A Keynesian Downturn in the Austrian Framework
The level of aggregation that characterizes the Keynesian framework precludes
any treatment of boom and bust as an instance of intertemporal
discoordination. Structural changes in the economy as might be depicted by a
change in the shape of the Hayekian triangle are no part of the analysis. The
triangle can change only in size, increasing with economic growth (but, in
light of the paradox of thrift, not with saving-induced growth) and decreasing
with occasional lapses from full employment.
The interest rate plays no role in allocating resources among the stages of
production and only a minor role in determining the overall level of investment.
Hence investment is treated as a simple aggregate, with the demand for
510 Modern macroeconomics
investment funds taken to be unstable and highly interest-inelastic. Further, to
the extent that investment is self-financing, such that increased investment
leads to increased income, which in turn leads to increased saving, the two
curves (saving and investment) shift together and hence the particular interest
elasticity of investment is irrelevant.
Straightforwardly, the circular-flow equation (the equality of income and
expenditure as an equilibrium condition) together with a simple consumption
function imply a positively sloped, linear relationship between investment
and consumption. Consider a wholly private economy in which income and
expenditures are in balance:
Y = C + I (9.4)
Consumer behaviour is described by the conventional linear consumption
equation:
C = c0 + mpc Y (9.5)
where c0 is the autonomous component of consumption spending and mpc is
the marginal propensity to consume. Combining these two equations so as to
eliminate the income variable gives us the relationship between consumption
and investment for an economy in a circular-flow equilibrium.
C = c0/mps + (mpc/mps) I (9.6)
where mps, of course, is simply the marginal propensity to save: mps = 1–
mpc. This upward-sloping linear relationship was clearly recognized by Keynes
(1937, pp. 220–21) and can be called the Keynesian demand constraint. It has
an intuitive interpretation that follows straightforwardly from our understanding
of the investment multiplier and the marginal propensity to consume.
The slope of this line is simply the marginal propensity (mpc) times the
multiplier (1/mps). Suppose the mpc is 0.80, implying an mps of 0.20 and a
multiplier of 5. An increase in investment spending of $100, then, would
cause income to spiral up by $500, which would boost consumption spending
by $400. This same result follows directly from the slope of the demand
constraint (mpc/mps = 0.80/0.20 = 4): an increase in investment of $100
increases consumption by $400.
The Keynesian demand constraint appears in Figure 9.11, sharing axes
with the production possibilities frontier. In Keynesian expositions, however,
the downward-sloping supply constraint plays a very limited role. When the
multiplier theory is put through its paces, the frontier serves only to mark the
boundary between real changes in the spending magnitudes (below the fronTh
tier) and nominal changes in the spending magnitudes (beyond the frontier).
Significantly, the economy is precluded by the demand constraint from moving
along the frontier.
The constraint itself is as stable as the consumption function – as is clear
from its sharing parameters with that function. Hence the point of intersection
of the constraint and the frontier is the only possible point of full
employment. (In the earlier Figure 9.9, which illustrates the paradox of thrift,
the demand constraint shifts downward, reflecting an increase in saving – and
hence a decrease in the consumption function’s intercept parameter c0. It was
precisely because of his belief that this parameter was not subject to change
that Keynes was not particularly concerned about the implications of increased
saving.) Finally, we can note that a more comprehensive rendering of
the Keynesian relationships – one that takes into account the demand for
512 Modern macroeconomics
money (that is, liquidity) as it relates to the interest rate – would alter the
demand constraint only in ways inessential to our current focus.
According to Keynes (1936, p. 315), economy-wide downturns characteristic
of a market economy are initiated by sudden collapses in investment
demand. The constitutional weakness on the demand side of the investmentgood
market reflects the fact that investments are always made with an eye to
the future, a future that is shrouded in uncertainty. Here, the notions of loss of
business confidence, faltering optimism and even waning ‘animal spirits’
(Keynes, 1936, pp. 161–2) come into play. In Figure 9.11, the demand for
investment funds collapses: it shifts leftward from D to D′. Reduced investment
impinges on incomes and hence on consumption spending. Multiple
rounds of decreased earning and spending pull the economy below the frontier.
The reduced incomes also translate into reduced saving, as shown by a
supply of loanable funds that shifts from S(Y0) to S(Y1). If the shift in supply
just matches the shift in demand, the rate of interest is unaffected.
