 Keynes and Hayek head-to-head and Just to let you know what's coming is that I'm going to start out with with the Keynesian Model that you see in some of the textbooks and so on and then eventually morph from there to the Austrian view and Note the changes you have to make to get to the Austrian view and see if you see any Anything wrong with those changes, okay? We see what's going on here Okay, here they are Keynes and Hayek head-to-head. It's not really too hard to put them that way There they go And just a brief characterization of both frameworks 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 wages or interest rate, but by changes in the level of employment Hayek's vision of the economy Suggests a means ends framework That's what you've seen earlier today in which the means of production are transformed over time Into consumable output. Okay, so that stark difference between the two theories Now with apologies to many of you who have had a course in basic macro and how many would that be? okay So lots of apologies here. We're going to take a brief review of The Keynesian circular flow framework, but you're going to see it It's going to look a little different than what you've seen in the textbooks Circular flow framework and so we have business organizations, which is just a a facility To bring workers and managers together Downstairs we got all the people we got workers and consumers and investors Okay, and it goes like this Do we have labor and other factor services? being provided in the business Organizations and that's that's the right way to say it labor and other factor services because Keynes He pretty much limited the input to labor as far as actually modeling it and He assumed that the other Inputs came along with it And then we have a reverse arrow that shows the income earned by labor and other factors Now if you look at the other side You get goods and services being produced there at the business organizations and They're bought by this these expenditures of consumer Consumption and investment so that's that's the circular flow And the thing that's more unique about my circular flow than what's in the textbook Is that they circulate? Well the things off right now I'll turn it on and you get a circular flow. Okay, you see how it works It's a little bit lethargic, but you can see why the dial is set to six, you know the Federal Reserve has the Dial set at six percent Okay, if you wanted to circulate faster just turn it over to Two percent And you get a and you get a boom in the economy and then if you start getting inflation Oh, you better flip it back or stop it and then you get a depression. Okay. That's the way it works It's a circular flow There there we go now, I'm trying to get it to go right here Now Hayek has got a whole different setup and it's all based on this stages of production so the two Graphics don't look anything alike and you wonder how you can start with one and end up getting to another The Keynesian equilibrium Condition as you have learned in school Is an income equals expenditures in other words the circulating that does on the Right half has to equal the circulating that does on the left half. Otherwise you have You have disequilibrium and Equilibrium conditions income equals expenditures For a holy private economy The income has to equal consumption expenditures plus investment expenditures We could add government spending, but I'm leaving that off In this particular PowerPoint so you have a holy private economy Y equals C plus I Okay now We put that on a graph and really all we're graphing is the left side of the graph in terms of expenditures and the right side of the Circular flow in terms of income and if the two thing has two things have to be equal in equilibrium Then you get a 45 degree line. That's what the equilibrium Is defined as all right so the economy is in Keynesian equilibrium somewhere along the 45 degree line The line itself identifying all the possible income Expenditure equilibrium points we draw the consumption equation the consumption function, which is The stable part of the economy as far as Keynes is concerned although will show later that it can Change and with consequences so there is the consumption equation it's Has a lower slope than 45 degree line And it doesn't start at the origin it suggests that even without any income People have some expenditures which clues you off right there that it's sort of a short-run thing. You must have had Some money built up before you lost all your income And and now you can still spin and then the slope is Called the marginal propensity to consume MPC you've heard about that and it means the slope of that line is Lower than one in other words. Yeah, you spend but you save to all right you spend and you save and The equation of that is c equals a plus by the a is simply the vertical intercept of the Slope is b over 1 And b over 1 is less than 1 and then we pile on to consumption investment So it has that same slope but only because it's sitting on top of Consumption so investment just Is what it is It doesn't have any Determinance that we that we can derive from the market process in fact It depends on what Keynes calls animal spirit 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 economic reality. Well, there's a Loose joint right there. I mean sudden, you know, that's that's kind of strange But it's that's where animal spirits come in you have fire in the belly or not and so on So consumption and investment as well as government spending are Portrait as additive Components of total spending the three components are distinguished largely in terms of their stability characteristics so you have Consumption which is seen as being stable. It doesn't move around too much investment which is being is unstable and Government spending which I'm not treating in this particular diagram as being stabilizing Okay, so it's government spending to the rescue Stabilizing an economy that otherwise would be unstable because of the unstable investment Spending okay, so here when we see the equilibrium point And and we can see it's equilibrium because there's income the horizontal distance and That vertical distance is consumption and the rest of it is Investment so y equals c plus i that gives you the the stable income at least stable until investment changes So holy private macro economy achieves an income expenditure Equilibrium when y equals c plus i note that income itself rather than prices wages or interest rate is the equilibrating variable you don't have prices changing and interest rate changing