CHAPTER 1 INTRODUCTION

Transcription

1 CHAPTER 1 INTRODUCTION The widespread belief among macroeconomists and the informed public in the failure of macroeconomics became so acute in the years after 2008 that many observers leveled the more stringent criticism that economics as a discipline had developed in a way that had emptied it of empirical content. Among the criticisms was that economics had largely become an axiomatic discipline consisting of highly unrealistic assumptions and mathematical derivations 1 but with limited empirical content and validity. 2 Further, most mainstream macroeconomic theoretical innovations in recent decades tended to be self-referential and inward-looking distractions, with research motivated by internal logic, intellectual sunk capital, and aesthetic puzzles rather than by the need to understand how the economy 1 As against the argument that fascination and reliance on too much mathematics had led economics astray, Cochrane (2009) contended that Math in economics serves to keep the logic straight, to make sure that the then really does follow the if, and the problem is that we don t have enough math (p. 7, italics in original). We agree provided that the math does not dictate the assumptions made and the degree of simplification incorporated in the theory. Those should be determined by the agenda of explaining the economic behavior being studied. 2 One assessment by a (non-economist) social scientist amounted to: it is not just a crisis of economies but a crisis of economics, so it is not just the world economy but the discipline of economics that needs saviors. Elster (2009) provides a wide-ranging assessment of the underpinnings of economics and claims that there is a fatal flaw in the foundations of economic theories: the unwarranted claim to precision and robustness actual economic agents are intrinsically less sophisticated than the models assume they are (Elster, 2009, abstract). Further, much work in economics and political science is devoid of empirical, aesthetic or mathematical interest, which means that it has no value at all (p. 9), and many of the articles published in these (leading) journals are in fact worthless (p. 22). 1

2 2 A Reformulation of Keynesian Economics works, let alone how the macroeconomy works during times of stress and financial instability (Krugman, 2009). Krugman claimed that a more or less Keynesian view is the only plausible game in town: in his words, Keynesian economics remains the best framework we have for making sense of recessions and depressions. 3 In the views of the critics of the existing macroeconomic analysis, the empirical failure of macroeconomics had its roots in the adoption since the 1970s of doctrines/approaches such as Ricardian equivalence, rational expectations, policy ineffectiveness, foundations of macroeconomics in microeconomics, real business cycle (RBC) theory, the (strong-form of the) efficient markets hypothesis, and dynamic stochastic general equilibrium (DSGE) models, etc. Economics is sometimes praised and sometimes criticized for emulating physics, so it would be interesting to look at some of the criticisms that have been leveled at physics in recent years. On this, the following quotes taken from The Economist (25 May, 2013, pp ) on the ongoing conundrum or impasse in physics seem to have an eerie resemblance to some of the preceding assessments of the current state of economics. Jim Baggot in Farewell to Reality bridles at the inequity of what he calls fairytale physics : the flights of mathematical fancy, based on nothing more than personal taste, that he feels have come to litter the theoretical landscape over the past two decades. Mr. Smolin believes that the impasse highlighted by Mr. Baggot is the result of applying theories that work for small, isolated systems to describe the universe as a whole. This criticism of physics sounds suspiciously like that leveled in recent years at economics: the preceding quotes, with physics replaced by economics, small, isolated systems by microeconomics and universe by macroeconomics would equally well apply to the attempt to base 3 In response to Krugman s views on the failings of macroeconomics and the need to revert to old-style Keynesian economics, Cochrane (2009) argued that the failure was not that of macroeconomics but of the policies that had been pursued: the sad fact is that few in Washington pay the slightest attention to macroeconomics research, in particular with a serious intertemporal dimension. Krugman s simple macroeconomics has dominated policy analysis for decades and continues to do so...if a simple failure of ideas caused bad policy, it is simpleminded Keynesianism that failed (p. 6).

3 Introduction 3 macroeconomics on microfoundations and notional general equilibrium. Further, the mathematical models which have dominated physics since the days of Isaac Newton have replaced processes unfolding in time with timeless laws. In Time Reborn, he (Mr. Smolin) argues that that the way out of the funk caused by doing physics in a box is to embrace time as a fundamental feature of reality. Here again, a similar charge can be leveled at economics. Its foundational concepts of the long run and the short run are essentially timeless and do not embrace time as a fundamental feature of reality. This book argues that these concepts have to be replaced with the behavioral concepts 4 of analytical time that are more in accord with the time dimensions adopted by economic agents in making their decisions. Finally, on the evaluation of theories in physics, as in economics: A hypothesis does not need to be framed in equations to be scientific.all it has to do is suggest observations by which it can be confirmed or refuted. (The Economist, 25 May, 2013, pp ). We agree fully: theories in economics need to have refutable predictions and the validity of a theory s predictions, compared with those of alternative theories, is the relevant criterion for judging between theories. On a specific point relevant to the approach that we take in this book, Caballero (2010) argued that the profession has been led astray by its adoption of the DSGE approach over the past decades and that it confused the internal logic displayed by the DSGE approach with its relationship to reality. He labeled the DSGE approach as an irresistible snake-charmer, with limited connection with reality (p. 86). Caballero argued that the DSGE approach is at the core of modern macroeconomics and this core needs to be reformulated. Since the equilibrium envisaged in virtually all DSGE models is a notional one with equality between notional demand and notional supply in all markets we call such models in this 4 These are designated in this book as the long term and the short term. But the name is not important. What is important is that these concepts incorporate, as we show in due course, time in a much more meaningful manner than the concepts of the long run & the short run.

