Critique of the new consensus macroeconomics and implications for india

AA Adjudicating Authority ABRR Asset–based Reserve Requirements ABS Asset-based Securities ABSPP Asset-based Securities Purchase Programme ACE Agent-based Computational Economics ADB Asi

India Studies in Business and Economics

Critique of the

New Consensus Macroeconomics and Implications for India

Dilip M Nachane

Foreword by Kaushik Basu

India Studies in Business and Economics

The Indian economy is considered to be one of the fastest growing economies of theworld with India amongst the most important G-20 economies Ever since theIndian economy made its presence felt on the global platform, the researchcommunity is now even more interested in studying and analyzing what India has tooffer This series aims to bring forth the latest studies and research about India fromthe areas of economics, business, and management science The titles featured inthis series will present rigorous empirical research, often accompanied by policyrecommendations, evoke and evaluate various aspects of the economy and thebusiness and management landscape in India, with a special focus on India’srelationship with the world in terms of business and trade.

More information about this series at http://www.springer.com/series/11234

Dilip M Nachane

Critique of the New

Consensus Macroeconomics and Implications for India

123

Dilip M Nachane

Indira Gandhi Institute of Development

Research

Mumbai, India

India Studies in Business and Economics

ISBN 978-81-322-3918-5 ISBN 978-81-322-3920-8 (eBook)

https://doi.org/10.1007/978-81-322-3920-8

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To the millions who lost their bread (in the global crisis) because of a handful who wanted more cake

Foreword: Dilip M Nachane ’s Macroeconomics

Dilip M Nachane’s new book on macroeconomic theory and policy is the kind ofbook that I would have loved to have had on hand, when I was Chief EconomicAdviser to the Government of India It is a remarkably comprehensive book thatstarts with a review of the main schools of macroeconomic thought, from Keynes’sGeneral Theoryto contemporary models of analysis, many of them inspired byactual policy challenges and crises, such as the globalfinancial crisis of 2008 Thebook closes with two chapters devoted exclusively to India, with a special focus onthefiscal and monetary policy concerns that India faced over the last decade Assuch, the book should be valuable to students of economics and to policymakers inIndia, with an interest in macroeconomic policy, wanting a refresher course.Macroeconomics as a discipline emerged with the groundbreaking work of JohnMaynard Keynes and his audacious effort to bring under one framework of analysisthe world of money andfinance, the world of goods and services, and the world oflabor and jobs The emergence of Keynesian macroeconomics coincided with thelast stages of the Great Depression, and subsequently became the go-to handbookfor countering recessions and crises But the world economy is a complex organismthat has continued to spring surprises in terms of new kinds of recessions that wouldnot respond to standard policy packages That led to the modifications of old ideasand impetus to look for new macroeconomic paradigms There were powerfulcriticisms of the Keynesian model by the Chicago school and, in particular, byMilton Friedman that led to the doctrine of monetarism as an alternative model.This book takes the reader through these various schools of thought, all the way

to the New Consensus Macroeconomics, which is presented and dissected at somelength, showing its strengths but also casting doubt on some of its features,including whether “consensus” is quite the right word for describing any kind ofmacroeconomics

But this is not a book on theory for the sake of theory Having presented some

of the main theoretical schools, the book ventures to discuss real-world problems

We learn at length how the subprime mortgage crisis emerged in the USA, became

a generalizedfinancial crisis, and then infected other markets and economies

vii

By 2009, the crisis had spread to emerging economies, including India Foreigninvestors nervous about the global economy, began withdrawing their money from

“distant” economies By September 2008, the Bombay Stock Exchange SensexIndex was plummeting From a level of 19325.7 in January 2008, it fell to 8995.5

by March 2009 Merchandise exports to advanced economies were beginning tostall, and by the end of 2009, GDP growth in India had sharply declined.Having been in the policy world at that time, I am acutely aware how the crisiswas part and parcel of our lives What made the job harder was that there was nogood paradigm to fall back on We had to use old-fashioned theory with a hand-some dose of common sense and gut feeling, to design policy and respond to thecrisis There will of course never be an exact textbook paradigm for most real-worldproblems; intuition and common sense will always play a role Nevertheless,Professor Nachane’s new book tries to make some amends for the current lacuna,

by blending our theoretical knowledge of macroeconomics with the actual rience in advanced and emerging economies Therein lies the strength of the book,and the reason why students of economics and practitioners of economic policy canbenefit from it

expe-Ithaca, USA

July 2018

Kaushik BasuCarl Marks ProfessorCornell University

The New Consensus Macroeconomics (NCM) which established itself in the 1980s

as the mainstream in macroeconomics essentially represents an “uneasy truce”between the then dominant new classical and real business cycle schools (associ-ated with Lucas, Sargent, Wallace, Kydland, Prescott, etc.) on the one hand and onthe other the nascent neo-Keynesian view (of Akerlof, Mankiw, Gordon, Phelps,Taylor, etc ) It combines features like Keynesian sticky prices and wages with thenew classical assumptions of rational expectations and efficient markets It alsoincorporates features from classical monetarism such as the natural rate hypothesisand a vertical Phillips curve Its econometric medium continued to be the dynamicstochastic general equilibrium (DSGE) models of the real business cycle school.NCM sets the tone for much of the macroeconomic (especially monetary) policyfollowed by the advanced economies in the period of the Great Moderation (1990–2005) Among the major policy recommendations of NCM, special mention may bemade of (i) inflation targeting, (ii) Taylor rule, (iii) non-intervention in asset markets(Jackson Hole consensus), (iv) light-touch regulation and (v) a strong belief in theability offinancial markets to regulate themselves (market discipline) So far as theemerging market economies (EMEs) are concerned, NCM (and especially its twinpillars—the rational expectations hypothesis (REH) and the efficient-markethypothesis (EMH)) supplied the intellectual basis for the successive waves offinancial liberalization undertaken by governments in these countries beginning inthe decade of the 1980s

The recent global crisis has posed a very serious challenge to the NCM Firstly,empirical models based on NCM failed to anticipate the occurrence of the crisis andlater its extent and severity Secondly, the solutions proposed within the NCMframework have met with limited success in the USA and actually compoundedproblems in the EU This has led to serious questioning of the NCM from fourmajor alternative schools, viz the post-Keynesian, the Austrian, the Minskyan andthe Marxist

ix

The above considerations constitute the underpinnings of the proposed book.The book addresses six major questions, viz.

(i) To what extent were the macropolicies based on the NCM responsible for thedevelopments leading up to the recent global crisis?

(ii) Has the NCM theoretical framework outlived its utility and is in need ofreplacement by a suitable alternative?

(iii) Do some of the other alternative theoretical frameworks provide more vincing explanations of the modern-day business cycles?

con-(iv) Is the current focus of regulation centred on capital requirements and marketdiscipline (Basel II to be succeeded by Basel III) appropriate?

(v) For the less-developed and emerging market economies, is financial alization (financial deregulation plus financial innovation) an unmixedblessing or is there a benchmark beyond which such liberalization can provedetrimental?

liber-(vi) What are the political economy considerations underlying the currentongoing process offinancialization in EMEs and is it in the long-term interest

of these nations?

