John Maynard Keynes Circular Flow Money Modern Macroeconomics Economics Essay

John Maynard Keynes Circular go down M acey Modern Macro economicals Economics EssayKeynesJohn Maynard Keynes an economist from Britain. Keynes economic theory was dwellingd on circular flow of groovy. His views and ideas greatly bear upon unexampled macroeconomics and upgradeable liberalism. In Keynes theory, one persons spending goes towards an sepa invests gelt, and when that person spends her earnings she is, in effect, supporting a nonhers earnings. This circle continues on and helps support a familiar functioning economy.However, the advent of theglobal financial crisisin 2007 has ca apply a revivification in Keynesian eyeshot. Keynesian economics has provided the theoretical underpinning for the plans of PresidentBarack Obamaof the coupled States, Prime MinisterGordon Brownof the United Kingdom, and other global baksheeshership to ease theeconomic recession.JMK was given low marks for his views on splashiness.His intentness with unemployment led him to ignore the issue of upgrade equipment casualtys completely.Since his death in 1946 his disclose has been linked to such flashists slogans as full employment at e very court, and silver doesnt matter.It is sm both wonder that he has been widely comprehend as an pomposityist and that our present lump is often described as the legacy of Keynes. state in Deficit The Political Legacy of ennoble KeynesBuchanan and WagnerLord Keynes himself moldiness bear substantial responsibility for our app atomic number 18ntly permanent and perhaps change magnitude fanf be. Without Keynes ostentatiousness would not be clear and present danger to the s footty society that it has surely now become. The legacy or heritage of Lord Keynes is the intellectual legitimacy provided to deficit spending pretension and the growth of organization.In alertity Keynes deplored pomposity warned repeatedly of its evils and recommended restricted petition management policies to delay it.Keynes strong aversion to pompousness is evident in even his earliest work. It appears in his Indian Currency and Finance (1913). There he definitely rejects the argument that a depreciating currentness is vantageous to trade contending that all advantages derived from largeness are and passing and that they occur more(prenominal) often than not at the expense of the comm unity and therefore do not get ahead the state as a whole.In his Economic Consequences of the Peace (1919) he tell Lenin is say to claim declared that the best way to pulverize the uppercaseist sy arrest was to debauch the currency. By continuing address of lump g overnments shadower confiscate, secretly and unobserved an important theatrical role of the wealth of their citizens. By this method they not only confiscate unless they confiscate arbitrarily and fleck the process impoverishes m any(prenominal) it actually enriches some.He then proceeds to prodigalen at least four ways that rapid puffiness p lant to falteringen the loving fabric and to undermine the foundations of the capitalist free food market system. First, unforeseen splashiness he says results in a capricious and totally arbitrary up inceptionrangement of riches that violates the principles of distri stillive saveice. Besides its inequities ostentatiousness withal renders personal line of credit undertakings essayier and thereby turns the process of wealth getting into a gamble and a lottery. In generating risk and injustice, inflation strikes not only at security, but at confidence in the equity of the animate distribution of wealth. indorsement inflation violates unyielding term arrangements based on the assumed stability of the value of funds. In so doing, inflation disturbs contracts and upsets all permanent relations between debtors and creditors which skeleton the ultimate foundation of capitalism. Third inflation generates social discontent and directs it a pass onst linemen whose windfall requital are wrongly perceived to be the cause instead than the consequence of inflation.This discontent is exploited by governments which being many of them reckless as hearty as weak seek to direct on to a class known as do goodeers the general indignation against the lots obvious consequences of their vicious methods.In other words governments actually responsible for causing inflation seek to deracination the blame onto businessmen who ensuantly lose confidence in their built in bed in society and become the easy victims of intimidation by government of their own reservation and a press of which they are proprietors. By making business a scapegoat and target of vilification and control inflation reinforces anti business attitudes and weakens support for what Keynes called the active and constructive element in the whole capitalist society.Finally inflation tends to breed such guide remedies as price regulation and earningseer-hunting that whitethorn do more persec ute than the inflation itself. Keynes was especially critical of the tendency of governments to re salmagundi to price controls which in his view lead to resource misal mending and a reduced supply of goods thereby compounding inflationary pressures.Regarding the dis-incentives to corpo very out-put occasioned by controls he state that the de equalry of a spurious value for