Introduction
We are ready to take our first peek under the bonnet of New Keynesian Economics, and where better to start than the Long-run. The Long run is the supposed natural state of the economy, where all factories and workers are fully employed, and the economy is producing goods and services at full capacity (given the currently available number of factories and skilled workers). New Keynesian Economists believe that the economy generally tends toward this state of being (although sometimes it may need a helpful shove or two if it gets off track in the short-run)
Table of Contents
Factors of Production
Our standard of living is determined by the amount of goods (homes, cars, cakes) and services (dentist and theme park trips) that we can buy (or ‘consume’ in economics jargon). But we can only consume if things have been made, and reasonably enough, we can only make what we have capacity to make. Society is limited by its ‘Factors of Production’, which consists of two categories: Labour and Capital. The long-run theory assumes that all labour and capital is fully utilised all of the time, an assumption it can make because of its belief that the total supply of goods and services in any given year must be consumed, which is an unbreakable law of economics known as the National Income Identity.
National Income Identity
Economies are intuitively circular. If I buy a car, I spend money and the car salesman earns income. So, for a closed economy (i.e. an economy that has no foreign trade or interaction with the outside world) the total money spent by everyone should also equal the total income of everyone. In aggregate this must be true and hence is called an identity (basically an unbreakable law of economics). It’s much easier for economists to focus on how we spend money than on how we earn it, as when you spend money you get a real good or service that should hopefully improve your standard of living (either now or in the future). There are four very distinct types of spending done by different groups of people in society, and these are essential to understand when talking economics:
- Consumption – this is the spending ordinary people do when they buy anything that is for them personally (rather than for a business). The long-run theory assumes the amount of consumption is a proportion of people’s income.
- Investment – this is money that businesses spend on buying new capital. This means investment in buying new factories, technologies and other equipment that will be used to increase the company’s ability to produce goods
- Government Purchases – this is money spent by the government on infrastructure (roads, buildings, tanks, public sector employees)
- Net Exports – the total inflow/outflow of goods from trade with the rest of the world. For simplicity I am mostly going to ignore Net Exports by explaining things using a closed economy (this is fine for understanding the concepts – but I explore the topic of foreign trade separately in a later article)
The idea that total spending must equal total income is called the National Income identity, and can be written as:
Y (National Income) = C (consumption) + I (Investment) + G (Govt Purchases) + NX (Net Exports)
Because the long-run theory assumes that the economy is at full capacity, we know what Y (National Income) will be. That means we know how much income everyone will earn for the year, so we will also know how much consumption will be (as the long-run theory assumes that consumption is a proportion of total income). The theory then assumes Government purchases are exogenous (i.e. the model does not predict what they will be, and they are taken to be given). As previously mentioned, I will be ignoring Net Exports for simplicity.
All of the above means that everything except the amount of money invested by businesses in new capital is pre-ordained. Let’s think about what that means:
If people start to consume less, say because they are worried they might lose their job due the economic crisis caused by Covid-19, then that’s not a problem for the long-run theory, as investment in new capital by businesses will go up to fill in the gap (because the equation has to balance and Investment is the only variable that is not fixed). This of course seems bizarre, if businesses are considering letting staff go why would they invest in new factories and equipment? The long-run theory explains this through the use of the interest rate.
How the Interest Rate Balances Total Demand with Total Supply
The idea is that the interest rate effects how much businesses choose to spend on investment. This is because the interest rate is like an opportunity cost, why would you build a new factory that might give you a 10% return on investment when you can put your money in a bank account and earn 11%. Therefore, if the interest rate is very high then Businesses will reduce total investment and if the rate is very low they will increase investment. But what controls the interest rate in this model????
In classical economics and almost all mainstream economic theories savings is assumed to equal investment. This is derived by some algebraic manipulation plus additional assumptions, explained in the next section. Read on if interested, or skip the next section if you don’t want to get bogged down in math.
Boring Math – Assumption and equations underlying why savings equals investment
First we need to understand what a function is, as I’m about to write a few. In economics a function states the variable we’re interested in on the left-hand side (e.g. Consumption) and then sets it equal to terms that explain it on the right hand side. The explanatory variable will always be expressed in the brackets, but importantly these macroeconomic functions don’t provide a detailed algebraic formula. For example, they don’t tell us how Y (Income) and T (Taxes) determine the total level of consumption, just that these are the variables involved. So let’s look at the National Income accounts again, but this time we’ll add functions to the components of spending:
- Consumption: C = c(Y-T) , Y is income and T is taxes. Income minus taxes is the disposable income that people have left to spend. Consumption therefore depends on disposable Income.