Thefirst four chapters of the book outline the evolution of macroeconomics fromthe publication of the General Theory of Keynes in 1936 to the establishment of abroad consensus (the New Consensus Macroeconomics (NCM)) around themid-1980s Chapters 5 and 6 deal, respectively, with the origins of the global crisis

in the USA and its transmission to the other major regions of the world Chapters 7

to 10 analyse the four major alternative perspectives on the global crisis offered bythe Austrians, the Minskyans, the post-Keynesians and the Marxists Chapter 11attempts to provide a consolidated overview of the main theoretical post-crisiscritique of the NCM, while Chapter 12 is devoted to a discussion of the critique

of the policy mix followed in the period leading up to the global crisis Chapter 13analyses in a Lakatosian framework, the process by which the mainstream NCMhas countered this critique and largely stood its ground, making certain ad hocchanges while keeping the main edifice intact While the mainstream frameworkremains intact, the harsh lessons of the crisis have not been lost on the policy-makers The comity of nations have been unanimous in advocating a coordinatedapproach to deal with global instability issues—the main partners in such a coor-dinated approach being national regulators and international bodies such as IMF,WTO, BIS Chapter 14 deals with the modalities of the amendments needed to thenational and global financial architecture to facilitate the dialogue necessary toachieve a coordinated response to crises that have the potential of destabilizing theworld trade and investment order The last two chapters deal with the Indian case indetail Chapter 15 outlines the main contours of thefinancial sector as it has evolved

in India over the past three decades, and the special challenges posed for thefinancial regulators in a system that is being aggressively pushed towards dereg-ulation and liberalization by a market-oriented domestic corporate structure togetherwith the imperative of participation in the globalfinancial community Our analysis

leads us to a somewhat critical assessment of thefinancial sector policies followed

in India since the initiation of reforms in 1991 In particular, we feel that the roadmap carved out for India’s financial sector, by the two recent official reports (PercyMistry and Raghuram Rajan), presents several pitfalls In the concluding chapter,

we analyse these pitfalls and suggest safeguards which need to be in place for aproper dovetailing of thefinancial sector into the rest of the macroeconomy

I must record my appreciation of the excellent library and computer facilitiesprovided by IGIDR, which were of great assistance to me in the writing of thisbook My particular thanks to Dr Mahendra Dev, Director, IGIDR, for his unfailingenthusiasm and encouragement in the writing of this book IGIDR is an intellec-tually vibrant place, and discussions with colleagues like Drs Ashima Goyal,Naveen Srinivasan, Subrata and Jayati Sarkar, and Rajendra Vaidya have alwaysbeen fruitful My long-standing friend, Dr Vikas Chitre, encouraged me in thewriting of this book and read the drafts of some chapters, providing incisivecomments, which have benefitted me enormously Mahesh Mohan providedmuch-needed secretarial help, and my student, Aditi Chaubal, was a great help withthefigures and references To all of them, I extend my heartfelt thanks

It is indeed a felicitous happening for the book that a person of Dr KaushikBasu’s eminence agreed to write the Foreword No words can adequately convey

my profound gratitude to him for sparing so much valuable time for this task

I express similar sentiments towards Drs C Rangarajan, Y.V.Reddy, Kunal Sen, R.Barman, Vikas Chitre, Errol D’Souza and Tirthankar Roy Their good wishesconstitute a happy augury for the book’s fortunes

The book would never have been completed without the active assistance andencouragement of the entire Springer team led by Ms Sagarika Ghosh Hercountless gentle reminders, endless deadline extensions and continuous encour-agement kept the book on the right track Ms Nupoor Singh was of great help withher editorial guidance, and Ms Krati Srivastava did a splendid job with thesupervision and execution of the printing process

Finally, my wife, Prafulla, has always been a tower of strength for all myendeavours My daughters, Bhagyashree and Aparna, have energetically spurred

me on, under the (possibly mistaken) impression that I was doing something reallyworthwhile No words would suffice to thank them, as well as my sons-in-law andgrandchildren I only hope that this book does not disillusion them

What Do the Experts Say

“Prof Nachane has written an extremely thought provoking book on nomics It is a masterly analysis of the post Keynesian developments The coverage

Macroeco-is wide, almost encyclopedic He also traces meticulously the theoretical pinnings of the various policy measures introduced particularly after 2008 crisis.The jury is still out on what the‘optimum’ level of ‘financialization’ is A must-readbook for every serious student of economics.”

under-—C Rangarajan, Former Governor of Reserve Bank of Indiaand Former Chairman, Economic Advisory Council to the Prime Minister

“The book is a unique and unparalleled treatment of a complex subject by aneminent economist, which is a must read for academicians, policy makers andfinancial market participants It reflects the author’s acknowledged command overthe theory and practice of economic policies globally, and his decades ofinvolvement in research and policy in India in the areas of money andfinance Thebook should prove of immense contemporary value in India, where money andfinance are currently under stress.”

—Dr Y V Reddy, Former Governor, Reserve Bank of India

“Following the Global Financial Crisis of 2008, the basic tenets of mainstreammacroeconomics have been increasingly questioned Dilip Nachane’s authoritativebook provides an insightful survey of the debates in modern macroeconomics Thesweep of the book is remarkable, from Marxian and Austrian economics to the NewConsensus Macroeconomics The book is a must-read for all scholars and students

of economics.”

—Dr Kunal Sen, Professor of Development Economics, University

of Manchester, UK; and Director-Designate of UNU-WIDER

xiii

“Professor Dilip Nachane has achieved a unique feat He elucidates the emergenceand the content of the New Consensus Macroeconomics, the post-crisis critiques of

it from a spectrum of perspectives encompassing the Austrian, the Post-Keynesian,the Minskyan, and the Marxist, and the hard lessons learnt from the crisis by thepolicy makers Arguing the need for monetary andfinancial stability for economicgrowth and social welfare, he critically analyses the macroeconomic policies andthe institutional and political economy aspects of financial liberalization forachieving this purpose, in the context of India.”

—Prof Vikas Chitre, Former Director, Gokhale Institute of Politics and

Economics, Pune, India

“In Macroeconomics history has affected the evolution of economic thought which

in turn has had a feedback on the course of history itself as this timely book reveals.Keynes broke with the Classics but Friedman later brought Classical principles back

in Dilip Nachane’s insightful book provides a perspective on these intellectualdevelopments that were associated with the Great Moderation of business cycles andthe Great Financial Crisis It reviews this seemingly chaotic history, and criticallyexamines the political economy of policies around financial intermediation andstability and the regulation of thefinancial sector.”

—Prof Errol D’Souza, Director, IIM-A (Ahmedabad)

“This is a book by a leading economist which is a master piece on macroeconomics –tracing the evolution of different schools of thought and the rationale behind them It

is a work of great scholarship and is thought provoking, which will be very usefuleven for a non-specialist.”

—Dr R Barman, Chairman, National Statistical Commission,

Government of India

“Written with clarity and insight, this book by a leading macroeconomist of Indiaexplains the historical context in which a consensus emerged within modernmacroeconomic thought, and how that consensus changed history A fascinatingread, and a work of outstanding scholarship.”

