Hoisted from Comments: Robert Waldmann on the Durability of Capital
Quote of the Day: Winston Churchill's Eulogy for Neville Chamberlain

Teaching Keynesian Economics to Your Bulldog


James Hanley at Adrian College is perplexed, and seeks a guide:

Lecturing on Keynes Today: Today in my political economy class I’m doing my Keynes lecture. This is one of my least favorites, and reading as much as I have over the last year about Keynes has just made it all the more confusing. My questions have grown while the answers have not, which makes it very hard to talk about to those who aren’t yet familiar with it. I think I need to spend the next year getting answers. Perhaps it’s time to try to strike up some direct communication with Brad DeLong–with any luck he’ll be pleased to try to teach a monetarist-leaning public-choice guy the logic of fiscal stimulus.

Well, here's one (perfectly valid and correct) way to look at it:

  1. Start with the quantity theory of money: PY = MV

  2. Note that V = V(i), that the lower are short-term nominal interest rates, the lower is velocity

  3. Observe that standard open-market operations swap bonds for cash--increase M by decreasing the supply of bonds to be held by the private sector

  4. Note that demand curves slope down--that if the supply of bonds drops, the price of bonds rises

  5. Note that a higher price of bonds is a lower nominal interest rate i

  6. Worry that under some circumstances--like right now--the velocity of money is especially sensitive to the interest rates--so that standard open-market operations that shrink the supply of bonds will have little or no effect on total spending PY because the bigger-M channel is offset by the smaller-B leads to lower-i leads to lower-V channel

  7. Observe that if the government increases the money supply M but holds the interest rate i constant by not reducing the supply of bonds B then this crowding-out problem does not arise, and monetary expansion is effective

  8. Figure out that if the government is going to expand M without shrinking B, then it has to buy stuff with the M--and ideally it has to buy stuff with the M that is as far from being a substitute for B as possible. Bridges seem good. So does cholesterol-reducing medicine. And smaller school class sizes

  9. Voila! The case for fiscal stimulus.

That is the argument for fiscal policy from the LM-side of the IS-LM scissors--and it is an argument that I think captures the spirit of Keynes's Treatise on Money. There is another argument for fiscal policy that starts from the IS-side of the IS-LM scissors--and that is the argument of the General Theory

But, as Hicks (1937) pointed out, it's a scissors: to ask which blade does the cutting--PY = MV(i) or I(i) = S--is to ask the wrong question.