Went through the consumption function this morning with my A2 class and I recalled the superb cake that A2 student Lara Hodgson made for the class a few years ago – here’s hoping for a similar cake this term. Remember that the standard Keynesian consumption function is written as follows:
C = a + c (Yd) – where:
C = total consumer spending
a = is autonomous spending
c (Yd) = the propensity to spend out of disposable income
Autonomous spending (a) is consumption which does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money from banks and other lenders. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income. The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. The higher the mpc the steeper the gradient of the consumption function line. As you can imagine the consumption of cake was fairly rapid.
Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Consumption Function Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.
There is concern that the current mix of expansionary monetary (near 0% interest rates) and fiscal (lower taxes and increasing government spending with COVID-19) policies will excessively stimulate aggregate demand and lead to inflationary overheating. Add to this negative supply shocks and you have an increase in production costs. This combination could lead to a 1970’s stagflation – rising inflation and unemployment – see graph below. Since the days of stagflation in the US and UK in the 1970’s inflation has been the number one target for central bankers. The main cause of inflation during this period was the price of oil –
1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
1979 – 200%↑ – supply-side – Iran Iraq War
US President Jimmy Carter’s attempts to follow Keynes’s formula and spend his way out of trouble were going nowhere and the newly appointed Paul Volcker (US Fed Governor in the 1970’s) saw inflation as the worst of all economic evils. Below is an extract of an interview from the PBS series “Commanding Heights”
“It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon.”
The policy of the time was Keynesian – inject more money into the system in order to get the economy moving again. This was also the case in the UK in the early 1970’s but Jim Callaghan’s (Labour PM in the UK ousted by Thatcher in 1979) speech in 1976 had reluctantly recognised that this policy had run its course and a monetarist doctrine was about to become prevalent. Below is an extract from the speech.
“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment. That is the history of the last twenty years”
With this paranoia about inflation central bankers began to implement a monetary policy targeting inflation in the medium term. In NZ the Reserve Bank Act 1989 established “price stability” as the main objective of the RBNZ. “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (originally 0-2%) – measured by the percentage change in CPI. Around the world central banks were adopting a more independent approach to policy implementation and with targeting inflation a new prevailing attitude seemed to be like an osmosis and suggesting that low prices = macro-economic stability as well. Also, raising interest rates is an unpopular political move and governments could now blame the central bank for this contractionary measure.
So are we now concerned that we will be entering another period of stagflation? Like the 1970’s we do have a supply-side issue (although not oil based) and expansionary demand side. The following are concerns:
Growth – Supply bottlenecks have led to growth slowdown in the US, China, Europe and the other major economies. Furthermore the Delta variant is increasing production costs as well as impacting the labour supply and ultimately reducing output growth. There is also the problem of moral hazard in that generous unemployment benefits are reducing the incentive to find work.
Demand Side – Excessive fiscal stimulus for an economy that already appears to be recovering faster than expected and it is assumed that the US Federal Reserve and other central banks will start to unwind their unconventional monetary policies. Combined with some fiscal drag next year (when deficits may be lower), this supposedly will reduce the risks of overheating and keep inflation at bay.
Supply Side – Again Delta is impacting many global supply chains, ports and logistical systems. Shortages of semi-conductors impacts the car industry as well as electronic goods thus increasing in inflation. Will the global supply side be positively influenced by better use of technological innovation in artificial intelligence and the return to normality on global supply distribution networks. Also will demand pressure eventuate especially when the threat of unemployment is ever present.
Although there are negative price shocks which could deter potential growth, expansionary fiscal and monetary policy could still increase the inflation rate. The resulting wage-price spiral could lead to astagflationary environment worse than the 1970s – when the debt-to-GDP ratios were lower than they are now. That is why the risk of a stagflationary debt crisis will continue to loom over the medium term.
Source: The Stagflation Threat Is Real – Nouriel Roubini – Project Syndicate 30th August 2021
Ha-Joon Chang’s book ‘A Pelican Introduction – Economics: The User’s Guide’ has a table in which he summarises the different schools of economics. I have just included some of them as these tend to be associated with the CIE AS Level and A2 Level courses.
This is something I use in my Behavioural Economics course which usually displays interesting results.
Economist John Maynard Keynes described the action of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose from a set of six photographs of women that are the “most beautiful.” Those who picked the most popular face are then eligible for a prize.
A naive strategy would be to choose the face that, in the opinion of the entrant, is the most beautiful. A more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of beauty is, and then make a selection based on some inference from his knowledge of public perceptions. This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents.
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).
•Players choose a number from 0 to 100 (all numbers allowed, including decimals). •Teacher collects all of the chosen numbers.
•Teacher averages the numbers. Call the average X.
•Teacher calculates 2/3 of X. Let Y = (2/3)X.
•Player whose number is closest to Y wins a prize.
•If there is a tie, tied players split the prize.
Although screened by the BBC in 2012 this 3 part series is very useful for A2 students looking at macro objectives and policies. Keynes has never been more applicable or contentious than the present day.
In Masters of Money, produced in partnership with the Open University, BBC economics editor Stephanie Flanders examines how three extraordinary thinkers, Keynes, Hayek and Marx, helped shape the 20th century and continue to exert a huge influence on our world today.
Stephanie begins by looking at John Maynard Keynes. Many argue only Winston Churchill had a greater impact on British life than Keynes over the last century. Even today his ideas remain crucial to one of the most important debates of our time: how can we escape from the economic crisis? Should governments borrow and spend their way out of trouble or slash spending and reduce the national debt?
