History of Economic Doctrines

Lecture 12

Classical Macroeconomics II
Marginalism and Macro: Early MicroFoundations for Neoclassical Macroeconomics Summary: The introduction of calculus provided intellectual ammunition for the view that the market automatically adjusts. Homeostasis (self curing) forces assure that nothing can go wrong in the long run. (Panglossian?) Austrian Economics: Carl Menger (subjective approach to the theory of value) von Wieser Coined the phrase marginal utility Eugen von Bohm-Bawerk: interest rates / roundabout production (postponed consumption ==> investment, and investment is expected to generate greater production later than the consumption forgone today). French Economists: Jules Dupuit .. price discrimination as a cure for inefficiencies of natural monopoly power. A.A. Cournot: formalized profit maximization with MR=MC, demand and supply curves. Monopoly and duopoly models. English Economists: Francis Ysidro Edgeworth William Stanley Jevons (sunk cost bygones are forever bygones) Austrian: Menger, von Bohm-Bawerk, and Weiser *sunk costs and investment saving Investment Saving - internal rates of discount - saving is positively related to the interest rate - I = change in capital/change in time -- as the capital-labor ratio (K/L) increases, the output per worker (Q/L) will increase -- the greater the K/L the lower the output per machine (Q/K). Price-wage-interest rate flexibility preclude Malthus' notion of general gluts - It is possible for the amount saved to exceed the amount invested -- BUT, interest rates will fall and eliminate the excess supply

-- interest rate adjustments investment = saving, thereby curing Malthus-style gluts. Neoclassicalism 1.. Wage-price flexibility - interest rates, wages, and prices are all flexible ensure that we live in the best of all possible worlds [Dr. Pangloss]: laissez faire
1. Say's Law of Markets supply creates its own demand

Jean Baptiste Say: demand is automatic because demand is the basis for decisions to supply ** Ensures that capitalism will work: this is pretty radical.

History of Economic Doctrines

Lecture 22

Neoclassical Macroeconomics I PRICING

English tradition (Micro) - supply factors determine pricing in the LR Continental - demand determines pricing in the LR (non-reproducible goods only) Jevons - married demand and supply together as determining price in the LR 19th Century Debates about Pricing Parallel with Todays Debates about Macro Classical Macro - supply creates own demand (Says Law) - Keynes rebuttal: just b/c you produce it today doesn't mean you want to buy it today -- argued that demand creates supply in SR -- no assurance, then, that demand is sufficient to clear markets

Neoclassical Macroeconomics
Supply-side orientation of orthodox macro has parallels with the English tradition on micro pricing.

1. flexible prices, wages, interest rates yields full employment 2. Says Law: Supply creates Demand 3. Quantity Theory a. MV = PQ (Fisher: based on equation of exchange.) b. Md = KPQ (Cambridge equation = demand for money)
- Quantity Theory of Money determines the price level -- MV = PQ = PT -- MV = PQ income velocity of money, deals with newly produced goods -- PT Fisher and transaction velocity of money, look at the # of times a dollar turns over per year, includes transaction on things that have turned over previously

* money supply determines ONLY levels of prices - in the LR you will get to full employment - Q = f (k, l) output is a function of resources) does not look at Aggregate Demand as determining Q, only P (following in the English tradition that in long run, p = g(q)=f(k,l), where q = micro market output) -- views macro analysis as trivial b/c wages and prices are flexible -- J.M. Keynes argues that in the LR we're all dead, so we must address the short run Walras - general equilibrium: look at interconnections; NO ceteris paribus Walras Law XS = XD (sum of xs = sum of xd) * relative prices matter - the sum of the excess demand in all markets will be the sum of the excess supplies in other markets shortage in one market means a glut in at least one other market Point: - surplus relative price is too high in that market for it to clear, so it must be that some other market has a relative price that is too low -- solution to unemployment: real wage (w/P) matters, so lower wages OR raise the price level (expand the money supply) --example: Great Depression : price level fell 1/3, wages fell 1/4 real wages rose Prof. Byrns example of Walras Law: an excess supply of labor may mean there is an excess demand for money. This accords with Keynes Liquidity Preference model. John Maynard Keynes* (Cambridge equation Md = kPQ) [or Md = ky.] examined how we change the money supply - concerned with MV = PQ if MV (aggregate demand) falls, then PQ (aggregate supply) falls -- if PQ falls it may be b/c people held onto money -- Solution? increase money supply by running a deficit (G= T + change MB + change bonds) Question: Is Keynesian multiplier analysis merely about changing the velocity of money? Keynes: - confidence and expectations, making the economy work

Neoclassical Macroeconomics
1) Says Law- Supply leads to Demand supply has demand built into it. act of supplying means that someone wants to buy something. basic economic problem- SCARCITY 2) a) Flexible wages: Wage Rate=Marginal Physical Product of Labor P*MPPL=VMP Malthus- tries to refute by saying people will work regardless because of need. b) Flexible Prices c) Flexible interest rates Competition stops when people are paid what they are worth. Ex: If someone is worth $15 an hour, the capitalist pigs will continually pay them slightly more then competitor until they are paid what they are worth. Exploitation and favors are less likely to be given in a capitalist society because most efficient worker is typically hired.

