Bryan Caplan  

Keynesian Questions

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My questions for DeLong sparked two good non-DeLong questions in the comments:

From Steve Roth:

Employers *are* more likely (than employees) to put the money under their mattress.

Perhaps not literally. But actually/practically.

Employers spend a smaller percentage of marginal earnings on immediate consumption (which would increase short-term AD).

They may spend a smaller percentage on immediate consumption, but AD isn't just consumption spending.  It's also investment spending - and remember that due to credit market imperfections, cash flow is a good predictor of business spending.  See e.g. here.  

Furthermore, my "mattress point" is that the direct beneficiary of the wage cut doesn't need to personally spend it for AD to rise.  He puts it in the bank, and the bank lends it to someone who will spend it.  (It's true, of course, that banks like to build up excess reserves during recessions, but this doesn't mean that they don't re-lend the marginal dollar deposited).

From david [not Henderson]:
I thought Keynesians (new, neo, paleo, etc.) believed that, due to downward price and wage stickiness, we get quantity adjustments in a recession, i.e., falling output and rising unemployment. But, once we're in the recession, the argument seems to be that the quantity adjustments would be even bigger if prices/wages weren't sticky(!).
Nope.  In standard New Keynesian models, if a magic wand makes prices and wages flexible, idle resources go right back to work.  See e.g. Mankiw's menu cost model.  The tradition of blaming recessions on price and wage rigidities, then warning against the evils of price and wage flexibility, is firmly rooted in what I call "dinosaur Keynesianism."  But I can't remember seeing any modern macro model that works that way.

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COMMENTS (9 to date)
Contemplationist writes:

Dinosaur Keynesianism!

I like it! Yes as a lay learner of econ, I was confused for a year or so about this inconsistency till I discovered Scott Sumner.

Its clear that a lot of Keynesians online at least have reverted to Dinosaur Keynesianism. Note Mark Thoma, Delong and of course Krugman. If wage stickiness causes recessions, why are they attacking attempts at wage flexibility?

Richard A. writes:

"The tradition of blaming recessions on price and wage rigidities, then warning against the evils of price and wage flexibility, is firmly rooted in what I call "dinosaur Keynesianism."

If I am reading Krugman correctly, he must like dinosaurs.

Doc Merlin writes:

There are no macro models that work that way. Its purely a political result.

Because political ideology influences economics.

Bill Woolsey writes:

Lower prices and wages, given nominal expenditure, raise real expenditure. Assuming output was expenditure contrained, lower prices and wages allow for increased real output and employment.

Expectations of falling prices and wages result in higher real interest rates and higher demand for for money, and reduced nominal and real expenditure.

Generally, to get to lower prices and wages, one needs falling prices and wages. And so, expectations of that occuring, reduces nominal expenditure. Generally, this should make the drop in nominal expenditure very sharp, and force a very rapid adjustment in prices and wages.

If people's expectations are based on past experience, more serious problems develop. Lower prices and wages imply that prices and wages have fallen. If people take that to mean that prices and wages will continue to fall, then this will raise real interest rates, raise money demand, and lower nominal and real expenditure, requiring an even lower level of wage and prices.

In my view, depending on price and wage adjustments to correct for decreased nominal expenditure is a mistake. Keeping nominal expenditure on a stable growth path, and reversing any deviations as soon as possible, is the best approach.

But that doesn't mean that a lower price and wage level isn't the way the market system adjusts real expenditure to the productive capacity of the economy.

Lee Kelly writes:
If a magic wand makes prices and wages perfectly flexible, then idle resources go right back to work.
Presumably, the corollary of is:
If a magic wand increases the money supply to offset the increase in money demand, then idle resources go right back to work.

However, would the allocation of resources be identical for both cases?

Intuitively, it seems as though the latter case would better direct spending toward new investments, whereas the former prices and ages would decline more generally.

Has anyone any thoughts?

The_Orlonater writes:

Well keeping the price level and interest low just sustains unprofitable long term projects and it will most likely decrease real savings which are needed to fund sustainable long term investments. After the crash, the deflation that is occurring is usually what was the new money created during the so called boom period, so in the short term there's going to be pain and it's the beginning of the readjustment process to making projects profitable. Anyway, practically speaking, would anybody really want to raise the current price level to before-crash levels? Does anybody really want housing levels to come to 2006-07 levels? But the falling money supply needs to have a good environment for restructuring. Such as not instituting in any interventions that stop wages from readjusting,price controls, threats that create regime uncertainty, deficits, etc. Then again, we don't want too much deflation so the money supply falls below pre-boom levels

James Christopher writes:

What is with Keynesian obsession with increasing AD in the first place? It's not as if demand is somehow going to sink below some imagined desirable level -- we are talking about human beings here. People want what they want, food/cars/houses/etc -- and people always want more -- at least until the point of some post-scarcity society -- which of course is getting into science and technology.

It's like starting with Keynes' whole flipping around of Say's Law, starting the whole demand-centric paradigm, that most of the thought is so wrapped up in focusing on the more positive side of things, trying to prove that their theory works in the abstract.

But then instead of engaging it on that aspect, what I look for is even if you take the more positive end of things for face value, and assume that it works out mathematically, are the more normative recommendations even based in physical reality -- are they even remotely wise? And of course, if the theory doesnt hold, then of course there goes the normative recommendations.

