Keynesian Economics Without the Consumption Function

In Prosperity for All,  (PFA) I describe a theory of Keynesian economics, developed in my recent body of work,  in which the transmission mechanism from demand to employment is through wealth, not through income. I call this, a theory of Keynesian economics without the consumption function.

I reject the Keynesian theory of aggregate demand, and I reject the theory of the multiplier that goes along with it. My reason is that the empirical evidence does not support a theory in which government expenditure  multipliers work by increasing consumption, as they must if the Keynesian consumption theory is correct. As Valerie Ramey has shown, when government expenditure goes up; consumption goes down.

Here is how I describe my reluctance to embrace the traditional Keynesian approach to aggregate demand in Chapter 10 of PFA,

Keynesian economics has two parts: a theory of aggregate supply and a theory of aggregate demand. Traditionally, Keynesians have focused on the theory of aggregate demand. The central part of that theory is the consumption function, and an implication of the theory of the consumption function is that an increase in government expenditure will cause GDP to increase by a multiple of the initial increase in spending. That theory is wrong. Consumption depends on wealth, not on income. PFA, pages 177-178

If consumption depends on wealth, and not on income, we should be concerned that movements in wealth may lead to socially inefficient fluctuations in the unemployment rate. Those movements are not simply temporary movements away from a social planing optimum, they are permanent movements in the unemployment rate that can lead to decades of misery for those without jobs.

Figure 1: Roger E. A. Farmer. (c) Oxford University Press.

Quoting again from PFA,

Figure 1 illustrates the implications of a theory of Keynesian economics without the consumption function. The aggregate demand curve does not slope upward with income; it is a horizontal straight line. The position of this line depends on the beliefs of market participants about the value of their financial assets. As the value of financial assets fluctuate, driven by self-fulfilling beliefs, so the aggregate demand curve moves up and down between the solid horizontal line and the dashed horizontal line. As people feel more or less wealthy, they buy more or fewer goods. Firms hire more or fewer workers and real GDP fluctuates between point YA* and YB*.  (PFA, page 178.)

But although, I reject the simple Keynesian version of Aggregate Demand, I do not reject Keynesian economics. The key idea in the General Theory is that high involuntary unemployment may persist as an equilibrium of a market economy. How can that be? In Prosperity for All,

I provide a foundation—Keynesian search theory—to the Keynesian theory of aggregate supply. This new theory is rooted firmly in the microeconomic theory of behavior. According to Keynesian search theory, everything demanded will be supplied and any unemployment rate can be an equilibrium unemployment rate.  (PFA pages 178-9.)  

The implications of these ideas, taken as a package, are profound. If demand works through wealth, the right policy to maintain full employment is an intervention in the asset markets, not in the goods markets. 

Reinventing the Keynesian Cross

In, Aggregate Demand and Supply, a paper I wrote in 2006 that was published in the International Journal of Economic Theory, I developed my own version, and interpretation, of the Keynesian Cross. The Keynesian Cross is a diagram that, in times gone by, was taught to every student of macroeconomics.  

The Keynesian Cross, a formulation of the central ideas in The General Theory, appeared as a central component of macroeconomic theory as it was taught by Samuelson in his textbook, Economics: An Introductory Analysis.  The Keynesian Cross plots income on the horizontal axis and expenditure on the vertical axis.

Figure 1: The Keynesian Cross (my interpretation using employment and output in wage units) 

In Figure 1, I have graphed a version of the Keynesian Cross that is closer in spirit to the General Theory than the version developed by Samuelson. In contrast to Samuelson’s version, my version plots employment on the horizontal axis and output, measured relative to the money wage, on the vertical axis. 

Following Keynes, I am measuring employment in units of ordinary labor and I am measuring output in wage units. I explain this diagram in my published paper Aggregate Demand and Supply.  The use of employment and output on the axes reflects the definitions in Chapter 4 of The General Theory.  In his exposition of Keynesian Economics, Samuelson amended this diagram by plotting income on the horizontal axis and expenditure on the vertical axis.

The student who truly understands [the Keynesian Cross] is well on the way to mastering the most important ideas in macroeconomics. It illustrates the two most important concepts in The General Theory, concepts that have formed the basis for everything I have drawn attention to in my work.

