 Okay, I think we're ready to begin the one o'clock session. I'm glad to hear the macroeconomic enthusiasts show up and we'll have another application of capital-based macro this afternoon. I call it kings and hi-hack head-to-head, partly because when the two principles debated, they tended to talk past one another. And I wouldn't rectify that. So we're going to put them head-to-head and it turns out it's not as hard as you'd think. There they are. But it didn't go well and the hi-hack dispaired and Keynes assumed he had won, as in fact he had not on the grounds of the logic of the macroeconomics that he advocated, but on the grounds of the attractiveness of the policy recommendations that it suggested. So the politicians certainly were more in favor of Keynes than hi-hack. Well, I want to try to turn that around this afternoon. You know, very briefly about divisions and frameworks of these two principles. So I write that Keynes' vision of the economy suggests a circular flow framework in which earning and spending are brought into balance by changes in the level of employment, not by changes in prices or interest rates or wage rates, but changes in the level of employment. Hi-hack's vision of the economy suggests a means-ends framework. It's not a circular flow, a means-ends framework in which the means of production are transformed over time. Time is there on the ground floor in hi-hack's theory over time into consumable output. So I'm going to subject you to a brief review of the Keynesian circular flow framework. I'm sure many of you, if not most of you, have seen one version or another of it, but you haven't seen my version, okay? So stay tuned here. We represent business enterprises at the top, business organizations, and that's just a facilitator to get the different people in the economy in line with one another. On the bottom, I put all the people are down there, they're workers, consumers, investors. And the way this works is that part of this flow is a flow of labor and other factor services. Now that other factor services kind of gets lost in Keynesian theory, it seems to be all labor. He theorizes in terms of labor, but suggests that, well, everything else sort of works in tandem with labor. So it's labor and factor services. And of course, businesses have to pay for that is called income. People get an income for laboring, we sort of knew that. And on the other side of the diagram, we get goods and services. Those are produced in the business organizations with the use of labor and other factors, but people have to pay for it. And that's expenditures for consumption and investment. So that's the story there. Now I bring in a policy from the outset because Keynesianism is nothing without policies. And here we have the Federal Reserve managing interest rates, I've got it turned off right now, let me turn it on. And my circular flow circulates, it doesn't do that in textbooks. And it's circulating pretty slow. But don't wonder, the interest rate is up at 6%. So if we use a Fed policy and just turn the interest rate down to 2%, it'll circulate faster. And don't worry about the ultimate consequences of that. That's the way it works. Slow back down. Okay, enough of that. Now that's Keynesianism. And Hayek, as you saw in the last lecture, argues in terms of the structure of production. Well, there's a lot of difference between those two frameworks. And I'm going to show you how to get from one to the other in the process, showing what all is wrong with the Keynesianism. Now you've all learned this from the textbooks and from principles 101 or whatever. The Keynesian system is an equilibrium when income equals expenditures. Notice it's not when demand and supply prices are the same, or when the interest rate is at its equilibrium level, it's when income equals expenditures, y equals e. It's y for income because little i is interest and big i is capital. So income equals expenditures. For a wholly private economy, then y equals c plus i. Add the government sector to be c plus i plus g. And here at Auburn, I'm very careful to spell out the holy, wholly private economy. Some of the people in this region of the country think holy means h-o-l-y. They get their religion and their politics and their economics all mixed together. All right, here we've got expenditures and income. And of course, to show that expenditures equals income, and that's the equilibrium condition, we just draw a 45-degree line, and there it is. So the economy is in Keynesian equilibrium somewhere, who knows where, right now along the 45-degree line, the line itself identifying all possible combinations of income and expenditure points, okay? So now we add to that the consumption equation, which just shows how much people consume on the basis of their income. And it's an upward-sloping curve. It has a positive intercept that means that when people earn nothing, they still spend something temporarily, I assume, otherwise they'd run out of money. And when they do earn, the more they earn, the more they spend. But they don't spend as much more as the amount that they earn. So the slope is something less than 45 degrees. And we can show, hey, the intercept is how much they spend if they have no income. The B is the slope of the line. It looks like this. You've all learned this in macro 101. And then we just pile investment on top of that. Investment in this model, that's the basic model of Keynes, is just autonomous investment. That is what it is caused by, if anything, animal spirits, we assume. So investment depends neither on current income nor on the rate of interest. It depends only on profit expectations, which themselves