Reformulation Of Keynesian Economics, A

Jagdish Handa

• Publisher: WSPC
• Year: 2015
• ISBN:
  9789814616119
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

John Maynard Keynes' response to the extreme distress of the early years of the Great Depression produced The General Theory, which represented an overhaul of the macroeconomics inherited by his generation. The economic upheaval (including the Great Recession) since 2008 raised serious doubts about the relevance of economics as it had come to be formulated and taught by the beginning of this century. While numerous books and articles have addressed the current distress of economies through contributions to specific parts of macroeconomics, none has offered an attractive alternative that represents a general overhaul of the macroeconomics inherited by the current generation. A Reformulation of Keynesian Economic does so, and provides a modern integrated version of macroeconomics for the modern economies as they function.This book's many insights and innovations include: discarding the classical concepts of the long run and the short run in favour of the behavioural concepts of the planning period (the long term) and the short term (the operating period); discarding the exogenous production function in favour of an endogenous one; distinguishing between the short-term and the long-term production functions; replacing the dynamic stochastic notional general equilibrium (DSGE) approach for the short term by a more general one that permits effective equilibrium and disequilibrium in specific markets; and, a reformulation of the financial sector analysis and of the Keynesian business cycle theory.This thoroughgoing revision of macroeconomics is must-read for macroeconomists, policymakers and graduate students. It can even be used as a textbook by instructors who question the inherited orthodoxy built around the DSGE model and are looking for an alternative formulation of macroeconomics.John Maynard Keynes' response to the extreme distress of the early years of the Great Depression produced The General Theory, which represented an overhaul of the macroeconomics inherited by his generation. The economic upheaval (including the Great Recession) since 2008 raised serious doubts about the relevance of economics as it had come to be formulated and taught by the beginning of this century. While numerous books and articles have addressed the current distress of economies through contributions to specific parts of macroeconomics, none has offered an attractive alternative that represents a general overhaul of the macroeconomics inherited by the current generation. A Reformulation of Keynesian Economic does so, and provides a modern integrated version of macroeconomics for the modern economies as they function.This book's many insights and innovations include: discarding the classical concepts of the long run and the short run in favour of the behavioural concepts of the planning period (the long term) and the short term (the operating period); discarding the exogenous production function in favour of an endogenous one; distinguishing between the short-term and the long-term production functions; replacing the dynamic stochastic notional general equilibrium (DSGE) approach for the short term by a more general one that permits effective equilibrium and disequilibrium in specific markets; and, a reformulation of the financial sector analysis and of the Keynesian business cycle theory.This thoroughgoing revision of macroeconomics is must-read for macroeconomists, policymakers and graduate students. It can even be used as a textbook by instructors who question the inherited orthodoxy built around the DSGE model and are looking for an alternative formulation of macroeconomics.Contents:IntroductionThe Reformulation of Macroeconomics — Main ElementsThe Production SectorThe Labour MarketAggregate Demand and Labour SupplyThe Financial SectorA Reformulation of the Expectations Hypothesis for Keynesian EconomicsA Reformulation of the Keynesian Business Cycle TheorySummary and ConclusionsKey Features:The book updates macroeconomic modelling for modern financial (as against merely barter or monetary) economiesOffers insights and innovations which are thought-provoking, and constitute an invitation to researchers to re-think macroeconomics, starting by rebuilding its foundations along more behavioural linesIntegrates financial capital into the analysis of production both in terms of the technology/equipment that the firm chooses over its planning period and the production levels in each of its operating periods

CHAPTER 1

INTRODUCTION

The widespread belief among macroeconomists and the informed public in the failure of macroeconomics became so acute in the years after 2008 that many observers leveled the more stringent criticism that economics as a discipline had developed in a way that had emptied it of empirical content. Among the criticisms was that economics had largely become an axiomatic discipline consisting of highly unrealistic assumptions and mathematical derivations¹ but with limited empirical content and validity.² Further, most mainstream macroeconomic theoretical innovations in recent decades tended to be “self-referential and inward-looking distractions,” with research motivated by internal logic, intellectual sunk capital, and aesthetic puzzles rather than by the need to understand how the economy works, let alone how the macroeconomy works during times of stress and financial instability (Krugman, 2009). Krugman claimed that a more or less Keynesian view is the only plausible game in town: in his words, “Keynesian economics remains the best framework we have for making sense of recessions and depressions.”³ In the views of the critics of the existing macroeconomic analysis, the empirical failure of macroeconomics had its roots in the adoption since the 1970s of doctrines/approaches such as Ricardian equivalence, rational expectations, policy ineffectiveness, foundations of macroeconomics in microeconomics, real business cycle (RBC) theory, the (strong-form of the) efficient markets hypothesis, and dynamic stochastic general equilibrium (DSGE) models, etc.