4 4 A Reformulation of Keynesian Economics book as the dynamic stochastic notional general equilibrium (DSNGE) ones. 5 Macroeconomics holds very many different schools and models, with heated debate among the proponents of the Keynesian school and those of the classical/neoclassical one. To Woodford (2009), writing just prior to or about the start of the financial and economic crises that began in 2008, macroeconomics had achieved a convergence in macroeconomic thinking. This convergence in modeling macroeconomics around the DSNGE technique represented the maturity of macroeconomics and a consensus on the essential nature of the macroeconomy. However, to Jeffrey Sachs, writing a year after the start of the crises and just two years after Woodward s publication, the state of macroeconomics had achieved a large and ultimately damaging consensus on economic thinking (Sachs, 2009, p. 1). He called for rethinking macroeconomics. Economies go through good times and bad, with those doing excessively so providing an as-if experiment on the validity of macroeconomics. The financial and economic crises in economies after 2008, the policies pursued in response and the slow recovery from the crises proved to be exceptional in this respect. At the very least, these crises compel us to reassess the validity of our knowledge and to rethink the general formulation of macroeconomics. This book is meant to be a contribution to these reassessments and rethinking on which there are already numerous contributions and very many more are likely to occur. Underlying this book is our belief that what is needed is not just a refinement or modification of the fine details of some of its component hypotheses but a reformulation of the core of macroeconomics. This book offers one such reformulation. This reformulation is in the Keynesian tradition, though not a regurgitation of any one of the extant models in that tradition. While we offer a set of ideas that we believe should form the core of the rethinking of macroeconomics, our presentation is not meant to be a detailed exposition of every part of the economy or even of the ideas that we propose nor do we believe that any particular part of our exposition should be treated as if it were set in stone. 5 Doing so clarifies that the distinction between notional equilibrium and effective equilibrium, in which at least one of the markets has the equality of effective demand and effective supply, which can differ from notional demand and supply.

5 Introduction 5 Among the rethinking proposed by some economists for the reform of economics though mainly by those who others think of as oldstyle Keynesians is a call for reversing the development of Keynesian economics in the past two decades. Some have even proposed the agenda of taking it back to its roots in Keynes The General Theory (1936). This would, however, mean abandoning the wealth of ideas in macroeconomics that have accumulated in the years since Keynes. While this book draws more of its ideas from the Keynesian tradition prior to the new Keynesian (NK) model that arrived in the 1990s, it is neither an investigation into what Keynes said or did not say in The General Theory, nor a detailed exposé of whether current Keynesian models adhere to or have departed from his ideas. Rather, this book looks into the Keynesian tradition generally and tries to update its core to arrive at a modern version that is empirically relevant, valid and au currant in the context of the functioning of the modern economy. We consider the modern economy to be a financial one, as against a monetary or a barter one: under our definition, a financial economy is defined as having both a medium of payments and a need for financial capital, which imposes the requirement that economic agents cannot engage in consumption, saving, production, acquisition of physical capital, employment of labor, etc., without financial capital, partly derived from internal sources such as that raised through issues of shares and retained earnings but with much of it obtained from external sources, such as from the issue of bonds and/or obtained in the form of credit. To avoid confusion about our terminology, we need to clarify our taxonomy of the various approaches in macroeconomics. This book uses the term classical paradigm to encompass: the traditional classical approach (i.e., encompassing ideas prior to Keynes The General Theory), neoclassical economics, the modern classical (sometimes called the new neoclassical one) model (i.e., the neoclassical one modified in the 1970s by the addition of intertemporal optimization continuous notional general equilibrium (NGE) and rational expectations but without Ricardian equivalence) and the new classical one (defined as the modern classical model with the addition of Ricardian equivalence). Of these major schools of the classical paradigm, the neoclassical one, extant from the 1940s to the 1970s and represented, say by Milton Friedman, among others, had allowed

