Elizabeth Dalzen
University of Wisconsin—Superior

Keynesian Theories
 Money Illusion/“Animal spirits”
 Keynes on Say’s Law
 Liquidity Trap

Non-keynesian
• Austrian economics
 Austrian Business Cycle Theory
• Classical
 Classical vs. Keynes
• Monetarism
 Quantity Theory of Money
 Inflation and Side Effects
 Government Spending
People think in nominal terms, not real terms
 Deflation

• ↓price level, ↓nominal wages, ↔real wages
• ↓price level, ↔nominal wages, ↑real wages ⇒ surplus
 Involuntary unemployment

Animal spirits:
• “A spontaneous urge to action rather than inaction…”*
• Decisions are made in the short-run, “In
dead.”**
the long run, we are all
• Confidence
*Keynes, The General Theory of Employment, Interest, and Money
**Keynes, A Tract on Monetary Reform
 Say’s
Law: People produce in order to
consume
• No general gluts
 What
if suppliers don’t spend?
• Hoarding (saving without investing)
• ↓AD ⇒ ↑unemployment ⇒ ↓AD ⇒ · · · Recession
 As
the interest rate approaches zero,
stronger liquidity preference
• Individuals don’t save (invest), banks don’t lend
 Flat
LM curve
• Impotent monetary policy
 Confidence
 If
• Money illusion
• Glut of unemployment
• Low interest rates
• Deflation
• Low consumer and business confidence
• Hoarding/Liquidity Trap
• Dearth of investment
 Then
• Increase national income by shifting IS curve, increasing
AD
 Gov’t. should spend, spend, SPEND!
 Expansion
of credit by banks
 A central bank is necessary for banks to expand
credit
• “if banks were truly competitive, any expansion of credit by
one bank would quickly pile up the debts of that bank in its
competitors, and its competitors would quickly call upon
the expanding bank for redemption in cash”*
*Rothbard, Economic Depressions: Their Cause and Cure
expansion ⇒ Inflationary Boom
 Domestic prices bid up ⇒ ↑imports
 Gold flows out of the country as payment
for imports
 As banks’ gold stores dwindle, panic!
 Credit
• Fractional reserve banking
 Banks
call in loans, ↓Money supply
(deflation)
 Economy contracts
 Interest
rate artificially depressed
 Malinvestment
• Low i rate is only temporary
 Overinvestment
in capital goods
• Not enough savings to buy all producers’ goods
 Capital
is heterogeneous
 Gold
Standard
 Money supply shouldn’t increase, even if
the population or supply of goods
increases
• Deflation problems
 Government
sanctioned ↑M ≈
counterfeiting
 Smallest
decision making unit: the
individual
 Homo economicus
• Rational
• Self-interested
• Utility maximizing
 Assume
perfect information
 Money
illusion/stickiness
• Example: Deflation
• Workers resist ↓nominal wages
• Businesses have 2 options:
 Raise prices ⇒ cost-push inflation
 Lay off wokers
 Workers seek new jobs
 Businesses offer wages that reflect workers real worth (if no
minimum wage laws, labor unions, etc.)
 Stickiness
due to:
• Time lags with change in price level
• Contract length
• Labor unions
 Misrepresentation
of Say’s Law
• Say never said that depressions and unemployment
are impossible
 Say’s
Law: supply creates its own demand,
so no general gluts
• requires flexible, self-correcting markets
• A temporary glut in the labor market is not a general
glut
 Hoarding:
why?
 Keynesian
economic man:
• Ruled by “animal spirits”
• Doesn’t make decisions for the long-run
• Incapable of thinking in real terms
• But somehow responds rationally to lower interest
rates by investing less of his money…?
 Also
has roots in classical economics
 Disagree with both Keynesians and
Austrians on inflation and the business
cycle
 Milton Friedman
 Quantity
theory of money:
• M*V=P*Q
 M=quantity of money in circulation
 V=velocity of money
 P=price level
 Q=index of the real value of final expenditures
 Keynes:
V is inherently unstable
• M, V move in opposite directions
 Friedman:
direction
M, V move in the same
 Inflation
is always a monetary
phenomenon
• M and P are not independent
• ↑M⇒↑P
 Since
M*V=P*Q, we have ∆M+∆V=∆P+∆Q
• Assume velocity is stable (∆V=0)
• ∆P=0 if and only if ∆M=∆Q
• To avoid inflation, the growth rate of the money
supply should be set equal to the growth rate of
output
 Monetarists
want monetary policy that
creates a stable framework
 Reducing inflation is not technically
difficult, but there are political barriers
 Possible side effects of reducing inflation:
• Recession
• Unemployment
 In
a liquidity trap:
• Even if the Fed increases M, banks hesitate to
lend (low interest rates)
• Bypass the banks, give money directly to
consumers
• Aggregate Demand boosted without increasing
government spending
 Where
does the money come from?
• Increased tax revenue
Borrowing from the private sector
 Government spends money that otherwise would have
been spent in the private sector
• Printing money
 Implicit tax on holders of dollar denominated assets
 No legislation involved

Keynesian Theories
 Money Illusion/“Animal spirits”
 Keynes on Say’s Law
 Liquidity Trap

Non-keynesian
• Austrian economics
 Austrian Business Cycle Theory
• Classical
 Classical vs. Keynes
• Monetarism
 Quantity Theory of Money
 Inflation and Side Effects
 Government Spending

References
•
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