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3.7 The Central Propositions of Orthodox Keynesian Economics

Finally in this chapter we draw together the discussion contained in sections

3.2–3.6 and summarize the central propositions of orthodox Keynesian economics

as they were in the mid- to late 1960s.

First Proposition: Modern industrial capitalist economies are subject to an

endemic flaw in that they are prone to costly recessions, sometimes severe,

which are primarily caused by a deficiency of aggregate (effective) demand.

Recessions should be viewed as undesirable departures from full employment

equilibrium that are generally caused by demand shocks from a variety of

possible sources, both real and monetary. As we will discuss in Chapter 6, this

view stands in marked contrast to the conclusions of real business cycle theory,

which emphasizes supply shocks as the major cause of aggregate instability.

Second Proposition: Orthodox Keynesians believe that an economy can be in

either of two regimes. In the Keynesian regime aggregate economic activity

is demand-constrained. In the classical regime output is supply constrained

and in this situation supply creates its own demand (Say’s Law). The ‘old’

Keynesian view is that the economy can be in either regime at different points

in time. In contrast, new classical economists, such as Robert Lucas and

Edward Prescott, model the economy as if it were always in a supplyconstrained

regime. In the Keynesian demand-constrained regime employment

and output will respond positively to additional real demand from whatever


Third Proposition: Unemployment of labour is a major feature of the Keynesian

regime and a major part of that unemployment is involuntary in that it

consists of people without work who are prepared to work at wages that

employed workers of comparable skills are currently earning (see for example,

Solow, 1980; Blinder, 1988a). As we will discuss in subsequent chapters,

this contrasts sharply with the view of many monetarist, new classical and

real business cycle economists who view unemployment as a voluntary phenomenon

(Lucas, 1978a).

Fourth Proposition: ‘A market economy is subject to fluctuations in aggregate

output, unemployment and prices, which need to be corrected, can be

corrected, and therefore should be corrected’ (Modigliani, 1977, 1986). The

discretionary and coordinated use of both fiscal and monetary policy has an

important role to play in stabilizing the economy. These macroeconomic

instruments should be dedicated to real economic goals such as real output

and employment. By the mid-1960s the early ‘hydraulic’ Keynesian emphasis

on fiscal policy had been considerably modified among Keynesian thinkers,

particularly Modigliani and Tobin in the USA (see Snowdon and Vane, 1999b).

However, supporters of the ‘New Economics’ in the USA were labelled as

‘fiscalists’ to distinguish them from ‘monetarists’. But, as Solow and Tobin

(1988) point out, ‘The dichotomy was quite inaccurate. Long before 1960 the

neo-Keynesian neoclassical synthesis recognised monetary measures as coequal

to fiscal measures in stabilisation of aggregate demand’ (see Buiter,


Fifth Proposition: In modern industrial economies prices and wages are not

perfectly flexible and therefore changes in aggregate demand, anticipated or

unanticipated, will have their greatest impact in the short run on real output and

employment rather than on nominal variables. Given nominal price rigidities

the short-run aggregate supply curve has a positive slope, at least until the

economy reaches the supply-constrained full employment equilibrium.

Sixth Proposition: Business cycles represent fluctuations in output, which are

undesirable deviations below the full employment equilibrium trend path of

output. Business cycles are not symmetrical fluctuations around the trend.

Seventh Proposition: The policy makers who control fiscal and monetary

policy face a non-linear trade-off between inflation and unemployment in the

short run. Initially, in the 1960s, many Keynesians thought that this trade-off

relationship was relatively stable and Solow and Tobin (1988) admit that in

the early 1960s they ‘may have banked too heavily on the stability of the

Phillips curve indicated by post-war data through 1961’ (see Leeson, 1999).

Eighth Proposition: More controversial and less unanimous, some Keynesians,

including Tobin, did on occasions support the temporary use of incomes

policies (‘Guideposts’) as an additional policy instrument necessary to obtain

the simultaneous achievement of full employment and price stability (Solow,

1966; Tobin, 1977). The enthusiasm for such policies has always been much

greater among European Keynesians than their US counterparts, especially in

the 1960s and early 1970s.

