“Economics of

Keynes”
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
 Neoclassical Synthesis
 By Mid-1960s the economics profession
was dominated by a synthesis of
orthodox IS-LM Keynesian and classical
long-run Growth economics with a
smattering of monetarist ideas thrown in
 Keynesian economics was seen as a
special case of a more general model
 Keynes status as a theorist had been
minimized
 The Economics of Keynes
 Clower, “The Keynesian Counter-Revolution: A
Theoretical Appraisal,” The Theory of Interest
Rates, Hahn and Brechling, ed. (1965)
 Leijonhufvud, “Keynes and the Keynesians: A
Suggested Interpretation,” AER (May 1967)
 Leijonhufvud, On Keynesian Economics and
the Economics of Keynes (1968)
 Clower and Leijonhufvud, “The Coordination
of Economic Activities: A Keynesian
Perspective,” AER (May 1975)
 Coordination Issues
 Unemployment and “effective
demand failures” are
disequilibrium situations arising
from coordination failures
 Keynes’ revolution was directed at
Walrasian General Equilibrium
analysis
 The Walrasian System
 “Auctioneer”
 Searches for the price vector P that clears
all markets
 No trades at non-equilibrium prices

 Economic agents
 Price-takers, quantity-makers
 Stock-flow liquidity
 All goods equally liquid at equilibrium P,
so all asset values can be equally realized
 The Walrasian System
 Two-good system (L and G)
 Auctioneer initially sets prices at (W/P)1
and P1; suppose values s.t. in L there is a
notional D < S, ESL and in G there is a
notional D > S, EDG.
 Auctioneer adjusts (W/P) down and P up
until equilibrium is established.
 In equilibrium, effective and notional
demand and supplies are the same.
 The Walrasian System
The Auctioneer takes account of
notional desires to buy and sell
by noting the excess demands
and supplies and turns them
into effective messages by only
permitting trades at
equilibrium
 The Clower-
Leijonhufvudian
System
What Keynes Really Meant
The CL “Keynesian” System
Keynes’ mission was to kill off
the Auctioneer myth and raise
the issue of information and
coordination problems of real
economies
The CL “Keynesian” System
 Without a Walrasian Auctioneer
 Economic agents are price-makers
 Trades can take place at non-equilibrium
prices
 buyers and sellers can be
constrained in carrying out some plans
 some goods are more liquid than
others, since not all assets’ full market
values can be realized
“Money buys goods
and goods buy
money; but goods
do not buy goods.”
The CL “Keynesian” System
 In non-clearing markets without an
auctioneer, one has to make a
distinction between notional
(unconstrained) and effective
(constrained) demands and supplies.
 Dual-Decision Hypothesis
 Plans to buy and sell are not realized
simultaneously; the decision to sell is
not automatically transformed into a
decision to buy; the sale must be
realized before a purchase is made.
The Dual Decision Hypothesis
 Planned (notional) purchases are not
made unless planned sales have been
realized (made effective).
 Dual-Decision Hypothesis

Only signals transmitted are

effective messages backed by
means of payment (money).
Effective demands can
diverge from Notional
demands.
The CL “Keynesian” System
 Two-good system (L and G)
 Suppose (W/P)1 > (W/P)e so that there
exists an ESL.
 Some labor sellers are constrained in
their demand for goods.
 Effective DG < notional DG.

 There is no incentive to raise P and

encourage production. If P doesn’t
increase, (W/P) doesn’t fall!
 Unemployment but not equilibrium.
“Price-incentives may be effective in all
markets and all prices may be
“flexible” and a market system may
still go hay-wire in its groping for the
coordinated solution.”
- Leijonhufvud, “Effective Demand Failures,” p. 111-112

 Though prices are flexible, prices do not change, even though

notional excess demands and supplies exist, because the
desires are not made effective.
 Prices may be “right,” but transacted amounts persistently
differ from desired rates of sales and purchases.
 Prices that were “right” may move away from their equilibrium
values, generating price signals that are false and make
coordination failure worse.
The CL “Keynesian” System
 Keynes recognized the difficulties of
finding P
 Keynes saw Q adjustments as
occurring before and faster than P
adjustments
 (reversing Walrasian adjustments)
The CL “Keynesian” System
 IS-LM gets Keynes wrong
 Key elements of IS-LM not in Keynes
 Rigid wages, liquidity trap, interest-inelastic
investment
 Keynes aggregates bonds and capital
goods
 IS-LM aggregates consumption goods and
capital goods
The CL “Keynesian” System
 C& L Claim: IS-LM gets Keynes wrong
 Two Key problems
1. Offer of L by unemployed ineffective
because does not constitute an effective
demand for goods; Workers are unwilling
to be paid in goods in a money economy.
2. Temporal problem that an increase in
saving does not send a signal to produce
more in the future… “future demands are
not effective demands.”
The CL “Keynesian” System
 Is Clower and Leijonhufvud’s Keynes
in Keynes?
 Keynes long struggle was to escape Marshall,
not Walras.
 Walrasian model was developed post-Keynes.
 Important to understanding Neoclassical
Synthesis debate, but perhaps not the Keynesian
episode.
 Second Thoughts
 How applicable is Dual Decision
Hypothesis version of Keynes to real
economies?
 Notion of corridor
 Inside, price adjustments dominate quantity
adjustments and we are in a classical world of
self-equilibrating markets
 Outside, quantity adjustments dominate price
adjustments and in a Keynesian world of
persistent disequilibrium
 Second Thoughts
 Keynes’ world
 Pure flow model of realized sales
determining current income which
determine current expenditure
 As soon as some market does not clear,
the dominance of quantity adjustments
causes multiplier repercussions
 Second Thoughts
 Real world
 Modern economies are stock-flow
economies
 Stocks are buffers between physical and
financial inflows and outflows
 Money-stock of liquid assets
 an important buffer that allows expenditures
to be maintained when receipts fall
 this is the reason for their existence
“Conclusions: (a) in such economies [stock-
flow], we must expect the propagation of
shocks impinging on flow to be heavily
dampened – as long as the shocks are not of
greater magnitude than anticipated by
transactors in making their decisions on the
levels of buffer stocks to maintain; (b) such
economies are, therefore, much more “robust”
than pure flow models would suggest – within
“the corridor”; if disturbances are of
unanticipatedly large magnitude, buffer
stocks may be exhausted – at which point,
the…”tight” income-constraint takes over.”
- Leijonhufvud, “Effective Demand Failures,” p. 117