Following up on yesterday’s Keynesian Cross post:
- The point, for those who missed it, is that using exactly the same reasoning that we find in Eco 101 textbooks to derive the Keynesian multiplier, we can conclude that sending all your money to me will make everyone rich. The conclusion is absurd; therefore the reasoning is invalid. And reasoning that’s invalid in one context is also invalid in another.
- Some commenters thought that my version of the Keynesian cross argument was an unfair caricature. I invite those commenters to peruse some actual Eco 101 textbooks. For example, they might browse through the section labeled “The Income-Expenditure Model” in a widely used textbook called Macroeconomics. The authors are Robin Wells and Paul Krugman.
- Let’s review the logic of that model. (See yesterday’s post for explanations of the notation.)
Step I: Start with an accounting identity (in this case C+I+G).
Step II: Throw in an empirical regularity (in this case C=.8Y).
Step III: Combine the two equations to get a third equation (Y=5(I+G).)
Step IV: Do a thought experiment involving a policy change (e.g. an increase in G) and predict the outcome by assuming that your equations will continue to hold after the policy change.
By contrast, my alternative model starts with an accounting identity (Y=L+E), throws in an empirical regularity (Y=.999999E), combines these equations to get a third (Y=1000000L) and then predicts the outcome of a thought experiment (send me your money!) by assuming that the equations will continue to hold. In other words, yes, exactly the same logic.
- The problem with the Landsburg multiplier story is that after you send me your money, the equation Y=.999999E is not likely to remain true. The problem with the Keynesian multiplier story is that after you increase government spending, the equality C=.8Y is not likely to remain true. Why not? Well, for one thing, if the government buys you a bowl of Wheaties, you’re correspondingly less likely to go out and buy a bowl of Wheaties for yourself. For another, if the government spends wastefully, you, as a taxpayer, are going to end up poorer, which means you’ll probably consume less. The exact nature of the change depends on the exact nature of the government spending. But there’s surely no reason to buy into the model’s assumption that there will be no change at all.
- What we have here is a particularly simple example of the so-called Lucas Critique, which was part of the revolution that swept through macroeconomics a few decades ago. Until then, it was routine in Keynesian macro models to assume that equations describing behavior would remain valid after a policy change. Lucas made the simple but pointed observation that this assumption is almost never justified.
- None of this means that you can’t write down sensible Keynesian model with a multiplier; it does mean that the Eco 101 version of the Keynesian cross is not an example of such. This in turn calls into question the wisdom of the occasional pundit who repeatedly admonishes us to be guided in our policy choices by the lessons of Eco 101.
- As I said yesteday, the idea for this post was not original with me; I’d thought that I vaguely recalled the source as Murray Rothbard. As some commenters pointed out, you can find the original here.