30 Jun 2011

OK for my Keynes, Krugman, and the Crisis class–we still have registrations rolling in, don’t be shy!–I have just assigned Chapters 1-3, and some selections from Chapter 12, to give about a 50-page excerpt from the General Theory to convey Keynes’ diagnosis of how the “classical” economists went wrong.

Now to make sure I know exactly what Keynes is doing–so that I can “dumb it down” for the layperson–let me ask the resident Keynesians for some clarifications, all related to Chapter 3:

* What is the unit of aggregate supply price and aggregate demand? In money?

* Is the aggregate supply price referring to the unit price, or the total proceeds? Keynes defines the aggregate supply price as the “expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment.” So does that mean total proceeds, or proceeds per unit of output?

* Related to this, are the functions Z=psi(N) and D=f(N) upward sloping? [UPDATE: It’s not psi, but I can’t remember my Greek letters…] (And what is the Y axis here–money?) So Keynes is saying that in the general case, D starts above Z, but has a lower slope, so that when N is really low, D is above Z, but eventually they intersect as N increases?

* Keynes says that when N is below the equilibrium point, then D is above Z, and so entrepreneurs have an incentive to hire more workers. But why? It sounds intuitive at first, but I’m not so sure it is. In particular, Keynes says that when N is such that D and Z intersect, the entrepreneurs profit has been maximized. But it seems to me the profit is zero at that point? (In a standard micro model, it’s fine for the producers to maximize profit at the point of zero-profit, because they’d earn negative profits at different levels of output. But that’s not what happens here. If N went below the intersection point, then wouldn’t aggregate profits go up?)

* Later on, when discussing the implications of the classical view, where D=Z at all levels of N, Keynes says “the forces of competition between entrepreneurs may be expected to push [N] to this maximum value.” But why? If Z and D overlap each other for all N, and Keynes has earlier argued that at the intersection point, aggregate profits are maximized, then why would entrepreneurs have an incentive to move N one way or the other, if Say’s Law holds?

#### 23 Responses to “Keynes Bask”

1. Subhi Andrews says:

I just finished watching the recording. I’m on West Coast time. Can’t attend the class live.

Can you talk about the monetarist argument about collapse in money supply? Not the surge in monetary base, but the collapse in broader monetary aggregates.

2. Joseph Fetz says:

“its not psi”

Good, I thought that maybe you were referring to “inflation” Badoom Tshhhhh!

• Tel says:

We should start a meme and get all economists using psi as the symbol for inflation metrics. Once enough people start doing it, that will become the standard. You know it makes sense.

3. Joseph Fetz says:

Bob, what kind of computer do you use? If you use a Mac you can just go into “edit” on the top bar of Safari (or, pretty much any Mac program), then choose “special characters” and insert Φ directly into the text of your blog (or, any other character that you wish).

4. Subhi Andrews says:

It looks like my comments are always waiting for moderation. I wonder if I have a track record of making stupid comments here that I don’t know off. 🙂

5. Dan says:

“* Related to this, are the functions Z=psi(N) and D=f(N) upward sloping? [UPDATE: It’s not psi, but I can’t remember my Greek letters…] (And what is the Y axis here–money?) So Keynes is saying that in the general case, D starts above Z, but has a lower slope, so that when N is really low, D is above Z, but eventually they intersect as N increases?”

Z is upward sloping because the total cost of production increases as output increases. Aggregate demand is (I + C) so D is upward sloping because consumption increases as ouput increases. I is the amount of investment needed to cover costs at a given output, so it merely shifts the curve upwards.

As for your last two questions, an economy’s aggregate profit is only maximized at Z=D. Otherwise, you are either overproducing or underconsuming. The market takes care of which individual firms are making profits or losses, but overall profits for the economy are maximized

• bobmurphy says:

Dan, thanks. I get the intuition behind the result, but I’m having trouble relating it to the actual definitions of Z and D. Z is the aggregate amount of proceeds necessary to make it just worthwhile for entrepreneurs to produce that much output.