—Prof Tirthankar Roy, Professor of Economic History,

London School of Economics

1 Keynesian Economics: Brief Overview 1

1 Introduction 1

2 Keynesian Economics 2

2.1 Main Constituents of the Keynesian Framework 2

3 The IS-LM Synthesis 9

3.1 Hicks’ IS-LM Synthesis 9

3.2 Keynes and the IS-LM Analysis 13

4 IS-LM Keynesianism 15

4.1 Real Balance Effect and Wage Flexibility 15

4.2 The Phillips Curve 18

4.3 Keynes and General Equilibrium 21

5 IS-LM Analysis for an Open Economy: Mundell–Fleming Model 22

5.1 The Basic Model 22

5.2 Monetary and Fiscal Policy Effectiveness Under Fixed Exchange Rates 25

5.3 Monetary and Fiscal Policy Effectiveness Under Flexible Exchange Rates 29

References 36

2 The Resurgence of Neoclassicism 39

1 Introduction 39

2 Monetarism: Main Tenets 40

2.1 Characteristics of Monetarism 40

3 Friedman’s “Modern” Quantity Theory of Money 41

3.1 Modern Quantity Theory 41

3.2 Supply of Money 43

4 The Phillip’s Curve and the Natural Rate Hypothesis 44

4.1 Expectations-Augmented Phillips Curve 45

4.2 Accelerationist Hypothesis and NAIRU 48

xv

5 A Monetary Policy Rule 49

6 Flexible Exchange Rates 53

7 Monetarism: Decline and Fall 56

References 57

3 New Classical Economics and Real Business Cycle Theory 61

1 Introduction 61

2 Four Basic Tenets of New Classical Theory 62

2.1 Micro-foundations 62

2.2 Complete Markets, Continuous Equilibrium and Gross Substitutability 63

2.3 Rational Expectations 64

2.4 Neutrality of Money 65

3 Main Policy Implications 65

3.1 Lucas Aggregate Supply Function and Equilibrium Business Cycle Theory 65

3.2 Anticipated Nominal Demand Shocks Do not Matter 67

3.3 Lucas Critique 69

3.4 Ineffectiveness of Feedback Policy Rules 70

3.5 Ricardian Equivalence 71

4 Real Business Cycles Theory 73

4.1 Basic Features 73

4.2 A Formal Model 75

4.3 An Evaluation 77

References 78

4 Towards a New Synthesis: New Consensus Macroeconomics 83

1 Introduction 83

2 Neo-Keynesian School: Role of Rigidities 84

2.1 Nominal Rigidities 84

2.2 Real Rigidities 89

3 Hysteresis and the Natural Rate of Unemployment 93

3.1 NRU Influenced by Cyclical Factors 93

3.2 A Role for Stabilization Policy 95

4 Multiple Equilibria and Coordination Failure 97

5 New Consensus Macroeconomics (NCM): Theoretical Aspects 97

5.1 Introduction 97

5.2 Main Features 98

6 Monetary Policy in the NCM 101

6.1 Inflation Targeting 101

6.2 Taylor Rule 102

6.3 Monetary Policy and Asset Prices 103

7 The Monetary Policy Framework of the NCM 103

8 Conclusion 104

References 105

5 Inception of the Global Crisis in the USA 109

1 Introduction 109

2 Long-Term Factors 110

2.1 The Great Moderation 110

2.2 Global Imbalances 112

3 Medium-Term Factors 118

3.1 Inappropriate Monetary Policies 118

3.2 Structural Flaws in the US Financial System 120

3.3 Lax Regulation of the US Financial Sector 126

3.4 Bursting of the US Real Estate Bubble and the Unfolding of the Crisis 128

4 US Policy Responses to the Crisis 130

4.1 Conventional Monetary Policy 130

4.2 Unconventional Monetary Policy 131

4.3 Fiscal Stimulus 134

References 137

6 Universalization of the US Financial Crisis 141

1 Contagion to the Rest of the World 141

2 Crisis Spreads to Europe 142

2.1 Crisis Transmission from the USA to EU 142

2.2 Euro Area Policies 143

2.3 Policies in the UK 152

3 The Crisis and Asia 155

3.1 China and the Global Crisis 155

3.2 India in the Global Crisis 160

3.3 Crisis and ASEAN 5 169

4 Crisis and the African Continent 171

5 Crisis and Latin America and The Caribbean 172

References 173

7 Austrian Business Cycle Theory and the GFC 177

1 Introduction 177

2 Haberler’s “Hydraulic” Version of the Austrian Theory 178

3 Criticisms of the“Hydraulic” Version 179

4 The Austrian Theory: A Restatement 180

5 The Austrian View of the GFC 182

6 Policy Recommendations 184

6.1 Monetary Policy 184

6.2 Productive Macroprudential Regulation 185

6.3 Real Sector Recommendations 188

7 Conclusion 188

References 188

8 The Crisis: A Minsky Moment? 193

1 Introduction 193

2 Minsky’s Theory of Investment 194

3 Financial Instability Hypothesis (FIH) 195

4 Disruption by a“Not Unusual” Event 196

5 Debt Deflation 196

6 Floors and Ceilings 197

7 Global Crisis: Collapse of“Money Manager” Capitalism? 198

7.1 Background 198

7.2 “Money Manager” Capitalism 199

7.3 Triggers for the Crisis 202

References 203

9 The Global Crisis According to Post-Keynesians 205

1 Introduction 205

2 Post-Keynesian Perspective on the Crisis 206

3 FIH Applied to Households 206

4 Financial Fragility in the Global Context 207

5 Herd Behaviour of Investors 210

6 Endogeneity of Money 211

7 Income Inequality and the Crisis 213

8 Godley’s Seven Unsustainable Processes 215

9 Conclusion 216

References 216

10 Marxian Perspective on the Global Crisis:“Povorot” or“Perelom”? 221

1 Marxian Crisis Theory 221

2 Stable Capitalism Phase in the USA (1890–1970) 224

2.1 Real Wage Trends (up to the Late 1970s) 224

2.2 Stabilization Strategies of Capitalism 224

3 Marxism and the Current Crisis in the USA 226

3.1 Reversal of Real Wage Trends (Post-1970s) and the Eruption of the Current Crisis 226

3.2 Weakening of Stabilization Factors 227

4 Marxian Solutions to the Crisis 228

References 230

11 The Post-crisis Critique of the NCM: Theoretical Aspects 233

1 Introduction 233

2 Representative Agent Equilibrium Models and Reductionism 234

3 Rational Expectations 236

4 Transversality Condition 237

5 Nature of Uncertainty 238

6 Complete and Efficient Markets 239

7 RBC and DSGE Models 242

References 247

12 NCM Critique: Policy Implications 255

1 Introduction 255

2 Rethinking Monetary Policy in the Wake of the Crisis 256

2.1 “Slipping Transmission Belt” Syndrome 257

2.2 Inflation Targeting, Asset Prices and Monetary Policy 260