Aggregate Supply not affected by price level. Q does not = f(p)

3) Q=f(K,L,N,E) capital, land, resources, population

Efficiency is key-if you do not perform efficiently, you are broke. If you can work, you will have a job. 4) Quantity Theory of Money: MV = PQ = PT MV = PQ income velocity of money, deals with newly produced goods PT Fisher and transaction velocity of money, look at the # of times a dollar turns over per year, includes transaction on things that have turned over previously * money supply determines ONLY levels of prices in the LR you will get to full employment Q = f (k, l) output is a function of resources) does not look at Aggregate Demand as determining Q, only P (following in the English tradition that in long run, p = g(q)=f(k,l), where q = micro market output)

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.

History of Economic Doctrines

Lecture 23 Quantity Theory of Money: Irving Fisher - Lots of transactions dont add to production. [The MVt=PT equation.] - The income version: V = PQ/M (Note: PQ = GDP) M = PQ/V (Note: V = frequency within which money turns over.) - % M + % V = % P + % Q Issue: How does M affect Q? - Historical theories about inputs: [o Ricardo: Land, labor o Austrian: Capital] o Q = f (L, N, K) (Note: N = technology?) Money has nothing to do with real world it is just a measuring device. Ex: Doubling the numeric value of each $ would not alter your behavior one iota. AD MV = PQ AS - V is determined by institutions and habits - Q is fixed by resources available [Q = f(K,L)] - Fisher: Velocity of money doesnt change much over time, and Q is fixed. o M / M = P/ P

Criticisms of Neoclassicism
- Assumes velocity and quantity are fixed -- BUT--spending is a function of expectations -- expectations of a reality cause that reality to unfold (helps explain Depression/Inflation)

** how do the foundations for your pessimistic/optimistic expectations determine the change in your spending? - Assumes hardcore analysis and independent reason, and ignores herd behavior of investors

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.

History of Economic Doctrines

Lecture 24
German Historicism

Rejected utility theory Favored Protectionist policies [Friedrich List was nine years old when Alexander Hamilton died.] Made mercantilists mistakes about wealth of nations, etc

American Institutionalism
In many ways, American institutionalism was a school of economic thought that developed as a reaction against the behavior of such successful people as JP Morgan, John Rockefeller and the Astor and Vanderbilt families. It was also a revolt against neoclassical theory and hyper-rational decision making. The most notable of the traditional American Institutional economists were Thorstein Veblen, John Rogers Commons, and John Kenneth Galbraith. The institutions in institutionalism refer to technical and ceremonial institutions. Maybe much of economic activity is based, not in self-interested optimization per marginalism, but is instead based in culture and institutions? Institutionalist rejected the idea of hyper-rational decision making by ordinary people (i.e., lightning-quick calculations and taking derivatives in ones head so as to maximize profit). Institutionalists also objected that orthodox economics ignored interdependence on other people in society. (Neoclassical economics views environment [e.g., culture, institutions, social norms and mores] as not affecting the motives and decisionmaking characteristics of people.) Aside: Public Choice analysis may be a somewhat right wing modern version of American institutionalism? Effect of government on the search of self-interest Thorstein Veblen (1857-1929) Veblen was a first generation Norwegian-American who was born on his parents farm

in Wisconsin, just before the Civil War. He was a child prodigy who read book after book while his siblings did the chores. Veblens parents recognized his intellect and sent him to Carleton College, where he wrote on such topics as A Plea for Cannibalism and An Apology for a Toper. Veblen bounced around academia, never studying or teaching in the same place for long. His lectures were a mix of ramble and mumble, deserved his bizarre reputation. All students, regardless of attendance or performance, received C grades, however, when one student protested that anything below an A would ruin his eligibility for a Rhodes Scholarship, Veblen gave him one without much fuss. Veblen had shorts teaching stints at many universities, however, they were marred by bitter fights with many of his colleagues and sordid affairs with their spouses. He died broke at 72, filling a slot as a visiting assistant professor at the University of Missouri. 1. Veblens views of human nature and economic behavior in many ways echo Darwinian evolutionary thought 2. Veblen developed an evolutionary economics based on human adaptations to ever-changing institutions, and categorized institutions as either technological or ceremonial 3. Veblen viewed show-offs who flaunt the extravagance of their spending patterns as practicing behavior he called conspicuous consumption 4. Veblen was most vehement with objections to the use of marginal utility theory 5. Anthropological and sociological theories underpinned many of the views of Veblen 6. Veblen was most adamant in condemning the notion that utilitarian calculation is the foundation for human behavior. He viewed people as creatively curious, creatures of propensities and habits 7. Veblen believed that property acquisition is a significant activity in the quest for social esteem. He also believed that businessmen are parasites who acquire unjust shares of the income produced by engineers 8. In his book, The Theory of the Business Enterprise, Veblen categorized the working class as comprising of engineers and business people (parasites) John Rogers Commons (1862-1945) John Rogers Commons was an American Institutionalist who championed social and economic reform through regulation. Much of the New Deal legislation of the 1930s, including public utility regulation, collective bargaining and labor dispute mediation, was built from the regulatory framework pioneered by Commons. Commons agenda of reforms for American labor markets included laws mandating workers compensation, job safety, unemployment compensation and the permissibility of collective bargaining. Clarence Ayres Ayres was the American Institutionalist who focused on and furthered Veblens views on technology. Wesley Clair Mitchell Mitchell was the institutionalist who established the National Bureau of Economic Research to provide economics with a sounder statistical foundation. He analyzed business cycles exhaustively using then-modern statistical techniques.