To create equilibrium is simply how many workers are working Either more or less and so on According to Keynes it is only by accident or design That the economy is actually performing at its full employment potential and I've had students ask me and very innocently Well, what's it? What else is there between accident and design? And and actually the right answer is it's it's market mechanisms at work for you and for me So in other words he rules out the possibility that there are mechanisms in the economy Changing prices changing interest rates and so on that could bring the economy into equilibrium So we assume here initially full employment conditions prevail if only by accident And it has to be by accident here because we don't have We don't have government spending in the picture so it's not by design All right Now in this diagram on the right I'm going to include The production possibilities frontier although you don't see this in the texts on on Keynesian theory, okay, and you can see by By that graph that sure enough we are in equilibrium a macro equilibrium in other words We're on the production possibilities Frontier so in capital-based macroeconomics full employment implies that the economy is Operating on its production possibilities frontier the PPF itself being defined in terms of sustainable output Levels of consumption and investment goods, okay, and I've even got a labor market that is In equilibrium I'm being real fair to Keynes at this point And showing how things work at their best even if only by accident In Keynesian macroeconomics full employment implies that the labor market clears at the going wage rate And that's the term that Keynes use the going wage rate All right The going wage rate itself having emerged during a period in which the economy was experiencing No macroeconomic problems, so you have this wage rate out there, and that's that's the one we need That's the one we want. That's the one that's a sort of a no problem economy and The Keynesians sort of keep that in mind when they're trying to fix an Economy that's got problems What should the wage rate be? So labor income that's y equals WN and the US they use the textbook use in For labor hours, I guess you call it number of labor hours and so you get the in and number I don't know how they came up with it, but The hourly wage times the number of worker hours gives you income well gives you Labor income Is fully representative of total income such that changes in labor income stand in direct proportion to changes in total income, which means that interest income and Profits other incomes. They'll they they all move up and down with labor income So as long as we sort of monitor labor income, we know generally what's happening to total income Of course, that's that's not right Because like the different components can vary one with another Okay, let's see. So there's labor income is it's that rectangle there the wage rate times the number of worker hours being expended so why sub FE that FE stands for Iron in chemistry, but it stands for a full employment here. Okay, it's a full employment income So Keynes is Keynes has got it knocked here. He's got everything in doing the right thing All right now here's my circular flow in miniature Which shows that expenditures equal income But it's it's not likely to stay that way because that investment magnitude is Not stable So what might happen here? According to Keynes a collapse of Investment activity the collapse being attributable to a waning of the animal spirits He used animal spirits three times at a page and a half That's the primary cause of Economic downturns. Well, he hasn't explained much there, you know What are these animal spirits in response to reduced investment and hence reduced employment opportunities? The economy spirals downward into a recession and possibly deep depression Well, there's the animal spirits Now that would spook anybody wouldn't it and when that happens Investment goes down Now I'm making fun of Keynes. I know but and so you can see there's excess inventories there and you can see them piling up here So something's got to give. Okay. Now what happens, of course, is the economy crashes and Goes to a much lower level of income And then here's the here are the little equations you had to memorize and and using your quizzes you have the change in investment and the change in Income that was a result of it And we could even give the equation Delta y equals one over one minus V times Delta I and we can see that Consumption changes to not not the consumption equation Shifts but you move down and so you got less consumption and now which what we see is worth pointing out is that When something happens bad Then everything goes down in investment goes down consumption goes down income goes down. Okay That's that's the way the thing works and there's see you don't have any prices or interest rate in this in this equation the simple interest spending multipliers one over one minus V which You see there in the equation it quantifies the relative rates of downward and upward spiraling and now we have the labor market in Trouble because the demand for labor shifted down to all right and yet Note that the going wage rate keeps going even after the market conditions that gave rise to it are gone you'd expect that wages would adjust to that Supply demand equilibrium and when you look at the the whole model at this point It makes you wonder why he titled the book the general theory how general is it? Now I'm going to skip over here One part just because it's Redundant at least for our purposes So I'm going to do some morphing from the circular flow to a means ends framework Starting from the Keynesian view the nature of the Keynesian style spiraling associated with recession depression and inflation Becomes more transparent when the production possibilities frontier is in play and it's me of course is putting it in play Not Keynes There it is Okay, now again, we're going to watch the waning of the animal spirits Causes investment to decrease and with it in common consumption But now what I want you to look at is the PPF diagram You know what's going to happen to the other one because you've already seen it, but let's watch the shift There's the shift in C plus I and here goes the economy So what you see that the economy falls inside the PPF Consumption and investment Move in the same direction. They both go down together. They both go up together No, there's no way you can move along the PPF and again you have You're going wage, but it's not an equilibrium anymore