are not well anchored in the economic system. And so that sort of gives you a clue that this economy is not going to be very stable, all right? Consumption in an investment, as well as government spending, are portrayed as additive components of total income. The three components are distinguished largely in terms of their stability characteristics. Why those three? Well, one of them is stable, that's consumption, one's unstable, that's investment, animal spirits. And G is seen as being stabilizing and supposed to offset the instability of investment. That's the world view there. Now, we see where that equilibrium level occurs, all right? Which doesn't necessarily imply that labor markets are clearing. In fact, chances are they're not, unless we're lucky. It might be a particular level where markets clear in labor. In fact, we're going to start out that way. But you can see what we have. We have income horizontally, and then consumption plus investment. That's what gives us our equilibrium. So the holy private economy achieves an income expenditure equilibrium on Y equals C plus Y. Note that income itself rather than wages, prices, and interest rate is the equilibrating mechanism. So if income is the equilibrating mechanism, then the economy is going to be in trouble, all right? Because it'll push income down to whatever it takes to get the equilibrating, it'll push income up to whatever it takes. And it's all driven by the unstable investment component. Okay, here we go. Kane says it's only by accident or design, that's his terms there, that the economy is actually performing at its full employment level. Some of my students ask, well, what else is there except accident and or design? Well, of course, it is spontaneous order in the market process. And so that's what's being eliminated. Can't be that because prices, interest rates, and so on, are not doing their job anyhow. They're not doing what they're supposed to be doing. So we assume here that initially, full employment conditions prevail if only by accident, just a good starting point for the developing theory. Okay, now when I say we're at full employment, what I must mean is that we're on the production possibilities frontier. And if we trace across like that, we say, okay, we're on the production possibilities frontier, lucky us, it could have been otherwise. In capital based macro, full employment implies that the economy is on the PPF. The PPF itself being defined in terms of sustainable output levels of consumption and investment. And now we show the labor market and we show sure enough it clears at an equilibrium wage. Now the way Keynes would describe that is, let's see, I probably have it here. In Keynesian macro, full employment implies the labor market clears at the going wage. He calls it the going wage. I think he introduced that term, the going wage. And the going wage is whatever the wage rate happens to be, and it tends not to change very easily, certainly not in the downward direction if it needs to, sticky downwards. So the going wage, the going wage itself having emerged during a period in which the economy was experiencing no macroeconomic problems, all right? But as soon as it experiences macroeconomic problems, we're in trouble because it doesn't change, or at least it doesn't fall. All right? So labor income, y equals w times n, and at least in this country we use n stands for labor. Don't ask me how that is, but n stands for labor, the quantity of labor. So it's just the price times quantity of labor. So labor income is fully representative of total income. Such that changes in labor income stands in direct proportion to changes in total income. That's strange because the other factors, capital and land, they all either move up and down together, up together or down together, but there's never any movement of one against the other. Isn't that strange? But that's it. And so labor income would be that rectangle there where you just multiply the wage rate times the number of work for hours and scale it up by whatever proportion of total inputs are something other than labor. That works at least for Keynes. Okay, let me bring back my E equals y curve. And look at this, according to Keynes, a collapse in the investment activity, the collapse being attributed to the waning of animal spirits. He uses that term, animal spirits, three times on a page and a half. And you assume that, okay, that's what he means, whatever that's supposed to mean. Okay, so the animal spirit is primarily a cause of the downturns. In response to the reduced investment and hence reduced employment opportunities, the economy spirals down into recession and possibly into deep depression. Well, let's watch that. Well, there's the animal spirits. Okay, so that would take the wind out of anybody. So the investment curve moves downward. And of course, now you see expenditures is less than income. We have disequilibrium and what happens is the economy spirals down because you have excess inventories there. In other words, you have income and then consumption investment and whatever's left is excess inventory. So the economy spirals down until it reaches a new equilibrium. That actually equals y again. So there's the change in investment and there's the change in income. What you had to learn when you took the course is that there's a multiplier effect because of the particular slope of that consumption line. And specifically it's delta y equals 1 over 1 minus b times delta i. 1 over 1 minus b is some positive above 1. It could be 2, 3, or 4, something like that. So income changes disproportionately to investment in a positive way. In other words, it's a larger