ASIDE:

Principal-Agent Problem

In The Modern Corporation and Private Property (1932), Adolph Berle and Gardiner Means documented the dominant position of the large corporation in the modern economy, the growing dispersion of ownership of common stock, and the separation of ownership from control. The growing dispersion of ownership of common stock and the separation of ownership from control brought light to a particular sort of moral hazard dilemma called the principal-agent problem.

John Kenneth Galbraith (1908-2006) Galbraith, who was Canadian-born and Berkeley-trainedwas considered by many to be the Last American Institutionalist. Although he outside the mainstream, he was still elected as the President of the American Economic Association in 1972 and was one of the better known economists in post-WWII America. John Kenneth Galbraith worked in many various capacities, including as an editor ofFortune magazine, a brief tour at Princeton and an extended tour at Harvard, director of U.S. Strategic Bombing Survey, as well as advisor and speechwriter for John Fitzgerald Kennedy, Eugene McCarthy and George McGovern. At 69, Galbraith was also the worlds tallest prominent economist. 1. Galbraith focused on the crucial role of advertising in creating and manipulating demand for consumer goods. 2. Believed that giant corporations manipulate markets and sometimes dominate government policies 3. Also believed that wasteful private consumption comes at the expense of social and public goods 4. The key point in Galbraiths book, The Affluent Society, is that advertising artificially and undesirably inflates consumer demand 5. Galbraith proposed countervailing power as a remedy for abuses of power in his book, American Capitalism 6. In his work, The Great Crash, Galbraith theorized that regulation and deregulation are a cyclical phenomena. Prosperity is accompanied by deregulation and increases in corporate fraud, while economic downturns lead to the exposure of corporate improprieties, resulting in new regulation, which is then moderated during the next prosperous period, and so on. Galbraith labeled corporate fraud as the bezzle. 7. Galbraith was highly critical of the economic power of big business and was an advocate of a new socialism through government supervision, despite the immense prosperity of the past six decades

Thorstein Veblen: Father of Institutionalism BIO: Education: B.A from Carleton College (1880) and Ph.D. in philosophy from Yale (1884). Ph.D. in Economics at Yale in 1884 Personal Facts: -A first generation Norwegian-American from Wisconsin.

-He had bad hygiene and looked somewhat simian [apelike]. -He taught at numerous universities, including University of Chicago, UC-Berkeley, and finally University of Missouri. -He opposed grade-grubbing and competition (especially honor societies) -He was a ladies man, which cost him several jobs. Thorstein always remained Asst. Professor (was never promoted) and supposedly gave every student a C, independent of academic performance. However, the story goes that Veblen gave one A to a student who begged for the grade so that he might be eligible for a Rhodes scholarship (all he did was ask!). -Alleged inventor of the automatic dishwasher [he dropped his dishes in a rain barrel and the sprayed them with a garden hose]. Philosophy and Ideas: He looked at issues like a cultural anthropologist, had an outsider view. Saw progress from science and technology Income distribution, puncturing icons, going after symbolism Defined instincts of humans -Parenthood, workmanship and idle curiosity-produce high quality efficient products. -Called Industrial Employments -Acquisitive Instinct-behavior that benefits oneself The Place of Science in Modern Civilization Assaulted the basic assumptions of neoclassical theory -Opposed the idea of Invisible Hand (assumed long-run) -Challenged fixed prices, resources, tastes, technology are constant *Velban wanted to study these factors that were held constant -Disagreed with the idea that self-interested individuals will promote what is best for society. *Believe that peoples who are in their own self-interest only benefit themselves. -Rejected that people produce for the good of society: 1. Believed that profit hurts general interest of society 2. Increase profits, by decreasing output and increasing prices (monopoly) 3. He questioned the benefit of Advertising -Rejected perfectly competitive markets -Wanted more inductive research -Wanted more Empirical Work Contributions -Challenged that markets are perfectly competitive -Use of factual material to test hypothesis -Link economics with other social sciences -Ease and reasons for people to be unethical in the economy, how one persons self interest can harm society. Major Publications: I. The Theory of the Leisure Class (1899): -Looked at consumption/ consumption patterns -Came up with conspicuous consumption

*Like diamond rings * Fur clothing, it is not necessary for survival but rather is used as a means of showing that one is on top of the social pecking order. -Conspicuous Consumption: Individuals do not consume goods to satisfy basic needs; but rather they consume goods to signal their position in the social hierarchy, sets up pecking order. Veblen good: A Veblen good is viewed by its owners as a status symbol, and such a good is valued by an individual because its high price places it beyond the reasonable budgets of other individuals.

