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Keynesian Tradition Notes

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Pip Reeve HT 10 W1 19.01.10 "Macroeconomics in the Keynesian tradition is founded on three pillars: nominal rigidities, absent markets and irrational expectations." Discuss. In this essay, I will discuss Keynes' original discussion of these three factors. I will then show how these are not adequately used in the IS-LM model and the problems these present. Finally, I will finish by presenting an alternative model which may be more realistic and relevant to the economy today. This new model uses some of these three pillars to varying extents. Keynes emphasised that fluctuations in output occur largely due to fluctuations in real aggregate demand. These fluctuations have real effects because nominal wages and prices are rigid in the Keynesian tradition. If all money wages and prices are lowered in the same proportion, it is possible for real quantities demanded to be different. This can occur if the nominal quantity of money stays the same, its real quantity increases, interest rates fall, and real demand increases. However, this will fail if the liquidity trap occurs. A failure of price adjustments to keep markets cleared allows for quantities to determine quantities. One example of this is real national income can determine consumption demand, a situation which is described by Keynes' multiplier effect. Keynes' theory refers to economies with incomplete markets, or absent markets. Some possible causes of missing markets are, firstly, found in the form of externalities. Externalities and public goods have no market as there is no incentive for any one individual to take any action. However, the externality can be seen as the benefit that could be created if firms and consumers were able to coordinate their prices in order to clear the market. Similarly, Keynes does not necessarily agree with the assumption that markets will always clear by price changing sufficiently such that demand will always equal supply. This will lead to a disequilibrium and there will therefore be an absent market for the excess supply or demand created. During the time when Keynes publicised this theory, future markets were rare, and contingent futures markets were even rarer. Today, the situation is similar and they are still scarce. Consumers rarely decide not to spend now because they have definite orders for future or contingent spending. It is often the case that these future markets result in the accumulation of assets that can be spent on anything at any future time. This means that the multiplier effects of lower current spending propensities are not balanced by specific and firm expectations of higher future demands. Since many capital goods have long lives and production takes time, organisations must make decisions about investment and production based on expectations. Due to forecasting problems these expectations can't be 'rational' in the modern sense of the word, as there will always be mistakes. Keynes strongly believed that expectations drive markets and have a self-fulfilling character. For example, bondholders may expect the interest rate to be higher in the future, so they sell their bonds, the bond prices decrease and the interest rate increases. In particular, Keynes stressed the highly important role of long term expectations of real variables. So, it is clear that normal rigidities, absent markets and irrational expectations are all fundamental to the Keynesian school of thought. There are, however, many problems with the widely taught IS-LM model. It has been suggested that it does not follow many of the traditional Keynesian attributes and it has little relevance to policy making today. Part of the reason for this is it is a static rather than dynamic analysis, which can only ever provide limited use. Although expectations are technically present in the IS-LM model as the marginal efficiency of capital schedule which is one of the determinants of the IS curve and the theory of liquidity preference, which forms the basis of the LM curve, includes the speculative demand for money. However, as expectations are exogenous variables, they are outside of this model and are therefore often overlooked. Also, expectations about future output or income may well be more important than current income for firms and consumers. Equally, expectations about interest rates are also important for current financial decisions. For example, in the present financial climate with very low interest rates, a consumer who takes out a variable rate mortgage, expecting interest rates not to rise is foolish. Furthermore, investment is also highly dependent on

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