the currency by the force of rightfulness expressed in the regulations of prices contains in itself however the seeds of final economic vector decomposition and soon dries up the source of ultimate supply.For by freezing prices at what are likely to be disbalance trains controls constitute a system of shambling the exchange of commodities at what is not their significant relative value and this not only relaxes production but finally leads to the waste and inefficiency of barter.Keynes concern with the dangers of inflation influenced his policy advice in the post war boom of 1920 when an outburst of infla tion threatened the British Economy.Nowhere does Keynes express his concern for inflation more strongly that in the TRACT. There his chief fear is that inflation whitethorn retart capital formation and inhibit recollective term economic growth. He specifies at least three ways that this can happen. He notes eldest the inflationary disincentive to saving. By eroding the real value of by savings inflation diminishes the capacity of the investing class to save and destroy the atmosphere of confidence which is a condition of the pass oningness to save.With a smaller peck of national income flowing into saving and investment the rate of capital assembling falls. And since according to Keynes The national capital must grow as fast as the national cut into supply for the maintenance of the same bill of life it determines that a fall in capital growth downstairs the required potential rate leave behind lower the living standards. In short by discouraging saving and capital format ion inflation may cause a fall in the aggregate capital/labour ratio and a corresponding drop in labour productivity and fruit per capita.A second mover regarding capital accretion is the undercharging of the depreciation during inflation and the consequent inadequate provision for the replacement of fatigue capital. This occurs because depreciation charges on capital equipment are computed on the basis of skipper cost earlier than replacements costs.These replacement costs hike with inflation. Thus when prices rise the depreciation charge calculated on the basis of the original cost are too small to replace the worn-out capital. The result may be an unintended depletion of the capital stock. In such condition said Keynes a country can even trench on existing capital or fail to make good its current depreciation. For it is one of the evils of a depreciating currency that it enables a community to live on its capital unawares.The increasing money value of the communitys capita l goods obscures temporarily a diminution in the real quantity of stock. Yet a trinity adverse effect on capital formation, he noted, is the increased business risk resulting from inflation. For inflation hyperkinetic syndromes to ordinary business risk the especial(a) risk directly a rise out of instability in the value of money. To compensate for this extra risk, businessmen add a risk premium to the rate at which they discount the future, and the exalteder discount rate discourages investment.The discouraging do of inflation on saving, in-vestment, and growth were not the only inflationary evils described by Keynes in the parcel of land. Others in-cluded (1) the injustice and inequity resulting from inflationary redistributions of income and wealth, (2) the resort to spurious inflation remedies-e.g., price controls, excess attains valuate incomees, profiteer-hunting and the like-remedies that constitute not the least part of the evils, often doing more harm than the inflat ion they are designed to cure, and (3) the social resentment and discontent produced by inflation.This resentment, when directed against the business class whose windfall profits are wrongly perceived as the cause rather than the consequence of inflation, works to discredit enterprise and to weaken support for the fecund element of society-the prop of society and the builder of the future He notes that out of the blue(predicate) inflation may temporarily arrive economic activity by raising profits and profit expectations. Profits rise, he said, because earnings and other costs lag behind rising prices during inflation. And with nominal wages follow behind prices, real wages fall, thus inducing producers to step up their employment of labor.Likewise, the lagged adjustment of market gratify rates to inflation and the consequent fall in the real cost of borrowing leads producers to expand their operations. Finally, inflation reduces the real burden of flash-frozen charges, there by giving a temporary fillip to profits and to economic activity. But Keynes insisted that any such stimulation would intimately likely be small and short-lived.to a greater finishover it would constitute an undesirable overstimulation of industrial activ-ity requiring undue strain on capacity and a corre-sponding over-exertion of labor. For these reasons he judged the overall benefits to be minimal. Consequently, when Keynes weighed the benefits of inflation against the evils, he found the last mentioned to farther outweigh the former and accordingly came down heavily in kick upstairs of price stability.He summarized his case for price stability best when he declared that, because inflation is unjust and deflation is inexpedient . . . , both are evils to be