Chapter 8. Lebanese American University. From the SelectedWorks of Ghassan Dibeh. Ghassan Dibeh, Lebanese American University

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1 Lebanese American University From the SelectedWorks of Ghassan Dibeh 2014 Chapter 8 Ghassan Dibeh, Lebanese American University Available at:

2 Chapter 8 Keynesian Instabilities "Analyzing business cycles means neither more nor less than analyzing the economic process of the capitalist era...cycles are not like tonsils, separable things that might be treated by themselves, but are, like the beat of the heart, the essence of the organism that displays them" Joseph Schumpeter In chapters 6 and 7, we have proceeded from the Hicks interpretation of the Keynesian revolution posited as the IS-LM model to the revival of Classical theory in the form of rational expectations and moving equilibrium. Positing the Keynesian revolution as IS-LM plus Phillips curve laid the foundations for the revival of classical theory once assumptions about inflationary expectations (adaptive then rational) and wage and price flexibility were combined to deal a severe blow to Keynesian economics. New Classical Macroeconomics, although not the harbinger of the macroeconomic consensus of the Great Moderation, it was, however, a main ingredient or the specter that guided the Great moderation s macroeconomic policy. This chapter will look at Keynesian economics from a different perspective, one that was lost in the Hicksian interpretation of the General Theory. At the beginning though we look at the countervailing forces that may nullify the Keynes and Pigou effects. This is a very important element of any economic theory of macroeconomic dynamics. Once wages and prices are assumed flexible, the following question posits itself: Do price and wage flexibility restore full employment equilibrium if the economy is knocked off of it?

3 Keynes in the General Theory relaxed his early assumption on the rigidity of wages and prices in the capitalist economy then proceeded to show that in the presence of the liquidity trap, the Keynes effect would be ineffective and that in the presence of adverse deflationary expectations, the downward spiral of wages and prices would actually intensify the depression rather than cure it. Irving Fisher, a contemporary of Keynes also advanced a theory of debt deflation that showed that deflation actually makes the depression more severe rather than less. In addition, James Tobin in the 1970, and 1980 s advanced the idea that the Keynesian revolution must be understood in a dynamic context not a static one. The Keynesian underemployment is a dynamic phenomenon and not a static one. The disequilibirating adverse expectations that deflations induce cause the economy to spiral away from full employment. Under such dynamics, the Pigou effect is nullified and the classical stationary state is unattainable. Keynes nullifies the Keynes Effect Keynes himself after introducing what came to be known later as the Keynes Effect was not very optimistic about the efficacy of the effect in generating full employment equilibrium as deflation occurs. Keynes argued that in a situation of deep recession, interest rates may drop to such a low level so that a liquidity trap may exist. A liquidity trap is a state of the economy where all increases in the money supply are held as hoard or are absorbed in the speculative demand for money. This makes the speculative demand for money infinitely elastic (. Under such conditions, the LM curve becomes flat at low levels of output and interest rates. No Shift in LM 0 0.

4 Figure 1. Liquidity Trap and the Effect of Deflation Another state of the economy may nullify the Keynes effect if investment is not sensitive to the interest rate. If, then a shift in the LM function to the right as a result of deflation will have no or only a very minimal effect on output. Figure 2. The minimal Effect of Deflation when Investment is insensitive to interest rates

5 Given that in a depression or a very severe recession, both of the above conditions may hold then the Keynes effect would be ineffective in automatically operating to push the economy into full employment and end the recession. Box 7.1 Liquidity Trap in Japan Japan experienced in the 1990s a deflationary spiral that no other advanced industrial nation experienced since the 1930s. Many observers, notably Nobel laureate Paul Krugman has asserted that Japan experienced a liquidity trap during this period. Interest rates in Japan reached zero rates and monetary policy was unable to increase monetary aggregates and hence affect economic activity as the propensity to hoard money was high. These are typical symptoms as we have seen of a liquidity trap. The Reverse Pigou Effect The notable economist Irving Fisher writing amidst the Great Depression advanced what came to be known as the Debt-Deflation Theory of the Great Depression. The theory showed that deflation during the Great Depression was harmful and intensified the downward dynamic of the economy. This makes deflation an intensifier of depressions rather than the cure to recessions and depressions as shown in the Pigou effect. In the economy, there are two kinds of positions: debtors and creditors. If the debtors and creditors are not distributed randomly in the population but creditors are concentrated in the wealthier population and the debtors in the poorer population, then the marginal propensity to consume by creditors is less than the marginal propensity of debtors, a Fisher Wealth Distribution Effect will occur as a result of deflation. When the real value of debt increases as a result of deflation, consumer-debtors decrease consumption (C) and business-debtors decrease investment (I) more than the respective increases by creditors resulting in reduction of aggregate demand. Given that such