6 6 A Reformulation of Keynesian Economics the factual possibility of output and employment being below their NGE (i.e., full-employment) levels and the possibility of deficient demand. This approach argued that the money supply, including its systematic component, was not neutral in this phase of the economy. The designation modern classical refers to the version of the classical paradigm which was initiated by Lucas (1972, 1973) and Sargent and Wallace (1975, 1976) and eventually evolved into the current version of the classical paradigm, whose core macroeconomic model assumes general equilibrium in notional terms and implies full employment, though with errors in price expectations affecting the levels of employment and output in the short run. The term new classical designates that subset of the modern classical approach which, in addition to the other assumptions, assumes Ricardian equivalence and implies the ineffectiveness of fiscal deficits/surpluses and of fiscal policy in changing aggregate demand. 6 The modern classical models are often built using the intertemporal DSNGE framework with perfect competition, NGE and rational expectations. The modern classical approach was the dominant one in macroeconomics from about the early 1980s to at least about 2008, when its validity during the USA financial and economic crises became questionable. By the term Keynesian or the Keynesian paradigm, we refer broadly to the ideas initiated by Keynes The General Theory (1936) and their evolution since Its manifestation since the mid-1990s is the new Keynesian (NK) model, with its early presentations by Clarida, Gali and Gertler (1999) and Mankiw and Reis (2002, 2006). However, the Keynesian approach is much more than the NK theory: in fact, its representation of the Keynesian tradition came to be questioned by many Keynesians in the years after A currently popular analytical platform for macroeconomics, including the NK model and the modern classical one, is the DSNGE one (Woodward, 6 This taxonomy leaves the modern classical theory as a more general theory not bound by the straitjacket of Ricardian equivalence and confines it to the subset labelled as the new classical version. Note that the general models of the modern classical approach, and its subset, the new classical model, are sometimes labeled as the new neoclassical approach. However, we believe that the modern classical approach is a more appropriate designation for them and we use this designation.

7 Introduction ). However, the financial and economic turmoil in the major economies of the world since 2008 led many economists to question the validity and relevance of this platform for macroeconomics including in this questioning, the relevance and validity of the NK model, as well as of its representation of the Keynesian heritage. Our agenda in this book is to provide another version hopefully a more valid one of the core of the Keynesian approach to macroeconomics. This agenda raises several questions. Can an updated version of Keynesian economics be formulated as a compact and coherent Keynesian model? If this can be done, should the resulting model be the NK one (e.g., as proposed by Clarida, Gali and Gertler, 1999; Mankiw and Reis, 2002, 2006)? Would it be a Keynesian version of the DSNGE framework (e.g., as in Christiano, Eichenbaum and Evans, 2005; Smets and Wouters, 2003; Woodford, 2009), or one of its variations, including among them the so-called hybrid version, formulated in the past few decades? However, even before the economic crisis starting in 2008, one assessment of the NK models had been that they were not yet useful for policy analysis (Chari, Kehoe and McGrattan, 2009). Further, in the post-2008 period, many observers, including many economists, concluded that such models which did poorly or sufficiently poorly in explaining the economic turmoil of in the USA and many other economies, did not provide the right framework for explaining the turmoil, and were not even truly representative of Keynesian ideas. If this assessment were accepted, what should be the relevant Keynesian model? Currently, the economic literature does not seem to provide a clear statement of a Keynesian model that is distinct from its NK offspring. This book attempts to do so. The resulting theory of the Keynesian approach is quite distinct from the NK variety and includes several components of the earlier Keynesian tradition that had been discarded by NK models. Keynesian economics is a living paradigm, continually evolving in its ideas and theories. Numerous developments have occurred in it over the years since Keynes own contributions. Not all of these are consistent with the others, and many of them are not to be found in Keynes own writings. Therefore, any formulation of the Keynesian macroeconomic model in an internally consistent form has to pick and choose among the numerous developments in the Keynesian tradition and discard the rest

8 8 A Reformulation of Keynesian Economics or leave them as side-stories. While the NK models represent the latest such selective formulation, quite a number of other selective formulations of the Keynesian model are also possible and could be appealing. This book represents our ideas on an internally consistent overview of the Keynesian macroeconomic approach, and offers it as a viable and hopefully very much preferable alternative to the NK model. The Keynesian paradigm has always been vitally concerned about the pathology of the economy (Solow, 1991). There can be many different causes of the breakdown interpreted as a deviation from the Walrasian NGE outcomes under perfect competition and efficient markets for all goods of the economy. Therefore, a single model cannot truly represent the Keynesian paradigm which encompasses many potential sources of breakdown of the economy as a whole and none is entitled to be called the Keynesian model. Further, given the possibility of numerous pathogens that can potentially lead to different types of departures from the well-functioning economy, any Keynesian framework with some claim to generality must allow the possibility of several potential causes of the breakdown of the economy. The impetus for our formulation of the Keynesian model comes out of our and many other economists long-standing dissatisfaction with macroeconomic modeling represented by the currently dominant DSNGE approach generally, and more specifically by the modern classical and NK models. This dissatisfaction became more pronounced with the ostensible failure of these models to explain the impact of the financial crisis starting in 2007 on the production and employment sectors of the US economy. There have indeed been many contributions and debates on which economic theory should be used to explain these events. From the hindsight of 2014, what seems amazing is the lack of any emerging consensus on the economists even ex post explanation of the crisis, thereby pointing to serious problems with the underlying sociology of economics, especially given its claim to be a science. These explanations have ranged from purely classical ones which attribute the crisis to negative (i.e., retrogressive) shifts in technology or/and to distortions in the goods or/and labor markets, while denying any role to shifts in aggregate demand (as, for example, in the recession following 2008 in USA (see McGratten and Prescott (2012) and