Now we're going to shift again get even lower Shifts down some more Like that still that going wages So the further waning Sends the economy deeper into the PFS interior movements inside the frontier and beyond Trace out a linear relationship showing how consumption varies with income and And so watch this in the PPF graph. I even showing one outside the PPF And we can draw a line there Like so it's called the Keynesian demand constraint You might wonder who named it that and it turns out it's me because No one else has drawn this diagram They didn't get it Let's see. I think I show you here a note that the investment were if the investment were to fall to zero the economy would settle into an income expenditure equilibrium with y equals C no I and That I can show you just with See, I thought I had it there Yeah, that line there that little white line That just shows I've got my Graphs lined up that when there's when it shows no investment in the one diagram it shows no investment in the other one too All right Now I want to get the equation of that line and I don't expect you to follow this. It's probably too small For you to see but we can easily see what's going on. We got C equals a plus b y and C plus i And so we've got three variables In two equations so we can massage those equations and End up just with one equation with two variables. In other words, we get rid of one Variable and that will allow us show you how Consumption and investment move with one another so I do the algebra. It's just simple algebra You can do it on your own and it gives you this at the intercept there is a over one minus b The slope is B over one minus B. So there's the equation Of the demand constraint And again, it's an equation. You'll never see in a in a principal's textbook. They just don't do that as soon as you see that Consumption investment are always moving together. You see that the PPF is really just out of play I'll skip over this and in the name of Saving time but these are the numbers that Keynes himself picked out To make the point although he didn't draw the graph and he says he says that There's always an equation of this type of relationship of this type meaning that upward sloping line and it has Tremendous significance, but no one seems to realize it All right. Well, of course the reason you have this line is because the whole economy is hamstrung and Is operating with the animal spirits? That's one of his examples Let's read this part the formula is not of course quite so simple because he is he assumed that a is zero and it's not In this illustration, but there's always a formula more or less of this kind Relating the output of consumption goods, which it is it pays to produce to the output of investment goods And that's what we've done This conclusion appears to me to be quite beyond dispute And it's only beyond dispute if you've bought into all of the assumptions that Keynes has made yet The consequences which follow from it are at the same time unfamiliar and of the greatest possible importance and Of course the importance is that if this happens to an economy and it's surely well Then we need government to the rescue To get us back to a full employment equilibrium That's the story there Okay to keep track of possible interest rates movements the loanable funds market can be brought into view and Keynes probably wouldn't appreciate this because they didn't like the loanable funds market But we'll put it in the view anyhow so there's the rate of interest versus savings and investment you saw that in the In the earlier model Upward sloping supply curve downward sloping demand curve like so Though Keynes argued that neither saving nor investment depended To any significant extent on the interest rate. He also argued that both curves as conventionally drawn Shift together leaving the interest rate unchanged So this is why interest rate was out of the picture for Keynes that he thought these two diagrams if the shifts It would shift together Right or left and so the interest rate wouldn't change Okay with loanable funds market in play and I'm jumping the cadence there with loanable funds markets in play We see that decreased investment is accompanied by a leftward shift in the demand for loanable funds Putting downward pressure on interest rates will we get that far? So here's So you can see C plus I fell because of the fall in investment and then so the demand for loanable funds Fell so it shifted to the left and at this point you might think well, okay, then you're going to get a lower interest rate But Keynes says no before that can happen The spiraling downward of income implies that the supply of loanable funds Also known as saving Shifts leftward to relieving the downward pressure on the interest rate so There goes the supply and once that happens the interest rate didn't change so Keynes says well Why are we fool with this curve because the interest rate doesn't change both curves shift together, okay now I Realized only at this point when I got to the model put together that that one single diagram In Keynes's general theory and you only had one was exactly This demonstration although you wouldn't guess it just by looking at the diagram Appearing in the general theory is the specific application of the loanable funds framework The implications according to Keynes is that loanable funds reckoning is at best superfluous and This hasn't been picked up just by the by the textbooks So here's the general theory and there's his diagram I could start by asking what all is wrong with that diagram On the horizontal axis is R which actually stands for interest. I guess rate of interest so that's interest and What do you see on the vertical diagram? That's a big sin, isn't it? I see our physicists Smiling What's on the well you can see it in the in the passages Let's see as shown on page 180 of his general theory Keynes presented the loanable funds market With the interest rate R on the horizontal axis you failed to label the horizontal the vertical axis The accompanying text indicates that saving and investment are measured there. So it's the same curve I've got except it's Backwards, okay Now what I want to do Keynes diagram can be flipped over and rotated 90 degrees to make it conform To modern renditions of the market for loanable funds and we'll get that So that's the diagram now with saving and investment and then the interest rate upstairs Also, two of those diagram two of those incomes We're just to show that income is a shift parameter. So we get rid of that Okay, now that looks more and more