Keynesian Macroeconomics Model

Keynesian Macroeconomic Model, Keynesian Macroeconomics

Keynesian economics is named after John Maynard Keynes, whose father, J. N. Keynes, was an important economist in his own right. The son's accomplishments quickly eclipsed his father's, however. In this and in several other ways J. M. Keynes's life is like that of J. S. Mill. Both had fathers who were contemporaries and friends of brilliant economists: James Mill was a friend of David Ricardo, and J. N. Keynes was a friend of Alfred Marshall. Both the younger Keynes and the younger Mill received the high-quality education typically provided to children of intellectuals, an education that equipped their innately brilliant minds to break new ground and to persuade others through the force of their writing. Both Mill and Keynes rejected, the policy implications of their fathers' economics and proceeded in new directions. But here the similarities end, for J. S. Mill was unable to break completely with the theoretical structure of his father and Ricardo; ultimately, he constructed a halfway house between classical and neoclassical theory. Keynes's break with the past—that is, with the laissez-faire tradition running from Smith through Ricardo, J. S. Mill, and Marshall__was more complete. Although he was familiar with the basic Marshallian partial equilibrium analysis, he constructed a new theoretical structure to address the aggregate economy that had significant effects on both economic theory and policy.

Keynes does not fit the stereotype of the intellectually narrow twentieth-century economist. He was criticized, in fact, for devoting too little of his time to economic theory and spreading his interests too broadly. Even as a student at Eton and Cambridge he displayed this proclivity to pursue a wide range of interests; hence he came to be known as a dilettante. His education completed, he entered the British government's India Office as a civil servant, where he remained for two years before returning to Cambridge. He was never exclusively an academic. His continuing interest in economic policy led him to take a number of government posts throughout his life. He was active in business affairs both for himself and as bursar of King's College, and his ability in business is manifested by the fact that his net worth rose from near bankruptcy in 1920 to more than $2 million by the time of his death in 1946. Keynes was interested in theater, literature, and the ballet; he married a ballerina and associated with a group of London intellectuals known as the Bloomsbury group, which included such notables as Clive Bell, E. M. Forster, Lytton Strachey, and Virginia Woolf. His unique mixture of talents enabled him to be an accomplished mathematician as an undergraduate, to write a book on probability theory, and to be a powerful and effective prose stylist, which is evident in the sheer literary mastery of both his Economic Consequences of the Peace and his essays, collected into two books as Essays in Persuasion and Essays in Biography.

The single most important aspect of Keynes the economist is his orientation toward policy. He attended the Versailles peace conference as a representative of the British Treasury Department but resigned abruptly in 1919. He was disgusted by the terms of the Versailles treaty, which imposed on Germany large reparations that he thought could never be paid. He received international acclaim for his criticism of the terms of the treaty, published in 1919 in his Economic Consequences of the Peace. In 1940 he wrote How to Pay for the War, and in 1943 he advanced a proposal called the Keynes Plan for an international monetary authority to be put into effect after World War II. As head of the British delegation to Bretton Woods, he was instrumental in the formation of the International Monetary Fund and the International Bank. But his most important contributions to policy and theory are contained in his book The General Theory (1936), which created modern macroeconomics and still forms the basis of much of what is taught in undergraduate macroeconomics. Paul Samuelson captured its importance when, reflecting on the Keynesian era, he wrote, "The General Theory caught most economists under the age of thirty-five with the unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea Islanders."

The Contextual Nature of The General Theory

Possibly no book in economic theory has a more presumptuous first chapter than Keynes's General Theory. To be sure, other economists had proclaimed their own originality and brilliance, but Keynes did it with such force that it seemed convincing. This lack of modesty apparently went back to Keynes's youth. When he took the civil service exam upon graduation from college and did not receive the top score in economics, his response was, "I evidently knew more about economics than my examiners." While Keynes was working on The General Theory, he wrote to George Bernard Shaw that he was writing a new book that would revolutionize the way in which the world thinks about economic prob­lems. The first chapter oiThe General Theory is one paragraph long. Here Keynes simply states that his new theory is a general theory in the sense that previous theory is a special case to be placed within his more general framework. By "previous theory" Keynes meant both classical and neoclassical economics, which he defined as the economics of Ricardo as it pertains to Say's Law, and of those who followed in this belief: J. S. Mill, Marshall, Edgeworth, and Pigou.

Although the single most important aspect of Keynes the economist was his policy orientation, his most important work, The General Theory, in spite of its policy overtones, is essentially a theoretical book whose major audience was to be found among professional economists. Keynes wrote, "This book is chiefly addressed to my fellow economists. I hope it will be intelligible to others. But its main purpose is to deal with difficult questions of theory, and only in the second place with the application of this theory to practice."

We can reconcile this seeming contradiction by understanding the way in which Keynes used theory. Many economic theories are what might be called noncontextual; that is, they are developed in an institutional void. Such theories are best understood by deductive logic; they begin with first principles from which conclusions are deduced on the basis of carefully stated assumptions. In making these assumptions, one does not take reality into account but tries instead to understand the inherent logic of the interactions among the assumptions. Such theories might be called analytic theories. General equilibrium analysis, done correctly, is an analytic theory. Because the assumptions are inevitably far removed from reality, drawing policy conclusions from broad-ranging analytic theories is extremely complicated.

Keynes used a different kind of theory, one that might be called "realytic," because it is a compromise between a realistic and an analytic approach. A realytic theory is contextual; it blends inductive information about the economy with deductive logic. Reality guides the choice of assumptions. Realytic theories are less inherently satisfying, but because they correspond closely to reality, it is easier to draw policy conclusions from them. Keynes did not start from first principles in The General Theory but instead used reality to guide his choice of assumptions.

Thus, although he concentrated on theory, he never lost sight of its policy implications.

An example might make the distinction between realytic and analytic theories clearer. Keynes assumed prices and wages to be relatively constant without attempting to justify those assumptions. Although he briefly discussed in The General Theory the implications of flexible prices, arguing that they do not solve the unemployment problem, a thorough consideration of their implications was of little concern to him; for the problem at hand—what to do about unemploy­ment—it was reasonable to assume fixed wages and prices. He could do this by using his realytic approach, whereas a truly analytic model would not have permitted such assumptions. Keynes left it to others to provide an analytic basis for his theory. Much of the subsequent development of macroeconomic thinking has been an attempt to provide an analytic base for macroeconomics.

Keynes began working on The General Theory immediately after completing his two-volume Treatise on Money, which made use of the quantity theory of money to discuss cyclical fluctuations. In The General Theory Keynes abandoned this approach, much to the chagrin of his colleague Dennis Robertson, with whom he had previously worked closely. He adopted instead a simple, new approach that focused on the relationship between saving and investment. To provide himself with a heftier target, Keynes lumped together the neoclassical disequilibrium monetary approach and the earlier classical approach, exagger­ated their beliefs, and called them collectively "classical theory." In so doing he created a caricature of classical thought that emphasized its differences from his new approach but concealed many of its subtleties.

Keynesian economics became embodied in the texts in a variety of models called the multiplier model (sometimes called the AE/AP model), the IS/LM model, and the AS/AD model. These models were the core of what was taught as macroeconomics through the 1980s and still appear in many recently published undergraduate texts. But cutting-edge macroeconomics, for the most part, went in different directions, as Keynesian economics lost favor.