2.3 Monetary Policy and Asset Prices—The Jackson Hole Consensus 262

3 Redefining the Role of Fiscal Policy 264

4 Regulatory and Supervisory Policy 266

5 Limitations of DSGE Models for Policy 267

References 270

13 Post-crisis NCM Theory Adaptations: Evolutionary, Revolutionary or Cosmetic? 277

1 Introduction 277

2 Methodological Considerations 278

3 Mainstream Reactions to the Crisis 281

3.1 The Loyalist’ Stand 282

3.2 The Position of the Moderates 285

3.3 The Insider Critics 287

4 The NCM Controversy in a Lakatosian Framework 290

4.1 The Lakatosian Framework 290

4.2 The NCM and the Post-crisis Critique 293

5 Perpetuation of the NCM Paradigm 297

References 300

14 Revisiting Domestic and Global Macroeconomic Policy in the Aftermath of the Global Crisis 305

1 Introduction 305

2 Role of National Policy-Making Bodies: Post-crisis Perspectives 306

3 Central Bank Jurisdiction: Rethinking Monetary Policy 309

3.1 Asset Prices and Financial Fragility—the Jackson Hole Consensus (JHC) 309

3.2 IT and Nominal Exchange Rate 312

3.3 IT and Fiscal Dominance 313

4 Financial Regulatory & Supervisory Authority Jurisdiction 313

4.1 From Micro-prudential to Macroprudential Regulation 313

4.2 Strengthening and Expanding the Scope of Regulation and Supervision 315

4.3 Reinforcing Prudential Standards 316

4.4 Devising Market Incentives for Prudent Behaviour 318

4.5 Early Warning and Prompt Corrective Action System (EWPCAS) 321

4.6 Reducing Costs of Financial Failures 323

5 Measures Under Government Jurisdiction 326

5.1 Revisiting Full Capital Account Convertibility 326

6 Role of the IMF and Proposed Reforms 329

7 International Advisory Groups 332

7.1 G20 and Its Role 332

7.2 Financial Stability Forum (FSF)/Board 334

8 International Financial Standard-Setting Bodies 335

8.1 The Bank for International Settlements (BIS) 335

8.2 International Organization of Securities Commissions (IOSCO) 339

9 Conclusion 341

References 342

15 Sustaining Growth with Monetary and Financial Stability in India: An Appraisal 355

1 Introduction 355

2 Monetary Policy 356

2.1 Brief History 356

2.2 Urjit Patel Committee (2014) 358

2.3 Alternatives to Inflation Targeting 359

3 Fiscal Policy 362

4 Financial Regulatory and Supervisory Policy 369

4.1 Introduction 369

4.2 Special Regulatory Authority 369

4.3 Coordination Among Regulators 370

4.4 Strengthening and Expanding the Scope of R and S to the Shadow Banking Sector 371

4.5 Reinforcing Prudential Standards for Financial Institutions 374

4.6 Market Incentives for Prudent Behaviour/Market Discipline 379

4.7 Reducing Cost of Financial Failures 381

4.8 Emphasis on Macroprudential Regulation 386

References 388

16 By Way of Conclusion: Selected Issues in Designing a New Architecture for the Indian Financial Sector 393

1 Introduction 393

2 HPEC and CFSR Reports: A Critical Appraisal 394

2.1 General Features 394

2.2 Principles-Based Versus Rules-Based Regulation 396

2.3 Integration of Financial Trading Regulation and Supervision 397

3 Financial Sector Legislative Reforms Commission (FSLRC) 399

4 Regulatory and Supervisory Independence: A Neglected Issue 401

5 Conclusions 404

References 405

AA Adjudicating Authority

ABRR Asset–based Reserve Requirements

ABS Asset-based Securities

ABSPP Asset-based Securities Purchase Programme

ACE Agent-based Computational Economics

ADB Asian Development Bank

ADR American Depository Receipts

AIF Alternative Investment Funds

AIPAC Alternative Investment Policy Advisory Committee

AMEs Advanced eCompanies

HPEC High-Powered Expert Committee (Percy Mistry Committee)IAIS International Association of Insurance Supervisors

IBBI Insolvency and Bankruptcy Board of India

IBC Insolvency and Bankruptcy Code

ICA Inter-Creditor Agreement

ICAI Institute of Chartered Accountants of India

IEC Independent Evaluation Committee

IFRS International Financial Reporting Standards

IIFC India Infrastructure Finance Company

ILO International Labour Organization

IMF International Monetary Fund

INR Indian rupee

IOSCO International Organization of Securities Commissions

IPA Insolvency Professional Agency

IRDAI Insurance Regulatory & Development Authority of IndiaIRF-FC Inter-regulatory Forum for Monitoring Financial ConglomeratesIR-TG Inter-regulatory Technical Group

IRS Interest Rate Swaps

IT Inflation Targeting

IUs Information Utilities

xxiii

JHC Jackson Hole Consensus

JLF Joint Lenders’ Forum

LBRR Liability Based Reserve Requirements

LCR Liquidity Coverage Ratio

LDC Less Developed Country

LR Leverage Ratio

LTV Loan to Value Ratio

MAP Mutual Assessment Process

MBS Mortgage Based Security

MEC Marginal Efficiency of Capital

MFMG Macro-Financial Monitoring Group

MIS Management Information Systems

MMMF Money Market Mutual Fund

MNREGA Mahatma Gandhi National Rural Employment Guarantee ActMPC Monetary Policy Committee

MRO Main Refinancing Operations

MTM Mark to Market

MURI Minimum Unemployment Rate of Inflation

NABARD National Bank for Agriculture and Rural Development

NAIRU Non-Accelerating Inflation Rate of Unemployment

NASDAQ National Association of Securities Dealers’ Automated QuotationNBFC Non-Bank Financial Company

NCEUS National Commission for Enterprises in the Unorganized SectorNCLT National Company Law Tribunal

NCM New Consensus macroeconomics

NFE Non-financial Entities

NGO Non-Governmental Organization

NHB National Housing Bank

NINA No Income, No Assets

NIVA No Income, Verified Assets

NPA Non-Performing Asset

NRH Natural Rate Hypothesis

NRI Non-Resident Indian

NSE National Stock Exchange (India)

NSI-D-NBFC Non-Systematically Important Deposit Accepting Non-Bank

Financial CompaniesOICV Organisation Internationale des Commissions de ValeursOLA Orderly Liquidation Authority

