The Birth and Development of Modern Macroeconomics

The problems associated with the “liberal” market economy, such as the political tensions between
the social classes, increasing monopolization of the economy, pressures on exchange rates in the Gold Standard system and imperialistic rivalries among the Great Powers, would lead to this collapse.

The Depression was especially acute for England, because of the costs of the war and the Gold Standard which she left in 1931. At the same time, England had been losing its cutting edge in industry and international trade for quite some time. Beginning from the 1860s, other European countries and the United States had completed their own industrial revolutions and become important rivals politically and economically.

The ex ante and ex post distinction refers to the division of time into some short equilibrium periods in which no change occurs. The term ex ante refers to a point of time at the beginning of the period, and ex post to the end. Ex ante situation characterizes the equilibrium position, as in the equality
between “planned” investment and savings in Keynes’s theory. Ex post magnitudes refer to a situation when all the adjustments are made, and they are actual values of the variables in question.

Knut Wicksell, with his distinction between the “natural rate of interest” and the market interest rate, opened up new dimensions in macroeconomics and monetary economics (Blaug, 1985: 639).

Methodologically speaking, Keynes revived the “macro” tradition of the Classical School, in the sense that the “aggregate” variables such as “effective demand”, savings, investment, money and government became fundamental units of analysis. Furthermore, he was able to integrate two separate analyses, namely the real analysis and the monetary analysis. His theory can be called the “monetary theory of production.” Through his emphasis on the function of money as a store of wealth, a Mercantilist idea that was discarded until him, Keynes was able to show that money is not “neutral” and analyzed the effects on monetary changes on real variables.

“Effective Demand” is defined by Keynes as the value of the aggregate demand function at its intersection point with the Aggregate Supply function (Keynes, 1936: 25).

For Keynes, the most important property of money as a store of wealth is its “liquidity”: it can be transformed into any form of wealth without a considerable cost. Money does not have a return of its own, but it is the most liquid form of wealth.

A. W. Phillips published a paper that suggests a significant statistical relationship between the rate of increases in money wage rate and the unemployment rates. This work is based on the idea that when there is a high demand for labor and unemployment falls, the rate of increase in money wages will rise. When unemployment will increase, on the other hand, the increase in the money wage rate will fall more than the increase in unemployment. In other words, according to Phillips (1958: 283), this relationship is
a nonlinear one. The Phillips relationship can be expressed as:
W’ = f(U) W’= dW/dt (the rate of increase in money wages),
where, W: money wage, U: unemployment rate

Lipsey (1960) transformed the model into a relationship between the rate of inflation and the unemployment rate. The reason behind this relationship is the idea of “cost-push inflation”, that is, when the wage rate increases, price increases will also follow. In this way, it is possible to show the relationship
between the inflation rate and the unemployment rate. The theoretical rationale behind this logic is again “Keynesian”: when the effective demand increases (through increases in government spending or in money supply), both output and prices are expected to increase. If there is a high unemployment rate, increases in the money prices will be limited, but when the economy approaches full employment, increases in prices will accelerate. In this way, it is possible to show a “trade-off”, a “menu choice”, between the inflation rate and the unemployment rate.

In Irving Fisher’s equation, the Quantity Theory is expressed as follows:

MV = PT, where M is money in circulation; V is the velocity of money, that shows the number of times that the average unit of currency is used in transactions, or the number of money changing hands in the economy in a year; P is the general price level, and T is the volume of transactions in a year. This is an identity because it is always true: the total volume of money
circulated in the exchanges within the economy is always equal to the value of total transactions.

Keynes’s General Theory had its share of criticism from the Classical- Neoclassical Monetary Economists. First round of criticisms was the debate between the “Cambridge school” of monetary economics, whose leading representative was Arthur C. Pigou, and the second round started in the 1950s by Monetarist criticisms led by Milton Friedman who criticized Synthesis Keynesianism. The third round, as the continuation of the second,
dominated the debates on economic policies in the 70s and 80s, led by the “New Classical” revolution. In fact, all of these rounds were centered around
the “Quantity Theory of Money”, formulated by David Hume in the late 18th century, although there are some forerunners of this view such as Richard Cantillon.

“Rational expectations” scheme was developed in 1962 by John F. Muth.

“NAIRU”, stands for “Non-accelerating Inflation Rate of Unemployment”

Lucas, however, criticizes the “myopic” vision of the adaptive expectations scheme because it only looks at the past values of the prices. An important problem with this scheme is that it looks only at the past values of the variable about which expectation is formed. Even if there is the possibility of inflation arising as a result of increases in money supply, people having adaptive expectations cannot recognize this, because they have to wait until it is included in their expectations. At the same time, the fact that they cannot consider the effect of, say, the increases in money supply or central banks announcements about their policy change in the future, before seeing their actual effects on prices. This scheme is not a rational way of forming expectations

For Alfred Eichner and Jan Kregel (1975)the important elements defining the Post Keynesian paradigm are: 1) emphasis of the importance of historical time and the growth processes and economic fluctuations; 2) an emphasis on the distribution of income in explaining economic activity; 3) Keynesian constraints (rejection of the Classical dichotomy; defining equilibrium as the equality between savings and investment; the assumption that nominal wages are exogenous); and 4) rejection of perfect competition and emphasis on imperfect competition in determination of prices. 

The term Ponzi Finance comes from Charles Ponzi, who was the “inventor” of the fraudulent investment scheme that is based on interest payments to the earlier lenders made out of the loans from more recent lenders.

Minsky distinguishes among three types of borrowing behavior for the firms to finance their investments, each following the other during a bubble. 1) At first, in the “Hedge Finance” phase, firms seek safe and reasonable evenues, and they can make their payments (interest and principal) from the current cash flows from investment. In this phase, firms are careful to regulate their credit demand in such a way that its cost should not exceed the expected revenues. 2) In the “Speculative Finance” phase, riskier investment projects are pursued by the firms, and the cash flows from the investment are not enough to cover both the interest and the principal. Only the interest can be paid out of revenues. 3) In the “Ponzi Finance” phase, revenues from the investment can cover neither the interest rate nor the principal, but borrowing is continued through the appreciation of asset values.

On the international level, The Bretton  Woods system, by maintaining stability, allowed the governments of each country to design and implement their own economic policies, even if at the expense of the restrictions of movements of short run capital throughout the world.

Socialism can never be a good alternative for Keynes because the basic problem of socialism according to him is its inability to solve the problem
of Economic Individualism and Social Liberty, even if it may have “an unselfish and enthusiastic spirit which loves the ordinary man” (Keynes, 1926: 344). Then, since capitalism is the best system from both an economic and a humanitarian point of view, it is essential to find ways that could solve the problems of the system

The three agencies of this regulation in the West were the state, the big business of monopoly capital and the trade unions.