Roger W. Garrison 2011

1. Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to F. A. Hayek’s Capital-Based Macroeconomics Is government policy the source of macroeconomic instability? Roger W. Garrison 2011

2. C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT Yfe The nature of the Keynesian-styled spiraling associated with recession, depression and inflation becomes more transparent with the production possibility frontier in play. Also, the PPF gives analytical legs to the views of Keynes’s opponents---to Milton Friedman’s Monetarism and F. A. Hayek’s Capital-based Macroeconomics. W S D N

3. C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT Yfe A waning of animal spirits causes investment to decrease and with it income and consumption. The economy falls inside its PPF. W S D N

4. EXPENDITURES C + I C = a + bY CONSUMPTION INCOME INVESTMENT Yfe Note that if investment were to fall to zero, the economy would settle into an income-expenditure equilibrium with Y = C. Thus, the vertical intercept of the Keynesian demand constraint is aligned with the intersection of the consumption function and the 45o line. A further waning sends the economy deeper into the PPF’s interior. Movements inside the frontier (and beyond it) trace out a linear relationship, showing how consumption varies with investment. W S D The straight line that passes through these points is the Keynesian demand constraint. N

5. C = a + bY where, in equilibrium, Y = C + I Hence, C = a + b(C + I) So, C = a + bC + bI C – bC = a + bI (1–b)C = a + bI C = [a/(1-b)]+[b/(1-b)]I C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT Yfe Note that each of the four points that define the economy’s spiral path constitute an actual or potential Keynesian equilibrium. At each of those equilibrium points, Y = C + I. We also know that C = a + bY. But rather than use these two relationships to solve for the equilibrium level of income, let’s use them to determine the implied relationship between investment spending and consumption spending.

6. C + I EXPENDITURES b (1 – b) a (1 – b) C = + I C = a + bY CONSUMPTION b 1 – b a (1 – b) INCOME INVESTMENT Yfe For simplicity, let a = 0 and b = 0.90. Then C = a + bY becomes C = 0.90Y. C = a/1-b)+ b/1-b)I becomes C = 9I, which led Keynes to write: C = [a/(1-b)]+ [b/(1-b)]I “If, for example, the public are in the habit of spending nine-tenths of their income on consumption goods, it follows that if entrepreneurs were to produce consumption goods at a cost more than nine times the cost of the investment goods they are producing, some part of their output could not be sold at a price which covered its cost of production.” “The formula is not, of course, quite so simple as in this illustration…. But there is always a formula, more or less of this kind, relating the output of consumption goods which it pays to produce to the output of investment goods…. This conclusion appears to me to be quite beyond dispute. Yet the consequences which follow from it are at the same time unfamiliar and of the greatest possible importance.” This is the Keynesian Demand Constraint. Keynes never wrote this equation, but he talk his readers through it.

7. Keynes denied that there are viable market forces that can move the economy along the Production Possibilities Frontier. Keynes argued that it is the instability of investment spending and, in particular, the waning of “animal spirits” that sends the economy spiralling into recession. By similar reasoning, Keynes realized, a waxing of animal spirits (known today as “over exuberance”), will set off an inflationary spiral. CONSUMPTION Policymakers, in Keynes’s view, should prescribe fiscal and monetary policies aimed countering these destabilizing forces that are inherent in market economies. INVESTMENT

8. Friedman didn’t doubt that there are viable market forces that can move the economy along the Production Possibilities Frontier. But he considered those movements to be largely irrelevant to macroeconomic issues. Friedman argued that it is the central bank’s propensity to create money that accounts for inflationary spirals. By similar reasoning, Friedman realized, a shrinking (or collapse) of the money supply will cause the economy to spiral into recession (or depression). CONSUMPTION Central banks, in Friedman’s view, should abstain from pro-actively managing the macroeconomy and, instead, should increase the money supply year-in and year-out at a rate that maintains long-run price-level stability. INVESTMENT

9. Hayek didn’t doubt that there are market forces that can move the economy along the Production Possibilities Frontier. And he considered these forces to be viable---but only if the central bank abstaines from manipulating interest rates. Hayek argued that an increase in saving, which finances more investment, will lead the economy clockwise along its production possibilities frontier. CONSUMPTION Similarly, a decrease in saving (and hence an increase in consumption) will lead the economy in a counter-clockwise direction. In Hayek’s view, when the central bank lowers interest rates (without there being any increase in saving), it misleads the economy. Resources get misallocated during a policy driven boom, which eventually end in a bust. INVESTMENT

10. Dissent on Keynes A Bridge to Milton Friedman’s Monetarism And to F. A. Hayek’s Capital-Based Macroeconomics Is government policy the source of macroeconomic instability? Roger W. Garrison 2011