shunned. The individualististic capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring-rod of value, and cannot be eff icient-perhaps can-not survive-without one It follows, he said, that the government should make price stability its primary policy goal. For, if we are to continue to egest the voluntary savings of the community into investments, we must make it a superlative object of deliberate State policy that the standard of value, in footing of which they are expressed, should be kept stableMonetarist Aspects of the nerve pathwayThe analytic thinking of inflation contained in the Tract has much in common with the position taken by todays monetarists. Specifically, inflation is discussed within the context of an analytical-model that is remarkably monetarist in spirit, embodying such standard monetarist ingredients as (1) the quantity theory of money, (2) the fancy of inflation as a assess on real money balances, (3) the monetary barbel to exchange rate determination, and (4) the Fisherian distinction between real and nominal interest rates. The paragraphs below summarize Keynes views on these elements in order to demonstrate that he was not the stereotype nonmonetarist caricature of the textbooks.Quantity Theory of MoneyThe Keynes of the Tract was an unequivocal ad-herent of the quantity theory. This theory, he said, is primitive. Its correspondence with fact is not open(a) to question 7 p. 61. His own version of the theory as elucidated in the Tract is essentially the same as the modern monetarist version and embodies the following monetarist elements (1) a money supply and admit theory of price level determination, (2) the view of money stock exogeneity, implying money-to-price causality, (3) the concept of the demand for money as a stable function of a few severalise variables, and (4) a concentrate on on the special role of price expectations in the money demand function. Regarding the money supply and demand theory of the price level, he said that two elements determine general prices and the value of money. First, the quantity, present and prospect ive, of money in circulation. Second, the hail of purchasing power which it suits the earthly concern to hold in that shape 7 p. xviii. elsewhere in the Tract he says that the price level depends on the currency policy. of the government and the currency habits of the people, in accordance with the quantity theory of moneyFinally, Keynes employed the quantity theory in his policy analysis, arguing (1) that inflation is caused by an excess supply of money, (2) that such monetary excess could stem from falls in money demand as well as from rises in money supply, (3) that the central bank possesses the power to delay the last mentioned and counteract the former, and (4) that it should employ this power to stabilize prices.For price stability he recommended deliberate countercyclical movements in the money supply to offset or vacate the procyclical impact of changes in money demand on prices. He thought that real money demand fluctuated with the state ofbusiness confidence, falling in booms, rising in slumps, and thereby amplifying cyclical movements of prices. The characteristic of the credit cycle, he said, consists in a tendency of real cash balances to diminish during the boom and increase during the falling off 7 p. 67.To counteract these he advocated deliberate monetary contraction in booms and monetary expansion in slumps. The time to deflate the supply of cash, he said, is when real balances are falling . . . and . . . the time to inflate the supply of cash is when real balances are rising, and not, as seems to be our present practice, the other way finish out 7 p. 149.In so stating, he rejected the monetarist case for a fixed monetary growth rate rule (which he argued is bound to lead to unsteadiness of the price level when money demand fluctuates) in favor of airinessary monetary management 7 p. 69. In the modern world of study currency and bank credit, he declared, there is no escape from a managed currency 7 p. 136.Note, however, that composi tion he rejected the monetarist case for rules instead of discretion in the conduct of monetary policy, he did voice the modern monetarist electric charge that discretionary monetary movements frequently tend to be procyclical rather than countcyclical.That is, he complained that the British monetary authorities had perversely engineered monetary expansions in booms when money demand was falling and monetary contraction in slumps when money demand was rising thereby aggravating rather than mitigating inflation and deflation. These -policy errors notwithstanding, however, he remained a strong advocate of discretionary monetary intervention in the pursual of price stability.The second monetarist ingredient that Keynes enunciates in the Tract is the concept of inflation as a impose on real money balances. As noted by the late Harry Johnson, this inflation tax analysis constitutes an essential part of the quantity theory approach to inflation. Consistent with that approach, Keynes ar gues that inflation is a method of tax revenue which the government uses to secure the command over real resources, resources just as real as those obtained by ordinary revenue enhancement 7 p. 37. What is raised by printing notes, he writes, is just as much