Bryan Caplan  

A Keynesian Conundrum

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This year, I'm prepping my 8th-grade homeschoolers for the Advanced Placement tests in European History, Microeconomics, and Macroeconomics.  The Macro test is less Keynesian than it used to be, but its Keynesian origin remains blatant.  And after years away from the simple Keynesian model, I noticed two things I never noticed before.

But first, let's back up.  In the simple Keynesian model, recessions can be overcome by raising government spending or cutting taxes.  In general, however, Keynesians prefer the former approach.  Why?  I'm sorely tempted to accuse them of leftist bias, but they've got an elegant response.  Namely:

Define people's Marginal Propensity to Consume out of a new dollar of income as MPC. 

Then if you increase government spending by $1000, nominal GDP rises by $1000 + MPC*$1000 + MPC^2*$1000 + ... = $1000/(1-MPC),

If you cut taxes by $1000, however, nominal GDP only rises by MPC*$1000 + MPC^2*$1000 + ... = $1000*MPC/(1-MPC).

If they have to cut taxes, similarly, Keynesians prefer to cut taxes on the poor.  I'm sorely tempted to accuse them of leftist bias, but once again, they've got an elegant response.  Namely: Poor people have a higher MPC than the rich, so tax cuts for the poor give you more bang for your buck.

But what if your problem is not recession, but inflation?  Then both of the preceding arguments reverse.  In terms of the simple Keynesian model:

1. Cutting government spending is a better way to reduce inflation than raising taxes.

2. Raising taxes on the poor is a better way to reduce inflation than raising taxes on the rich.

I'm pretty sure I've never heard any Keynesian policy analyst say either of these things.  But they flow out of the simple Keynesian model just as naturally as their stock anti-recessionary recommendations.  If leftist bias isn't the explanation, what is?

Update: Interfluidity said some of what - until now - I've never heard any Keynesian policy analyst say.


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COMMENTS (12 to date)
Oliver writes:

So what does this model predict will happen to GDP if you raise taxes by $1000 and increase government spending by $1000?

Oliver Sherouse writes:

Isn't the idea that if you're not in a liquidity trap, monetary policy is effective? So yes, raising taxes on the poor is better than raising taxes on the rich, but those are both far worse than raising interest rates?

Put another way, I've never heard of Keynesians advocating for raising taxes *at all* as an anti-inflationary measure, so why would they bother talking about which taxes would be most effective?

pyroseed13 writes:

@Oliver Sherhouse

In response to your first paragraph, that is correct, but I don't remember ever encountering the concept of a liquidity trap until I took macro in college. The kind of Keynesianism presented in AP Macro is a very simple framework that reflects economic thinking prior to the Great Inflation. Remember, Keynesian economists for the most part in the 60s and 70s thought that monetary policy was impotent. As for your second paragraph, that is...sort of Bryan's point. There was a strong push against Reagan's tax cuts because it was claimed by Krugman and others that they would lead to inflation. But I don't recall anyone in that period arguing for raising taxes to fight inflation, even though the logic of their model implies it.

Ilverin writes:

A leftist Keynesian might say the Diminishing Utility of Income means taxes on the rich should be a lot higher such that the Marginal Propensity to Consume is a small factor.

Scott Sumner writes:

Oliver, It would be nice if Keynesians understood their own model as well as you do.

For instance, we are not at the zero bound, yet many Keynesians continue to call for fiscal stimulus. The Eurozone was not at the zero bound during the Great Recession, yet many Keynesians called for fiscal stimulus.

Andrew_FL writes:

Inflationist bias.

Below Potential writes:

@Oliver

"So what does this model predict will happen to GDP if you raise taxes by $1000 and increase government spending by $1000?"

According to the model the net effect of this would be expansionary.

Below Potential writes:

@Brian Caplan

Here is a possible explanation for why Keynesians never mention that
cutting government spending is a better way to reduce inflation than raising taxes and that raising taxes on the poor is a better way to reduce inflation than raising taxes on the rich:

today virtually all Keynesians are New-Keynesians. According to the New-Keynesian model monetary policy is never impotent - unless the mandate of the central bank makes monetary policy artificially impotent at the ZLB by preventing it (the central bank) from committing to a more expansionary monetary policy in the future.

That is, only at the ZLB and(!) with a central bank being artificially made impotent in a ZLB environment by its mandate arises the situation when New-Keynesians may support anti-cyclical fiscal policy measures - despite the fact (acknowledged also by New-Keynesians) that fiscal policy is beset with inefficiencies when used to steer AD.

Since monetary policy is never impotent when it comes to reducing inflation (after all, there is no Upper Bound on interest rates), a situation where a New-Keynesian may call for anti-cyclical fiscal policy measures to reduce inflation never arises.

Since there is never a need for contractionary fiscal policy to fight inflation (because no matter the mandate, monetary policy is always able to reduce inflation), the whole topic never comes up and hence neither the two sub-topics you mentioned in your post.

RobT writes:

Could this be an explanation?

Too much stimulus causes inflation, whereas fighting inflation too aggressively causes a recession. So use the more aggressive policy to minimize as much long-term unemployment as possible and take the risk of higher inflation; and use the less aggressive policy to fight inflation in order to minimize the risk of causing a recession. Also, there isn't a Zero Upper Bound problem.

Ghost writes:

A number of good posts.

Here is a Keynesian who from the 1960s who, not really believing in monetary policy, did ask for tax increases to offset the spending that LBJ was doing anyway:

https://en.wikipedia.org/wiki/Gardner_Ackley

Thaomas writes:

@ Scott:

For instance, we are not at the zero bound, yet many Keynesians continue to call for fiscal stimulus.

I do not think that is a correct interpretation of what "Keynesians" -- Say DeLong or Summers -- are "calling for." Rather, it is a belief that, given slack in the labor market and probably other markets too and the low real rates at which governments can borrow, there are many projects, "infrastructure," with positive NPVs. Some may call that "fiscal stimulus" but that seems a misnomer. Borrowing to carry out high NPV projects has nothing to do with the ZLB, which is a problem only for the narrowest of conceptions of "conventional" monetary policy.

Thaomas writes:

The way taxes on wages were cut on the poor in 2009 -- unfortunately only temporarily -- was both real-income improving (reducing a distortion in the price of labor) and redistributionally progressive. If that is "leftist" we need more "leftist" policy making.

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