9 Introduction 9 Mulligan (2009), on the Great Recession 7 ) to purely Keynesian ones, which attribute the economic crisis to shifts in aggregate demand due to financial shocks, while denying any role to goods and labor market distortions or productivity shifts. Such a wide divergence of opinions must surely be an embarrassment of riches, but not necessarily in a good way, for any science. In the views of some economists, the preceding comments may be overdoing the divisions among economists. For instance, Woodford (2009) claimed that macroeconomics had achieved a high degree of convergence with a new synthesis built on the DSNGE modeling structure. He claimed that this approach was flexible enough to encompass models based on the assumption of perfect competition with fully flexible wages and prices, as well as models assuming imperfect competition or/and temporary rigidities of wages and prices, adjustment costs, etc. However, an essential component of the DSNGE models is their common assumption of general equilibrium in notional terms, which is at odds with much of the Keynesian tradition. The latter had asserted the potential for disequilibrium, especially in the labor market, or of equilibrium in only effective (but not notional) terms, especially in the commodity market, so that the new synthesis built on the DSNGE platform does not encompass Keynes own model and many of the earlier Keynesian ones. It is also doubtful whether the DSNGE-based synthesis with its general equilibrium assumption can in a meaningful sense cover the case when there exists involuntary unemployment, which any model worth being called a Keynesian one should allow: the possibility of involuntary unemployment is an essential aspect of the Keynesian heritage and is also a real possibility for the economy, as the economic performance of several economies after 2007 has shown. However, in spite of Woodford s (2009) claim about the new synthesis between the Keynesian and classical models around the DSNGE technique and focusing on the then-extant Keynesian models, while some Keynesians viewed the crisis as a validation of pre-dsnge Keynesian ideas, few Keynesians explicitly used or mentioned the NK theory/model or the DSNGE structure of the new synthesis to explain the crisis, so that if the crisis were to be seen as a validation of Keynesian ideas, the validation must 7 See also Prescott (1999) on the Great Depression.

10 10 A Reformulation of Keynesian Economics be that of aspects, of the Keynesian tradition, rather than of the NK one. This assessment has colored our reformulation of the Keynesian macroeconomic model, so that it relies heavily on the older Keynesian ideas than the NK model, though it does also borrow some ideas from the NK model itself. Our reformulation of the Keynesian model relies mostly, though not exclusively on, what had been the Keynesian tradition until the arrival in the mid-1990s of the model. As a rather personal interpretation of the earlier tradition, our reformulation runs the risk of not being accepted by many Keynesians, 8 or being treated as out-dated, especially since some of its aspects revert to the earlier (pre-1990s) Keynesian tradition than the au currant NK one. 9 Our approach models this tradition in a form that facilitates its comparison with both the modern classical model, especially its RBC representation, as well as its comparison with the NK one and, we believe, provides a richer framework that is likely to provide empirically more valid implications. Any formulation or reformulation of the Keynesian macroeconomic framework needs to embody the Keynesians central propositions that firms produce what they expect to sell and there is no reason that such production decisions will always produce in the economy an employment level that is consistent with full employment or with the amount that labor is willing to supply at the going wage rate. These propositions apply in both the short term and the long term and do so irrespective of the market structure, i.e., whether there is perfect competition or one of the forms of imperfect competition. They also do so whether prices and wages are sticky, rigid or flexible However, that is as it should be under our view of Keynesian economics as a living paradigm, with some common themes at its core, but allowing ample variations in individual expositions. 9 The NK models, except for their assumptions of monopolistic competition and staggered price adjustments, are in some ways closer to the stochastic intertemporal general equilibrium modeling of the modern classical kind than what many view as the Keynesian heritage stretching from Keynes The General Theory (1936) to the arrival of the NK models in the 1990s. 10 Keynes did not rely on sticky wages or prices, monopoly power or economic instability for these propositions. Nor did he rely on unanticipated demand or supply changes, or disappointed expectations. These, and many other factors, can make matters worse but are not necessary for the failure of employment to equal full employment levels.