like my diagram. In fact, the only thing different is that he's got the He's got the upward sloping thing Sort of backwards as far as bowed out. He's got him bowed the wrong direction, but we'll forgive him so he's showing that both The supply and the demand shifted a rate that keep interest rates Unchanged and therefore he doesn't need to use this diagram You can see it over there, too Keynes also denied whoop. Let me go back. Keynes also denied that an increase in saving would have the effect of Imagine by the loanable funds there is Keynes paradox of the thrift As articulated in his general theory is to the point Every attempt he says every attempt to save more by reducing consumption. Yeah, that's the way you save more Will so affect incomes That the attempt necessarily defeats itself This is called the paradox of Thrift and now for the first time we're going to let the consumption fall Okay, Keynes thought that was rare it didn't fall much it didn't fall often, but it could fall And if it does and it falls because people decide to save more Then that that really bollocks is up the economy so now almost everything will shift here because that That constraint up there that demand constraint Has the parameters of the shift of the consumption function in it so it'll shift too So let's make it everything shift that's supposed to shift it goes like that Okay Don't expect you to fully digest this particular diagram, but you can see what will happen Okay, the right word shift in the supply of loanable funds puts downward pressure on interest rates, but Here's the Keynesian part before there is any movement along the demand for loanable funds The pressure is relieved as Reduced consumption causes income and hence saving to fall Okay, so they reduce consumption that's in the economy and depression income fell and if income fell it can't save As much anymore and so the saving shifts left to and again you get Keynes's view that the interest rate isn't affected by that kind of change I'm watching the clock here. So hence the peer the paradox of thrift try to save more and you'll instead earn less That's that's the paradox of thrift and Cain really not a paradox. It's just a result of a Absolutely hamstrung economy That isn't directed by movements in wage rates interest rates Output prices or anything of the short of the sort Okay You know, let's see. I lost something there. I'll come back To resolve Cain's paradox of thrift requires that we've replaced the Keynesian cross Which reflect the economy circular flow with a hiking triangle. Okay. I think I'm in good shape time wise because now I'm going to There is step by step show what we have to do to get from Cain's to hi-hack And I sort of reset the the whole thing where we've got Just just the outline of what Of how things are set up without any shifting at this point. Okay So the level of consumption that appears as part of the Keynesian circular flow also appears as the capital based framework and as the consumable output of a temporally sequence production activities so That's consumption in the Keynesian theory. Well, that's consumption at the end of that hiking triangle So let me put that hiking triangle in there There it is So I've jettison's C plus i plus g And put the hiking triangle in Um Cain's however assumed a fixed structure of industry Which in the current context implies a hiking triangle of fixed shape The only live issue being the triangle size which presents Which represents the level of employment and the extent of capital utilization And so I'm going to I'm going to use this diagram this whole diagram here Sticking to the Keynesian principles But showing how they work out with high all right See we've still got a ppf that you can't move along So as before We begin with the economy functioning at its full employment level The labor market is representative of each and every stage of production That make up the economy's capital structure in other words. He just had the labor market And so to show that it would look something like this Okay, it's it's not stage specific labor markets It's all the labor markets and to the extent they move and all they move together Market mechanisms in play here are still those envisions by Keynes In accordance with the paradox an increase in saving Causes the economy to spiral down to a less than full employment level. Let's watch that Okay, there's the increase in savings And there's the aftermath And you see the triangle doesn't change shapes it can't in his viewpoint And so it just ends the economy up in depression And we got less employment to boot Note that the sole effect of the structure of production comes from the initial reduction in consumption the derived demand effect works undemandaged On all the earlier stages All right, the interest rate is effectively out of play The leftward shift of savings Took the downward pressure off of interest rates and in any case the capital structures assumed to be fixed So You know, nothing's going to happen. That's good in that kind of a model Okay, I'm resetting it now Now three modifications are needed to transform the Keynesian vision into a Hayekian vision. I've still got I've got exactly enough time And I want you to pay attention to which What is it that we're revising? And see if you could think of any problems with the revisions One divide the structure of production into stages all right, well I think we can do that. There they are. We've got different stages and two Allow stage specific labor markets in which wage rates adjust to change market conditions Okay, we can do that. All right I'm about to get there Get rid of the Keynesian demand constraint and we can get rid of it because Now you've got labor markets That change relative to one another and you've got a triangle that's going to change Shapes and and not just sizes And in that case you can move along the ppf and if you can move along the ppf then then that So-called demand constraints out of play All right And there's a question about how to get rid of it. We'll try this It's gone And now what you have is a is a hayekian model the paradox of thrift becomes a gateway to growth. Okay a little bit of With wage rates and interest rates both adjusting to change market conditions the economy can move along the ppf And the structure of production can adjust to increase to an increase in saving You've seen this before so you'll see it one more time and there it is Hayek says mr. Keynes aggregates conceal the most fundamental mechanisms of change Don't want to be too judgmental here Okay, there you have it