You will no doubt have seen the Keynes v Hayek Rap which was produced by econ stories. Now the debate turns to the Chinese economy – which of these economist’s policies is more prevalent? The Economist Free exchange column addressed this issue recently.
In order to maintain the level of economic activity in an economy Keynes believed in investment spending to maintain aggregate demand and employment. However, Hayek believed that investment spending might be directed in the wrong areas and would leave the economy poorly coordinated and workers stranded in the wrong jobs. Economist Andrew Batson has argued that Hayek seems to be gaining the upper hand in the battle of ideas as China is now keen to avoid the Hayek malinvestment even if there is less aggregate demand and growth which Keynes favoured. As mentioned in previous posts there has been huge investment in China in areas that normally stimulate growth in downturns – eg. creation of new cities or infrastructure projects.
There are others that say the Chinese economy has areas of its infrastructure that need to be developed. Cities like Beijing and Shenzen are congested and need investment spending on them. Although Hayek believed that malinvestment would result in a worse downturn what is different in China is that their high investment is backed by even higher savings. This means that investment projects don’t need to generate high returns in order pay back external creditors. According to The Economist the real cost of malinvestment is with the empty shopping malls, vacant apartments etc when there are poor medical facilities and overcrowding in housing. Might a more market approach be a better driver of the economy rather than that of central planning?
John Authers of the FT wrote an interesting piece on John Maynard Keynes the investor. An era of non-Keynesian policy has culminated in a classic liquidity trap in which lower interest rates to stuimulate growth in the economy has little or no effect. Nowadays Keynes is back in fashion but how did Keynes the investor perform? In his early years he was a familiar figure in the City of London, where he made a fortune in the stock market, lost it all, and made it back again. Recently an academic publication analysed Keynes’ record an an investor and from 1924 to 1946 he managed the endowment fund of King’s College, Cambridge. The chart shows that any 100 that Keynes invested at the outset would have been worth 1,675 by his death in 1946. But what is significant about his performance as an investor was that the economic environment at this time included the Crash of 1929, the Depression and World War II. As John Authers alludes to, it is difficult to compare Keynes with investors today but if you take long-term illiquid investments like forestry, real estate, private equity and hedge funds you can get a more valid comparison. The table below shows that the return on investment by Keynes was higher than that of the market under similar conditions i.e. equity growth.
If you compare him to Warren Buffet and his main investment Berkshire Hathaway, Keynes’ King’s endowment did better – see graph.
How did he do it? Was it Animal Spirits?
* he invested in equities – no one wanted to invest in this area therefore inefficiencies were prevalent and profits could be made
* he steered clear of diversification
* put fairly large sums of money into enterprises that he knew something about
Keynes could see when he made a mistake, deal with it, and modify his behaviour.
Below is a chart which looks at the dangers of over optimism in markets – Keynes referred to this as ‘Animal Spirits’. Nobel economist Daniel Kahneman describes overconfidence as the engine of capitalism but there are concerns whether the success of entrepreneurs in markets is due to their skill or the fact that a lot of luck is involved. One thing is for sure – when they are successful they tend to become overconfident about their ability to survive a crisis. This in turn inflates asset prices which makes asset buyers more optimistic about borrowing more money and banks more confident of repayment. However, as we have seen it all comes to a head and the bubble bursts.
A recent article in the New Zealand Herald, by Susan Guthrie and Gareth Morgan, attacks the lack of comprehension of why we tax and why we distribute the proceeds via state transfer payments. During the industrial revolution the disparities of wealth amongst the population led economist philosophers of the “enlightenment period’ to conclude the purpose of taxation was to “favour the diffusion rather than the concentration of wealth” – John Stuart Mill. The founder of capitalist system, Adam Smith, was critical of teh inequality it brought to society and acknowldeged that tax progressivity was desirable.
Ever since moral philosophy and economics parted ways and mathematical advances reduced the subject of economics to answering “what if” questions, we’ve suffered from a vacuum of understanding of why we tax and why we distribute the proceeds via state transfer payments.
Indeed we are so preoccupied with determining how big a budget deficit or size of government we can get away with, how we can cut the cost of welfare, how next year’s outlook compares with last year’s, that the rationale for why we redistribute has, to all intents and purposes, been forgotten.
In 1948 the United Nations supported the morals of the classical economists – Adam Smith, John Stuart Mill, Thomas Malthus etc. Its Declaration of Humand Rights stated: “Everyone has the right to a standard of living adequate for the health and wellbeing of himself and his family including food, clothing, housing and medical care and necessary social services, and the right to security in the event of unemployment, sickness, disability, widowhood, old age or other lack of livelihood in circumstances beyond his control.”
Gutherie and Morgan argued that modern economics is still too focused on GDP and it doesn’t recognise the contribution of people in society that perform unpaid work or voluntary work for their communities. However once you start to exclude people from the capitalist system they become polarised and public disorder breaks out. For so long UK policies have been devoid of moral or ethical justification and this has acted as a catalyst to the riots in London and other centres.
Our tax and welfare policy is in urgent need of reconstruction so it ensures equal opportunity for all to participate and fully realise their potential in society in its widest sense – whether it be the paid or the unpaid workforce.
The chauvinism in policies that disparage unpaid work – whether it be care of the elderly, juveniles or of the community – has run way too far and will alienate more and more.