change, okay? Notice also that consumption falls too. Not the consumption equation, it doesn't fall. But since we spiral down, then the level of consumption is something less. So when investment goes down, consumption goes down. That's sort of hardwired into the Keynesian system. And that by itself tells you that this system is not going to work very well. Isn't that right? Okay. So the simple investment spending multiplier quantifies the relative rates of the downward or upward spiraling. Now, look at the labor market. What happens to the labor market according to Keynes is not that the wage rate changes. It's just the demand for labor changes that shifts to the left. But wages are sticky downwards. And so at that wage rate, you have unemployment. And again, the Keynesian solution is to pump up the economies of government spending or printing press money, whatever it takes to get the economy back to where it was. Note that the going wage keeps going, even after the market conditions that gave rise to them are gone, okay? The going wage got going back when we had no macro problems, whatever that was, okay? Now, from this point, I'm going to skip, I've done enough of this. I'm not going to have time for much more. So I'm going to skip to morphing from the circular flow to the means ends framework. That would be the hyacinth, all right? So we've got that straight. We know what the Keynesians look like. So the nature of the Keynesian stylized spiraling associated with recession and depression and inflation becomes more transparent when the PPF is in play. So let's put it in play like we did before, and it looks like that. Again, where full employment would just happen to be, a wane of animal spirits causes investment to decrease in with it income and consumption. The economy falls inside the PPF, so now I want you to look at the PPF and see what movement there is when this C plus I falls, all right? So now the economy moves inside the PPF. That's the story. And that's totally consistent with what Keynes is saying. He said, he doesn't bring that along. He doesn't show the PPF. He showed we're inside the PPF. And as before, we have a sticky wage rate that doesn't equilibrate markets for labor. The further waning sends the economy deeper into the PPF's interior. Now, there's a further waning. There it goes again. Okay. And there more reduction in demand for labor, but no change in the wage rate. Now, if we just draw a line, moving inside the frontier and beyond, trace out a linear relationship showing how consumption varies with investment. In other words, if we put these things back on there altogether, you can see that's sort of the path that consumption and investment can take. You can go northeast or you can go southwest, but it never goes along the PPF. You can't go along the PPF. And so that's the track along which the economy moves in the Keynesian view. I call it the demand constraint. I get to call it that because nobody else draws it. So I'll name it what I want. Because it all depends on demand. How much demand is there in consumption plus investment? If it changes, then the economy moves along that constraint. To show that I've derived this C, note that if investment were to fall to zero, the economy would settle into an incoming expenditure equilibrium with Y equals C. In other words, that vertical intercept of the demand constraint is consistent with there being no investment, of course. And so it's all consumption, whatever there is of it. Now, one thing, just looking ahead for a minute, look at that line, look at that line. See, one of the things Keynes did was sort of design his policies or design his theories with what he was seeing out his window. And of course, he was writing this in 36 after the big crash in this country and in the Western world, really. And what he saw was both investment and consumption falling. The economy crashed, all right? Both in the US and certainly in Britain. And so that crash, as much better represented, Hyak would say, by that orange arrow we had in the last lecture. So he's seeing something that looks empirical. The whole economy is crashing. He's trying to reconcile, well, how did this happen? Well, he didn't think it happened because of bad policy. He thought it happened because markets don't work very well. And so that's the way he justified his system. I write an equation for this. I don't want you to even copy this down. But what you can do, if you want to, is take these two equations, c plus i and c equals a plus b y. So that's total expenditures. Equals c plus i. And you can work them to remove the y and show how consumption moves with investment. And what you get is the equation of that line. You have the intercept of a over 1 minus b. You have a slope of b over 1 minus b. And that equation, c equals, you can read the rest of it. That's the equation of that line. That's based solely on c equals a plus b and the addition of consumption and investment. Now, I'm going to skip a part here just because it takes up too much time. But Keynes, when he drew this line, he says nobody recognizes this. But they ought to understand it. And he comes up with even a simpler formula than I do because he had a zero intercept for the consumption equation. And he says, the conclusion appears to me to be quite beyond dispute. Well, it is quite beyond dispute if you accept all of his assumptions that the wage rate won't change. It's sticky downward. That investment is autonomous and moves with animal spirits. And so on, if you assume all that, then yes, you can get this equation. And he says, yet the consequences which follow from it are at the same time unfamiliar