-The Poors goal is not to rid themselves of the leisure class; their goal is to emulate them. People want to climb the social ladder and acquire these symbols of status. positional good: A positional good is a good that is more highly valued by its owner than the good would be valued were the individual isolated from the rest of society because the positional good serves as a signal of the owners class, status, or power. Rolls-Royces, tattoos, expensive jewelry or furs, massive boom-boxes, or black leather jackets festooned with hardware are often positional goods. See also bling.

II.

Theory of Business Enterprise: - He theorized that people who make money into 2 Groups: 1. Engineers (Blue Collar workers): These individuals create the inventions and goods that are later mass produced and sold. 2. Business Men (parasites, also called the Ceremonial Class) These Individuals take those good created by the Engineers and make money off it for their own profit. He regarded the Ceremonial class as rip off artists. The Leisure Class was admired by all class of people because they made money with ease. -Investment bankers facilitate roundabout production- Veblen disagrees

John Commons: (views similar to Fabian socialists in some ways) Contributions: -Public Utilities: He was an advocate for public municipalities to undertake large projects for the public good such as highways, telephone polls, electricity, and sewage. He viewed these public utilities as a appropriately break even, or they might be permitted to generate funds for the municipalities. That extra profit would allow the municipalities to provide for schools, police, and other public benefits. He devised a rate structure that as an individual increased the amount of utilities they used the cheaper the extra units would become. - Some areas where government needs to be involved according to Commons -Utilities

-Tend to gravitate towards Monopoly. Ex: AT & T - Took lessons from Dupuit - Price Discrimination - Price for the last unit > MC - Shouldnt allow capitalists to own utility companies. Instead, these should be owned by government or be coops - Government should regulate rate structures and a lot of other industry. - His views were very similar to Fabian socialist in some ways.

Aside: tournament theory:

Tournament theory is an explanation for tremendous disparities in incomes within a hierarchy. According to this theory, the huge compensation associated with being at or near the top of the hierarchy provides enormous incentives for subordinates to strive harder to be promoted so that they can capture these economic rents for themselves.

Clarence Ayers:

John Neville Keynes: Bio: -Father of John Maynard Keynes -Neoclassical Economist a Contemporary of Marshall Contributions: -Distinguished between normative and positive economics -Normative: impossible to prove -Positive: can be scientifically proven -Is there always a clear distinction between the two? No -Ex: there is no possible way to scientifically prove superiority of Pareto efficiency is it better to be efficient? -Almost all issues are a mix of normative and positive -E.g., The mere fact that we believe that knowledge is good shows that any inquiry has an element of normative. Extra Info: John Neville Keynes wanted to make economics more scientific, therefore he advocated eliminating value judgments. This was the type of Neoclassical Economics, which Veblens was rebelling against. A major argument in economics is can economic analysis be performed accurately without the addition of value judgments.

Wesley Clair Mitchell:

Contributions:
- Professor at Columbia, One of the first directors of the New School for Social Research. - Founded the National Bureau of Economic Research in 1920, in order to study the

the U.S.business cycle for which that organization - He almost single-handedly contrasted the way to analyze business cycles. - His life-long interest in business cycles culminated in his authoritative opus with Arthur F. Burns,Measuring Business Cycles (1946). John Kenneth Galbraith: Bio: - world's tallest economist

Contributions: Public Poverty & Private Opulence - people don't take care of the public goods in society Solution per Galbraith? Shift resources to public goods so that they are as nice as our homes Induced Demand - we consume stuff b/c they are status symbols - we know things are status symbols b/c advertisements and society tells us so - status competition results (similar to Veblens conspicuous consumption) Embezzlement: The bezzle - tremendous amounts of fraud are built into our system as the result of regulations - Business Cycles -- deregulation during prosperity encourages fraud and abuse -- reregulation during down turns

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.

History of Economic Doctrines

Lecture 25

Austrian Economics
Carl Menger (Austrian)

Carl Mengers intellectual lineage has a distinctly Ricardian flavor. He avoided dependence on complex formal mathematics and statistics, and largely ignored historical and institutional influences, while advocating a greater use of abstract reasoning and deductive logic [praexology] in building intellectual models. Principle of Economics (1871) Using the concept of subjective value to governing all economic activities, Menger developed the marginalist value theory. According to him, goods will be consumed to the point where the marginal utility of all goods are equal relative to their price (MUx/MUy=Px/Py). Note: the term diminishing marginal utility was coined by Friedrich von Wieser, a follower of Mengers Austrian school, but the concept was first discussed in rigorous fashion by A. Jules. E. Dupuit. The subjective determination of consumption demands, Menger claimed, would determine the demand for factors of production. (Note: Mengers subjective theory of value was opposed by German Historical School)