11 Introduction 11 Since firms produce to meet demand that they expect, not necessarily the level that is consistent with the NGE level of production, the reformulation of the Keynesian approach needs to begin with the notion of expected effective demand, which was central to Keynes (1936) own analysis and has remained central to Keynesian analysis ever since. The relevance of expected effective demand rests on the axiom that, in the modern economy, the employment of inputs and production by firms has to be planned, and occurs, prior to sales. In modern terminology and according to our interpretation, giving a non-trivial role to the notion of expected effective demand implies that the macroeconomic, and the associated microeconomic, outcomes on output, employment and unemployment and numerous other real and nominal variables, such as consumption, investment, price level and balance of payments, etc. are conditional on the amount that firms individually and collectively expect to be able to sell, i.e., on the expected demand function. This assertion on the importance of effective demand is diametrically opposed to that by the axiom adopted by classical economics, that firms individually and collectively would be able to sell as much as they want at the market-established prices and can confidently plan production on the basis of this assumption. At the analytical level, the firms ability to do so assumes that the structure of the economy satisfies two requirements: (i) perfect competition, and (ii) efficient markets. Of these, perfect competition allows each firm to sell all that it wants to produce on the basis of its production technology and the market prices of its output and inputs, without affecting the market price. Its supply function under these conditions is independent of the demand function of the product that it sells. An efficient market is defined a one that instantly or virtually instantly adjusts the market price to restore equilibrium between demand and supply so that no firm that produces its profit-maximizing output on the basis of the established market price is left with unintended changes in inventories. If such changes were to occur, they would indicate to the firm that its profit-maximization production strategy based on the market price had failed and needed to be revised to one based on its perception of what it could sell, i.e., on its perceived effective demand. Therefore, the relevance of the Keynesian notion of effective demand requires that there be either imperfect competition and/or that markets be sluggish,

12 12 A Reformulation of Keynesian Economics preferably both. 11 Subsuming the two requirements of perfect competition and efficient markets in the definition of perfect markets, the relevance of effective demand requires the absence of perfect markets. For the Keynesian macroeconomic model, the notion of effective demand has to be buttressed by the specification of the structure and functioning of the relevant sectors and markets of the economy. Among these, the specification of the labor market and the asset markets is absolutely essential to Keynesian analysis, as is that of the formation of expectations. Keynesians in general have long accepted the modern classical propositions that economic agents should be viewed as rational in making their choices, with consumers/workers maximizing utility and firms maximizing profits. Our reformulation of Keynesian economics accepts these propositions and accepts the axioms of utility (or expected utility) maximization for consumers/households and profit maximization for firms, just as classical (and NK) models do. It also accepts the use of rational expectations for the expected values of the variables, just as classical (and NK) models do. However, there are very significant differences in the very interpretation of rational expectations and the variables on which these expectations are formed. The difference on the latter between our analysis and classical ones lies in their approaches to the role and efficiency of markets: Keynesians assume that all of the markets are not always so efficient that they establish notional equilibrium soon enough after each and every potential disturbance while the modern classical models assume that they do so. This difference implies differences in the variables on which optimizing agents need to form expectations and on the states of economy that would occur. For the classical paradigm, the assumptions of perfect competition and efficient markets imply that, in response to any shifts in demand or supply, markets establish the market-clearing prices, so that these prices convey all the information that firms and households need for planning their production, consumption & labour supply so that firms and workers form expectations on prices and based on these price expections changes 11 By sluggish markets, we mean that they take significant periods of time to establish the price that would equate notional demand and notional supply, with this duration away from equilibrium having significant consequences for production and consumption, etc.

13 Introduction 13 in market-clearing prices by altering their decisions on the quantities demanded/supplied. Therefore, in this paradigm even under uncertainty, firms and workers/households are taken to form expectations on the prices (including wages) that the markets will establish. However, in the Keynesian paradigm, the relevant variable for firms is the expected demand for products, 12 and for workers is the availability of jobs and incomes, not just the nominal or real wage. This difference between the two paradigms on the variables on which expectations are formed prima facie leads to the presumption that the expectations hypothesis (EH) relevant to the two paradigms may also be different. We examine the appropriateness of the expectations formation hypothesis for the two paradigms in Chapter 7, with an introduction to this topic provided in a subsequent section of this introductory chapter. Looking at the Keynesian paradigm, since, as mentioned earlier, this paradigm has numerous and fairly diverse contributions, a single compact and internally consistent model cannot integrate all its contributions. This leads to a need to pick and choose among the Keynesian heritage. The NK model does so in one way. This book does so in quite a different way. The following section, Section 1.1, provides an introduction to the more important themes that we have selected from the Keynesian paradigm, with later sections expanding on these themes. 1.1 Keynesian Focus on the Pathology of the Economy The broad focus of the Keynesian paradigm is said to be on the pathology of the economy, with the pathogens producing changes in real macroeconomic variables (Solow, 1991). 13 These pathogens may be ones that only produce deviations that are too brief and not significant enough to require intervention by policy makers, or they may be significant and of a sufficient duration and have an impact over long periods of time. In our view, the Keynesian focus on the pathology of the economy encompasses the study of pathogens that affect the performance of the economy, whether over short or long periods. 12 Chapter 3 provides the theoretical basis for this statement. 13 Macroeconomics is in practice usually the study of system-wide pathology: the business cycle, unemployment, inflation (Solow, 1991, p. 82).

