monetarist theories against PK theories, and therefore Monetarism emerged as dominant Macro theory in the Reagan-Thatcher era. Explain some of the key failures of Monetarist policies in this era. Explain some of the absurd assumptions of Monetarist theories.
Answer: Stagflation of 1970’s ended the great debate between Keynesian and Monetarists in favor of Monetarists. In 1970’s there was Yom Kippur War, in which US supported Israel and Arab countries retaliated by imposing an oil embargo. This resulted in cost push inflation with high unemployment at the same time. This was not in line with the Keynesian theories and they were not prepared to offer policies for this unexpected situation. They offered some policies such as wage and price control but these were not in line with Keynesian thoughts. In early 1970’s, Keynesian school was dominant but things changed after this oil price shock. According to shock doctrine, Chicago school was prepared with their policies but waiting for the right time i.e. a shock. According to Friedman, who was master of psychology, people believe anything in a shock. The solution they presented was the deregulation and free markets. This led to Reagan-Thatcher counter revolution. Reagan in US and Thatcher in UK started implementing free market policies of Classicals which had been rejected by Keynes.
In 1980’s monetarists suffered a defeat when Federal Reserve tried to implement Friedman’s rule to hit money growth targets but failed to hit them. The reason is that central bank cannot control money supply. In 2014, Bank of England published a paper in which they admit that standard theory of money multiplier is wrong. This is not in line with the creation of money and explained the process of money creation by banks. This was learned by policy makers in 1980’s but not by economists who continued to teach false theories. At that time there were large number of papers written on the stability of demand for money because money was not behaving according to the theories of monetarists. They quietly concluded that money demand is not stable. They tried many definitions of money but failed again. The solution to this problem was discovered by Richard Werner in his quantity theory of credit.
4. In the past few decades, policies have been based on the EAPC - Explain how policies based on Minskian ideas would be like. Explain how taking sectors of the economy into account offers an advance over the original Keynesian theories based on expansionary monetary policy to fight recessions.
Answer: Following are the policy recommendations of Minsky:
· Minsky believed that Government need to promote policies that should create jobs in the most neglected sector of the economy. These job opportunities will reduce unemployment and will alternatively raise the living standard of people.
· Like Keynes Minsky also believed in government spending in targeted area rather than “pump priming”. Investments were not made in public sector because it had been thought to work out in private sector. We can create more jobs by spending in public sector. We need to pour money into the sectors where there are jobs e.g. infrastructure.
· The global warming creates a large number of possibilities for creating jobs i.e. planting trees, moving towards cleaner energy production, retrofitting buildings to make them energy efficient, reforestation etc. A large number of jobs can be created moving towards green economy.
But with all these projects, we may not be able to create enough jobs; because there are problems like skill mismatch, discrimination in ethnic groups, gender, education, criminal records and geographical mismatch (jobs need to be created where the unemployed live). Keynes noted that and made a point that whenever an economy improves it is more important to rightly distribute and target the more desirable locations/ area, where jobs are needed. And for these reasons Minsky say’s Government should be an employer of the last resort. i.e. everybody should get a job and that the job should be productive. He believed that training and education programs were ineffective and people that need jobs should be hired as they are, where they are, by the government, and on-the-job training should be a key.
Post-War Evolution of Macroeconomic Thought - YouTube Lecture 11 of Adv Macro II on Minsky Ch2: The Road Not Taken