6 losses to aggregate demand are not offset by creditors, then the Fisher effect will swamp the Pigou effect. Figure 3. The Fisher Wealth Distribution Effect causes a leftward shift in IS Figure 4. Reverse Pigou Effect in AS-AD Framework Expectations and Dynamics: Is Price Flexibility Stabilizing?

7 We have seen that the introduction of price flexibility has led to an ambiguous result in terms of the final equilibrium state of the economy. Is the final state of the economy, the Keynesian underemployment equilibrium or the Pigou full employment equilibrium or what Pigou called the Classical Stationary State? This indeterminacy can be summarized as follows: Keynesian Underemployment Equilibrium -Weak Pigou Effect -Weak Keynes Effect -Fisher Effect Strong - - Pigou Classical Stationary State -Pigou Effect Dominates So is there a way out of this theoretical impasse? The empirical record or historical experience has been interpreted in different ways. It will be discussed later in chapter on macroeconometrics. For now, the theoretical impasse is discussed in terms of further theory this time by taking into account dynamic considerations. Up till now all the macroeconomic models discussed are static models defined in terms of equilibrium states and changes are actually jumps from one equilibrium state to another as a result of a change in some exogenous variable (G, T, M, P, ). Under such a static assumption, many argued (including economists sympathetic to the Keynesian theory) that the Pigou effect dominates and that the Classical Stationary State is the only stable equilibrium of the economic system. The classicals argued that as long as a cut in the price level leads to higher output and employment (however slight), and since prices can go down with no limits, then the economy will eventually move to full employment. The Keynesians have persistently argued against this eventual possibility. The reduction in the price level necessary to make the Pigou effect dominate

8 and push the economy towards full employment as Wassily Leontief quipped would make the economy worth a dime! Which is an impossibility! Another criticism investigates the role that expectations would play under such price dynamics. Lawrence Klein early on (in 1947) wrote against the possibility of a classical stationary state by bringing in deflationary expectations into the model of the economy. He said that the classicals have argued themselves directly into a trap and that the effects of unlimited wage cuts and a proportionate decrease in nominal product prices will be those of the economics and hyper-deflation and social revolution.. (where) adverse expectations must certainly occur production plans would be postponed. This process would have to stop The method of stopping it would be the overthrow of the capitalist system. Hence according to Klein, hyper-deflation (that the classical economists were willing to admit to be necessary for bringing about the Classical stationary state), will trigger adverse expectations that would deviate the economy further away from full employment rather than the other way around. James Tobin has championed such an approach to the question dealing with the stabilizing or destabilizing effect of price flexibility in contrast to the hitherto comparative static approach of comparing the state of the economy under two different price levels and where the jump from to is assumed to be instantaneous with no price trajectory. This according to Tobin is the implicit assumption made by both New Classical models and New Keynesian Models. He said that for these theorists the possible instability of the price adjustment process is an embarrassment. They tacitly avoid it by assuming perfect flexibility, so that after surprise shocks, prices jump to their new equilibria without passage of time. What is important for Tobin (and Keynes of course) is the dynamic trajectory of the economy through time. Tobin argued that the question applies to real time and sequential processes. Therefore the static long-run Pigou-effect does not entitle any one to give a

9 positive answer. (to the question) does the market economy unassisted by government policy, possess effective mechanisms for eliminating general excess supply of labor and productive capacity. Dynamic IS-LM models with expectations On the road to dynamics: a static IS-LM model with expectations First, when we want to include expectations into macroeconomic models, we have to start differentiating between nominal and real interest rates something that we have not done before. The nominal and real interest rates are related by the Fisher equation (1) where r real interest rate, i nominal interest rate, π expected inlation at t 1. Substituting(1) in the investment function then Deriving the IS curve (2) (3) Deriving the LM curve, we have now the money demand function as a function of the nominal interest rate or Then the LM curve becomes M ( ) d = L( y, i) P (4) Graphically the IS-LM model (3) and (4) becomes