14 14 A Reformulation of Keynesian Economics The adequacy of macroeconomic mechanisms for equilibrating aggregate demand and supply Does the modern economy possess a macroeconomic mechanism that can be counted on to ensure that notional aggregate demand equals the notional output that firms collectively want to produce with labor employed at its full-employment level? Neoclassical economics had relied on the Pigou effect 14 and/or the real balance effect, also called the Patinkin effect (Patinkin, 1965), 15 as providing such a mechanism. In practice, the outcomes of the Pigou effect are so doubtful that Pigou himself distrusted this mechanism and called it a toy. Pesek (1988) described the reasoning behind Pigou s own assessment of this effect in: [Pigou himself] described what later came to be called the The Pigou Effect as a mere toy, based on so extremely improbable assumptions as to never be played on the checkerboard of real life It would not work in any except the most formal version of a most naïve model [because, outside its ceteris paribus assumptions, a fall in aggregate demand would also bring about] simultaneous bankruptcies and deflation [which] keep shifting both the LM and IS functions, and therefore the aggregate demand function towards the origin. The result is much more likely to be a depression rather than full employment. (Pesek, 1988, pp. 6 7). In reality, the Patinkin effect is also extremely weak, possibly even weaker than the Pigou one. This is especially so for a closed economy, since the Patinkin effect relies on the increase in the real value of the money stock, which is very small relative to income and wealth, for its effect on consumption. Hence, while the Patinkin and Pigou effects may be operational, they are not likely to deliver an aggregate demand equal to full-employment output within a time frame acceptable to firms, workers, the general public, and the policy makers. While neoclassical economics had relied on the Pigou and Patinkin effects to eliminate a demand deficiency, modern classical 14 The Pigou effect represents the impact of changes in the price level on consumption through changes in the real value of wealth held in a financial form (i.e., in money and bonds) (Handa, 2009, pp ). 15 The Patinkin effect represents the impact of changes in the price level on consumption through changes in the real value of money holdings (Handa, 2009, pp ).

15 Introduction 15 economics probably because these two mechanisms came to be recognized as being very weak in practice usually fails to specify such a mechanism or retreats to the mythical (i.e., non-operational in the context of free enterprise economies) ones of an auctioneer (at the level of the economy!) or a benevolent social planner, whose specified attributes are inconsistent with the nature of democratic, free enterprise economies. Expositions that rely on such fictional/non-operational entities do not really address the possibility of a mismatch in the macroeconomy between notional aggregate demand and notional output produced with full employment. Nor do expositions that just resort to the assumption, without an explicit specification of a valid equilibrating mechanism, of general notional equilibrium as the persistent state of the economy. The preceding arguments illustrate that the critical difference between the modern classical and the Keynesian approaches is not that the former is optimizing while the latter is not, or that the former has rational expectations (i.e., those based on all information available to the economic agent) while the latter does not. It is also not that the modern classical model has agents whose actions exhaust trades that are to the perceived mutual advantage of the exchanging parties while Keynesian models allow such trades to continue to exist. On this point, the critical difference between these schools arises when the functioning of the macroeconomy at its macro level and its impact on individual economic agents and markets is taken into account. To the Keynesians, the macroeconomy sometimes ends up in situations in which the economy is not operating at full employment and also does not possess sufficiently fast-acting mechanisms to revert soon enough to full employment, while to the modern classical economists, the economy continuously maintains full employment or reverts to it soon enough after a disturbance. This is a factual question, but which contrary to the role of economics as a science is often treated as one of faith. In 2006, after several decades of reasonably good performance (with fairly short recessions) of the developed economies and relatively low unemployment rates, economists faith tended to side with the modern classical economists. By 2000, after a couple of decades of short and mild recessions, economists believed that macroeconomic theory had delivered the Great Moderation so that Robert Lucas could declare in 2003, that the central problem of depression prevention has been solved. But by 2014,

