24 October1929

1. History of Modern MacroeconomicsLecture 2. The Great Depression: Keynes and His Critics (the 1930s)Kevin D. HooverDepartment of EconomicsDepartment of PhilosophyCenter for the History of Political EconomyDuke University Econ 314S: History of Modern Macroeconomics (Fall 2017)

2. 24 October1929 Econ 314S: History of Modern Macroeconomics (Fall 2017)

3. Econ 314S: History of Modern Macroeconomics (Fall 2017)

4. Unprecedented Unemployment Econ 314S: History of Modern Macroeconomics (Fall 2017)

5. Econ 314S: History of Modern Macroeconomics (Fall 2017)

6. Econ 314S: History of Modern Macroeconomics (Fall 2017)

7. Rural Devastation Econ 314S: History of Modern Macroeconomics (Fall 2017)

8. Econ 314S: History of Modern Macroeconomics (Fall 2017)

9. Econ 314S: History of Modern Macroeconomics (Fall 2017)

10. Econ 314S: History of Modern Macroeconomics (Fall 2017)

11. John Maynard Keynes(1883-1946) Econ 314S: History of Modern Macroeconomics (Fall 2017)

12. Keynes is the Most Influential Economist of the 20th Century(by articles in JSTOR) Econ 314S: History of Modern Macroeconomics (Fall 2017)

13. Keynes’s Paternity: Natural and Academic Alfred Marshall (1842-1924) John Neville Keynes (1852-1949) Econ 314S: History of Modern Macroeconomics (Fall 2017)

14. Some Bloomsburies Lytton Strachey1880-1932 (by Dora Carrington) Duncan Grant1885-1978 (Self-portrait) Virginia Woolf1882-1941 E.M. Forster1882-1941 Econ 314S: History of Modern Macroeconomics (Fall 2017)

15. Keynes and the Arts Econ 314S: History of Modern Macroeconomics (Fall 2017)

16. Maynard and Lydia Econ 314S: History of Modern Macroeconomics (Fall 2017)

17. Keynes’s Books circa 1930 1919 1921 1930 1923 Econ 314S: History of Modern Macroeconomics (Fall 2017)

18. If the books seem dry . . . Maynard and Lydia again Econ 314S: History of Modern Macroeconomics (Fall 2017)

19. Now “in the long run’ [the neutrality of money] is probably true. If, after the American Civil War, the American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that . . . p would be just 10 per cent greater than [it] actually [is] and that the present values of k [and y] would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. Keynes, A Tract on Monetary Reform A Doctrinaire Quantity Theorist and the Urgency of the Present Econ 314S: History of Modern Macroeconomics (Fall 2017)

20. Malthus as a Precursor to Keynes Theoretical writers are too apt, in their calculations, to overlook these intervals [i.e., trade cycles]; but eight or ten years, recurring not unfrequently, are serious spaces in human life. They amount to a serious sum of happiness or misery, according as they are prosperous or adverse, and leave the country in a very different state at their termination. T. Robert Malthus, Principles of Political Economy Econ 314S: History of Modern Macroeconomics (Fall 2017)

21. Perfectionist and Imperfectionists Accounts of the Business Cycle • Ricardo-Malthus debate as a prelude • Say’s Law: • Supply creates its own demand • No general gluts • Capital always finds productive uses • No natural barriers to full employment • Imperfectionist: Labor resistance (implicit or explicit) to real wage cuts the source of unemployment • Perfectionist (Keynes): unemployment in the nature of the economy Econ 314S: History of Modern Macroeconomics (Fall 2017)

22. The General Theory of Employment Interest and Money (1936) • “Monetary theory of production” • Perfectionist account of the business cycle • Real output not prices the central theoretical focus Econ 314S: History of Modern Macroeconomics (Fall 2017)

23. “Mr. Keynes and the Classics”: The Most Influential Interpretation of the General Theory Sir John Hicks(1904-1989) IS-LM Model Econ 314S: History of Modern Macroeconomics (Fall 2017)

24. The IS Curve: Consumption and Savings Functions • Consumption function: C = a + bY • b = marginal propensity to consume (mpc) • Accounting Identity: Y = C + S S = Y – C = Y – a – bY = -a + (1 – b)Y • 1 – b = marginal propensity to save (mps) Econ 314S: History of Modern Macroeconomics (Fall 2017)

25. The IS Curve: Present (Discounted) Value $1 today + $1 x 0.10 = $1.10 one year from now present value interest future value or yield PV + PV x r = FV PV(1 + r) = FV PV = FV/(1 + r) Generalize: let t= # of years in future, then PV = FV/(1 + r)t Econ 314S: History of Modern Macroeconomics (Fall 2017)

26. Yield of a Financial Asset • Long-term, zero-coupon bond: • PV = pB= market price; • FV = face value = payoff at maturity; • then, rB = yield to maturity = (FV/pB)1/t - 1 Econ 314S: History of Modern Macroeconomics (Fall 2017)

27. Yield of a Capital Good • Example: a truck with a 10-year life: • PV = pT= purchase price; • FV = Rt = revenue earned by using truck in production in year t; • r = d = yield over the life of the truck; • then, d = the value that solves the equation:pT= R1/(1+d)1 + R2/(1+d)2 + R3/(1+d)3 + . . . + R10/(1+d)10 • Keynes calls d the marginal efficiency of capital (mec) Econ 314S: History of Modern Macroeconomics (Fall 2017)