Economics is sometimes praised and sometimes criticized for emulating physics, so it would be interesting to look at some of the criticisms that have been leveled at physics in recent years. On this, the following quotes taken from The Economist (25 May, 2013, pp. 84–85) on the ongoing conundrum — or impasse — in physics seem to have an eerie resemblance to some of the preceding assessments of the current state of economics.

Jim Baggot in “Farewell to Reality” bridles at the inequity of what he calls ‘fairytale physics’: the flights of mathematical fancy, based on nothing more than personal taste, that he feels have come to litter the theoretical landscape over the past two decades.

Mr. Smolin believes that the impasse highlighted by Mr. Baggot is the result of applying theories that work for small, isolated systems to describe the universe as a whole.

This criticism of physics sounds suspiciously like that leveled in recent years at economics: the preceding quotes, with “physics” replaced by “economics,” “small, isolated systems” by “microeconomics” and “universe” by “macroeconomics” would equally well apply to the attempt to base macroeconomics on microfoundations and notional general equilibrium. Further,

“the mathematical models which have dominated physics since the days of Isaac Newton have replaced processes unfolding in time with “timeless laws”.”

In “Time Reborn,” he (Mr. Smolin) argues that that the way out of the funk caused by doing ‘physics in a box’ is to embrace time as a fundamental feature of reality.

Here again, a similar charge can be leveled at economics. Its foundational concepts of the long run and the short run are essentially “timeless” and do not embrace time “as a fundamental feature of reality.” This book argues that these concepts have to be replaced with the behavioral concepts⁴ of analytical time that are more in accord with the time dimensions adopted by economic agents in making their decisions.

Finally, on the evaluation of theories in physics, as in economics:

A hypothesis does not need to be framed in equations to be scientific.All it has to do is suggest observations by which it can be confirmed or refuted. (The Economist, 25 May, 2013, pp. 84–85).

We agree fully: theories in economics need to have refutable predictions and the validity of a theory’s predictions, compared with those of alternative theories, is the relevant criterion for judging between theories.

On a specific point relevant to the approach that we take in this book, Caballero (2010) argued that the profession has been led astray by its adoption of the DSGE approach over the past decades and that it confused the internal logic displayed by the DSGE approach with its relationship to reality. He labeled the DSGE approach as an “irresistible snake-charmer,” with “limited connection with reality” (p. 86). Caballero argued that the DSGE approach is at the core of modern macroeconomics and this core needs to be reformulated. Since the equilibrium envisaged in virtually all DSGE models is a notional one — with equality between notional demand and notional supply in all markets — we call such models in this book as the dynamic stochastic notional general equilibrium (DSNGE) ones.⁵

Macroeconomics holds very many different schools and models, with heated debate among the proponents of the Keynesian school and those of the classical/neoclassical one. To Woodford (2009), writing just prior to or about the start of the financial and economic crises that began in 2008, macroeconomics had achieved a convergence in macroeconomic thinking. This convergence in modeling macroeconomics around the DSNGE technique represented the maturity of macroeconomics and a consensus on the essential nature of the macroeconomy. However, to Jeffrey Sachs, writing a year after the start of the crises and just two years after Woodward’s publication, the state of macroeconomics had achieved a “large and ultimately damaging consensus on economic thinking” (Sachs, 2009, p. 1). He called for “rethinking macroeconomics.”

