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Describe how different interpretations of the General Theory led to alternative schools of thought in Macroeconomics By Luciano Figari Student number 604636 Graduate Diploma in Economics SOAS, University of London

Introduction: Keynes’ deep influence in economic thinking It is not highly common for economists to agree on anything. However, most of them agree on two things: Keynes‟s ‘General Theory of Employment, Interest and Money’ deep influence in economic thinking and the difficulty to fully understand what Keynes‟s was actually trying to say in his book. Economists agree on the importance of Keynes‟s work because the publication of his „General Theory’ in 1936 led to the Keynesian Revolution, the most significant event in 20th century economic science (Samuelson, 1988). As a consequence of the Keynesian Revolution, in the period between 1950s and 1960s, Keynes´s macroeconomic ideas dominated economic thinking, at least in the U.S. and the U.K. There were two main reasons for this: the inability of the Classical model to explain the Crash of 1929 and its aftermath; and the successful implementation of demand management policies during the post-WWII recovery. On the other hand, it is commonly argued that Keynes‟ work is not an easy read. Consequently, many interpretations of Keynes‟s work have been made, leading to the creation of different schools of thought. In a paper called ‘Keynes’s General Theory: Interpreting the Interpretations’ (1991), Bill Gerrard analysed why different interpretations of Keynes have occurred. Some of the reasons include confusions generated by Keynes himself due to his “technical incompetence”, “stylistic difficulties”, “inconsistencies” and “mistakes”. Other confusions, Gerrard said, are generated by readers because of their “selective reading”, “inappropriate framing” and “reliance on secondary sources”. It is important to note when describing the different schools of thought that “the work of Keynes is still the main single point of reference, either positive or negative [… The schools of thought] still define themselves in relation to Keynes‟s ideas, either as a development of some version of his thought or as a restoration of some version of a pre-Keynesian „classical‟ thought ” (Vercelli, 1991: 3). According to Coddington (1983), there are three main interpretations of Keynes‟s work: the „hydraulic‟ interpretation, which this essay describes in part 1; the „fundamentalist‟ interpretation, discussed in part 2; and the modified general equilibrium approach, examined

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in part 3. At the end there is a conclusion with some thoughts on the consequences of the findings.

The house where Keynes lived from 1916 to 1936 is located in 46 Gordon Square, just a hundred metres away from SOAS, University of London. Probably some of Keynes´ most brilliant ideas occurred to him behind these two windows.

Part 1: The ‘hydraulic’ interpretation The hydraulic interpretation of Keynes‟s focuses on analysing how markets work when prices and wages are less than perfectly flexible. It is an orthodox interpretation of Keynes that led to the creation of the neoclassical synthesis, a school of thought which dominated economic thinking during the 1950s and 1960s. In the 1970s, when the Neoclassical Synthesis models were harshly criticized, some economists tried to improve these models, leading to the creation of New Keynesianism. Part 1.1 The Neoclassical Synthesis Following the publication of Keynes's General Theory of Employment, Interest and Money in 1936, a fierce debate began between Classicals and Keynesians. In the mid-1950s, Samuelson (1955) stated that the pro or anti Keynes´s debate had ceased and that most economists were now committed to the „neoclassical synthesis‟, trying to integrate Keynes´s and the Classicals´s ideas into one single model. Under the neoclassical synthesis, the classical and neoclassical models were used to analyse microeconomic issues and the long-run analysis of Page 2 of 8

growth, whereas Keynes´s macroeconomic model was used to analyse short-run aggregate phenomena (Snowdon and Vane, 2005: 101).

For Snowdon and Vane (2005, 144), the main propositions of the neoclassical synthesis until the 1960s are:

1. Modern industrial capitalist economies are prone to recessions caused by insufficient aggregate demand from different sources, both real and monetary. 2. The economy can be supply and/or demand constrained. 3. Recognizes the existence of the involuntary unemployment phenomenon. 4. Both monetary and fiscal policy play a pivotal role in stabilizing the economy. 5. Prices and wages are not fully flexible. Hence, the greater impact of changes in aggregate demand will be in the short run on real output and employment rather than on nominal variables. 6. Business cycles are not symmetrical fluctuations around the full employment trend. 7. When implementing fiscal or monetary policies, there is a trade-off between inflation and unemployment in the short run. However, the neoclassical synthesis had a weakness: it didnâ€&#x;t provide a convincing reason based on rational behaviour for wage and price rigidities. These inconsistencies led to the creation of a new school of thought, the New Keynesian. Part 1.2 The New Keynesian approach This line of thought was conceived in the 1970s during the first phase of the New Classical revolution, as a response to the work of the new classical economist Lucas, who had exposed theoretical flaws and inconsistencies in the old Keynesian model (Snowdon and Vane, 2005: 361). New Keynesians believe that the neoclassical synthesis contains some fundamental truths, and if appropriately modified, Keynesianism will once again become the dominant school of thought in macroeconomics. That is the reason why New Keynesiansâ€&#x; priority is to create a coherent theory of aggregate supply providing a rational explanation to wage and price rigidities based on acceptable microfoundations. This is opposed to the Neoclassical Synthesis models, which tended to Page 3 of 8

assume nominal rigidities. Another essential task for New Keynesians is to clarify when the invisible hand does, and does not, efficiently coordinate the market.

New Keynesians agree with the following four propositions of the orthodox Keynesian school (Snowdon and Vane, 2005: 360): 1. “Unemployment equilibrium” can exist if an economy is unregulated. 2. Business cycles are mainly caused by aggregate demand disturbances. 3. Monetary policy has an impact in output and employment, but in very deep recessions it can be ineffective. 4. Government intervention can improve macroeconomic stability and economic welfare.

As shown in the second proposition, New Keynesians disagree with the New Classical explanation of instability. However, they do share two New Classical methodological premises: macroeconomic theories require solid microeconomic foundations; and macroeconomic models are best constructed within a general equilibrium framework (Snowdon and Vane, 2005: 360).

It should be noted that New Keynesian ideas are heterogeneous; therefore its authors are grouped in one single school of thought for convenience rather than for accuracy. Some of the most prominent New Keynesians authors are Gregory Mankiw, Lawrence Summers, Olivier Blanchard, Stanley Fischer, Bruce Greenwald, Edmund Phelps, Joseph Stiglitz and Ben Bernanke, among others. Part 2: The ‘fundamentalist’ interpretation During the 1950s and 1960s, fundamentalists accused the „hydraulic interpretation‟ of being a “misinterpretation” and “bastardization” of Keynes‟s work (Snowdon and Vane, 2005: 71). In their opinion, Keynes‟s work was a direct attack to neoclassical orthodoxy and, consequently, mixing Keynes‟s ideas with neoclassical models was extremely inappropriate.

The fundamentalist interpretation led to the creation of the Post Keynesian school of thought, a heterogeneous group which consists of two large groups: the „American‟ and the „European‟ (Holt, 1997). The „European‟ group includes the body of work associated with economists Page 4 of 8

such as Geoff Harcourt, Richard Kahn, Nicholas Kaldor, Michal Kalecki, Joan Robinson and Piero Sraffa. The „American‟ group includes the work of economists such as Victoria Chick, Alfred Eichner, Jan Kregel, Hyman Minsky, Basil Moore, George Shackle, Sidney Weintraub and Paul Davidson (Davidson, 2005: 452).

According to Davidson (2005, 452-453), many authors of the European group and at least one of the American group should not be considered Post Keynesians because they use variants of a classical model rather than Keynes‟s financial and monetary analytical approach. In Davidson‟s view, only the authors that use analytical models that adopt Keynes‟s principle of effective demand should be called Post Keynesians.

The fundamental building blocks of Post Keynesian theory are: 1. The non-neutrality of money. 2. The existence of non-ergodic uncertainty in some important decision-making aspects of economic life. 3. The denial of the ubiquitousness of the gross substitution axiom.

Some Post Keynesians of the American group have focused on the impact of uncertainty in the economy. They have developed a particular perspective about uncertainty, where in some situations it is impossible to predict future outcomes on the basis of past or current probability distributions obtained from market data. Under this circumstances, decisions makers may either avoid making a decision between alternatives because they have no idea of what is going to happen or they can make decisions following their instinct or, as Keynes‟s called it, their „animal spirit‟ (Davidson, 2005: 463). Part 3: The modified general equilibrium approach The modified general equilibrium approach rejects Keynes‟s proposition of market failure. It is a restoration of the pre-Keynesian „classical‟ Walrasian general equilibrium theory. This approach led to the creation of the New Classical school of thought. New Classical theories became popular during the 1970s because Keynes‟s ideas could not explain the inflation and unemployment which was occurring at that time.