The first is the idea of beliefs as an independent driver of business cycles. ... The second is ... that any unemployment rate can persist as a steady state equilibrium. 

An important research question for macroeconomics is: what are the determinants of the aggregate demand curve and why does it shift around in sometimes unpredictable ways over time? In my view, Keynes’ theory of the consumption function is inadequate to answer this question.  We should instead explicitly model the connections between consumption and wealth.

I have included my version of the Keynesian cross in a new paper I have just completed that explains the connection between ideas developed in my books and papers and those of economists who self-identify as Post-Keynesians. Look out for my new paper, Post-Keynesian Dynamic Stochastic General Equilibrium Theory, coming next week. A discussion of the Keynesian cross can also be found in my new book Prosperity for All, pages 156--158 and pages 174--175. 

Keynes Betrayed

" To complete the reconciliation of Keynesian economics with general equilibrium theory, Paul Samuelson introduced the neoclassical synthesis in 1955...

... In this view of the world, high unemployment is a temporary phenomenon caused by the slow adjustment of money wages and money prices. In Samuelson’s vision, the economy is Keynesian in the short run, when some wages and prices are sticky. It is classical in the long run when all wages and prices have had time to adjust....

... Although Samuelson’s neoclassical synthesis was tidy, it did not have much to do with the vision of the General Theory...

... In Keynes’ vision, there is no tendency for the economy to self-correct. Left to itself, a market economy may never recover from a depression and the unemployment rate may remain too high forever. In contrast, in Samuelson’s neoclassical synthesis, unemployment causes money wages and prices to fall. As the money wage and the money price fall, aggregate demand rises and full employment is restored, even if government takes no corrective action. By slipping wage and price adjustment into his theory, Samuelson reintroduced classical ideas by the back door—a sleight of hand that did not go unnoticed by Keynes’ contemporaries in Cambridge, England. Famously, Joan Robinson referred to Samuelson’s approach as 'bastard Keynesianism.'

The New Keynesian agenda is the child of the neoclassical synthesis and, like the IS-LM model before it, New Keynesian economics inherits the mistakes of the bastard Keynesians. It misses two key Keynesian concepts: (1) there are multiple equilibrium unemployment rates and (2) beliefs  are fundamental. My work brings these concepts back to center stage and integrates the Keynes of the General Theory with the microeconomics of general equilibrium theory in a new way. "

Prosperity for All: Pages 25-26

Why Markets Fail

" I will make here a simple but strong claim. Free trade in competitive markets does not, in general, lead to a Pareto Optimal outcome. I will show that that there are two reasons why markets fail. The first is a systemic failure of financial markets. The second is a systemic failure of labor markets. In the following sections I will explain why both financial markets and labor markets fail, and I will present a policy that can improve the standard of living for all of us. Laissez-faire capitalism is a good deal better than the central planning that was implemented in Maoist China or Soviet Russia. However, unregulated free markets can sometimes go very badly wrong. There is no excuse for a society that condemns 50% of its young people to a life of unemployment.  We can and must seek prosperity for all."

Prosperity for All, Page 9.

Which Free Market?

"When Hayek criticized socialism, he was informed by experience. Beginning in the 1920s, Soviet leaders pursued central planning as an alternative to the free market system as a way of allocating resources, and China followed suit when the communists came to power in 1947. Hayek’s critique proved prescient as the failed experiments of communism were swept away with the opening of China to trade in 1972 and the fall of the Berlin Wall in 1989.

Hayek believed that central planning was inferior to free markets and that market capitalism is the best possible form of social and economic organization. He was right to infer that some form of market organization is better than central planning at allocating resources and creating wealth. But, that observation does not help us to decide which form of market organization is to be preferred.

There is no such thing as the free market. All market systems operate within systems of rules that define which property rights will be enforced and which will not. Those rules are themselves determined by the interaction of human beings in a political process that is still evolving. We cannot just decide that goods will be allocated in a free market. We must decide which free market. That is what I mean by institutional design."

Prosperity for All Chapter 1, Pages 7-8.