Econ 488: The Advanced Macro Adventure!

Lekachman, Robert. 1966. The Age of Keynes, 58-111. New York, NY: Random House.

Chapters three and four in Lekachman’s book describe the factors leading up to Keynes’ General Theory, some of his earlier influential work, the major innovations the General Theory introduced, and the impact this work had on economic thought in general. Keynes’ early work mostly pertained to public policy and applied economics. Up until this point, economics had been mostly research for the sake of the advancement of knowledge, but offered little in the way of advice to policymakers. Keynes argued that economic theory isn’t just a method of observation, but rather a set of tools that can be used to make informed decisions by narrowing an otherwise large set of possible outcomes. One of his first major attacks on classical economic theory related to its treatment of investment, which assumed that investment is necessarily a perfect conversion of savings into capital. In fact, this is not true. Saving is not always transferred into investment, and when this is the case overall output is lowered since these funds are neither being used in consumption nor are they being recycled into capital. Prior to his general theory, Keynes also speculated about the existence of a multiplier effect, specifically in relation to government spending.

In his General Theory, Keynes focuses most importantly on the effect aggregate demand has on equilibrium conditions. Previously, Say’s Law implied a self-perpetuating equilibrium where any change in supply would lead to equivalent adjustments in demand. Variation in demand was assumed to have no effect on aggregate demand, but rather only on the make up of aggregate demand. Realistically, aggregate demand is influenced by consumption, investment and government policies. In particular, Keynes focused on the topic of consumption since an individual’s decision on how best to allocate his funds is influenced by a number of possible perspectives not influenced by the interest rate at all, but mostly relating to expectations on economic conditions. Previous labor theories naively assumed that individuals rationally assessed a cost benefit analysis in regard to wages, and that if they are unable to find a job at the wage rate they feel they deserve they will remain voluntarily unemployed. Realistically, in a time where jobs are scarce, workers may adjust their expectations and accept a job below their marginal product of labor, or may have no other choice than to remain involuntarily unemployed. Keynes also discusses the importance of expectations in the investment market, as these are not definite figures. He considered expectations for capital to be more or less arbitrary, and accentuates the importance of fleeting hopes on the part of investors.

Stylistically, this book maintains the complexity of Keynes’ theories without using convoluted, overwhelming language. The parts that are anecdotal are both relevant and brief (which is rarely the case when such items are included). Lekachman focuses on the environmental factors which inspired Keynes, placing his work in both a historical and social context. This approach makes it easier for a reader to internalize the concepts of Keynes’ work, and also lends to the credibility of the theory itself. Since the book is also written chronologically (as opposed to being separated by topics), it is also easier to see the progress of Keynes’ ideas and how his later ones were more perfect revisions of his own previous positions.

Blaug, Mark. 1978. The neoclassical theory of money, interest, and prices. In Economic Theory in Retrospect, Third edition, 645-664. Cambridge University Press, London:

Blaug’s chapter on neoclassical monetary theory, overall, is extremely technical but concise. He explains how neoclassical theory stemmed from its classical predecessor and how it developed over time. In particular he focuses on Fisher’s transaction approach and Wicksell’s cash balance approach.
            The quantity theory of money was primary monetary theory until the 1930’s, stating that as the money supply increases, prices increase. However, the theory fails to recognize the dual uses of money; it is both a means of exchange and of storing value. Furthermore, it assumes that the velocity of circulation (V) is a constant, and lacks a mechanism explaining how the money market returns to equilibrium. Classical quantity theory is only good for explaining how money supply influences prices in the long run. Neoclassical quantity theory focuses on the short run, and assumes that V is unstable during a transition period between equilibria.
            Fisher’s work was one of the first to treat V as though it were inconstant. He primarily assumed that the supply of money was equal to the percent of aggregate income held as cash adjusted for price. His work did not allow for changes in interest, price, or price level as he assumed that these changes were only temporary deviations from the equilibrium. As was the issue with classical quantity theory, the only purpose for currency was to prevent people from spending beyond their means.
            Wicksell’s theory augmented Fisher’s work by explaining the relationship between money and price in terms of the interest rate. Wiksell differentiated between currency and credit, referring to the former exclusively as money and the latter as bank deposits. Credit is more elastic, and has a better response time to changes in the interest rate. When discussing interest, he often referred to a “natural rate”, which he took to mean the marginal efficiency of new capital. Since the marginal efficiency of new capital can only be predicted, Wicksell describes a “cumulative process” that addresses discrepancies between the market interest rate and expected returns from investment. In the cumulative process, disequilibrium occurs when there is an increase in net investment. The bank interest rate will then have to increase so net investment remains less than or equal to voluntary savings. In a monetary equilibrium, the loan rate will correspond with the expected returns on new capital, the demand for capital equals the supply of savings, and prices will not move. In this case, money is neutral and has no impact on the price level.
            In one time period, if investment exceeds savings then output will not be translated into disposable income, and there will be inflation. If savings exceeds investment, output will have a lower money value. To stabilize price, the market rate of interest will be determined based on the supply and demand of loan funds. Demand for loan funds is the sum of the demand for investment and inactive cash. The supply for loan funds is the sum of personal and business savings and bank credit. An increase in technology leads to an increase in productivity which would lead to variation in prices. To prevent this, the money supply must increase or output will stagnate.
            Wicksell’s cumulative process fails to mention the stabilization of forced savings, the real balance effect, and changes in expectations. He assumes that expectations are determined based on the previous period, and that changes in prices will lead to future, equal changes in prices. If this is the case, there will be eternal equilibrium instability in the money market. In reality (not in Wicksell’s argument), firms expect lower prices in the future and lower returns, and will therefore choose to invest less causing investment and price to hover around an equilibrium level.
            Keynes separated the saving/investment equilibrium from the employment equilibrium. In an economy with underemployment, fiscal measures should be taken to change output and prices in the short run. He adds to the previous model further by including government spending. Inflation occurs when demand exceeds output, leading to the real balance effect: people will decrease their spending because of the decreased value of their money, leading to increased savings. Prices will increase after an increase in the money supply, and banks will raise the interest rate to slow investment. The increase in cash transactions will help slow inflation.
            Blaug concludes by walking through Wicksell’s Lectures. Wicksell states that V is constant in a pure-cash economy, and that it is a function of the liquidity preference in a pure-credit economy. The demand for money should be divided into that of an individual and of the market. An individual’s demand for money is negatively correlated to prices. Demand for money in the market place is positively correlated with prices, as it results from an increase in the supply of commodities. The normal interest rate is determined by returns on real capital, equilibrium in the supply and demand of savings, and has no effect on the price level. When the market rate decreases, voluntary savings decrease and forced savings increase. Finally, Wicksell disliked the gold standard in banks as it forced them to appease both domestic and international prices for gold.

All you sneaky devils already took the library books that I searched for oh-so dilligently last night, so Greenlaw gave me a website to look at!

 http://cepa.newschool.edu/het/essays/mac…

The website outlines neoclassical macroeconomic theory, starting with Fisher and working up to a complete economic model. Basically, it was everything we learned in Intermediate where you have the four graphs going at once and you feel very accomplished after realizing you understand what’s going on in each of them.

The model assumes that wages are highly flexible, and adjust instantly to price changes. All shocks to the system are assumed to be from external events, and the money supply is exogenous to the model completely. Wage/price determines the location of equilibrium in the labor market, which determines the supply of goods and services that will be produced. Demand determines what the rate of interest will be.

The biggest issue with this model is that it completely denies the importance of the money market in the aggregate economy. All changes in money are considered “illusory” and do not effect the real economy. Monetary theory was tacked on to the end of the neoclassical macromodel, but never really worked into it.

Expect this to be updated more thoroughly later.

this is my first post!