Capital-Based Macroeconomics
Adapted from Time and Money:
The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001
Keynes and Hayek: Head to Head
2009
Keynes and Hayek: Head to Head
John Maynard Keynes
1883 — 1946
Friedrich A. Hayek
1899 — 1992
Visions and Frameworks
Keynes’s vision of the economy suggests a circular-flow
framework—in which earning and spending are brought into
balance by changes in the level of employment.
Graphically, the circular flow appears as the Keynesian cross,
the cross’s intersection identifying the particular state of the
economy in which income and expenditures are in balance.
Hayek’s vision of the economy suggests a means-ends
framework—in which the means of production are
transformed over time into consumable output.
Graphically, the means and ends appear as the Hayekian triangle,
the triangle’s shape depicting the intertemporal pattern of
investment. In equilibrium, the pattern of investment corresponds
to the intertemporal preferences of consumers.
A BRIEF REVIEW
of the
KEYNESIAN
CIRCULAR-FLOW
FRAMEWORK
SKIP
BUSINESS
ORGANIZATIONS
LABOR
AND OTHER
FACTOR SERVICES
THE
CIRCULAR-FLOW
FRAMEWORK
WORKERS
INCOME
CONSUMERS
INVESTORS
BUSINESS
ORGANIZATIONS
EXPENDITURES
consumption
plus
Investment
LABOR
AND OTHER
FACTOR SERVICES
GOODS
AND
SERVICES
WORKERS
INCOME
CONSUMERS
INVESTORS
BUSINESS
ORGANIZATIONS
EXPENDITURES
consumption
plus
Investment
SLOW
6%
FAST
2%
WORKERS
INCOME
CONSUMERS
INVESTORS
CONSUMPTION
EXPENDITURES
consumption
plus
Investment
BUSINESS
ORGANIZATIONS
STAGES OF PRODUCTION
WORKERS
INCOME
CONSUMERS
INVESTORS
CONSUMPTION
EXPENDITURES
consumption
plus
Investment
BUSINESS
ORGANIZATIONS
STAGES OF PRODUCTION
WORKERS
INCOME
CONSUMERS
INVESTORS
SKIP
EXPENDITURES
consumption
plus
Investment
BUSINESS
ORGANIZATIONS
In Keynesian equilibrium,
INCOME equals EXPENDITURES.
Y=E
For a wholly private economy:
Y=C+I
WORKERS
INCOME
CONSUMERS
INVESTORS
EXPENDITURES
C+I
1
a
45o
Investment
The
As
taught
economy
atdepends
allislevels,
in a
INVESTMENT
Keynesian
the
neither
consumption
on (current)
equilibrium
C = a + bY income
somewhere
function
nor
is an
on
along
the the
rate
o line—the
45interest.
essential
of
component
It depends
line itself
b
identifying
of
only
theonKeynesian
profit
all possible
income-expenditure
framework.
expectations,
The
which
CONSUMPTION
equilibriumstability
presumed
themselves
points.
are notof
this function underlies
well-anchored
in
Keynesianreality.
economic
thinking.
INCOME
INCOME
Consumption and Investment (as well as Government Spending)
are portrayed as additive components of total spending. The three
components are distinguished largely in terms of their stability
characteristics: stable (C ), unstable (I), and stabilizing (G).
A wholly private macroeconomy achieves an income-expenditure
equilibrium when Y = C + I. Note that income itself (rather than
prices, wages, or the interest rate) is the equilibrating variable.
EXPENDITURES
C = a + bY
CONSUMPTION
C+I
According to Keynes, it is
only by “accident or design”
that the economy is actually
performing at its fullemployment potential.
Yfe
INCOME
INVESTMENT
We assume here that,
Labor income
In (Y
capital-based
= WN)
macroeconomics,
In full
Keynesian
employment
macroeconomics,
implies that
initially, full employment
is fully representative
the economy
of is operating on its production
full employment
possibility
implies
frontier,
that
conditions prevail—if only
total income,the
such
PPF
that
itself being defined in terms
the labor
of sustainable
market clears
output
at the
by accident.
changes in labor
levels of consumption and investment
going goods.
wage rate, the going
W
income stand in direct
wage itself having emerged
S
proportion to changes
during a period in which the
LABOR
D
INCOME
in total income.
economy was experiencing no
N
macroeconomic problems.
