History of Modern Macroeconomics
Lecture 3.2. The Great Depression: Keynes and
His Critics (the 1930s)
Kevin D. Hoover
Department of Economics
Department of Philosophy
Center for the History of Political Economy
Duke University
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John Maynard Keynes
(1883-1946)
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Keynes is the Most Influential Economist of the
20th Century
(by articles in JSTOR)
Economist
Keynes
Name in Title
Name in Article
1,428
30,249
Friedman
130
17,828
Samuelson
110
14,524
Lucas
44
9,535
Prescott
10
4,846
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Keynes’s Paternity: Natural and Academic
John Neville Keynes (1852-1949)
Alfred Marshall (1842-1924)
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Some Bloomsburies
Duncan Grant 1885-1978 (Self-portrait)
Virginia Woolf 1882-1941
Lytton Strachey 1880-1932 (by Dora Carrington)
E.M. Forster 1882-1941
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Keynes and the Arts
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Maynard and Lydia
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Keynes’s Books circa 1930
1919
1921
1930
1923
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If the books seem dry . . . Maynard and
Lydia again
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A Doctrinaire Quantity Theorist and the
Urgency of the Present
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
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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
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Perfectionist and Imperfectionists
Accounts of the Business Cycle


Ricardo-Malthus debate as a prelude
Say’s Law:






Supply creates its own demand
Capital always finds productive uses
No natural barriers to full employment
No general gluts
Imperfectionist: Labor resistance (implicit or explicit)
to real wage cuts the source of unemployment
Perfectionist (Keynes): unemployment in the nature
of the economy
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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
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“Mr. Keynes and the Classics”: The Most
Influential Interpretation of the General Theory
Sir John Hicks
(1904-1989)
IS-LM Model
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The IS-LM (originally IS-LL) Model – 1
 Aggregate Supply: classical
except for sticky nominal wages
 Aggregate Demand: IS
 Consumption Function
C = C(Y)
0 < C < 1
 Investment Function
I = I(r)
I < 0
 Accounting Identity/Equilibrium
Condition
Y = C + I or S = I
 The IS Curve:
Y – C(Y) – I(r) = 0
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The IS-LM (originally IS-LL) Model – 1
 Aggregate Demand: LM
 Money Supply
MS M
 Money Demand or Liquidity Preference:
D
M = L(Y, r) L/Y > 0, L/r < 00
 /Equilibrium Condition
S
D
M =M
 The LM (or LL) Curve:
M  L(Y , r )  0
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Hick’s IS-LM Interpretation of Keynes
r
IS Curve2
LM Curve
IS Curve1
Effect of Monetary Expansion
Flat section = absolute liquidity preference
Y
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Keynes: Heterogeneity

Relative social position in labor markets and
aggregate supply

Coordination failure (ex ante and ex post)

Fallacies of composition

Monetary economy
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Uncertainty and Rationality – 1

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.]
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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
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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
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Implications of Uncertainty
r
IS Curve
r
LM Curve
IS Curve
LM Curve
Tranquil periods
slide up and down
IS curve
Tranquil periods
slide up and down
LM curve
Periods of
reassessment IS
curve shifts bodily
Y
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Periods of
reassessment IS
curve shifts bodily
Y
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The Trade Cycle

Investment major source of fluctuations

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marginal efficiency naturally falls as boom
progresses
large shifts from reassessments of future profits –
dimmed animal spirits
firms hesitate to cut wages
wage cuts reduce income and have adverse
multiplier effects
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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
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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
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The Central Message (or Central
Innovation) of The General Theory

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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
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Thanks

The End
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