Austrian School
A number of economists influenced by Menger and later became known as the Austrian economists. Friedrich von Wieser students of Menger Principle Laws of Value (1884) Established that factor prices are determine by output prices through the process of imputation: marginal utility from consumption price of a final good prices of the factors used in production Developed the theory of opportunity cost relative prices reflect foregone opportunities, that is the price of good x1 in terms of x2 is the amount of good x2 that has to be offered (and thus foregone). (Note: Marshallian tradition focuses on actual cost) Eugen von Bhm-Bawerk students of Menger Capital and Interest, a Critical History of Economical Theory (1884) (Exploitation theories of interest) is not only incorrect, but in theoretical value are to be found together so great a number of the worst fallacies. Positive Theory of Capital (1889) Interest would exist even in a socialist society because present goods are valued more than an equal amount of future goods. First, people's marginal utility of income will fall over time because they expect higher income in the future Second, for psychological reasons the marginal utility of a good declines with time. Third, the "technical superiority of present over future goods," that is people postpone consumption to invest in capital goods that can generate greater amount of future goods (Note: The first and second reason refers to the positive time-preference, that is people systematically

prefer present consumption over future. However, Bhm-Bawerk insisted that the third reason was independent of the first two, which resulted in his controversies with Irving Fisher and J.B. Clark. ) Ludwig Edler von Mises The Theory of Money and Credit Extended Austrian marginal utility theory to money. -- Money is demanded for its usefulness in purchasing other goods, rather than for its own sake (objective exchange value). Argued that business cycles were caused by the uncontrolled expansion of bank credit. (Note: Misess money theory was later developed into a business cycle theory by his student, Friedrich August von Hayek ) Friedrich August von Hayek Business Cycle Theory According to Hayek, the market was evolved slowly as the result of human actions. One reason that causes the market to fail was increases in the money supply by the central bank. He argued that such increases would drive down interest rates, making credit artificially cheap. Businessmen would then make capital investments that they would not have made. But long-term investments are more sensitive to interest rates than short-term ones. Therefore, he concluded that there would be too much investment in long-term projects relative to short-term ones, and that the boom must turn into a bust. (Note: Hayeks theory of business cycle resulted in his battle with Keynes, and he responded with the idea of the tradeoff between unemployment and inflation that resembled Phillip Curve) Economic Calculation (1920) Claimed that efficient allocation of resource was impossible under socialism Socialist Capitalist Debate Joseph A. Schumpeter the wild child of Austrian school tradition The Theory of Economic Development (1912) Excluding any innovations and innovative activities leads to a stationary state. The entrepreneur disturbs this equilibrium and is the cause of economic development. Capitalism, Socialism, and Democracy (1942) Distinguished inventions from the entrepreneur's innovations. Entrepreneurs innovate, not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization, which leads to led to gales of "creative destruction" as innovations caused old inventories, ideas, technologies, skills, and equipment to become obsolete. Monopolists continuously innovate in order to retain their monopoly power. In advanced capitalism, the intellectual and social climate needed to allow entrepreneurship to thrive will not exist, thus capitalism will be succeeded by socialism.

Ludwig von Mises Business Cycles - accepts Austrian marginalist approach to income w = MPPPL x P i=S=I von Thunen and location - would NOT accept Neoclassical conclusions about money -- Neoclassicalism: money doesn't matter; neutrality of money - Inflation matters a lot -- distributional consequences of inflation make investment planning problematic Oscar Morgenstern - Game Theory

- false precision of economic data that is reported -- example: income data from NY (high income tax) v. Nevada (no income tax) provides incentives for some people to lie Hayek Road to Serfdom - paved with higher amounts of government - criticized Keynes b/c saw it as more government involvement -- Keynes: government fiscal spending to correct business cycles -- Hayek felt that once in place, government does not shrink back to the same level - groups of leaders gravitate to the top and spoil things when government is empowered Joseph A. Schumpeter Schumpeter's Law -semi-inconsistent with Hayek, and semi-inconsistent with Schumpeters own prediction of the supplanting of capitalism by socialism - taxation as a percentage of GDP can't exceed 22% -- would cause a tax revolt - capitalism causes income to skyrocket -- positive income elasticity demand for freedom -- people demand better government seeds for demise of capitalism as democratic nations evolve into socialism

Austrian Macroeconomics
1. Austrians Do NOT like aggregation and Quantitative analysis - Quantitative analysis comes from statistical data, which is self reported - for this data to be true it would have to have a mean distribution error of zero: people lie about, e.g., their incomes. - prefer a subjective a priori approach: better to trust your instincts. 2. Favor policies that are fairly conservative: cynical of government - government should defend property rights, provide military - beyond that, little other room for government - libertarian

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.