Maybe there is just a big hole I'm missing somewhere, but basically from everything I can see, even if Keynesian recommendations performed as advertised, they are still totally disconnected from reality & lacking in any shred of wisdom.

I mean, I've seen endless debates about the multiplier, whether government spending is the most effective means of utilizing the multiplier, while I'm sitting there thinking that the fact that government stimulus "works", as "proven" by the theory behind the multiplier concept.... is exactly why it's so bad.

So government builds a useless bridge. Steel is consumed. Construction workers keep their job. Steel workers are able to keep their job, getting paid by this government spending. And so forth. And all the focus that you see in the media is talking about how the stimulus increased economic activity, and people on TV are debating about how well/how much it increased economic activity, etc,.

Meanwhile, I'm simply palming my face, thinking, why is the focus solely on these numbers of economic activity -- of course they are up after the stimulus, but what does it really MEAN, as far as physical reality is concerned?

I mean, do the people on TV really think that consuming capital on a useless project, paying 30 bureaucrats to install a toilet seat -- which of course lets them consume a minimal amount of resources (food, their wages buy a new car, etc), while they have produced nothing.

(I'm exaggerating a bit of course about the toilet seat, but hey.. we've all seen the stories of government "efficiency")

Do the people on TV really think that this is a good thing? If you want to help out unemployed people, you can just help them directly. You don't need to create useless unneeded "jobs", wasting even more capital on these wasteful projects in addition to what you pay them. What good does stimulating consumer spending do, in terms of what is happening in the real world? So maybe there is some analysis that shows that government stimulus of $100 billion resulted in increased capital investment of something actually worthwhile, somewhere. So great, we've consumed 50 bil on consumer goods -- that physical capital is gone down the drain. We have some outstanding government projects, like that bridge which isn't needed, and will never be needed. And then maybe 5 bil ends up going towards investment.

But the economic indicators are improved -- and that's the main thing that matters? Employment is up.... in what? In excess retail sectors that should be restructured to begin with? In more useless bureaucracy? More useless projects?

Economic activity is up..... through what means? At what cost? How was this increase achieved in physical terms?

From what I've seen to all the above, the people on TV... and Keynesian, say yes.

Stimulus is good because *insert theory here*......... which results in *insert final conclusion here*.

I'll let other people on forums, in everyday discussion, etc question the theory part, while I question the wisdom of the final conclusion -- even if you take the theory at face value.

Steve Roth writes:

Hi Bryan:

Since you took the time to answer me on this, I've been taking the time to think about, and research, your answer.

To boil it down:

Is "investment spending" really the same thing as spending on goods and services, either theoretically or practically?

Imagine, all in the same year:

1. I get a $1,000 bonus for creating CDOs.

2. I stow it in my pension fund.

3. The pension fund buys common stock in a company.

4. The company buys a new piece of equipment.

The last bit is obviously demand--for goods. What about the preceding?

Which of these contributes to velocity?

Isn't the inclusion of "investment spending" in AD confusing pools with flows?

Is demand for securities in any way similar, theoretically or practically, to demand for goods and services?

Is "investment spending" an oxymoron?

Should investment be counted as part of "aggregate demand"?

Excuse me if these are freshmanic questions, but I've dug long and deep (yes, into the models to the extent of my abilities...) without finding satisfying answers--long enough to think that the answers are no more obvious than seemingly obvious constructs such as GDP. (i.e. "When a man marries his maid, GDP goes down." "When a man burns down his house and rebuilds it, GDP goes up.")

Steve Roth writes:

I figured out what was wrong here:

"Furthermore, my "mattress point" is that the direct beneficiary of the wage cut doesn't need to personally spend it for AD to rise. He puts it in the bank, and the bank lends it to someone who will spend it."

This is true for both employees and employers.

Whatever they don't spend is "savings" (not "investment"). *Some* of those savings get spent (eventually) by others. Kind of obvious.

But viz your mention of credit market imperfections. Not instant, not 100%. So if we're after an immediate boost to velocity, spending is better.

By your reasoning, it doesn't matter whether employers and employees have different saving/spending patterns, because savings and spending recirculate in exactly the same manner to create velocity.

But they don't.


1. Savings do not contribute to AD--only gross private domestic investment does. (Which is *spending* on property, capital goods and inventory.)

2. Savings--or any securities purchases/sales--do not contribute to velocity either, because they don't contribute to GDP.

>cash flow is a good predictor of business spending.

That's kind of obvious and beside the point; is aggregate *savings* a good predictor of business spending?

I would suggest at least at the moment, no. Because

1. Demand for business credit is very low:

2. Savings are effectively stored (and circulated) in a mattress that we call the financial system (i.e. Fed excess reserves) and do not contribute to velocity until they exit. The inflows and outflows of marginal dollars to/from that mattress are determined far more by fed and treasury policies than by savings rates.

And why just ask that about business spending? Consumer spending is just as good for velocity. (*GDPI*, of course--by either people or companies though it's more likely by companies--both increases velocity and also creates wealth/capital base.)

Which brings us back to the question that's obscured by the whole mattress dodge:

Who contributes to velocity (what everyone likes to call The Multiplier) by spending more (whether on consumption or GDPI, whatever): employees or employers?

And I ask again: don't we know the answer to that?

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