Economies go through good times and bad, with those doing excessively so providing an as-if experiment on the validity of macroeconomics. The financial and economic crises in economies after 2008, the policies pursued in response and the slow recovery from the crises proved to be exceptional in this respect. At the very least, these crises compel us to reassess the validity of our knowledge and to rethink the general formulation of macroeconomics. This book is meant to be a contribution to these reassessments and rethinking — on which there are already numerous contributions and very many more are likely to occur. Underlying this book is our belief that what is needed is not just a refinement or modification of the fine details of some of its component hypotheses but a reformulation of the core of macroeconomics. This book offers one such reformulation. This reformulation is in the Keynesian tradition, though not a regurgitation of any one of the extant models in that tradition. While we offer a set of ideas that we believe should form the core of the rethinking of macroeconomics, our presentation is not meant to be a detailed exposition of every part of the economy or even of the ideas that we propose nor do we believe that any particular part of our exposition should be treated as if it were set in stone.

Among the rethinking proposed by some economists for the reform of economics — though mainly by those who others think of as “old-style Keynesians” — is a call for reversing the development of Keynesian economics in the past two decades. Some have even proposed the agenda of taking it back to its roots in Keynes’ The General Theory (1936). This would, however, mean abandoning the wealth of ideas in macroeconomics that have accumulated in the years since Keynes. While this book draws more of its ideas from the Keynesian tradition prior to the new Keynesian (NK) model that arrived in the 1990s, it is neither an investigation into what Keynes said or did not say in The General Theory, nor a detailed exposé of whether current Keynesian models adhere to or have departed from his ideas. Rather, this book looks into the Keynesian tradition generally and tries to update its core to arrive at a modern version that is empirically relevant, valid and au currant in the context of the functioning of the modern economy.

We consider the modern economy to be a financial one, as against a monetary or a barter one: under our definition, a financial economy is defined as having both a medium of payments and a need for financial capital, which imposes the requirement that economic agents cannot engage in consumption, saving, production, acquisition of physical capital, employment of labor, etc., without financial capital, partly derived from internal sources such as that raised through issues of shares and retained earnings but with much of it obtained from external sources, such as from the issue of bonds and/or obtained in the form of credit.

To avoid confusion about our terminology, we need to clarify our taxonomy of the various approaches in macroeconomics. This book uses the term “classical paradigm” to encompass: the “traditional classical approach” (i.e., encompassing ideas prior to Keynes’ The General Theory), neoclassical economics, the “modern classical (sometimes called the ‘new neoclassical’ one) model” (i.e., the neoclassical one modified in the 1970s by the addition of intertemporal optimization continuous notional general equilibrium (NGE) and rational expectations but without Ricardian equivalence) and “the new classical one” (defined as the modern classical model with the addition of Ricardian equivalence). Of these major schools of the classical paradigm, the neoclassical one, extant from the 1940s to the 1970s and represented, say by Milton Friedman, among others, had allowed the factual possibility of output and employment being below their NGE (i.e., full-employment) levels and the possibility of deficient demand. This approach argued that the money supply, including its systematic component, was not neutral in this phase of the economy. The designation “modern classical” refers to the version of the classical paradigm which was initiated by Lucas (1972, 1973) and Sargent and Wallace (1975, 1976) and eventually evolved into the current version of the classical paradigm, whose core macroeconomic model assumes general equilibrium in notional terms and implies full employment, though with errors in price expectations affecting the levels of employment and output in the short run. The term “new classical” designates that subset of the modern classical approach which, in addition to the other assumptions, assumes Ricardian equivalence and implies the ineffectiveness of fiscal deficits/surpluses and of fiscal policy in changing aggregate demand.⁶ The modern classical models are often built using the intertemporal DSNGE framework with perfect competition, NGE and rational expectations. The modern classical approach was the dominant one in macroeconomics from about the early 1980s to at least about 2008, when its validity during the USA financial and economic crises became questionable.

By the term “Keynesian” or the “Keynesian paradigm,” we refer broadly to the ideas initiated by Keynes’ The General Theory (1936) and their evolution since 1936. Its manifestation since the mid-1990s is the “new Keynesian (NK)” model, with its early presentations by Clarida, Gali and Gertler (1999) and Mankiw and Reis (2002, 2006). However, the Keynesian approach is much more than the NK theory: in fact, its representation of the Keynesian tradition came to be questioned by many Keynesians in the years after 2008.