- Investment: I = I(R) , r is the interest rate. Investment depends entirely on the interest rate
- Government Purchases: G = G , assumed to be exogenous and therefore taken as given
So if we take our simplified National Income Accounts Equation (Excluding Net Exports because we are assuming a closed economy) and plug in our Functions:
Y = C + I + G
Y = c(Y-T) + I(R) + G
Income is determined by the factors of production, so this is fixed, Taxes are set exogenously as is Government spending. So, using a horizontal line over a letter to denote a variable as fixed (i.e. \bar{Y} instead of Y) I donate these as fixed numbers:
\bar{Y} = c(\bar{Y}–\bar{T}) + I(R) + \bar{G}
\bar{Y} – c(\bar{Y}–\bar{T}) – \bar{G} = I(R)
Income (Y) less what people consume (c(Y-T)) leaves the ‘private saving’ of all individuals. Likewise, Government Income (T) minus Government Spending (G) leaves Net Government savings (also Known as ‘public saving’). As the left-hand side of the above equation contains both private and public saving, we can say that it represents total savings. Substituting in S (savings) for the left-hand side of the equation we get:
\bar{S} = I(R)
Savings = Investment = Complete Nonsense
The important point is that this is a key building block of almost all major economic theories – and it is completely wrong. The idea that savings must equal investment is virtually an economic law in New Keynesian Economics, but I’ll list the key arguments against it:
- Not all saved money can be invested. Think about the cash stuffed away under your mattress, that can’t be invested in a business because you’ve not put it in a bank (where the bank might then lend it out to a business – at least according to New Keynesians)
- OK but most of your money is held at the bank, so the bank is probably loaning it out to customers for you, right? Well maybe, but in recent times (due to deregulation) banks invest far more of their money in financial markets (investing in complex financial instruments that focus on hedging risk – these transactions in no way ‘invest’ money in new capital). This sort of transaction wouldn’t be counted as ‘Investment’
- What about if you buy stocks as a way to save your money? We’ll that’s not investment either (as they are second-hand items, like buying a 50 year old house – it’s not new investment). When you buy a stock the company doesn’t raise any more money to invest in job creation (with the exception of IPOs)
- Finally – do banks need savings from their depositors to make loans? The answer is a definitive NO. That’s not how banking works and the fact that mainstream economics misses this is quite frankly disgraceful. If a bank wants to give you a loan it will do so, provided it can borrow the funds from the central bank at a lower rate of interest. The actual process of lending money to businesses for Investment is unrelated to the value of depositors’ savings that banks can actually access)
But Savings equals Investment is derived from the National Income Identity, so by definition it must be correct, what is going on here? Well, the algebra that derives the ‘proof’ conveniently assumes that National Income is fixed. This is clearly not true in reality, or else recessions would be impossible. When you remove this assumption you cannot ‘prove’ with algebra that savings equals investment
Predictions of New Keynesian Economics
But I’ve written this article to explain New Keynesian Economics in the long-run, so let’s assumes all the assumptions are actually right. So, what would happen if everyone started spending less and trying to save their money due to the fear of losing their job? According to the long-run theory of New Keynesian Economics there would be a big increase in the amount of savings, which would mean that the banks would want to loan it all out, but the demand for loans to make investments hasn’t changed. So, the banks lower the interest rate on loans, which would cause businesses to decide to make more Investments in plant and machinery.
This extra investment from businesses would perfectly offset all the lost consumption from the public deciding to spend less. This would also mean that everything produced gets bought, and so all the companies keep operating at 100% capacity and no one need worry about losing their job in the first place – if only they’d understood and fully believed the long-run theory of New Keynesian Economics in the first place!
Criticisms
There are clear and alarming flaws in the logic of New Keynesian Economics in the long-run. Briefly:
- The assumption that the economy is always at full capacity has no sound justification to back it up. To allow this assumption to hold true New Keynesian’s have created the empirically unsupported assumption that investment responds both strongly and instantly to small changes in the interest rate
- Investments response to the interest rate is assumed to be powerful and instant. This ignores the fact that businesses weigh up a huge number of uncertain factors when deciding to make a major capital investment, of which the interest rate is just one small factor. See this academic paper by S.P. Kothari, Jonathan Lewellen and Jerold Warner for an empirical study searching for correlation between numerous variables and Investment from 1952 to 2010. They do not find the interest rate to be predictive of Investment.