So if N < N(full), then D is above Z. So entrepreneurs are receiving more total proceeds than they would need, in order to make it just worthwhile to produce that much output. If you were a businessman, and could choose between the following outcomes, which would you prefer: (A) You are receiving the revenue from your customers that makes it just barely worthwhile for you to operate. (B) You are receiving more revenue from your customers than the bare minimum needed to make it worth your while to operate. I think you would clearly prefer (B), which occurs to the left of full-employment N. Also, you didn't answer my question about the case where D=Z for all N, what Keynes considers the special case when Say's Law holds. In that situation, entrepreneurs should maximize profit at any N (assuming it's true that profit is maximized when Z=D). So why would there be any tendency for the economy to move towards full employment? Why wouldn't the economy be stable at any old N, which is actually what Keynes himself seems to suggest at parts when he says that equilibrium N is indeterminate when Say's Law holds?

• Daniel Kuehn says:

Regarding profits –

– First, it’s typical to think about an entrepreneurial income for the service of organizing capital. Keynes refers to this in the final chapter too. So it’s not a matter of “wow if we compete we’ll have an income of zero!”

– Regardless of how that is specified, though, positive profits attract other entrepreneurs who exhaust profit opportunities. It’s not a question of what entrepreneurs prefer. You’re rightly pointing out here that entrepreneurs would like to be monopolists. But that doesn’t mean they’ll get the chance.

• Daniel Kuehn says:

It’s not as if entrepreneurs all talk about what the level of N will be. It’s an emergent order that drives profits (as defined by economists) to zero.

6. Dan says:

Bob,

1) “So if N < N(full), then D is above Z. So entrepreneurs are receiving more total proceeds than they would need, in order to make it just worthwhile to produce that much output. "

I'm reading it differently than you. D above Z means that pent up demand is going unmet by producers which is resulting in lost aggregate profits. Producers receive nothing for unmet demand. The pent up demand can be met by hiring more workers which will increase Z until D=Z @ full employment.

2) I believe that full employment is the ONLY possible outcome in a world where Say's Law always holds. If production always creates its own demand, firms will continue to enter into the market and hire workers until they hit some sort of structural boundary. This is what free market capitalism is all about right?

Good luck with the class!

Dan

• bobmurphy says:

Dan,

Obviously I agree that (1) if demand is higher than supply, that market forces push up quantity and price, and entrepreneurs make more profit, and that (2) Say’s Law leads to full employment.

But that’s not what I’m asking. I’m saying, *given the definitions that Keynes sets up*, I don’t see how those follow.

• Joseph Fetz says:

Which definitions? From my memory the definitions were somewhat loose depending upon the context. I must admit, this stuff is a little out of my league at the moment, because it’s been about 2 years since I read Keynes’ GT (even then it didn’t fully click). I am more familiar with the synthesis than the original.

7. Dan says:

I’m looking at the book A Guide To Keynes…maybe this is where the confusions lies:

States the author:

“Keynes is wrong (p. 29) when he makes D = f(N). Points in D which have become observable and the points in Z which have become observable are indeed always equal, but it is an error to say that D is a function of N. Z (not D) is a function of N, that is, Z = f(N).”

He goes on to say that the C part of D is a function of N, the I part is autonomously determined.

“Indeed to make D = f(N), when Z = f(N) would be the same as saying that the Aggregate Demand Function is identical to the Aggregate Supply function, in other words, Say’s Law. Keynes’ argument is in fact precisely the opposite. What he means to say should be quite evident, though this part of the exposition is certainly confusing.”

“There is no inherent reason to believe that investment outlays plus consumption outlays would always tend to equal the cost at any given output; there is no assurance that Demand would tend to equal any given Supply”

Dunno if this helps..sufficed to say I don’t think everything Keynes stated in his book is correct according to modern Keynesians.

• bobmurphy says:

Hmm. Well, from the small excerpts you’ve given us, it seems to me that guy is talking nonsense. Keynes is saying Z and D are both functions of N, but different functions. So they’re not necessarily the same, which is what (Keynes claims) Say’s Law requires.

8. David S. says:

You actually deserve credit for reading Keynes and trying to understand Keynes, though of course no one takes the General Theory “as is”.

9. Dan says:

Bob,

I’m gonna leave this one to you and Daniel Kuehn to hash out. Final thoughts on this…basically Z=D for all N is not possible in Keynes’ world, if it was then he would have no argument against Say’s Law. It is not possible because D will ALWAYS have a different slope than Z because the marginal propensity to consume.