The solitary diagram that Keynes presented in his General Theory (p. 180) is
constructed to make this very point. Abstracting from considerations of liquidity
preference, Keynes tells us, the supply of loanable funds will shift to match
the shift in investment demand. Further, an inelastic demand for investment
ensures that even if the interest-sensitive demand for money allows for a
reduction in the interest rate, the consequences of the leftward shift in investment
demand will be little affected. More to the point of the present contrast
between Keynesian and Austrian views, the economy’s departure from the
production possibility frontier and the leftward shifting of the supply of loanable
funds are but two perspectives on the summary judgement made by Keynes.
The market economy in his view is incapable of trading off consumption
against investment in the face of a parametric change – in this case, an increased
aversion to the uncertainties associated with investment activities. The
economy cannot move along its production possibilities frontier.
The reduction in demands all around is depicted by a shrunken Hayekian
triangle. With an unchanged rate of interest, there can be no time-discount
effect. Hence an untempered derived-demand effect reduces the triangle’s
size without changing its shape. But even if, following Keynes, we were to
allow for a change in the rate of interest, the change would be in the wrong
direction, compounding the economic collapse. A scramble for liquidity would
increase the interest rate, with consequences (not shown in Figure 9.11) of
further reduced investment, further reduced incomes, further reduced consumption
and further reduced saving.
The Austrians would be on weak grounds if they were to deny even the
possibility of a self-aggravating downward spiral. Markets are at their best in
making marginal adjustments in the face of small or gradual parametric
changes. A dramatic loss of confidence by the business community may well
send the economy into a downward spiral. Axel Leijonhufvud (1981) discusses
price and quantity movements relative to their equilibrium levels in
terms of a ‘corridor’. Price or quantity deviations from equilibrium that
remain within the corridor are self-correcting; more dramatic deviations that
take prices or quantities outside the corridor can be self-aggravating.
The Austrians are on firmer grounds in questioning the notion that such
widespread losses of confidence are inherent in market economies and are to
be attributed to psychological factors that rule the investment community.
Business people’s confidence may instead be shaken by economy-wide
intertemporal discoordination, which itself is attributable to a prior credit
expansion and its consequent falsification of interest rates. If this is the case,
then Keynes’s theory of the downturn is no more than an elaboration of the
secondary contraction that was already a part of the Austrian theory of boom
and bust.
The level of aggregation that characterizes the Keynesian framework precludes
any treatment of boom and bust as an instance of intertemporal
discoordination. Structural changes in the economy as might be depicted by a
change in the shape of the Hayekian triangle are no part of the analysis. The
triangle can change only in size, increasing with economic growth (but, in
light of the paradox of thrift, not with saving-induced growth) and decreasing
with occasional lapses from full employment.
The interest rate plays no role in allocating resources among the stages of
production and only a minor role in determining the overall level of investment.
Hence investment is treated as a simple aggregate, with the demand for
510 Modern macroeconomics
investment funds taken to be unstable and highly interest-inelastic. Further, to
the extent that investment is self-financing, such that increased investment
leads to increased income, which in turn leads to increased saving, the two
curves (saving and investment) shift together and hence the particular interest
elasticity of investment is irrelevant.
Straightforwardly, the circular-flow equation (the equality of income and
expenditure as an equilibrium condition) together with a simple consumption
function imply a positively sloped, linear relationship between investment
and consumption. Consider a wholly private economy in which income and
expenditures are in balance:
Y = C + I (9.4)
Consumer behaviour is described by the conventional linear consumption
equation:
C = c0 + mpc Y (9.5)
where c0 is the autonomous component of consumption spending and mpc is
the marginal propensity to consume. Combining these two equations so as to
eliminate the income variable gives us the relationship between consumption
and investment for an economy in a circular-flow equilibrium.
C = c0/mps + (mpc/mps) I (9.6)
where mps, of course, is simply the marginal propensity to save: mps = 1–
mpc. This upward-sloping linear relationship was clearly recognized by Keynes
(1937, pp. 220–21) and can be called the Keynesian demand constraint. It has
an intuitive interpretation that follows straightforwardly from our understanding
of the investment multiplier and the marginal propensity to consume.
The slope of this line is simply the marginal propensity (mpc) times the
multiplier (1/mps). Suppose the mpc is 0.80, implying an mps of 0.20 and a
multiplier of 5. An increase in investment spending of $100, then, would
cause income to spiral up by $500, which would boost consumption spending
by $400. This same result follows directly from the slope of the demand
constraint (mpc/mps = 0.80/0.20 = 4): an increase in investment of $100
increases consumption by $400.