History of Economic Doctrines

Lecture 30 Consumer Theory

Consumer Theory * Goal: provide foundations for law of demand - preference for simplicity in our models -- no more complex than needed to understand the problem at hand --Weak v. Strong Assertions: weak assertions give more room for generalization - we aim for predictability from models Jevons - influenced by Bentham's felicific calculus: ways to measure utility mathematically - imagined machinelike tabulations of individual utility PROBLEMS 1. Nobody knows how to calculate a "util" 2. Non-additivity: can't add the utility of various goods b/c one depends mightily on another 3. Not interpersonally comparable Cardinal Utility - the differences b/t utility have a consistent meaning (example: 4-3 = 1, 3-2 =1) Kelvin Lancaster - Attributes of Goods -- break down the pleasure/utility you derive from the attributes of a good, not just the the pleasure you derive from the good itself Pareto - utility maximization Ordinal Utility - Assumptions 1. Preferences 2. Consistency 3. Complete * weaker assertions than Jevons - ability to rank, transitivity (example: A > B > C) - provides foundation for Hicks and modern demand theory Kahneman & Tversky - established that people don't know what will make them happy -- you don't know what you will like; you must experience it -- but they know when they are happy

History of Economic Doctrines

Lecture 33

Keynesian Economics and the Economics of Keynes

John Maynard Keynes and the Great Depression [ Keynes Bio Link ] -Monetarists vs. Keynesians

Monetarists: AD depends on money supply

Keynesians AD = C+I+G+X-M

Keynes Belief: -An Increase in aggregate demand at full employment led to an increase in the price level. -Also that a decrease in aggregate demand would lead to a quantity adjustment in which producers decreased production (Keynes thought that, in a recession, people would only produce if they thought that someone would buy the goods that they produced.) -Demand creates its own Supply\ Neoclassical Macro v. Keynesian Theory Neoclassical The market is a machine that generates the best of all possible worlds. [to quote Dr. Pangloss, from Voltaires Candide.] - Assumes flexible w, i , p and Says Law -- yields full employment - AD just determines price levels -- price levels determined by the money supply: M/ M P/ P Keynes - Neoclassical paradigm is not valid in the SR when AD falls because of sticky wages and prices Quantity Adjustments Similar Debates Price Adjustments to Disequilibria Quantity Adjustments to Disequilibria Joseph Bertrand duopoly model Cournot duopoly model Leon Walras ttonnemnt equilibration Alfred Marshall partial equilibrium models Classical/neoclassical macroeconomics John Maynard Keynes .- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - English classical : Supply Prices [labour Austrian: Demand Prices [subjective] theory] -Keynesian Theory Keynes thought that a capitalist economy would experience high unemployment as a long term situation unless some external forces were used to reduce it. He believed that this external force must come from government and should take the form of large expenditures on public works projects capable of utilizing and mobilizing willing workers who are unemployed. Keynes did not believe in the long tradition of laissez-faire policies, which strongly discourage government intervention in the economy. 1. Keynesian theory accepts the classical and neoclassical theory that flexible wages, interest rates and prices, combined with Says Law, ensure full employment and a maximum value for output in the long run. But Keynes famously wrote, but in the long run we are all dead.

2. Keynesian theory concludes that, in the depths of a deep depression or recession, demand creates its own supply. This is in contrast to Says Law, with states that supply creates its own demand. 3. Keynesian Aggregate Expenditures are the sum of: C+I+G+ (X-M) as these planned spending relate to income 4. Keynesian theory suggests that, during severe depressions, excessive unemployment can be reduced by increases in government purchases 5. The Great Depression finally ended when the U.S. government entered World War II 6. Keynes theorized that the demand for money depends on the prevailing interest rate and expectations about economic conditions. This notion is known as liquidity preference 7. The Keynesian concept of sticky wages and interest rates turns neoclassical macroeconomics on its head 8. Keyness precautionary demand for money states that we have cash on hand because cash is needed to purchase goods or services not planned for -Money is: 1. Medium of exchange, 2. Standard measure of value 3. Store of value- this idea is distinctly Keynesian 4. Standard of deferred payment -precautionary -speculative (assets) Money as an asset: liquidity preference Bond example: PV = A ---I -If interest rates are expected to go up, then people would not want to buy bonds. Keynesian Multipliers and Fiscal Policy -Aggregate Demand AD= C + I + G + XZ-M Demand creates its own supply If AD falls, it wont be a price adjustment (classical and neoclassical thought), but a quantity adjustment Savers and investors are very different people with different motives.

-savers may save for a rainy day or save in order to consume at a later date -this means that an increase in saving does not necessarily translate to an increase in investment In a recession you cant count on investors to bail the economy out (they wont invest when people arent consuming); therefore, you need government spending to lift the economy out of a recession. n PV = T=1

AE -----------T (1+i)

-Theory of rational expectations: no one can make money except by accident.

MD ---- = f (wealth, r, i, i, h, e, (p) P b -Monetary Theory -Added an enormous amount to monetarist theory -Added concept of velocity preventing economy from reaching full employment. -Fiscal policy: way of injecting money into system. -Attempting to increase AD by increasing money supply and velocity. -Modern Monetarism Considered to be generally derived from Keynes 1936 work The General Theory of Employment, Interest and Money. Subject of debate as to whether money affects prices or output. MV =PQ -Quantity Theory of Money Cambridge equation: MD = KPQ

-Under the classical theory: if one holds $, then one gives up the right to alternative uses of the money.

Figure 32-2

-Economics of AD -If the economy starts at full employment at point a, an increase in Aggregate Demand (AD2) will cause prices to rise proportionally. But a decrease in Aggregate Demand (AD1) will result in quantity adjustments, to point b. The economy will be in a depression at output Q0. -The red segment corresponds to short run Keynesian Aggregate Supply during depressed times.