16 16 A Reformulation of Keynesian Economics after several years of very poor performance of the USA and European economies and quite high unemployment rates, the faith of many, perhaps most, economists had been badly shaken. Clearly, these economies did not function in NGE for several years after As a consequence, the faith of many economists shifted to the Keynesian position that the modern economy may not always operate in NGE. Of course, a scientific paradigm or approach should be more than a belief or a matter of faith. It should be able to stand the test of empirical validity. The performance of the USA and European economies after 2008 provides an acid empirical test of the existence versus absence of NGE at the macroeconomic level and of the validity of the modern classical and the Keynesian approaches Other major themes of the Keynesian approach Uncertainty about the future and the formation of subjective expectations under imperfect knowledge is another major theme of the Keynesian tradition. These factors play a more significant role in the determination of the current and future course of the economy in the Keynesian tradition than in the classical one. Their role is more fully discussed in Chapter 8 in the context of EH. However, some aspects of this role are discussed at appropriate points later in this chapter and in the following chapters. As pointed earlier, the Keynesian tradition emphasizes that firms produce to meet expected demand and their production-employment decisions need not result in full employment. Further, some of the sectors of the economy may possess effective rather than notional equilibrium, so that the overall economy need not be in NGE. These propositions of the Keynesian tradition differ significantly from the corresponding ones of the classical approach and are discussed more fully in the context of the theory of the firm in Chapter 3, of the labor market in Chapter 4 and of aggregate demand in Chapter 5. Another proposition of the Keynesian tradition is apparent from the title of Keynes The General Theory (1936). This is the claim that the Keynesian approach encompasses not only states of disequilibrium and of effective equilibrium but also of NGE, while the classical one only deals with the NGE state. The validity of this claim for the Keynesian versus the

17 Introduction 17 classical traditions as well as for the reformulation of macroeconomics is offered in this book Some criticisms of the Keynesian approach Early criticisms of the Keynesian approaches had argued that Keynesian economics allows irrational behavior and lacks acceptable microfoundations for its macroeconomics. However, by now, Keynesians in general have long accepted the propositions that economic agents should be viewed as rational, with consumers/workers maximizing utility (or, under uncertainty, expected utility) and firms maximizing profits. The reformulation of Keynesian economics in this book also accepts these propositions and the Keynesian tradition has never really denied optimal behavior though it does require that it be done under the conditions that exist in the economy. The main objection of this tradition, starting with Keynes, has really not been to the assumption of optimizing behavior of economic agents but to the assumption of NGE, as the basis of the appropriate microeconomic foundations of macroeconomics. This objection can be to the assumption of market equilibrium, defined as the equality of demand and supply, and/or to the empirically-relevant demand or/and supply functions being notional ones. Consequently, in the Keynesian view, an economy may not possess NGE because one or more of its markets do not have equilibrium or, while all its markets do have equilibrium, the applicable demand or/and supply functions in one or more of its markets are not notional ones, so that, while all markets have equilibrium, some markets do not have notional equilibrium. Our objection to the assumption of NGE is for both these reasons. Another criticism of earlier Keynesian economics had been that it uses only backward-looking expectations, which are not rational since merely backward-looking expectations would not be based on all of the information available to economic agents. By now, Keynesian economics has accepted the proposition that economic agents form their expectations rationally. Our approach also assumes rational expectations though in the limited sense that it relies on the formation of expectations based on all available information, irrespective of whether the relevant information includes information on prior or future periods. Therefore, in our context, the relevant data set has simultaneously backward and forward-looking

18 18 A Reformulation of Keynesian Economics elements. However, there is a vital difference between our approach and the modern classical one about the relevant variables on which economic agents form their expectations. In addition, as Chapter 8 argues, the interpretation of what makes expectations rational, differs between that in our approach and that in the modern classical approach. This issue becomes especially important when the economy does not continuously maintain NGE. Further, critics of Keynesian macroeconomics insist that a viable model must not have individual agents who fail to exhaust trades that are to the perceived mutual advantage of exchanging parties (Barro, 1979; italics added for emphasis), and that the modern classical models satisfy this requirement while Keynesian models do not. In fact, Keynesians subscribe to this proposition, just as the modern classical economists do. To see how the Keynesian and modern classical schools approach this proposition, consider the following scenario. Suppose that, ignoring demand considerations, firms (in perfect competition) agree to pay the workers that they do employ a real wage (w) equal to the marginal product of labor (MPL). Now suppose that aggregate demand falls and reduces the demand for each industry and each firm in the economy. Some workers are then laid-off by their employers because of the fall in the demand for the firms products, even though these workers continue to be willing to accept the going wage (equal to MPL)- and have the skills and education to generate the MPL that used to equal the market wage. However these laid-off workers do not receive wages, which reduces the demand for the firms products. How would mutual advantage work in this situation? If the firm had chosen to continue employing the worker in question, it would accumulate unsold inventories (equal to his marginal product). Since such unintentional holdings of inventories are costly to keep, the firm does not perceive any advantage to itself in continuing to employ the workers it does not need to meet the limited demand for its product. The workers, however, would benefit from their employment, especially since they were guaranteed to be paid the MPL. In this scenario, in the modern economy while it would be to the advantage of (the unemployed) workers to trade (their labor), it would not to the advantage of firms to do so. Hence, in this situation, there is no mutually-beneficial exchange between the firm and its laid-off worker but only if they were in fact employed. In the preceding illustration, one could avoid the absence of a mutuallybeneficial exchange between the firm and its workers due to inadequate