The Keynesian demand constraint appears in Figure 9.11, sharing axes
with the production possibilities frontier. In Keynesian expositions, however,
the downward-sloping supply constraint plays a very limited role. When the
multiplier theory is put through its paces, the frontier serves only to mark the
boundary between real changes in the spending magnitudes (below the fronTh
tier) and nominal changes in the spending magnitudes (beyond the frontier).
Significantly, the economy is precluded by the demand constraint from moving
along the frontier.
The constraint itself is as stable as the consumption function – as is clear
from its sharing parameters with that function. Hence the point of intersection
of the constraint and the frontier is the only possible point of full
employment. (In the earlier Figure 9.9, which illustrates the paradox of thrift,
the demand constraint shifts downward, reflecting an increase in saving – and
hence a decrease in the consumption function’s intercept parameter c0. It was
precisely because of his belief that this parameter was not subject to change
that Keynes was not particularly concerned about the implications of increased
saving.) Finally, we can note that a more comprehensive rendering of
the Keynesian relationships – one that takes into account the demand for
512 Modern macroeconomics
money (that is, liquidity) as it relates to the interest rate – would alter the
demand constraint only in ways inessential to our current focus.
According to Keynes (1936, p. 315), economy-wide downturns characteristic
of a market economy are initiated by sudden collapses in investment
demand. The constitutional weakness on the demand side of the investmentgood
market reflects the fact that investments are always made with an eye to
the future, a future that is shrouded in uncertainty. Here, the notions of loss of
business confidence, faltering optimism and even waning ‘animal spirits’
(Keynes, 1936, pp. 161–2) come into play. In Figure 9.11, the demand for
investment funds collapses: it shifts leftward from D to D′. Reduced investment
impinges on incomes and hence on consumption spending. Multiple
rounds of decreased earning and spending pull the economy below the frontier.
The reduced incomes also translate into reduced saving, as shown by a
supply of loanable funds that shifts from S(Y0) to S(Y1). If the shift in supply
just matches the shift in demand, the rate of interest is unaffected.
The solitary diagram that Keynes presented in his General Theory (p. 180) is
constructed to make this very point. Abstracting from considerations of liquidity
preference, Keynes tells us, the supply of loanable funds will shift to match
the shift in investment demand. Further, an inelastic demand for investment
ensures that even if the interest-sensitive demand for money allows for a
reduction in the interest rate, the consequences of the leftward shift in investment
demand will be little affected. More to the point of the present contrast
between Keynesian and Austrian views, the economy’s departure from the
production possibility frontier and the leftward shifting of the supply of loanable
funds are but two perspectives on the summary judgement made by Keynes.
The market economy in his view is incapable of trading off consumption
against investment in the face of a parametric change – in this case, an increased
aversion to the uncertainties associated with investment activities. The
economy cannot move along its production possibilities frontier.
The reduction in demands all around is depicted by a shrunken Hayekian
triangle. With an unchanged rate of interest, there can be no time-discount
effect. Hence an untempered derived-demand effect reduces the triangle’s
size without changing its shape. But even if, following Keynes, we were to
allow for a change in the rate of interest, the change would be in the wrong
direction, compounding the economic collapse. A scramble for liquidity would
increase the interest rate, with consequences (not shown in Figure 9.11) of
further reduced investment, further reduced incomes, further reduced consumption
and further reduced saving.
The Austrians would be on weak grounds if they were to deny even the
possibility of a self-aggravating downward spiral. Markets are at their best in
making marginal adjustments in the face of small or gradual parametric
changes. A dramatic loss of confidence by the business community may well
send the economy into a downward spiral. Axel Leijonhufvud (1981) discusses
price and quantity movements relative to their equilibrium levels in
terms of a ‘corridor’. Price or quantity deviations from equilibrium that
remain within the corridor are self-correcting; more dramatic deviations that
take prices or quantities outside the corridor can be self-aggravating.
The Austrians are on firmer grounds in questioning the notion that such
widespread losses of confidence are inherent in market economies and are to
be attributed to psychological factors that rule the investment community.
Business people’s confidence may instead be shaken by economy-wide
intertemporal discoordination, which itself is attributable to a prior credit
expansion and its consequent falsification of interest rates. If this is the case,
then Keynes’s theory of the downturn is no more than an elaboration of the
secondary contraction that was already a part of the Austrian theory of boom
and bust.
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