Liquidity Preference -Inversely proportional relationship between interest rates and bonds -As i decrease, prices of bonds increase Criticisms of Neoclassical Assumes velocity and quantity are fixed -BUT: -spending is a function of expectations -expectations of a reality cause that reality to unfold (helps explain Depression/Inflation) ** How do the foundations for your pessimistic/optimistic expectations determine the change in your spending? - Assumes hardcore analysis and independent reason, and ignores herd behavior of investors -W, I & P Sticky

Wage Rate & Sticky Prices 1940s 1970s Keynesian paradigm reined -prices adjust much faster than wages; wage rate is the stickiest set of prices -p > i > w Example: 9-11 attacks - Fed increased money supply because it expected output to decrease -the recession worsened: velocity of money went down as money supply rose -anything that reduces spending/buying tends to reduce inflation Reasons for Wage Stickiness 1 2 3 Goods in spot markets, wages by contract Cut wages people riot Peak-end rule (Kahneman & Tversky) - its NOT where you are that matters, but where you were 4 Efficiency Wage - firms pay workers above the opportunity cost of their next best alternative to ensure diligence -quality is a function of price -wages would be more flexible at the lower equilibrium wage

Lerner Wage-Price Reaction Functions

Keynesian Quantity Adjustment vs. Instantaneous Price Adjustments

- the more out of whack a market is, the faster the rate of adjustment that takes place -- extreme surpluses (excess supply): high decrease in prices -- extreme shortages (excess demand): high increase in prices - markets adjust more easily to excess demand (increasing prices) than to excess supply (decreasing prices) prices go up easier than they go down - prices adjust up/down faster than wages do -- longer sticky unemployment: goods sold in spot markets, labor by contract

-Velocity Effect M+V=P+Q M 5%, V 5%, no effect on P and Q. Perpetual of dynamic disequilibrium Objection: if everything is cause and affect then the notion of dynamic disequilibrium does not exist. -Great Depression: Banks will not make loans M , and people who do receive money choose to save it, but not in the bank, thus further reducing the money supply. Keynes solution: find a way to boost AD.

"[Monetarism] has benefited much from Keynes' work...If Keynes was alive today, he would no doubt be at the forefront of the counter-revolution. You must never judge a master by his disciples." -Friedman

Figure 32-4 Keynesian Quantity Adjustments -Government Intervention Believed that the invisible hand may be too slow. Government intervention was thus necessary. * Aggregate Expenditure = C + I + G + (X-M) * During recession, we cannot count on consumption to rise since people tend to save more than spend. People are afraid seeing others around them without a job. * Investment will also not rise since investors are unsure if their investments will give them the returns since people are not buying.

* Trade does not change since any activities to limit import could start trade wars and thus effectively reducing trade benefits * Government spending is the only thing that can rise to get the AE back to its original point. One big problem, however, is that once government starts spending more it is hard for them to cut back. * Keynes believed that capitalism leads to disparities in income distribution -this inequality leads to depressions -governments will use imperialistic wars as mechanisms to get out of recessions/depressions Government Intervention History: -Smoot- Hawley tariff passed in 1930 set the highest tariffs in US history -other countries retaliated by increasing their tariffs on US goods -lead to severe worldwide losses of the gains from international trade -US adopted these suggestions during the New Deal -Great Depression ended when the US entered WWII -Keynes believed that unfair reparations placed on Germany after WWI would lead to the next world war; he was correct. Ralph Byrns proposes an Easter Egg Hunt (the eggs will be stuffed with money) as a substitute for wars -demonstrates that wars are not needed for Keynesian multipliers to work theoretically. -problem with Keynesian multipliers is that government spending is addictive Criticism or Alternatives to Government Spending Argument against Keynesian cure: -after recession ends, government spending remains the same until next recession when spending goes up again One alternative to increasing government spending is lowering taxes -decreased taxes means that people spend more -may not work in a deep recession if people are too pessimistic -this is a demand side argument for cutting taxes -the previously discussed Laffer curve is a supply side argument for cutting taxes -Other Ideas: Paradox of Thrift -peoples attempts to save more may lead them to saving less because increased savings can lead to decreased investment -recession or depression may result from this decreased investment and subsequently people will make less money, leading to decreased savings

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.

History of Economic Doctrines

Lecture 33

Neoclassical Macroeconomics: Aggregate Supply (price adjustments)

Economics of aggregate supply - AD doesnt matter; AD only for price levels 1. Says Law- supply creates its own demand 2. Flexible wages, labor, prices ensure that markets clear Yields full employment: best of all possible worlds -- Quantity Theory of Money adds a little macro to all the micro -- Q = f (K, L): output is function of resources available and the technology used -- in the LR, the Aggregate Supply curve is vertical -- in the long run, money is neutral [Q g(M)] -- AD determines the price level, with AS given

A neoclassical Aggregate Supply corresponds to the vertical blue line. The price level is exactly proportional to the money supply