19 Introduction 19 demand by assuming that the firm facing inadequate demand could pay some of its workers in kind (i.e., in the product produced by the firm). But such an argument would be absurd in the modern monetary economy. To see the absurdity of this argument, imagine university professors being paid in the product they produce in exchange for their services as lecturers and researchers, lawyers accepting payment for their services in the product they produce, or steel workers being paid in bits of steel, etc. In the modern economy, such exchanges would not occur because it would not be rational for either firms or workers to agree to such an arrangement.the workers paid in kind would not be able to trade the products they received for the products that they want or would only be able to do so only after devoting considerable additional time to finding the requisite buyers. Therefore, to the Keynesians, macroeconomic events in a modern monetary economy, such as an overall inadequacy of product demand relative to full-employment output, may result in situations that firms and workers, acting individually, cannot correct by entering into what might ostensibly appear to be mutually advantageous exchanges between unemployed workers and firms The deceptive integration of the analysis of the consumer and the firm The NGE approach lends itself to an integrated/unified mathematical analysis of consumption, input supplies and production. In this unified analysis, households act as consumers who buy commodities, supply labor and physical capital, and receive incomes in exchange. As part of their supply of capital, households own firms, thereby exercising complete control over the firms production and pricing policies, etc., and receiving any profits the firms make. These households maximize utility or, under uncertainty, expected utility, and, in the process, determine their supply of labor, the firms production and the receipt of income from it, as well as their consumption. 16 This unified analysis of the firm and the household does not have a separate analysis of the firm and the household, with such separate analysis providing a potential for a divergence of interests and bargaining between them either as firms versus workers or as firms versus consumers. The end-result of this unified analysis is that, unless 16 See, for example, Blanchard and Fischer (1989), Chapter 2.

20 20 A Reformulation of Keynesian Economics transactions costs, frictions and rigidities are imposed, there can never be commodity production in excess of commodity demand and labor supply in excess of labor demand and there can never be also the need or scope for undesirable accumulation of inventories, wage bargains, strikes and industrial unrest, etc. There can also be no impact of financial intermediation 17 on production and consumption and many other disturbing aspects of the way, modern economies function. Such a hypothesized economy is really no different from one consisting only of self-sufficient economic units (in which each economic agent is self-sufficient, producing exactly what he wants to consume, consuming exactly what he produces, and putting in exactly the amount of work/labor (as against taking leisure) and supplying the exact amount of physical capital needed for this production level). Its analysis, while it may be mathematically elegant, is not only inappropriate for a modern exchange economy in which hardly any economic agent is self-sufficient, the co-ordination between consumption, labor supply and production through markets is not perfect/seamless, and the objectives of firms and their workers and of the owners and managers of firms can be quite at odds. Since such a unified analysis is far removed from the way that economies and their economic agents function, its implications can be downright misleading and it implied policies can be quite harmful in practice. Since Keynesians want to explain the economy as it functions, a unified analysis of consumption, production and distribution of incomes does not represent the Keynesian view of how production, consumption, labor markets, and ownership and management of firms are organized. In the Keynesian view, consumers and firms are different entities, with very different interests and objectives, and the control of firms and their production policies by shareholders, let alone by households/workers, is at best, very tenuous. In reality, only a very small proportion of consumers/ workers in the economy have a direct stake in the ownership of firms or are able to exercise control over their production policies. Further, financial 17 Nor is there scope for a central bank that sets the nominal interest rate in financial markets and manipulates it at frequent intervals, which are of too short a duration for firms to adjust their physical capital stock sufficiently to bring about the equality of the marginal productivity of capital (MPK) to the real interest rate.

21 Introduction 21 intermediation between firms and households is not trivial in the sense of being just pass-through, since, even for those persons who hold corporate bonds or stocks, it severely dilutes the control of households over firms. In addition, looking beyond the closed economy to the partially or wholly globalized one, consumption and production can occur in different countries, the location of ownership of firms and of production can differ, and the financial intermediation between households and firms can be spread among many countries. The labor income from production can flow to workers in one country while the consumption of the goods produced is done by consumers in another country, and at least parts of the income from production can flow to residents of some other countries. Therefore, we consider an integrated/unified analysis of consumption, labor supply, production and income distribution to be inapplicable to the economies as they do function, and, therefore, as inappropriate for the Keynesian framework of production by firms and consumption by households. In view of this assessment, this book avoids an integrated analysis of production and consumption, as well as avoiding the DSNGE technique, though accepting intertemporal optimization by economic agents. 1.2 The Technology of Production One of the shibboleths of economics has been the assumption of an exogenous technology that yields for economic analysis, a production function that is exogenously given to economic agents. Further, this production function is the same for long-run analysis and short-run analysis, though the latter usually involves the additional assumption of a fixed physical capital stock which is an assumption on inputs rather than on the nature of the technology represented by the production function. Our approach questions the validity of both of the preceding two assumptions that is, of an exogenous production function and of the identity of the production functions relevant to the analyses of long periods and short periods The production function as the chosen technology A common observation about production processes in any country is that there are almost always very many different production processes that can