10 Figure 5. Leftward shift in IS as result of expected deflation An expectation of deflation ( recession. A dynamic IS model with adaptive expectations 0 will shift the IS curve to the left and lead to a In the previous model, the inclusion of expectations in the IS-LM model was done without the consideration of actual price dynamics. Since deflation is a dynamic process where the trajectory of price is important, we have to consider a dynamic model. A dynamic model with inflationary expectations that abstracts from the LM function by considering the nominal interest rate to be constant (i.e. determined exogenously the central bank) can be represented as follows IS Interest rate rule Fisher Equation Adaptive Expectation Phillips Curve Substituting, we get the dynamic system that represents the time evolution of output and inflation

11 (5) (6) It can be shown that in this system, a negative aggregate demand shock, say engendered by the collapse of the Philips curve ( 0 will lead to a reduction in output as can be seen from equation (5). The reduction in output by equation (6) will lead to a reduction in inflation which in turn will feed back into equation (5) through an increase in real interest rate (term ) leading to a further reduction in output which will further reduce inflation and the above process will repeat itself further pushing the economy away from its initial equilibrium output. Hence, in this economy the flexibility of prices has acted as a destabilizing factor and deflation will further push away the economy from equilibrium. A Simulation of the dynamic system (to be developed) Temin s model of Great Depression (to be developed) A sketch of Tobin s model with price level and price dynamic effects [Advanced] The attentive reader may have noticed that we have abstracted from the possible countervailing force of the Pigou effect in the above two models. He is right. In our attempt to concentrate on the destabilizing effect of deflation and flexible prices, we have assumed away the Pigou effect. However, the Pigou effect must be taken into consideration when price flexibility is assumed. Hence again the final determining effect of price flexibility is the relative strength of the two effects: the price level effects (Keynes and Pigou effects and the price change effect or the expected deflation effect). The second effect as we have seen is operational when the economic process is occurring in real time which is how things are in reality hence the importance of the assumption that prices follow a certain trajectory when the economy is subjected to demand shocks

12 rather than the assumption of instantaneous price jumps that ensure equilibrium comparisons between two states of the economy at different prices. We can construct a formalism that explains the differences according to the evolution of the state variable of the economy. Under the static assumption the economy s state does not evolve in time but takes different values at different times where the states,,.., are produced by instantaneous realizations of different prices,,.,. In the dynamic assumption the state of the economy evolves under a governing equation of the type, where the states of the economy are, are solutions to this dynamic equation. The stability of the state of the economy is also a resultant of the governing equation. James Tobin has developed a dynamic model that takes into account the two effects of price level and price changes. The model is a three dimensional differential equation system whose technical level is beyond the scope of this book. However, Tobin introduced a qualitative approach to understanding the model. The Tobin model posits real aggregate demand as function of the price level p and expected inflation x or E, where 0 and 0. The function E plotted in (x, p) space represent the loci of combinations of (x, p), such that the aggregate demand is at a certain level. Lower loci represent higher demand. The curvature of is the result of the Keynes effect weakening as interest rates fall and hence the effect of increase in real money balances decline.

13 Suppose initially the economy was in a state represented by,, 0,, which says that the level of real aggregate demand generates full employment output with the equilibrium price level equals to and expected inflation at equilibrium is zero. Suppose now that the economy experiences a negative real demand shock (such as collapse of MEC) that shifts that is compatible with downward to which makes the old real aggregate demand less than the aggregate demand needed to generate full employment. Suppose that the p is flexible and is responsible for the adjustment of the economy to the new full employment state defined by,, 0,. There are two ways that this can happen: 1. The New Classical models say that the price instantaneously jumps from to with no passage of time. Hence instantaneously, we have. This we can call simultaneous action. This implies that the economy as a system possesses the ability to adjust with no time lapse between its different states ψ, ψ,.., ψ. This also implies that at no time we have 0. Hence the transition from ψ ψ is not a dynamic process.