D is made up of (C+I). C is a direct function of N, but I is not a direct function of N (even though N can influence it)

10. Daniel Kuehn says:

I’m fairly confident in all my responses except to #5. I’m only somewhat confident in that response.

11. Tel says:

On thinking about this further, Keynes really knocks down a straw man here. Classical economics is built around equilibrium analysis, which is to say that if unmolested, the economic system will settle all by itself to a situation where various things balance. The “laws” of classical economics are fundamentally equilibrium laws, and I would argue that Say’s Law is also an equilibrium law.

Such an analysis has nothing to say about far-from-equilibrium conditions other than to say they will be less optimal than the equilibrium position, and over time (one way or another) they must return to the equilibrium position. Getting more specific: Say’s Law does not claim that Z=D for all values of N, it merely claims that Z=D at the economic equilibrium position.

Now, I’d be the first to say that equilibrium analysis has its share of limitations, but Keynes does not sensibly address those limitations.

• Daniel Kuehn says:

1. I agree on what Say’s Law says about Z=D. Keynes saying that “supply creates its own demand” must mean that the f(N) and φ(N) are equal for all values of N” could be interpreted two ways: (a.) that the Z and D schedules themselves are identical, or (b.) that adjustments in N shift one or both of the curves to bring them into equilibrium. While it’s initially unclear, all the rest of hte language of the chapter seems to imply that Keynes means (b.), which makes more sense.

2. I don’t think Keynes is talking about far-from-equilibrium stuff or even standard disequilibrium stuff at all here. He’s presenting a theory of equilibrium underemployment.

Obviously, we can still profitably talk about the market process and action out of equilibrium. But Keynes’s point is that the classics don’t even have a cruder understanding of the ultimate equilibrium right.

• Tel says:

So if Say makes the claim that Z=D at equilibrium, and Keynes also makes the claim that Z=D at equilibrium, and neither of them are really discussing far-from-equilibrium situations, then it seems like we have complete agreement.

Strange that so many people seem to believe that Keynes proved Say’s Law wrong in some way.

• Daniel Kuehn says:

Well, Keynes says that Say says that any movement along the supply schedule will produce an accomodating movement of the demand schedule to maintain equilibrium, because increased supply – by creating the means to purchase – “creates its own demand”. Keynes doesn’t say this. Keynes says yes, the two are in equilibrium but there is no guarantee that it’s a fully employment equilibrium. According to Keynes’s version of Say competition between entrepreneurs guarantees full employment.

So in a sense you’re right – their disagreement is not over whether there is an equilibrium. It’s over whether there is a full employment equilibrium.

• Tel says:

Keynes says that Say says that any movement along the supply schedule will produce an accomodating movement of the demand schedule to maintain equilibrium,

I’m aware of Keynes’ claim, but I still see it as nothing more than a strawman claim. Say was a classical economist, his theory revolved around an economic equilibrium and such equilibrium only exists at one single point value. You can’t have equilibrium existing all along a curve, where one particular value of N is the natural value and other values of N only exist by dint of external force being applied to the system.

Say does make some effort to consider the external force of good and bad harvests: when a good harvest hits the system, food is more plentiful and economic activity is stimulated by that (remember, in Say’s time food is equivalent to energy, so a good harvest is a bit like a new oilfield being discovered). The point being that changing external forces kick the system to new values off N where it settles back into an equilibrium.

However, under no circumstances does this imply that φ(N) = f(N) for all values of N. If year A has a good harvest and year B has a poor harvest then two different φ(N) curves must exist — an “A” curve and a “B” curve. In either case there is only one value of N that is the natural value, but the intersection happens at a different N for the simple reason that they are completely different curves.

… their disagreement is not over whether there is an equilibrium. It’s over whether there is a full employment equilibrium.

I don’t see anywhere that Say makes an attempt to define “full employment”, so this is another straw man. For that matter, the who Keynesian definition of “full employment” is itself a bit shaky and quite frankly only makes sense within a political context, not an economic one… but that’s a longer story that an single blog comment deserves.