OLIR Optimum Long-run Inflation Rate

OTC-D Over-the-Counter Derivatives

PCA Prompt Corrective Action

PDCF Primary Dealer Credit Facility

PDMA Public Debt Management Agency

PFRDA Pension Fund Regulatory & Development Authority

PPM Private Placement Memorandum

PPP Purchasing Power Parity

QE Quantitative Easing

R&S Regulation & Supervision

RBI Reserve Bank of India

RBP Risk-based Premium

RD Revenue Deficit

REER Real Effective Exchange Rate

REH/RET Rational Expectations Hypothesis/Theory

RWA Risk-Weighted Assets

SARFAESI Securitisation and Reconstruction of Financial Assets and

Enforcement of Securities Interest ActSAT Securities Appellate Tribunal

SDR Special Drawing Rights

SEBI Securities and Exchange Board of India

SEC Securities Exchange Commission

SGP Stability & Growth Pact

SIDBI Small Industries Development Bank of India

SI-D-NBFC Systematically Important Deposit Accepting Non-Bank Financial

CompaniesSIFI Systematically Important Financial Institutions

SIV Special Investment Vehicles

SIVA Stated Income, Verified Assets

SLR Statutory Liquidity Ratio

SMA Special Mention Accounts

SMP Securities Market Programme

SPE Special Purpose Entity

SPV Special Purpose Vehicles

SRM Single Resolution Mechanism

SRP Scientific Research Programme

TLAC Total Loss Absorbing Capacity

TSLF Term Securities Lending Facility

TW-SB Trip Wires & Speed Bumps

ULIP U/nit Linked Insurance Plan

UNCTAD United Nations Conference on Trade and Development

UNDP United Nations Development Programme

UPC Urjit Patel Committee

URR Unremunerated Reserve Requirements

VaR Value-at-Risk

VAR Vector Auto-regression

VLTRO Very Long-term Refinancing Operations

VM Variation Margin

WARP (Wald’s) Weak Axiom of Revealed Preference

WMA Ways & Means Advances

WTO World Trade Organization

ZLB Zero Lower Bound

About the Author

Dilip M Nachane is currently Chancellor, University of Manipur, Imphal, India;Professor Emeritus, Indira Gandhi Institute of Development Research (IGIDR),Mumbai, India; National Fellow, Indian Council of Social Science Research(ICSSR); Honorary Fellow, Institute of South Asian Studies (ISAS), NationalUniversity of Singapore; and Honorary Fellow, Indian School of PoliticalEconomy, Pune, India He has earlier served as Director, Department of Economics,University of Mumbai (1993–1999); Vice Chancellor, IGIDR (2007–2010);Visiting Professor, University of British Columbia, Vancouver, Canada (1988–1989); Visiting Professor, University of Ulster, UK (1991–1992); HallsworthFellow, University of Manchester, UK (1987–1988); and Fulbright Fellow,University of Texas, Austin, USA (1982–1983) He has served on several officialcommittees such as Technical Advisory Committee on Monetary Policy, ReserveBank of India (2005–2011), and Member, Vijay Kelkar Committee on RegionalImbalances in Maharashtra (Government of Maharashtra, 2011 onwards) He waselected President of the Indian Econometric Society (TIES) (2002–2003) He hasbeen continuously listed in Marquis’ International Who’s Who for the last 15 years.For his outstanding contributions to research and teaching of economics in India, hereceived the UGC Pranavananda Saraswati Award for Best Teacher in Economics,

2004 He has published the following book with the Oxford University Press,

“India Econometrics: Theoretical Foundations’ and ‘Empirical Perspectives” Hehas also edited/coedited seven volumes including the“India Development Report

2011” He is currently Editor-in-Chief of the Journal of Quantitative Economics(Springer), and Coeditor of Macroeconomics and Finance in Emerging MarketEconomies (Taylor and Francis)

xxvii

Chapter 1

Keynesian Economics: Brief Overview

Abstract Writing against the background of the Great Depression of the 1930s,Keynes was trying to develop a theoretical understanding of why unemploymentcould be persistent in a capitalist economy The received theory at that time (whichKeynes dubbed as classical but which today is usually termed as neoclassical)attributed this hysteresis in unemployment to the downward rigidity of nominalwages due to“money illusion” on the part of workers We begin this introductorychapter with a brief overview of the economics of Keynes’ General Theory anddiscuss various attempts at its formalization and synthesis with the earlier neo-classical economics, embodied in the IS-LM framework We then introduce thePhillips curve and its incorporation into Keynesian analysis In thefinal section, weintroduce open economy considerations into the IS-LM framework

In his Presidential Address to the Eastern Economic Association on the occasion ofthe 50th anniversary of the publication of Keynes’ General Theory of Employment,Interest and Money (henceforth GT for short), Solow (1986) describes it as “themost influential work of economics of the 20th century” Many economists wouldperhapsfind the title of Klein’s book The Keynesian Revolution a bit overenthu-siastic and Diebold’s statement (see Adams 1992, p 31) that “before Keynes andKlein there really was no macroeconomics” highly exaggerated Yet, Keynes GT iswidely regarded by most writers as the logical starting point for any narrative onmacroeconomics Perhaps, there is no greater compliment to an individual than onecoming from his severest critics And in Keynes’s case, it came from Pigou, when

in the course of his Marshall Lecture (1952–53) he admitted “Nobody before him(Keynes), so far as I know, had brought all the relevant factors, real and monetary atonce, together in a single formal scheme, through which their interplay could becoherently investigated”

We begin this introductory chapter with a brief overview of the economics ofKeynes’ GT and discuss various attempts at its formalization and synthesis with the

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D M Nachane, Critique of the New Consensus Macroeconomics

and Implications for India, India Studies in Business and Economics,

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1

earlier neoclassical economics, embodied in the IS-LM framework We thenintroduce the Phillips curve and its incorporation into Keynesian analysis In thefinal section, we introduce open economy considerations into the IS-LMframework.

Writing against the background of the Great Depression of the 1930s, Keynes wastrying to develop a theoretical understanding of why unemployment could bepersistent in a capitalist economy The received theory at that time (which Keynesdubbed as classical but which today is usually termed as neoclassical) attributedthis hysteresis in unemployment to the downward rigidity of nominal wages due to

“money illusion” on the part of workers With nominal wages rigid downwards, thefall in prices due to industrial recession led to a rise in real wages, and a contraction

in employment While this view was held by a majority of economists writing onthe issue at that time, as its archetypical representative Keynes selected Pigou(1927,1933), in whose writings the view finds its most systematic articulation

This section is devoted to a discussion (somewhat brief, since most readers would

be reasonably familiar with the contents) of the basic Keynesian analysis in theGeneral Theory

Aggregate Demand and Supply : The starting point of Keynesian analysis is theconcept of aggregate demand and supply Whereas aggregate demand refers to thetotal planned expenditure in an economy, aggregate supply refers to the totalplanned production The economy is in equilibrium when aggregate demand andsupply are equal

Let us now examine the components of aggregate demand YD These are,respectively, (i) domestic private consumption C, (ii) domestic private investment I,(iii) government expenditure G (including both consumption and investment goods)net of taxes T, (iv) exports of consumption and investment goods X and (v) imports

of consumption and investment goods M Thus, we can write

YD¼ C þ I þ G  Tð Þ þ X  Mð Þ ð1Þ

If YS denotes aggregate supply, then the equilibrium condition is

YS¼ YD¼ Y ¼ C þ I þ G  Tð Þ þ X  Mð Þ ð2Þwhere we denote the equilibrium output as Y (2) is the famous Keynesian nationalincome identity

A traditional way of introducing the Keynesian theory of unemployment is viathe concepts of aggregate demand and supply curves We note the very obvious factthat as total employment in the economy increases, output also increases This may

be denoted by the relation

We know from (1) that the aggregate demand is made up of four components,viz C, I, (G− T) and (X − M) Let us see how each of these is affected by a fall inthe aggregate price level First of all we note that the component of governmentexpenditure and taxes is unaffected by the price level The fall in the aggregate pricelevel increases the real value of the money balances held by households A part ofthis additional purchasing power is spent on consumption, but a part is also invested

infinancial assets Thus, C increases but additionally, the rate of interest is reduced,thereby stimulating investment Thus, both C and I increase Finally, the fall in theprice level makes exports cheaper so that X increases; simultaneously, becausedomestic goods are now cheaper relative to imports, there is a decrease in imports