EXPENDITURES
C
ΔI+ I
EXCESS INVENTORIES
C = a + bY
ΔC
1
ΔY = (1 – b) ΔI
E=
<Y
ΔY
Yfe
INCOME
According to Keynes, a collapse of investment activity (the
collapse being attributed to a waning of “animal spirits”) is the
primary cause economic downturns. In response to reduced
SKIP
investment and hence reduced employment opportunities, the
economyWspirals downward into recession and possibly into
Note that the going wage keeps
S
deep depression.
going—even after the market
D
conditions that gave rise to it are
The simple investment-spending
multiplier, 1/(1-b), quantifies
N
gone.
the extend of the downward spiraling.
EXPENDITURES
C+I
C = a + bY
Yfe
INCOME
A further loss of confidence
In theon
Keynesian
the part of
construction,
the business
prices and the
community will send the
wage
economy
rate are
even
sticky
further
downward.
from its fullemployment potential.
But note that they’re not stuck too high.
W
They’re stuck just right. The going wage rate
S
will clear the labor market once again—as
D
soon as spending and hence labor demand
recover to their full-employment levels.
N
EXPENDITURES
C+I
C = a + bY
Yfe
INCOME
Recovery may be self-initiating. Waning animal spirits may
become waxing animal spirits. In due time, a pressing need to
maintain or replace depreciating capital may account for the
lower turning
W point of a bust-and-recovery sequence.
S
(Keynes, of course, preferred not to wait it out. He advocated
D
make-work projects, deficit spending, and monetary stimulation
N
to get the economy turned
around.)
EXPENDITURES
C+I
C = a + bY
INCOME
Yfe
Recovery may continue as further investment activity drives
labor-demand back to its full-employment level...
W
S
D
N
EXPENDITURES
C+I
C = a + bY
INCOME
From full-employment
onward, there is upward
Recovery
may in
continue as further investment
activity
drives
The equilibrium
points
pressure
on both
prices
level...
but
thereAnd
is since
the laborlabor-demand
market tracedback
out to its full-employmentand
wage
rates.
nothing
about
the and
recovery
during the
recovery
and“animal spirits” that will bring
prices
wage rates are
process
an end at full
W employment.
inflationary
spiraltoconstitute
not sticky upwards, the
S
the so-called L-shaped
economy experiences a
Over-optimism may push the economy beyond
its inflation.
fullsupply curve.
spiraling
D
employment level.
Yfe
N
MORPHING FROM
CIRCULAR FLOW
TO MEANS AND ENDS
EXPENDITURES
C = a + bY
INCOME
Yfe
CONSUMPTION
C+I
INVESTMENT
The nature of the Keynesian-styled spiraling associated with
recession, depression and inflation becomes more transparent
with the production possibility frontier in play.
W
Also, the PPF helps buildSa bridge from Keynes to Hayek.
D
N
EXPENDITURES
C = a + bY
Yfe
INCOME
CONSUMPTION
C+I
INVESTMENT
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
C = a + bY
Yfe
INCOME
CONSUMPTION
EXPENDITURES
C+I
INVESTMENT
Note that if investment
A further
were towaning
fall to zero,
sendsthe
theeconomy
economywould
settle into an income-expenditure
deeper into the
equilibrium
PPF’s interior.
with Y = C.
Movements inside the frontier (and beyond
Thus,
the
vertical
intercept
of the Keynesian demand constraint
W
it) trace out a linear relationship, showing
is aligned withS the intersection of the consumption function and
how consumption varies with investment.
the 45o line.
D
The straight line that passes through these
N
points is the Keynesian demand constraint.
