The Keynesian Synthesis
Learning Objectives
By the end of this section, you will be able to:
- Explain the coordination argument, menu costs, and macroeconomic externality
- Explain the Phillips curve, noting its impact on the theories of Keynesian economics
- Graph a Phillips curve
- Identify factors that cause the instability of the Phillips curve
- Analyze the Keynesian policy for reducing unemployment and inflation
While Keynes’ own work, especially in the General Theory, was considered revolutionary in the world of economics, it wasn’t long before his ideas were merged into orthodox thinking within the discipline. This resulted in what has variously been called New Keynesianism, the Keynesian Synthesis, or, as economist and colleague of Keynes himself, Joan Robinson called it, Bastard Keynesianism. From this view Keynesian economics is not about a fundamentally different way of understanding capitalist economies. Instead, Keynesian economics is simply an approach within orthodox economics that focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. In particular, the Keynesian view of recession is based on the fundamental insight that aggregate demand simply is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment.
The first building block of this Keynesian diagnosis is that recessions occur when the level of demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment. Suppose the stock market crashes, as in 1929, or suppose the housing market collapses, as in 2008. In either case, household wealth will decline, and consumption expenditure will follow. Suppose businesses see that consumer spending is falling. That will reduce expectations of the profitability of investment, so businesses will decrease investment expenditure.
This seemed to be the case during the Great Depression, since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The U.S. economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929—and yet the economy had shrunk dramatically. This also seems to be what happened in 2008.
As Keynes recognized, the events of the Depression contradicted Say’s law that “supply creates its own demand.” Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP. The question becomes, then, how can this view be reconciled with an orthodox economics in which Say