and are the greatest possible importance. What's the importance? The importance is that if government understands that, it knows when to have stimulant packages. It knows when to pump money into the economy to make it run and so on. That's what's going on here. OK, to keep track of interest rate movements, the loanable funds market can be brought into view. And here it looks like I'm doing something sort of against Keynes because, like I said before, he threw out the loanable funds market. And here we put it back in. There's a supply of it and a demand for it. And I can show you here then why he threw it out. Because he came to believe that the interest rate didn't affect anything. And it goes like this. Though Keynes argued that neither savings nor investment dependent in any significant extent on the interest rate, he also argued that both curves, as conventionally drawn, shift together, leaving the interest rate unchanged. Those curves are virtually welded at the intersection and they can move left and right. But it doesn't affect the interest rate. Let me show you how that works. There's the demand for investment falling as C plus I fell. But because it fell, income falls. The economy goes into recession. And if income falls, you can't save as much. So the saving curve shifts too. Spiraling downward of income implies that the supply of loanable funds also shifts leftward, leaving the downward pressure and relieving the downward pressure on interest rates. So that would be the way that the loanable funds market works. So why do we need to keep track of the interest rate if both of those curves change at once? Now here's the thing I discovered after I got this far on the model is that one single graph in Keynes was this graph that I just drew. Let me show you. His isn't as pretty as mine. And he's committed the ultimate sin in drawing a graph. Do you see what his ultimate sin is? Didn't label the vertical axis. Come on, Keynes, do better than that. OK. But he put R on the horizontal axis. R meant rate of return on investment. So that's an interest, really, interest rate. So he's got the axis reversed. He's got interest on the horizontal axis. And if you read the passage, his investment, then he says or saving. He means hand saving on the horizontal axis. So it looks like that. It still doesn't look quite like mine because it shifted around. But if we flip it over and rotate it, we can get it to work. Flipped over and rotated 90 degrees, and it looks like that. Now, those are funny supply curves. Most supply curves are concave the other way. He just screwed up there. And several of those shifts curves, I think I say that, some of the saving curves are intended only to demonstrate that income is a shift parameter. And so I'm going to knock those out, all right? And now I've got that same graph that I had in my PowerPoint. And Keynes uses it to make the exact same point, OK? What he says is that if that demand shifts to the left, then the supply will shift to and by the same amount such that the interest rate doesn't change, all right? So that's just dead on what we've got in our graph. And that's strange because this graph is just wholesale neglected by other macroeconomists. Some of them can't make sense of it. Maybe partly because there's no label on the axes and the thing is flipped around and so on. Who knows? OK, so it's that same graph. Keynes also denied that an increase in saving would have the effect imagined by the loanable funds theorists. Keynes' paradox of thrift, as articulated in his general theory, is to the point, every attempt to save by reducing consumption will so affect incomes that the attempt necessarily defeats itself. OK, so don't save because the economy will fall into depression. People have less income out of which to save, all right? Who just don't do it? And you can see it that way. Let me do that again because you've got to watch everything go at once. Even the demand constraint shifts in this case. And the economy ends up, as it normally does in Keynesian way. OK, to try to save more, you'll instead earn less. All right, once again, the economy is in the dumper. OK, now, how's our time? OK, we're pretty good. To resolve Keynes' paradox of thrift, requires only that we replace the Keynesian cross, which reflect the economy's circular flow with a Hayekian triangle which depicts the beans and the ends in their temporal sequence. Let's do that and see what we can come up with. Let me clean up the diagram. The level of consumption that appears as a part of the Keynesian circular flow also appears in the capital-based framework as a consumable output of a temporal sequence of production activities. So there's consumption in the Keynesian theory. Well, we can use that level of consumption, but realize that the key variables that give rise to it are the variables of that Hayekian triangle. OK, so now, I've got the thing set up with the triangle and I'm still going to use the Keynesian vision. This is what is the payoff, I think. You use the Keynesian vision and then switch to the Austrian vision. So the level of, let's see, we had that. Keynes, however, assumed a fixed structure of industry. He does that in the early chapters of the general theory. We assume, what, for purposes of simplicity, or do we really believe it, that the structure of industry is fixed? Well, if it is, we're in trouble right there, all right? But his analysis is based on a fixed structure of industry, which I take to mean a fixed structure of production in the Hayekian literature, which in the current context implies a Hayekian triangle of fixed shape, the only live issue being the triangle size, which