14 2. The Keynesian solution involves on the contrary the dynamics of price p and price expectations x which in turn makes the transition.subject to dynamic laws and hence the state of the economy becomes subject to,,. We are not going to posit again specific dynamic equations for the evolution of but we will discuss possible time trajectories of as represented in figure 6. - Path A will be generated if there is a path of positive inflation and expected inflation that would push the economy to full employment. However, this path is highly unlikely as the price movement takes the wrong direction. Under a negative real aggregate demand, prices are expected to decline. - Path B will be realized if the Keynes (and Pigou) effect outweigh the detrimental effects of deflationary expectations. Aggregate demand recovers and the economy will eventually goes to equilibrium at the state,, 0,. - Path C will be realized when deflationary expectations outweigh the price effects. The economy will veer away from the state,, 0, and the gap between Y and Y * increases pushing the economy towards recession and depression. Tobin s continuous time model (to be developed) Price Rigidity for Economic Stability Lawrence Klein observed that in the real world one observes neither hyperdeflation nor full employment. The explanation is that wages are sticky. The solution to the Keynesian system which gives a value of employment not on the supply schedule persists when wage cuts do not occur. Because workers do not bid against each other, we do not experience the hopeless demand spiral. Price stability is important to the stability of the capitalist system and price flexibility thought by the classicals as

15 imparting flexibility to the capitalist system that ensure the achievement of the full employment state is wrong. Tobin said of the centrality of effective demand that unless a reduction of the money wage would somehow increase aggregate real demand, there is no mechanism by which the mutual latent willingness to demand and supply more labor at a lower wage could be actualized. This is the Keynesian impasse (Tobin, 1981, p.4) Keynes s outline of the Business Cycle In chapter 22 of the GT, Keynes outlined a theory of the business cycle that is incomplete but attempted to extend the basic insights gained by the largely static model that aimed at finding the equilibrium level of output. The extension is concerned with fluctuations in time which define the business cycle in the capitalist economy. For Keynes, fluctuations in mpc, L(r) and MEC play the major part in economic fluctuations with the fluctuations in MEC playing the major part in the business cycle. If we recall the MEC is the discount rate such that 1 Hence, the major determinant of the MEC is the current expectations to the future yield of capital goods. Since these expectations are precarious, economic crisis or downturn occur as a result of sudden collapse of the MEC rather than as a result of the rise of interest rates. This happens in the later stages of the boom when optimistic expectations are strong enough to offset the rising abundance of capital, rising costs of production and the rise in interest rates that all occur in the last stages of the boom. A sudden wave of pessimism that hits investors collapses the MEC. Moreover, as organized markets are made up of ignorant buyers and speculators, this intensifies the sudden pessimism of market participants which lead to drop in the value of stock markets. This in turn leads

16 to a drop in the mpc if the economy experiencing such events has large stock-minded public like the US since the 1920 s and more economies nowadays. In addition, the collapse of the MEC leads to uncertainty about the future which leads to a large increase in the liquidity preference L(r) which increases interest rates leading to a further drop in investment. Keynes attributed to the precarious nature of investment decisions in the uncertain environment of capitalist, the reason behind economic fluctuations. He said investment is being made in conditions which are unstable and cannot endure because it is prompted by expectations that are destined to disappoint. Keynes concluded that In conditions of laissez-faire the avoidance of wide fluctuations in employment may...prove impossible without a far reaching change in the psychology of investment markets I conclude that the duties of ordering the current volume of investment cannot be left in private hands. The outline of the business cycle can be represented in the following sketch:

17 Sketch of Keynes' Business Cycle Economic Expansion over-optimistic expectations of Q stock market 'feed' into such expectations sudden pessimisim MEC + (collapse) (Stock market) + (Crisis) Depreciation of

18 Problems 1. Suppose that an economy has the following balance sheet Assets Liabilities $10 billion $ 10 billion ' Where initial price level is P 1. Suppose that the price level went to P = If debtors 0 = have a mpc = and creditors have a mpc = The interest rate on debt is 10%. By how much the GDP would expand or contract as a result of change in the price level. Assume average mpc in economy is The Federal Reserve (the central bank of the US) decided on Tuesday December 16, to establish a target rage for the federal funds rate (interest rate) form 0% to 0.25% in order to fight the recession. The Financial Times headline the next day said that the Fed is moving into uncharted waters. Why do you think that the FT said that? Explain using models and graphs. 3. The following data is for a fictitious economy:(fisher equation of interest rate). C = y G = 50 I e = ( i π ) M d = y 0. i P 05 M s P = 200 e where i= nominal interest rate and π =inflationary expectations. a. Derive IS curve and plot it (i vs. y) b. Derive LM curve.

19 e c. If initial π = 0, find equilibrium y. e d. If π = 10%, calculate new GDP and real interest rate. e. If you were a policy maker what would you implement in fiscal or monetary policy to counteract effects of deflationary expectations in d. 4. Dynamic Model problem (develop later)