EXPENDITURES
C+I
C = a + bY
CONSUMPTION
a
b
C = (1 – b) + (1 – b) I
b
1–b
a
(1 – b)
Yfe
INCOME
INVESTMENT
For simplicity, let a = 0 and b = 0.90. Then C = a + bY becomes C = 0.90Y.
And C = a/(1-b) + b/(1-b) I becomes C = 9(I), which led Keynes to write:
“If,
forformula
example,
the public
are in
the so
habit
of spending
of their
“The
is not,
of course,
quite
simple
as in thisnine-tenths
illustration….
But
income
consumption
goods,
entrepreneurs
to of
there is on
always
a formula,
more itorfollows
less ofthat
this ifkind,
relating thewere
output
produce
consumption
goods
at a cost
more than
nine
timesofthe
cost of
consumption
goods which
it pays
to produce
to the
output
investment
the
investment
goods theyappears
are producing,
partbeyond
of their dispute.
output could
goods….
This conclusion
to me tosome
be quite
Yet the
not
be sold at awhich
price which
itsat
cost
production.”
consequences
follow covered
from it are
theofsame
time unfamiliar and of
the greatest possible importance.”
EXPENDITURES
C = a + bY
INCOME
To keep track of possible interest-rate
movements, the loanable-funds market can
be brought into view.
Though Keynes argued that neither saving nor
investment depend to any significant extent on
the interest rate, he also argued that both curves
(as conventionally drawn) shift together, leaving
the interest rate unchanged.
INVESTMENT
RATE OF INTEREST
Yfe
CONSUMPTION
C+I
S
D
SAVIING (S)
INVESTMENT (D)
EXPENDITURES
C = a + bY
INCOME
With the loanable-funds market in play, we see
that decreased investment is accompanied by a
leftward shift in the demand for loanable funds,
Appearing
putting downward
in Keynes’s
pressure
General
on the
Theory
interest
is this
rate.
specific applicationWof the loanable-funds
S
But the spiraling
downward of
income implies
framework.
The implications,
according
to
that the is
supply
of loanable
funds
(a.k.a.
saving)
D
Keynes,
that the
loanable-funds
reckoning
is,
also
shifts
leftward, relievingNthe downward
at
best,
superfluous.
pressure on the interest rate.
INVESTMENT
RATE OF INTEREST
Yfe
CONSUMPTION
C+I
S
D
SAVIING (S)
INVESTMENT (D)
As shown on page 180 of his General Theory,
Keynes presented the loanable funds market
with the interest rate [ r ] on the horizontal axis.
i
Although he failed to label the vertical axis, the
accompanying text indicates that “saving” and
“investment” are measured vertically.
Keynes’s diagram can be flipped over and
rotated 90 degrees to make it conform to
modern renditions of the market for loanable
funds.
S, I
S, I
Some of the saving curves are intended only to
demonstrate that income is a shift parameter
and are not otherwise relevant to Keynes’s
argument. So, let’s omit them
i
ieq
S’ = I’
S=I
S, I
Some ofbelieved
Keynes
the saving
thatcurves
a shiftare
in investment
intended to
demand would
demonstrate
that
beincome
accompanied
is a shift
byparameter
a matching
shift are
and
in the
notsaving
otherwise
schedule.
relevant to Keynes’s
argument. So, let’s omit them.
Yfe
CONSUMPTION
C
INCOME
Appearing in Keynes’s General Theory is this
specific application of the loanable-funds
framework. The implications, according to
Keynes, is that the loanable-funds reckoning is,
at best, superfluous.
INVESTMENT
RATE OF INTEREST
EXPENDITURES
C+I
S
D
SAVIING (S)
INVESTMENT (D)
EXPENDITURES
C
INCOME
Hence
Keynes
The
To
resolve
rightward
the
also
Keynes’s
Paradox:
denied
shift inthat
“Paradox
supply
an increase
ofofloanable
Thrift”
in saving
requires
funds
would
puts
only
that
downward
have
wethe
replace
pressure
effectthe
imagined
Keynesian
on the by
interest
the
cross,
loanablerate.
which
Try to save more and you’ll instead earn less!
funds theorists.
reflects
the economy’s
Keynes’s
circular
“Paradox
flow,of
with
Thrift,”
the as
But before there is any movement along the
articulatedtriangle,
Hayekian
in his General
which depicts
Theory means
is to theand
point:
demand for loanableW funds, the pressure is
ends in their temporal sequence.