M Thus, a lower aggregate price level P corresponds to a higher level of aggregatedemand Y Hence, the aggregate demand curve AD is downward sloping.Let us now turn to the supply side The Keynesian aggregate supply(AS) essentially consists of three stretches—a flat stretch (corresponding to arecessionary phase), an upward sloping middle stretch and a vertical slopingfinalstretch corresponding to full employment of resources In a recession, it may bereasonable to assume that employment of labour can be increased without raisingwage costs, since a pool of unemployed labour is available Similarly, the use ofother resources which are lying idle can be activated without increases in rentals.Thus, output can be increased without raising average costs Hence, the AS curve ishorizontal over an initial stretch (up to the output level Y1 in Fig.1) However asthe economy recovers, and the availability of unemployed resources dries up, wagesand other rentals start rising Further with more intensive use of resources,diminishing returns may set in Thus over the employment levels Y1to Yfin Fig.1,

the AS curve is upward sloping The output level Yf corresponds to the fullemployment level, beyond which no further expansion in output is possible.The AS curve then becomes vertical The middle upward stretch of the AS curve issometimes referred to as the short-run AS (SRAS) curve, while the vertical stretch

is referred to as the long-run AS (LRAS) curve

The point of intersection of the AD and AS curves represents an equilibrium forthe economy, and the corresponding level of output (Yein Fig.1) is referred to asthe level of effective demand

For a detailed discussion of these concepts, refer to (Bade and Parkin 2011;Schiller and Gebhardt 2016; D’Souza 2008, etc.) The Appendix to the chapteroffers a related but distinct approach to the problem, which has the advantage ofoffering a bridge between Keynes’ Treatise and the General Theory

The Multiplier : The origin of the concept of the employment multiplier is widelyattributed to Kahn (1931), who argued that any investment increases “direct”employment in the investment goods sector, and as the wages and profits generated

in this sector are spent on consumption goods, there will be secondary effects onemployment The effects are passed on successively, but with diminishing intensity,until they become negligible In sum, the total employment generated will be amultiple of the original direct employment, the multiplier depending on theemployment intensity of the investment and consumption goods sector Keynestook up this idea and applied it to investment outlays (rather than employment) (seeMarcuzzo2002)

Basic to the Keynesian multiplier is the idea of a consumption function, whichrelates consumption (C) to income Y In the exposition, for the sake of simplicity,

we take the consumption function to be linear

where a and c are constant parameters c is termed as the marginal propensity toconsume (it is the addition to consumption due to a unit rise in income) and c 1;since people usually consume only a portion of any increment in income

LRAS P

Fig 1 Aggregate demand and supply

If investment I now increases by a quantityDI, by the national income identity(2), the direct increase in income DY is simply DI This leads to an increase inconsumption ofðcDIÞ in the first round, c2DI in the second round and so on ad

infinitum The total increase in income is thus

Interestingly, the idea of an expenditure multiplier seems to have been firstenunciated by Hawtrey in January 1931 in a working paper (No 66) for theMacmillan Committee (see Davis1981, pp 216–217)

Marginal Efficiency of Capital : The view about investment held by the classical school prior to the General Theory was thatfirms invested in machinery tothe point where the marginal productivity of capital was equal to its rental (proxied

neo-by the rate of interest) The marginal productivity of capital was assumed to be astable and declining function of the level of capital Keynes recognized that in amodern capitalist economy, expectations (about returns) played a key role indetermining the level of investment, and these expectations were subject to moodswings of exuberance and pessimism Hence, investment was inherently volatileand uncertain Further, this uncertainty was pure uncertainty of the Knightianvariety, which cannot be captured in well-defined probability distributions overoutcomes (statisticians refer to this as non-ergodic uncertainty) To allow for thecrucial role of expectations in determining investment, Keynes introduced theconcept of the marginal efficiency of capital

Let a machine whose supply price2is Q, yield prospective (expected) returns tothe entrepreneur of R1; R2 .Rn over its expected lifetime of n years Further, itsscrap value at the end of its life is supposed to be S Then the marginal efficiency ofcapital is that rate of discount q, at which the net present value (left-hand side of (6)below) of the machine equals its supply price Q, i.e

(see Keynes1936; Tsoulfidis2008; Fuller 2014, etc.)

1 The left-hand side of ( 5 ) is a convergent geometric series (if c is strictly less than 1) with the sum shown on the right-hand side.

2 To Keynes, the supply price of a piece of machinery is the amount which would just induce a producer of that machine to engage in its production It is to be distinguished from the market price Following the convention of later writers, we do not pursue this distinction here.

Keynes now considers an entrepreneur contemplating the number of machines of

a particular type to buy If q1; q2 .qk are the marginal efficiencies of successiveunits, then there is a good case for assuming that these decline with each additionalunit obtained, i.e q1 q2    qk This according to Keynes results from the factthat with each fresh unit of a particular type of machine produced, its expected yielddeclines and the cost of producing it (supply price) increases (see Keynes 1970

[1936], p 136) If we draw a diagram showing the marginal efficiencies sponding to successive units of machinery, then such a curve would be downwardsloping The entrepreneur would carry on purchasing machinery as long as he canborrow funds in the market at a rate lower than the marginal efficiency of capital,i.e till the point of intersection between the marginal efficiency of capital scheduleand the horizontal line indicating the long-term interest rate (point K* in Fig.2).Thus in Keynes’ General Theory, the quantum of investment depends on theinterest rate as with the neoclassicals But whereas for the latter the investmentschedule is a stable function of the interest rate, in Keynes, the schedule is highlyvolatile, depending on expected returns, which could swing violently and unpre-dictably with the moods of the market This unpredictable volatility is at the heart ofKeynes’ theory, an insight often lost in the later attempts to formalize the Keynesiananalysis (see Sect.3)

corre-Liquidity Preference Theory : The third pillar of Keynesian economics is theliquidity preference theory Keynes view of the rate of interest differed funda-mentally from that of the earlier neoclassicals The rate of interest is not (according

to Keynes) the price which equilibrates the demand for investment funds with thesupply of savings (as the neoclassicals supposed) Instead, in the Keynesian liq-uidity preference theory, the interest rate is the reward demanded by economicagents to relinquish their control over liquidity

Keynes distinguished between three motives for holding money, viz thetransactions, precautionary and speculative motives (see Keynes 1970 [1936],

p 170) Thefirst two motives are a predictable function of income, and Keynes didnot focus much on them The speculative motive is what Keynes concentrated on,

Fig 2 Marginal ef ficiency of capital (MEC) schedule

as in his view, that was unpredictable and played a key role in determining marketinterest rates Assuming that people have only two choices of the medium in which

to hold their funds, viz money (liquid but earning no return) and infinite durationbonds (consols) (which are not fully liquid but which earn some interest given bythe coupon rate).3The market rate of interest rin the General Theory is determined

by the demand for liquidity (money was defined in Keynes’ time, usually, as cashplus bank current account deposits)—the so-called liquidity preference schedule—and thefixed supply of money Minjected in the economy by the central bank (see