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Some of the most influential New Classical economists are Robert Lucas, Thomas Sargent, Robert Barro, Edward Prescott, Neil Wallace and Patrick Minford.

According to Snowdon and Vane (2005: 223), the central features of the New Classical approach in the early 1970s were:









microfoundations within a Walrasian general equilibrium framework. 2. Neoclassical assumption that all economic agents have a maximising rational behavior. 3. Agents do not suffer from money illusion and, therefore, they optimize their decisions basing only on real magnitudes. In other words, they make rational expectations. 4. Economic agents have imperfect information and firms know the general price level for other markets only after a time lag. 5. Continuous market clearing.

The younger generations of New Classicals focused on building the rational expectation hypothesis (REH), which became the dominant way of modelling endogenous expectations. The REH opposes to Keynes‟s theory of expectations, which were exogenous, irrational and driven by „animal spirits‟ (Snowdon and Vane, 2005: 225-226).

For the New Classicals, deviations of output and employment from their long term equilibrium natural level occur only when economic agents make expectational errors. In their view, any predictable fiscal or monetary policy will be taken into account by economic agents when they are forming their rational expectations. Therefore, predictable government policies will not produce expectational errors and, hence, will have no effect on the economy. Consequently, and assuming that the private sector is optimizing as efficiently as it can, there is no need or role for the government in the economy (Hillier, 1991: 168). Conclusion: Keynes is not dead As this essay has examined, the rise and decline of schools of economic thought has always been contingent on social and historical circumstances. The Great Depression paved the way for Keynesianism, whereas the stagflation of the 1970s spurred Monetarism and the New Classical models. In the same way, Neoliberalism and the free-market paradigm have been Page 6 of 8

discredited with the financial crisis of 2007, which led to the Eurozone crisis and volatility in emerging markets. Movements like Occupy Wall Street, the „Indignados‟ in Spain or the creation of international student societies asking for a change in economics are just some of the proofs which demonstrate that there exists an increasing discontent with the predominant Neoclassical views.

Even though each school of thought provides interesting frameworks that help to understand how the economy works, none of them has been able to answer all the questions that the global society is asking. Consequently, there is currently a crisis in economic thinking and a new school of economic thought is urgently needed. I certainly don‟t know how this new school of economic thought will be. A good starting point could be to use insights from other social sciences, such as political sciences, history, psychology or sociology, in order to have a broader perspective of the real nature of human behaviour. Anyhow, after analysing Keynes‟s deep influence in economic thinking over the last 80 years I can confidently state that the new model will definitely have Keynes‟s work as a reference point. References Coddington, A. (1983), Keynesian Economics: The search for first principles, London: Allen and Unwin

Davidson, P. (2005), The Post Keynesian school, in ( ed) Snowdon, B. and Vane, H. Macroeconomics Its origins, development and current state Edward Elgar Publishing Limited Gerrard, B. (1991), Keynes’s General Theory: Interpreting the Interpretations, Economic Journal, March.

Hillier, B. (1991), The Macroeconomic Debate: Models of the Closed and Open Economy, Blackwell Publishing

Holt, R.P.F. (1997), Post Keynesian School of Economics, in T. Cate (ed.), An Encyclopedia of Keynesian Economics, Cheltenham, UK and Lyme, USA: Edward Elgar.

Samuelson, P.A. (1955), Economics, 3rd edn, New York: McGraw-Hill Page 7 of 8

Samuelson, P.A. (1988), In the Beginning, Challenge, July/August.

Snowdon, B. and Vane, H. (2005) Macroeconomics: Its origins, development and current state Edward Elgar Publishing Limited

Vercelli, A. (1991), Methodological Foundations of Macroeconomics: Keynes and Lucas, Cambridge: Cambridge University Press.

Wood, J.C. (1994) John Maynard Keynes Critical Assessments Second Series Kent: Mackays of Chatham

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