taken from the public as is a beer duty or an income tax 7 p. 52.Regarding the inflation tax he says that a government can live by this kernel when it can live by no other. It is the form of taxation which the public find hardest to evade and even the weakest government can enforce, when it can enforce nothing else 7 p. 37. In discussing the inflation tax, Keynes stresses that it is a tax on cash balances.The burden of the tax, he says, falls on cashholders, i.e., on the holders of the original . . . notes, whose notes after inflation are worth . . . less than they were before. The inflation has amounted to a tax . . . on all holders of notes in proportion to their holdings. The burden of the tax is well spread, cannot be eva ded, costs nothing to collect, and falls, in a rough sort of way, in proportion to the wealth of the victim.No wonder its superficial advantages have attracted Ministers of Finance 7 p. 39. He next explains how inflationary money creation transfers rear resources from cashholders to the government. He notes that a given, say, 25 portion inflation rate requires an similar rate of rise of cash holdings just to maintain real money balances at desired levels. To accomplish this, cashholders cut expenditures on goods and go and add the unplayed out proceeds to money balances.The reduced private outlay for goods and services releases re-sources which the government acquires with newly issued money that is then added to private cash balances. In this way inflation enables the government to appropriate real resources from cashholders just as surely as if it had taken part of their earlier money balances and spent the proceeds on goods and services.How much the government gets depends upo n the quantity of real balances the public wishes to hold when the inflation rate is 2.5 percent. Assuming the public desires real balances totaling $36 million, the governments tax take is 25 percent of that sum or $9 million. Or, as Keynes himself put it in discussing the cause of the hypothetical 25 percent inflation tax on real balances of $36 million, by the process of printing the additional notes the government has transferred to itself an amount equal to $9 million, just as successfully as if it had raised this sum in taxation 7 p. 39.Keynes discussion of the inflation tax includes a sophisticated analysis of the best rate of inflation from the point of view of maximizing tax revenue. In this connection he makes four points. First, from the formula that tax yield equals tax rate times tax base, it follows that the yield of the inflation tax is the increasing product of the inflation rate (tax rate) and real cash balances (tax base), respectively.Second, the tax base is n ot invariant to the tax rate but falls when the last mentioned rises. That is, when the government raises the tax rate the tax base tends to shrink as people seek to avoid the inflation tax by changing their habits and economizing on real money holdings. Were this not so, said Keynes, there would be no limit to the sums which the government could extract from the public by means of inflation 7 p. 42.Third, because the tax base shrinks with rises in the tax rate, the government will realize more revenue from a tax rate rise only if it causes a less-than-proportionate fall in the base. A government has to remember, he said, that even if a tax is not prohibitive it may be unprofitable, and that a medium, rather than an extreme, imposition will yield the greatest gain 7 p. 43.Fourth, it follows that there is one inflation rate that maximizes tax revenue and that occurs where the helping increase in the tax rate equals the percentage shrinkage in the tax base, i.e., where the elastic ity of real money demand with respect to the inflation rate is unity. Here is the concept of the tax-maximizing rate of inflation, that plays such a key role in the modern monetarist analysis of inflationary finance.A Treatise on Money (1930)If the Tract is far-famed for its quantity theory-inflation tax analysis, the Treatise is equally famous for its celebrated fundamental equations of prices and the corresponding distinction between income inflation and profit inflation.8 Constituting the central analytical core of the Treatise, the fundamental equations express price level increases as the sum of two components, namely (1) increases in profit per unit of output, and (2) increases in unit costs of production (chiefly labor costs).Of these two components of price change-namely changes in profit and changes in costs, respectively-Keynes labels the former profit inflation and the latter income inflation. Profit inflation occurs when prices are outrunning costs, leaving a large and development margin for profit. By contrast, income inflation occurs when wages are rising as fast as prices thereby preventing profit growth.It should be noted that Keynes income inflation does not correspond to what today is called cost-push inflation, i.e., an exogenous rise in wages and hence prices caused, for example, by the exercise oftrade union monopoly power. Rather it is the induced endogenic result of an increased demand for labor and other resources generated by forward profit inflation.9 For, according to Keynes, most income inflations do not stem from free (spontaneous) increases in wages caused by the