-- the amount that people want to spend is proportional to the amount of money available money is only useful for transactions and accounting purposes: Money is merely: (1) a medium of exchange. (2) money is a standard unit of account [i.e., it is a common denominator as a

measure of valuerelative prices] -- MV = PQ

Business Cycles
--booms and busts are not a problem because they self-cure (homeostatic) -- during depressions: prices fall, people buy gold (on Gold Std per Mill) --Consequently, economy adjusts

KEYNESIAN THEORY: ECONOMICS OF AGGREGATE DEMAND (QUANTITY ADJUSTMENTS)

Neoclassical macro may be correct for the long run, but does NOT accord well with what people are actually experiencing during a recession or depression -- Keynes: neoclassical mechanisms are slow: SR matters greatly. In the LR we are all dead. Keynes argued that his is a General Theory - general b/c it applies to both short and long run - focuses on the SR 1. Wages, prices, interest rates are sticky 2. Keynes Law -- demand creates its own supply [In the short run] -- economics of AD -- if the economy starts at full employment at point a, an increase in Aggregate Demand (AD2) will cause prices to rise proportionally. But a decrease in Aggregate Demand (AD1) will result in quantity adjustments, to point b. The economy will be in a depression at output Q0. The red segment corresponds to short run Keynesian Aggregate Supply during depressed times.

3. Liquidity Preference

-- inversely proportional relationship between interest rates and bonds -- as i decreases, prices of bonds increase

Criticisms of Neoclassicism
- Assumes velocity and quantity are fixed -- BUT--spending is a function of expectations -- expectations of a reality cause that reality to unfold (helps explain Depression/Inflation) ** how do the foundations for your pessimistic/optimistic expectations determine the change in your spending? - Assumes hardcore analysis and independent reason, and ignores herd behavior of investors

Summary of Some Macroeconomic Theories

MACROECONOMICS

Classical Dynamics Ricardo Malthus Smith (Marx) population economic growth gains from trade razor edge existence

NEOCLASSICAL
long run started looking at intricacy of machinery flexibility of w, p, i Says Law (SD) Q- full employment

best of all possible worlds equation of exchange o o MV=PQ M/M=P/P

Marshall (time analysis) o o o Immediate (market) period Short-run Long-run Technology is fixed/held constant across all time

Welfare o Y/Pop = f(K/L) o Capital accumulation to increase welfare

Y/Pop = f(tech) technological advance increases welfare

KEYNES
short run w, p, & i are NOT flexible Keynes Law: demand creates its own supply He turned the neoclassical theory on its head Fiscal policy A monetary theorist Money as o o o Medium of exchange Unit of account Store of value Interest rate and its important effects on the demands for money

Demand for money o o o Transaction Precaution Asset Money as an asset: liquidity preference

FRIEDMAN
admired Adam Smith and his idea of the invisible hand and advocacy of libertarian ideals of the least government as the best government government as an inefficient bureaucratic mess o in favor of voucher system in education choose own education

eliminate all regulation that limits access to a profession in favor of very limited form of monetary policy o rate of monetary growth should be identical to that of the potential growth of economy o o to avoid/reduce inflation fixed annual percentage

the economy as intrinsically stable saw the Fed as people with too much power who are bored and like to play at the expense of the economy

Monetary Theory: o Unimportance of transitory income and importance of long-term permanent/life-long income in determining market demand for money Md/P = f(Yperm, r, i-bonds, i-money, expectations) Part of Chicago tradition (1920-1940s) Friedman published this idea of demand for money and gained tremendous reputation Expectations about inflation and permanent income as the most important

factors 2 other major monetary theorists (members of the Chicago school around the same time): o Harry G. Johnson o Brilliant, alcoholic

Don Patinkin Wrote incomprehensibly but great notes from classes at University of Chicago as contemporary of Friedman

Patinkin was angry that Friedman was receiving all of the press, so he vilified Friedman as a fraud and a liar Friedman invented the Chicago oral tradition it didnt really exist

Savage and Friedman came up with a theory for why people make bad bets o Ex: gambling, life insurance,

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.

Marx v. Marginalism Marxists view neoclassical focus and analysis as trivial

1. neoclassical economists are viewed as concentrating on the functioning of machinery rather than on the alienation/exploitation/dehumanization that the machinery (capitalism) does to the people/workers.

Marxist predictions:2. Business cycles

(a) huge violent fluctuations that get bigger and bigger (dynamic instability)-- resulting in an ever-increasing concentration of income (b) as capital increases monstrously (i) the rate of return to capital will go down over time [diminishing profitability] (did not happen) (ii) increase in inequality (debatable) (iii) concentration of market power (happened) -- automobile, steel, computer industries -- globalization opens up markets and may eliminate some of the need we see for antitrust laws (iv) class interests dominate political attitudes and much of market behavior appears realistic link to public choice theory (appears to be a correct tendency) (v) ever more violent imperialistic wars as capitalists look for new resources to exploit (and, according to the Hobson-Lenin version of Marxism, new markets in which to sell) -- results in a big revolution as proletariat tire of domination by capitalist elites and the bourgeoisie Smith: - monopolies can't survive unless they receive protection from the government -- example: AT&T