Ninth Proposition: Keynesian macroeconomics is concerned with the shortrun

problems of instability and does not pretend to apply to the long-run

issues of growth and development. The separation of short-run demand fluctuations

from long-run supply trends is a key feature of the neoclassical

synthesis. However, stabilization policy that combines tight fiscal policy with

easy monetary policy will ‘bring about an output mix heavier on investment

and capital formation, and lighter on consumption’. This mix will therefore

be more conducive to the growth of an economy’s long-run growth of potential

output (see Tobin, 1987, pp. 142–67, Tobin, 2001). ‘Taming the business

cycle and maintaining full employment were the first priorities of macroeconomic

policy. But this should be done in ways that promote more rapid

growth in the economy’s capacity to produce’ (Tobin, 1996, p. 45).

The orthodox Keynesians reached the peak of their influence in the mid-

1960s. In the UK Frank Paish (1968) concluded that on the basis of Phillips’s

data, if unemployment were held at around 2.5 per cent, then there would be

a good chance of achieving price stability. In the USA, reflecting on the

experience of 20 years of the Employment Act of 1946, the 1966 Annual

Report of the Council of Economic Advisers concluded on the following

optimistic note with respect to the effectiveness of Keynesian demand management

policies (emphasis added):

Twenty years of experience have demonstrated our ability to avoid ruinous inflations

and severe depressions. It is now within our capabilities to set more ambitious

goals. We strive to avoid recurrent recessions, to keep unemployment far below

rates of the past decade, to maintain essential price stability at full employment,

to move toward the Great Society, and, indeed, to make full prosperity the normal

state of the American economy. It is a tribute to our success under the Employment

Act that we now have not only the economic understanding but also the will

and determination to use economic policy as an effective tool for progress.

As we now know, this statement turned out to be far too optimistic with

respect to the knowledge that economists had about macroeconomics and the

ability to target the economy toward increasingly lower unemployment targets

(see DeLong, 1996, 1997, 1998).

Does this mean that Keynesian economics is dead (Tobin, 1977)? Certainly

not. Paul Krugman (1999) has warned economists that the 1990s have witnessed

‘The Return of Depression Economics’. Krugman’s argument is that

‘for the first time in two generations, failures on the demand side of the

economy – insufficient private spending to make use of available productive

capacity – have become the clear and present limitation on prosperity for a

large part of the world’. Krugman sets out to remind economists not to be

complacent about the possibility of economic depression and deflation, particularly

in view of what happened in the Japanese, Asian Tiger and several

European economies during the 1990s. DeLong (1999a, 1999b, 1999c) has

also emphasized that the business cycle and threat of deflation are far from

dead. Several economists have argued that the Japanese economy appears to

be caught in a ‘liquidity trap’ (Krugman, 1998). Krugman (1999) writes:

Even now, many economists still think of recessions as a minor issue, their study

as a faintly disreputable subject; the trendy work has all been concerned with

technological progress and long-run growth. These are fine important questions,

and in the long run they are what really matters … Meanwhile, in the short run the

world is lurching from crisis to crisis, all of them crucially involving the problem

of generating sufficient demand … Once again, the question of how to keep

demand adequate to make use of the economy’s capacity has become crucial.

Depression economics is back.

So even given that there were significant deficiencies in the orthodox Keynesian

framework that required new thinking, the issues that concerned Keynes have

not disappeared.

In the next chapter we discuss the development of the orthodox monetarist

school which, over the period of the mid-1950s to the early 1970s, highlighted

a number of weaknesses both at the theoretical and empirical levels of

the then-prevailing orthodox Keynesian framework.

James Tobin was born in 1918 in Champaign, Illinois and obtained his BA,

MA and PhD from Harvard University in 1939, 1940 and 1947, respectively.

He began teaching while a graduate student at Harvard University in 1946. In

1950, he moved to Yale University where he remained, until his death in

2002, as Professor of Economics, with the exception of one and a half years

in Washington as a member of President Kennedy’s Council of Economic

Advisers (1961–2), and academic leaves including a year as Visiting Professor

at the University of Nairobi Institute for Development Studies in Kenya


James Tobin was one of America’s most prominent and distinguished

Keynesian economists. He was a longstanding advocate of Keynesian

stabilization policies and a leading critic of monetarism and the new classical

equilibrium approach. He made fundamental contributions to monetary and

macroeconomic theory as well as important contributions to the links between

cyclical fluctuations and economic growth. In 1981 he was awarded

the Nobel Memorial Prize in Economics: ‘For his analysis of financial markets

and their relations to expenditure decisions, employment, production and


Among his best-known books are: National Economic Policy (Yale University

Press, 1966); Essays in Economics: Macroeconomics (Markham, 1971;

North-Holland, 1974); The New Economics One Decade Older (Princeton