Fig.3) The liquidity preference schedule plots the amount of money demanded(for speculative purposes versus the rate of interest) It is downward sloping (as thereward for parting with money decreases, people desire to hold more of it), and itflattens out towards the right (see Fig.3) This latter tendency is dubbed as theliquidity trap and occurs because of two factors: (i) at very low rates of interest,there is always the expectation that the interest rate may rise, and (ii) a small rise inthe interest rate imposes huge losses on bondholders when the interest rate is verylow.4

Some important criticisms of the liquidity preference theory may be found inAppelt (2016), Panico (1988), Bibow (2005), etc

Money Wages and Unemployment : The neoclassical theory, by subscribing toSay’s law, saw full employment as the automatic consequence of the working ofmarket forces in an environment characterized by fullyflexible wages and prices.Many neoclassical writers (see, e.g Pigou1950) were careful to emphasize that fullemployment may not always exist, but tends to be established The short-term/disequilibrium departures from unemployment could arise because of downwardwage inflexibility in the short run, but in the long run, there are strong forces thatimpel real wages to fall in the face of unemployment This fall in real wages wouldautomatically restore the demand for labour by employers and increaseemployment

Keynes’ contention regarding the relationship between wages and ment is quite complicated He has actually two theories about this Firstly, inChap.2 of the General Theory, he notes his point of agreement with the neoclas-sical position“…an increase in employment can only occur to the accompaniment

unemploy-of a decline in the rate unemploy-of real wages” (Keynes1970[1936], p 17) But he disputes

on pragmatic grounds, the neoclassical postulate that in practice workers and

3 It is a straightforward matter to generalize Keynes ’ analysis to the multi-assets case with differing degrees of liquidity and returns streams (see, e.g Patinkin 1956 ; Tobin 1958 ).

4 Consider 2 situations First, suppose a person holds a bond whose face value is 100 and the coupon rate is 5% If the current market rate of interest is also 5%, then the market price of the bond is also 100 Suppose the market rate of interest rises by 25 basis points (0.25%) to 5.25%, the price of the bond will fall to 95.23 (since now only this amount of investment is needed to get a return of 5) Next, suppose on the other hand the initial market rate of interest had been 1%, the price of the same bond would have been 500 Now if the rate of interest rate rises to 1.25%, the price of the bond would drop to 400 Thus whereas in the first situation the loss to the bondholder

is about 4.75% of the initial price, in the second situation the loss on the initial price is 20%.

employers can bring real wages down through a process of mutual bargaining ofmoney wages He is thus attributing the long-term unemployment associated with along depression to money wage rigidity The money wage rigidity could beattributed to“money illusion” of workers in general, who are reluctant to let wagesdecline in money terms, even if this leads to lesser unemployment But there is anadditional factor in the picture—workers in any specific industry are also keen toprotect their wages relative to those of workers in other sectors Thus, a generalwage reduction cannot be achieved via bargaining between unions and manage-ment, sector by sector The only possibility is a general wage reduction by gov-ernment fiat, which in a capitalist democracy would involve a considerableinfringement of individual rights Much of the later literature in the neo-Keynesiantradition (discussed in the Chap.4) is aimed at providing theoretical explanations ofwhy real wages may be rigid in actual economies.5

But if this were all to the Keynesian theory, it would have hardly been the basisfor an intellectual revolution The second, more substantive theory, elaborated inChap 19 of the General Theory goes on to develop the argument that even if moneywages wereflexible, the required fall in real wages (to raise employment) may notnecessarily occur In the Keynesian theory, any fall in the general level of moneywages would bring about a rise in employment, if the following three possibilitiesapplied in conjunction If, however, not all of them were applicable, the outcomewould depend on the relative strengths of the possibilities which held true and thosewhich did not The three possibilities considered were a fall in the money wagesleading to (i) a rise in the marginal propensity to consume, (ii) a fall in the long-terminterest rate and (iii) a rise in the marginal efficiency of capital Keynes (1970)[1936] in Chap 19 considers all three possibilities in detail

Fig 3 Liquidity preference schedule

5 An early writer who attempted to provide justi fication for this fact is Smith ( 1956 ) whom Darity and Young (rightly) regard as foreshadowing the neo-Keynesians.

Because a fall in money wages may not lead to an equivalent fall in prices,income distribution shares would shift in favour of profits and away from wages.Since the rich entrepreneurs would tend to save more than the poorer workers, themarginal propensity to consume is most likely to fall.

Since a fall in money wages would lead to lower mass purchasing power,business expectations of future sales from their product would contract, loweringthe marginal efficiency of capital for all items of mass consumption

Finally, while a contraction of incomes would lower the transactions and cautionary demand for money, thereby making more money available to satisfy thespeculative motive, this would only lower the rate of interest if the economy wasnot operating on the horizontal section of the liquidity preference schedule; i.e theeconomy was not already at a very low rate of interest But even if the market rate

pre-of interest were above the liquidity trap, the lowering pre-of money wages would create

a situation of social unrest in which people’s desire for liquidity would rise; i.e theliquidity preference schedule would shift outwards (from LL1to LL2 Fig.3) With

a given level of money supply, this would set up a tendency to raise the rate ofinterest Of course, if the money supply were increased, then the rate of interestcould still fall But then the following question arises—if a fall in the interest ratecould be engineered both by a fall in money wages or by an increase in moneysupply, why not choose the latter method which is much easier to implementpolitically and can be done almost with a stroke of the pen? A general money wagereduction across all sectors by contrast (as we have seen above) is almost infeasible

in a modern democracy, where each sector might be dominated by a distinct union

Immediately following the publication of the General Theory, a number of youngereconomists tried to formalize the underlying analysis in mathematical terms (seeDarity and Young1995for a detailed critical appraisal of these early efforts) Themost famous of this is, of course, the IS-LM formalization of Hicks (1937), butthere were several other somewhat less famous, but equally insightful, formaliza-tions by Champernowne (1936), Lerner (1936), Meade (1937), Harrod (1937),Modigliani (1944), Hansen (1953), Lindahl (1954), etc We confine our attention tothe Hicksian analysis, which we discuss in some detail The discussion in the nextfew sections is restricted to the context of a closed economy, i.e one which does notengage in foreign trade

Hicks’ (1937) paper is significant for three reasons Firstly (as mentioned above), itattempted to present a formalization of the largely verbal reasoning in the General

Theory; secondly, it showed that both the neoclassical and the Keynesian systemswere really particular characterizations of a more general meta-model; andfinally,this meta-analysis could be encapsulated in simple diagrammatic terms.