28. The Investment Decision • Should a firm with funds = pTpurchase the truck (i.e., invest)? • if d > rBtruck earns more than purchasing a bond instead; so invest; • if d < rBtruck earns less than purchasing a bond instead; so do not invest. • Punchline: • for given marginal efficiencies of capital, the higher interest rates, the fewer projects will be good investments (d > rB); • therefore, investment and market interest rates are inverse. Econ 314S: History of Modern Macroeconomics (Fall 2017)

29. The IS-LM (originally IS-LL) Model – 1 Econ 314S: History of Modern Macroeconomics (Fall 2017)

30. The LM Curve: Capital Gains and Losses • An example: • a 1-year , zero-coupon bond with face value of $1000; • pB= $1000/(1 + rB); • let rB = 5%, then pB= $952.38; now if • rBfalls: rB = 4%, then pBrises: pB= $961.54 = capital gain • rBrises: rB = 6%, then pBfalls: pB= $943.40 = capital loss • Example generalizes to all bonds: • a fall in market interest rates results in capital gain; • a rise in market interest rates results in capital loss. Econ 314S: History of Modern Macroeconomics (Fall 2017)

31. Liquidity Preference – 1 • Money M =M1+ M2 • M1= M1(Y) = transactions demand for money = the quantity equation • M2 = M2(r) = speculative demand for money Econ 314S: History of Modern Macroeconomics (Fall 2017)

32. Liquidity Preference – 2 • Let everyone have a different idea of a normal rate of interest = rN: • if r < rN , r is expected to rise • = expected capital loss to bond holders (“bears”); • therefore, avoid bonds; hold money • if r > rN , r is expected to fall • = expected capital gain to bond holders (“bulls”); • therefore, hold bonds; avoid money Econ 314S: History of Modern Macroeconomics (Fall 2017)

33. Liquidity Preference – 3(Keynes’s Account of Speculative Demand) • The higher r, the more people find r > rN and the more want to hold bonds and avoid money (i.e., the more bulls) • The lower r, the more people find r < rN and the more want to hold money and avoid bonds (i.e., the more bears) • The market rate of interest (r) = that rate that balances bulls and bears Econ 314S: History of Modern Macroeconomics (Fall 2017)

34. The IS-LM (originally IS-LL) Model – 1 Econ 314S: History of Modern Macroeconomics (Fall 2017)

35. Aggregate Supply: Labor Market – 1 • Keynes’s two classical propositions: • Proposition I: real wage = marginal product of labor  labor-demand curve • Proposition II: real wage = marginal disutility of labor (in modern terms: real wage = marginal rate of substitution between consumption and leisure)  labor-supply curve • Keynes accepts Proposition I and denies Proposition II • Hicks captures Keynes’s position with the assumption of fixed nominal wage rates. Econ 314S: History of Modern Macroeconomics (Fall 2017)

36. Aggregate Supply: The Labor Market – 2 Econ 314S: History of Modern Macroeconomics (Fall 2017)

37. Hick’s IS-LM Interpretation of Keynes Econ 314S: History of Modern Macroeconomics (Fall 2017)

38. The Keynes That IS/LM Forgot • Heterogeneity • Uncertainty Econ 314S: History of Modern Macroeconomics (Fall 2017)

39. Heterogeneity • Relative social position in labor markets and aggregate supply • Coordination failure (ex ante and ex post) • Fallacies of composition • Monetary economy Econ 314S: History of Modern Macroeconomics (Fall 2017)

40. Risk vs. Uncertainty (Treatise on Probability) “the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system of 1970. About these matters there is no scientific basis on which to form any calculable probabilities whatever. We simply do not know.” [Keynes 1937, pp. 113-14; Collected Works, vol. 14.] Uncertainty and Rationality – 1 Econ 314S: History of Modern Macroeconomics (Fall 2017)

41. Uncertainty and Rationality – 2 • Conventions as a solution to uncertainty “a convention . . . assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change . . .” Keynes General Theory, p. 152 Econ 314S: History of Modern Macroeconomics (Fall 2017)

42. Uncertainty and Rationality – 3 • Room for psychology and temperament (“animal spirits”) but not irrationality: “. . . it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motives on whim or sentiment or chance.” Keynes, General Theory, p. 163 • Rationality requires decision Econ 314S: History of Modern Macroeconomics (Fall 2017)

43. Implications of Uncertainty Econ 314S: History of Modern Macroeconomics (Fall 2017)

44. The Trade Cycle • Investment major source of fluctuations • marginal efficiency naturally falls as boom progresses • large shifts from reassessments of future profits – dimmed animal spirits • firms hesitate to cut wages • unemployment and wage cuts reduce income and have adverse multiplier effects Econ 314S: History of Modern Macroeconomics (Fall 2017)

45. Policy to Fight a Slump • Government expenditure (especially public works) can replace investment = socialization of investment • Indirect effect on expected future profits and firms confidence (animal spirits) dominate Econ 314S: History of Modern Macroeconomics (Fall 2017)

46. Policy to Maintain a Boom • Predictable and consistent monetary and fiscal policy supports conventional response to uncertainty • “In estimating the prospects of investment, we must have regard . . . to the nerves and hysteria of those upon whose spontaneous activity it largely depends.”Keynes, General Theory, p. 162 Econ 314S: History of Modern Macroeconomics (Fall 2017)

47. The Central Message (or Central Innovation) of The General Theory • Perfectionist account of the failure of real wage changes to clear the labor market • Distinction between aggregate supply and demand • The multiplier • Liquidity preference • The liquidity trap • Activitist (fiscal) policy • Focus on uncertainty Econ 314S: History of Modern Macroeconomics (Fall 2017)

48. Thanks  The End Econ 314S: History of Modern Macroeconomics (Fall 2017)