represents the level of employment and the extent of capital utilization. We began as before with the economy functioning at its full employment potential. But now, when I show you this full employment potential, notice that it's not associated with a particular stage. It's just associated with all the stages. The labor market is representative of each and every stage of production that make up the economy's capital structure. So let's see how that looks. OK, so it's not specific to a single stage. All the stages have that same labor market. And I guess they would if that structure was fixed. If it was always fixed, then, yeah, it would. Looks like that. The market mechanisms in play here are still those envisioned by Keynes. So I'll use his market forces and show you what happens. Then we'll turn around and use Hayek's market forces. In accordance to the paradox, an increase in saving causes the economy to spiral downward to a less than full employment level, an increase in saving. All right, so here's the supply of saving. Let's increase it. There it is. It goes to the right. All right, goes to the right. And what does that cause? Well, you know, Hayek would say, if people save more, there's more investment materials to take possession of and increase the economy's capacity and so on. And Keynes might have a thought about that, but he says before, yeah, but before that happens, the economy falls inside the frontier. And when it does that, of course, that supply curve shifts back because at a lower level of income, then people can't save as much, even though that's what they tried to save, with a higher income. So that's his paradox of thrift again. So look what all changed. We're still back to the same old interest rate. And again, this is why Keynes doesn't be not paying that much attention to interest rate. It always turns out to be that same thing. But now the triangle hasn't changed in shape, but it's changed in size. And a lot of it that was used before is now just idle. And that's a depression. That's the problem. Even the demand constraint changed because the parameters in that demand constraint make that necessary. Okay. And again, here's the labor market according to Keynes. In other words, it's the same old wage rate. Wage rates are sticky. So you got unemployment. You've got a slack economy. You've got the same old interest rate. That's Keynes, all right? And so you need some government policy to fix it. Note that the sole effect on the structure of production comes from the initial reduction in consumption that derived demand effect works undemandaged on all the earlier stages. See, he doesn't pick up the interest rate demand or the interest rate effect, the discount effect, so-called, and the reason he doesn't is because the interest rate doesn't stay down any time, hardly any time, because that saving curves shifts back left and we got the same old interest rate. Or even if he did, notice the interest rate down. He's already assumed a fixed structure of industry, so that's not gonna have any effect. The interest rate is effectively out of play. The leftward shift of the savings took the downward pressure off of interest rates in any case, the capital structure is assumed to be fixed. That's Keynes now. This is all bizarre, I think. It's pretty bizarre, but this is Keynes. And what makes it more bizarre is the title of his book is The General Theory. Well, how general is it? To me, it's a quirky, quirky theory, all right? But it's one that suggests policy changes that the government is thrilled about. They're gonna take credit for beefing up the economy and so on, okay? Now I'll just reset the thing. Now, what I've gotta do is morph this thing back to the Austrian view. And what's interesting is I'm gonna make three changes. There's three changes. And I want you to think about which one, if any, or how many would probably be unacceptable to a professional economist today? Who would just balk at these changes I'm gonna make? Well, let's see how it goes. Three modifications are needed to transform the Keynesian vision into the Hayekian vision, right? And the first one is divide the structure of production into stages. Because if it's fixed, like Keynes says, you don't even have to talk about stages. So that's an easy thing to do. See, it's almost done now. Okay, so we've divided it into stages. Allow for stage-specific labor markets in which wage rates adjust to changes in market conditions. So we can't make do with just one labor market. It's one per stage. I'm just gonna use two stages because they don't have enough room for the rest. Well, let's do that. All right, so they both have labor markets. They look the same now, but they can change in different ways depending on what happens to the interest rate. Okay, that's the story. What else do I, oh, the third thing is to get rid of that Keynesian demand constraint. Boy, that's nice. How do we do that though? Watch. Watch. Watch. Feels good, doesn't it? Feels good, doesn't it? Okay. Now a little hyperbole here, but that's okay. So the paradox of thrift becomes a gateway to growth. The thing can work, okay? So with wage rates and interest rates, both adjusting to changing market conditions, the economy can move along as PPF will glory be and the structure production can adjust to an increase in saving, Hallelujah. All right. So here we got an increase in saving. Oh, the market is at work for you and for me. And again, I don't know if I said this before, but one of Keynes' remarks was that Mr. Keynes' aggregates conceal the most fundamental mechanisms of change. Not to take sides here, but rejected. Okay, there you have it. Thank you.