A currently popular analytical platform for macroeconomics, including the NK model and the modern classical one, is the DSNGE one (Woodward, 2009). However, the financial and economic turmoil in the major economies of the world since 2008 led many economists to question the validity and relevance of this platform for macroeconomics — including in this questioning, the relevance and validity of the NK model, as well as of its representation of the Keynesian heritage.

Our agenda in this book is to provide another version — hopefully a more valid one — of the core of the Keynesian approach to macroeconomics. This agenda raises several questions. Can an updated version of Keynesian economics be formulated as a compact and coherent Keynesian model? If this can be done, should the resulting model be the NK one (e.g., as proposed by Clarida, Gali and Gertler, 1999; Mankiw and Reis, 2002, 2006)? Would it be a Keynesian version of the DSNGE framework (e.g., as in Christiano, Eichenbaum and Evans, 2005; Smets and Wouters, 2003; Woodford, 2009), or one of its variations, including among them the so-called “hybrid version,” formulated in the past few decades? However, even before the economic crisis starting in 2008, one assessment of the NK models had been that they were “not yet useful for policy analysis” (Chari, Kehoe and McGrattan, 2009). Further, in the post-2008 period, many observers, including many economists, concluded that such models which did poorly or sufficiently poorly in explaining the economic turmoil of 2007–2013 in the USA and many other economies, did not provide the right framework for explaining the turmoil, and were not even truly representative of Keynesian ideas. If this assessment were accepted, what should be the relevant Keynesian model? Currently, the economic literature does not seem to provide a clear statement of a Keynesian model that is distinct from its NK offspring. This book attempts to do so. The resulting theory of the Keynesian approach is quite distinct from the NK variety and includes several components of the earlier Keynesian tradition that had been discarded by NK models.

Keynesian economics is a living paradigm, continually evolving in its ideas and theories. Numerous developments have occurred in it over the years since Keynes’ own contributions. Not all of these are consistent with the others, and many of them are not to be found in Keynes’ own writings. Therefore, any formulation of the Keynesian macroeconomic model in an internally consistent form has to pick and choose among the numerous developments in the Keynesian tradition — and discard the rest or leave them as side-stories. While the NK models represent the latest such selective formulation, quite a number of other selective formulations of the Keynesian model are also possible and could be appealing. This book represents our ideas on an internally consistent overview of the Keynesian macroeconomic approach, and offers it as a viable — and hopefully very much preferable — alternative to the NK model.

The Keynesian paradigm has always been vitally concerned about the pathology of the economy (Solow, 1991). There can be many different causes of the “breakdown” — interpreted as a deviation from the Walrasian NGE outcomes under perfect competition and efficient markets for all goods — of the economy. Therefore, a single model cannot truly represent the Keynesian paradigm — which encompasses many potential sources of breakdown of the economy — as a whole and none is entitled to be called “the Keynesian model.” Further, given the possibility of numerous pathogens that can potentially lead to different types of departures from the well-functioning economy, any Keynesian framework with some claim to generality must allow the possibility of several potential causes of the breakdown of the economy.

The impetus for our formulation of the Keynesian model comes out of our and many other economists’ long-standing dissatisfaction with macroeconomic modeling represented by the currently dominant DSNGE approach generally, and more specifically by the modern classical and NK models. This dissatisfaction became more pronounced with the ostensible failure of these models to explain the impact of the financial crisis starting in 2007 on the production and employment sectors of the US economy. There have indeed been many contributions and debates on which economic theory should be used to explain these events. From the hindsight of 2014, what seems amazing is the lack of any emerging consensus on the economists’ even ex ...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Preface
• Contents
• About the Author
• Chapter 1 Introduction
• Chapter 2 Reformulating Macroeconomics: Main Elements
• Chapter 3 The Production Sector
• Chapter 4 The Labor Market, Employment and Wages
• Chapter 5 The Demand for Commodities and the Supply of Labor
• Chapter 6 The Financial Sector in the Financial Economy
• Chapter 7 A Reformulation of the Expectations Hypothesis for Keynesian Economics
• Chapter 8 A Reformulation of the Keynesian Business Cycle Approach
• Chapter 9 Summary and Conclusions
• References
• Index