For his meta-analysis, Hicks considers a two-sector model—a consumer goodssector whose physical output we denote by Cþ and an investment goods sector

with physical output Iþ: It is assumed that both sectors are composed of a largenumber of perfectly competitive firms Let NCand NI denote the aggregateemployment in the two sectors and because capital stock in the two sectors isassumed by Hicks to befixed in the short run (in keeping with the General Theoryformulation), the output in each sector depends only on the employment of labour

in that sector If the aggregate technical production functions in the two sectors aredenoted by fCand fI, we get the following relation

where N is the total employment in the economy

To begin with, Hicks assumes that the money wage rate isfixed at x ¼ x

If PCand PI denote the price of consumption and investment goods, tively, then because of the assumption of perfect competition in both sectors, pricewill equal the marginal cost, i.e

Y ¼ C þ I þ G  Tð Þ ð13ÞHicks assumes that consumption depends on both income (Y) and rate of interest

r If we denote the savings in the economy by S, then

S¼ s r; Yð Þ ð14ÞInvestment is assumed to depend on the market rate of interest Thus

The Hicksian meta-model (7)–(19) embeds both the Keynesian and the classical model as special cases The neoclassical model involves replacing (14) and(16) by

In the neoclassical system, the investment function (15) is assumed to be alargely stable relation, whereas in the Keynesian system, it is highly volatile andunpredictable Similarly, in (16), the speculative component of the demand formoney introduces a strong element of uncertainty

The immense popularity of the Hicksian analysis owes much to the geometricdevice that Hicks used in order to present his meta-model Using a two-dimensionalgraph, with income (Y) plotted on the x-axis and the rate of interest (r) on the y-axis,

he derives two curves The first of these curves (which we call the IS curve)represents the goods market equilibrium, obtained by solving (14), (15) and (18).For a given level of r, say r0, from (15) we get the corresponding investment level

I0 For equilibrium in the goods market, (18) must hold and equating the right-handside of (14) to I0 we get the level of income Y0 consistent with I0 and r0 Thus foreach level of r, we get a corresponding value of Y and the resultant plot is called the

IS curve This curve is downward sloping and moves to the right if G is increased or

T is decreased.6The second curve is drawn to represent the money market librium and is obtained by equating the demand for money (16) to the given moneysupply M (17) It thus shows all combinations of r and Y at which the demand formoney equals a given level of money supply and is thus a curve, each point ofwhich represents money market equilibrium This curve (referred to as LM) isupward sloping and depends on the level of real money supply As real moneysupply increases, the LM curve shifts outwards.7If a liquidity trap exists (say at rl),then the LM curve is almostflat for a stretch at rl(for even if the level of income islow, and the transactions demand for money is correspondingly low too, all thisadditional money will be absorbed once the rate of interest hits the lower bound rl).Similarly, the LM curve is likely to be vertical to the right—if incomes rise so high(full employment level) that the transactions demand for money absorbs virtually allthe money supply, very little will be available to satisfy the speculative motive andinterest rates will shoot up sharply (in practice, no monetary authority will stand bypassively and watch this happen, but intervene and increase the money supply).The economy is in overall equilibrium at the point (Y*, r*) where the IS-LMcurves intersect (see Fig.4) In this diagrammatic representation, afiscal stimuluscorresponds to an increase in G by the government through public investment, or adecrease in T through tax cuts, and shifts the IS curve to the right A relaxation ofmonetary policy (an increase in real money supply) corresponds to an outward shift

7 That the LM curve slopes upwards can be seen as follows As Y rises, more of the money supply will be diverted to the transactions motive and less will be available to satisfy the speculative motive People will hold less money only if the rate of interest is higher By a similar argument, a rise in money supply means that at the same level of income, more will be available to satisfy the speculative motive leading to a fall in the rate of interest Thus, the LM curve will shift outwards.

shift) By contrast, a shift in the IS curve leaves income more or less unchanged (theinsignificant shift from Y0to the new equilibrium Y1in Fig.5a) while producing asharp change in the rate of interest The vertical stretch of the LM curve thuscorresponds to the classical near full employment case.

If, by contrast, the economy is on the horizontal stretch of the LM curve (seeFig.5b) with interest rate at its floor level, and high unemployment with outputmuch below capacity (i.e a depression), an increase in money supply (an outwardshift in the LM curve) fails to affect either the output or the rate of interest

A change in the IS curve (either because of an increase in government expenditure

G, or a change in the marginal efficiency of capital or propensity to consume) on theother hand strongly affects income (as evidenced by the shift in income from Y0 to

Y1in Fig.5b We are thus in the Keynesian world, where monetary policy is largelyineffective, and the only alternative available to emerge from the recession is toincrease government investment in public works Finally over the middle stretch ofthe LM curve, we have a hybrid world which is neither purely neoclassical norpurely Keynesian, in which the relative efficacy of fiscal and monetary policy woulddepend on the relative slopes of the IS and LM curves

Thus, the Hicksian IS-LM model is a meta-model of which the Keynesian andneoclassical models are special instances It is in this sense that the IS-LM modelmarks a synthesis—we call it the Old Neo-Classical Synthesis to distinguish it fromthe more recent New Synthesis which forms the subject matter of Chap.4

In one of his early articles, Samuelson (1947) had observed thus “until theappearance of the mathematical models of Meade, Lange, Hicks and Harrod, there

is reason to believe that Keynes himself did not truly understand his own analysis”.Careful research by Rymes (1987, 1989) has resulted in a compilation of notes

Y* Income

Rate of interest

r*

IS

LM

r l

Fig 4 IS-LM framework

taken by students attending Keynes lectures during 1932–1935 From the notes ofthe lecture on 4 December 1933, it appears that Keynes formalized his theoreticalsystem in the following equations (see Dimand2017, p 8) These equations arereproduced below (notation slightly changed to conform to that used by us):

Neo-classical Special Case

The Keynesian Special Case

Fig 5 a Neoclassical special case b The Keynesian special case

M¼ L r; gð Þ ð20Þ

Y ¼ C þ I ¼ u Y; gð Þ þ h r; gð Þ ð23ÞThe close resemblance between Hicks’ formalization of the Keynesian systemand the above system is immediately apparent.8(Note, in particular, Keynes’ use ofthe variable η to highlight the uncertainty underlying the various relationships.)Thus, Samuelson’s statement is quite misplaced—Keynes was fully aware of theway his system could be formalized The only reason for him not using this for-malization in the General Theory was that in keeping with the preferred mode ofarticulation of his times, he chose to present his analysis in verbal terms

In the years following the General Theory, criticisms, amendments and extensionsfollowed in quick succession It is not possible for us to consider all these laterdevelopments, but we focus on three of the most important, viz the real balance/wealth effect, the Phillips curve and the attempts to extend the Keynesian analysis

to the general equilibrium context

As we have seen above, Keynes in the General Theory had maintained (Chap 19)that even if money wages were flexible, in a depression wage cuts would beineffective in restoring full employment A number of writers critically examinedthis proposition, in an attempt to salvage the neoclassical view, that in theory, wagecuts could restore employment, howsoever infeasible their applicability in practice.Among the most notable of these attempts was Pigou (1943, 1947, 1950), whointroduced the so-called wealth effect Keynes had postulated that the consumptionfunction depended primarily on current income Y Pigou, by contrast, made con-sumption a function not only of current income Y, but also of “real net wealth”

W As W increased, people felt themselves richer and consumed more out of their

8 The only difference between the two formulations is that Keynes uses the consumption function rather than the savings function, and he drops the income level Y from his demand for money function.