powers and activities of trade unions 8, p. 151.Instead they stem from profit-induced rises in the demand for (and hence prices of). labor and other factor resources. That is, a profit inflation. stimulates firms to expand output and hence their demand for factors of production. This leads, to a bidding up of factor prices that raises production costs and generates inc ome inflation.This process continues until wages and other factor prices rise sufficiently to eliminate excess profits.10 go steadyn this way, income inflations. possess three distinctive features. They occur at the expense of profit inflations, eventually annihilating the latter. They fill not cause a rise in prices since they are generally offset by compensating falls in profit inflation.Finally, they are a crucial part of the process that transforms inflation-engendered profits into costs and thereby terminates the. temporary stimulus to economic activity. Having developed the distinction between profit and income inflation, Keynes used it to analyze the effect of inflation on output and economic growth. Regarding these effects he reached two main conclusions.For a recent exposition of the fundamental equations and the corresponding concepts of income and profit inflation, see Patinkin 11 pp. 33-8. What follows draws heavily from Patinkin. This point is stressed by Patinkin 1 1 p. 37. 10 See Keynes 8 pp. 241-2 and Patinkin 11 pp. 37, 45. First, only profit inflation has the power to stimulate output and growth. It is the teaching of this treatise, he said, that the wealth of nations is enriched, not during income inflations, but during profit inflations . . . at times, that is to say, when prices are running away from costs 9 p. 137.More precisely, profit inflation stimulates both current and long-term real output. It stimulates current output by raising prices relative to wages thus lowering real wages and increasing employment. And it stimulates long-term real output by chemise income from wages to profit thereby permitting faster capital accumulation and a higher rate of economic growth.In short, the effects of profit inflation include the spirit of buoyancy and enterprise and the good employment which are engendered but mainly the-rapid growth of capital wealth and the benefits obtained from this in succeed eld 9 p. 144. These benefits, however, ar e possible only when prices are outrunning costs, leaving a substantial margin of profit to finance investment and growth.They cannot occur in income inflations where wages rise as fast as prices and thus cancel out the very profits. that constitute both the means and the inducement to economic growth. It follows that income inflation, unconnected profit inflation, is incapable of enhancing growth. Second, what matters for investment and growth is how long it takes for profit inflation to give way to income inflation, and this depends on the speed of adjustment of wages to prices.If the time interval is short and wages adjust rapidly to prices, then inflation will have little or no impact on capital formation and growth. But if the interval is long and wages adjust behind to prices, then the stimulus may be considerable and profit inflation, in Keynes own words, becomes a most potent instrument for the increase of stash away wealth 8 p. 267.Regarding the interval, Keynes appare ntly felt that it had indeed been long in item diachronic episodes-quite long enough, he said, to include (and, perhaps to contrive) the rise . . . of the greatness of a nation 9 p. 141. In this connection he advanced the speculation that the early industrialisation of England and France had been powered by profit inflation.It is unthinkable, he declared, that the residue between the amount of wealth in France and England in 1700 and the amount in 1500 could ever have been built up by thrift alone. The intervene profit inflation which created the modern world was surely worth while if we take the long view 9 p. 145. Lest one wrongly conclude from the previous that Keynes of the Treatise was an out-and-out inflationist, three cautionary observations should be made.First, he was referring to gently rising prices and not to the rapid double-digit inflation that is unfortunately so common today. More precisely, he was referring to slow creeping secular inflation of no more than 1 t o 2 percent per year. Today such mild inflation would be viewed as constituting virtual price stability.Second, his analysis of beneficial inflation refers chiefly to capital-poor preindustrial societies and not to wealthy modern capitalist economies.11 Most of his historical examples are taken from the pre-capitalist or early-capitalist era when western Europe was very poor in accumulated wealth and greatly in compulsion of a rapid accumulation of capital 9 p. 145 and 8 p. 268. beneath these conditions it is conceivable that slowly-creeping profit inflation might indeed have spurred industrialization not only by diverting resources from consumption to capital formation, but also by breaking feudal bonds, stimulating enterprise, encouraging market-oriented activity, and getup the scope of the market. These latter benefits, however, are no longer available to wealthy, market-oriented modern capitalist economies that are more likely to find secular inflation a curse rather than a bl