S
“Every ...as
relieved
attempt
reduced
to save
consumption
more bycauses
reducing
income
D
consumption
and
hence saving
will so
toaffect
fall. incomes
that the
attempt necessarily defeats itself.”
N
INVESTMENT
RATE OF INTEREST
Yfe
CONSUMPTION
C+I
S
S
D
SAVIING (S)
INVESTMENT (D)
EXPENDITURES
C
CONSUMPTION
C+I
CONSUMPTION
INCOME
The level of consumption that appears as a part
of the Keynesian circular flow also appears in the
capital-based framework as the consumable
output of a temporal sequence of production
activities.
INVESTMENT
RATE OF INTEREST
Yfe
S
D
SAVIING (S)
INVESTMENT (D)
CONSUMPTION
CONSUMPTION
CONSUMPTION
Note
thathowever,
the
sole
effect
the
structure
We begin,
Keynes,
The
market
level
ofasmechanisms
consumption
before,
assumed
withon
in
that
the
play
a economy
appears
“fixed
herestructure
are
asofstill
a part
of
production
comes
from
the
initial
in
those
functioning
industry,”
of
the envisioned
Keynesian
which
at itsinfull
circular
by
the
employment
Keynes.
current
flow
context
alsoreduction
level.
appears
implies
in athe
consumption.
The
derived-demand
effect
works
a Hayekian triangle
capital-based
framework
of fixed
as shape,
the consumable
the
only
live
W
W
In accordance
The
labor market
with
is the
representative
paradox, anofincrease
each of in
undiminished
ontriangle’s
all the
stages.
issue being
output
of a temporal
the
sequence
size,
which
of production
represents
S earlier
S
saving
the
stages
causes
of production
the economy
thatto
make
spiral
updown
the to a
the level of employment and the extent of
activities.
The
interestcapital
rate isstructure.
effectively
less-than-full-employment
economy’s
level.
D out of play. The
D
capital utilization.
leftward shift of savingN tookNthe downward
pressure off of interest rates. And, in any case, the
capital structure is assumed to be fixed.
INVESTMENT
RATE OF INTEREST
STAGES OF PRODUCTION
S
S
D
SAVIING (S)
INVESTMENT (D)
CONSUMPTION
CONSUMPTION
Three
modifications
are needed
transforma the
And now,
the “Paradox
of Thrift”tobecomes
“Gateway to Growth.”
Keynesian vision into the Hayekian vision:
With wage rates and the interest rate both
1.adjusting
2.
3.
Allow
Divide
Get
ridfor
the
ofto
stage-specific
the
structure
Keynesian
of
production
labor
Demand
markets---in
into
Constraint.
stages.
changing
market
conditions,
thewhich
wage
rates can
adjust
to changed
conditions.
economy
move
along its market
PPF and
the
structure of production
can adjust to an
increase in
saving.
INVESTMENT
RATE OF INTEREST
STAGES OF PRODUCTION
W
W
W
S
S
S
S
D
D
D
D
N
N
N
SAVIING (S)
INVESTMENT (D)
CONSUMPTION
EXPENDITURES
BUSINESS
ORGANIZATIONS
“Mr. Keynes’s aggregates
conceal the most fundamental
mechanisms of change.”
STAGES OF PRODUCTION
WORKERS
INCOME
FACTOR
OWNERS
CONSUMERS
Keynes and Hayek: Head to Head
John Maynard Keynes
Friedrich A. Hayek
Capital-Based Macroeconomics
Adapted from Time and Money:
The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001
Sustainable and Unsustainable Growth
The Macroeconomics of Boom and Bust
2009
Capital-Based Macroeconomics
Adapted from Time and Money:
The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001
Keynes and Hayek: Head to Head
2006