essing.For this reason Keynes refrained from recommending even middling inflationary policies for modern economies. Finally, it should be remembered that Keynes was referring to profit inflation characterized by prices persistently rising faster than wages and not to modern inflations in which wages sometimes rise ahead of prices or at least follow them without delay thereby wiping out the profits generated by the price increases.12 As previously mentioned, Keynes held that inflation stimulates growth only if wages lag advantageously behind prices leaving a large and persistent margin of profit to finance capital formation.This wage lag, however, is hardly characteristic of modern inflations in which wages rise swiftly not only to restore real earnings eroded by past inflation but also to protect real earnings from expected future inflation. The clear meaning is that Keynes would have opposed these modern inflations, which according to his analysis are income rather than profit i nflations.Accordingly, it is not surprising that Keynes, at the end of a long passage extolling the historical accomplishments of profit inflation, nevertheless declared, I am not yet converted, taking everything into ac-11 On this point see Haberler 2 pp. 98-100. 12 See Haberler 2 p. 99. count, from a preference for a policy today which, whilst avoiding deflation at all costs, aims at the stability of purchasing power as its ideal physical object 9 p. 145.There is no reason to believe that he ever changed that position. On the contrary,. there is strong evidence that he remained a determined antagonist of inflation and an adamant proponent of price stability even to the extent of warning of the potential danger of inflation in 1937 when the unemployment rate was in excess of 10 percent of the labor force.Articles in The Times (1937)The most convincing evidence of his continuing strong opposition to inflation in the 1930s even after the publication of his celebrated General Theory , appears in four articles he wrote for The Times in early 1937.13 There, in discussing policies for dealing with unemployment at the business cycle peak of 1937, he made it richly clear that his primary concern was preventing inflation.In particular, he argued that the 1937 unemployment rate, although very high (indeed, as high as 12 percent), was nevertheless at its stripped noninflationary level at which demand pressure must be curtailed to prevent inflation. Accordingly, he recommended a sharp cutback in government expenditure on the case that the economy was rapidly approaching the point where further increases in aggregate demand would be purely inflationary. I believe, he said,. that we are approaching, or have reached, the point where there is not much advantage in applying a further general stimulus at the marrow squash 4 pp. 11, 44, 65.In so stating, he identified the noninflationary full employment rate of unemployment (NIFERU) below which industrial bottlenecks frus trate the intended output and employment effects of aggregate demand expansion policy so that mainly prices rise.14 beyond that point, he said, noninflationary reductions in joblessness could only be achieved by specific morphological policies designed to lower the full employment rate of unemployment itself. As for the existing high level of that unemployment rate, he attributed it to structural rigidities in the 1.These articles are reprinted and discussed in Hutchison 4. Unless otherwise noted, all references in this section are to Hutchison. 14 The NIFERU concept also appears in the General Theory where Keynes asserts that beyond a sealed point, structural impediments (a series of bottle-necks) would prevent the noninflationary expansion of output and employment long before full capacity is reached.At the bottleneck point any further increase in aggregate demand would, in his words, largely spend itself in raising prices, as distinct from employment 10 pp. 300-l. British econo my, in particular to a substantial mismatch between the location and skill mix of the labor force and the location and composition of demand. As he put it, the economic structure is unfortunately rigid and this rigidity prevented output and employment from responding to increases in aggregate demand so that only prices rise 4 pp. 11, 65-6.It follows, he said, that to achieve noninflationary reductions in unemployment we are more in need today of a rightly distributed demand than of a greater aggregate demand 4 pp. 11, 66. In other words, noninflationary reductions in unemployment cannot be obtained by expansionary aggregate demand-management policies but rather require a different technique 4 pp. 11, 14, 44, 66.To this end he advocated specific structural policies to reduce unemployment on the grounds that noninflationary reductions in unemployment could only be achieved via measures that eradicate structural rigidities and lower the equilibrium unemployment rate itself. In so ar guing, he foreshadowed by 30 years the modern monetarist concept of the natural rate of unemployment.He also refuted the popular contention that he was an inflationist who advocated full employment at any cost. That is, his 1937 articles amply demonstrate that, far from being an inflationist, his main consideration was preventing inflation-even at a time when the u