The Rises and Falls of Keynesianism and Monetarism

The following is extracted from a paper on the history of macroeconomics that I’m now writing. I don’t know yet where or when it will be published and there may or may not be further installments, but I would be interested in any comments or suggestions that readers might have. Regular readers, if there are any, will probably recognize some familiar themes that I’ve been writing about in a number of my posts over the past several months. So despite the diminished frequency of my posting, I haven’t been entirely idle.

Recognizing the cognitive dissonance between the vision of the optimal equilibrium of a competitive market economy described by Marshallian economic theory and the massive unemployment of the Great Depression, Keynes offered an alternative, and, in his view, more general, theory, the optimal neoclassical equilibrium being a special case.[1] The explanatory barrier that Keynes struggled, not quite successfully, to overcome in the dire circumstances of the 1930s, was why market-price adjustments do not have the equilibrating tendencies attributed to them by Marshallian theory. The power of Keynes’s analysis, enhanced by his rhetorical gifts, enabled him to persuade much of the economics profession, especially many of the most gifted younger economists at the time, that he was right. But his argument, failing to expose the key weakness in the neoclassical orthodoxy, was incomplete.

The full title of Keynes’s book, The General Theory of Employment, Interest and Money identifies the key elements of his revision of neoclassical theory. First, contrary to a simplistic application of Marshallian theory, the mass unemployment of the Great Depression would not be substantially reduced by cutting wages to “clear” the labor market. The reason, according to Keynes, is that the levels of output and unemployment depend not on money wages, but on planned total spending (aggregate demand). Mass unemployment is the result of too little spending not excessive wages. Reducing wages would simply cause a corresponding decline in total spending, without increasing output or employment.

If wage cuts do not increase output and employment, the ensuing high unemployment, Keynes argued, is involuntary, not the outcome of optimizing choices made by workers and employers. Ever since, the notion that unemployment can be involuntary has remained a contested issue between Keynesians and neoclassicists, a contest requiring resolution in favor of one or the other theory or some reconciliation of the two.

Besides rejecting the neoclassical theory of employment, Keynes also famously disputed the neoclassical theory of interest by arguing that the rate of interest is not, as in the neoclassical theory, a reward for saving, but a reward for sacrificing liquidity. In Keynes’s view, rather than equilibrate savings and investment, interest equilibrates the demand to hold the money issued by the monetary authority with the amount issued by the monetary authority. Under the neoclassical theory, it is the price level that adjusts to equilibrate the demand for money with the quantity issued.

Had Keynes been more attuned to the Walrasian paradigm, he might have recast his argument that cutting wages would not eliminate unemployment by noting the inapplicability of a Marshallian supply-demand analysis of the labor market (accounting for over 50 percent of national income), because wage cuts would shift demand and supply curves in almost every other input and output market, grossly violating the ceteris-paribus assumption underlying Marshallian supply-demand paradigm. When every change in the wage shifts supply and demand curves in all markets for good and services, which in turn causes the labor-demand and labor-supply curves to shift, a supply-demand analysis of aggregate unemployment becomes a futile exercise.

Keynes’s work had two immediate effects on economics and economists. First, it immediately opened up a new field of research – macroeconomics – based on his theory that total output and employment are determined by aggregate demand. Representing only one element of Keynes’s argument, the simplified Keynesian model, on which macroeconomic theory was founded, seemed disconnected from either the Marshallian or Walrasian versions of neoclassical theory.

Second, the apparent disconnect between the simple Keynesian macro-model and neoclassical theory provoked an ongoing debate about the extent to which Keynesian theory could be deduced, or even reconciled, with the premises of neoclassical theory. Initial steps toward a reconciliation were provided when a model incorporating the quantity of money and the interest rate into the Keynesian analysis was introduced, soon becoming the canonical macroeconomic model of undergraduate and graduate textbooks.

Critics of Keynesian theory, usually those opposed to its support for deficit spending as a tool of aggregate demand management, its supposed inflationary bias, and its encouragement or toleration of government intervention in the free-market economy, tried to debunk Keynesianism by pointing out its inconsistencies with the neoclassical doctrine of a self-regulating market economy. But proponents of Keynesian precepts were also trying to reconcile Keynesian analysis with neoclassical theory. Future Nobel Prize winners like J. R. Hicks, J. E. Meade, Paul Samuelson, Franco Modigliani, James Tobin, and Lawrence Klein all derived various Keynesian propositions from neoclassical assumptions, usually by resorting to the un-Keynesian assumption of rigid or sticky prices and wages.

What both Keynesian and neoclassical economists failed to see is that, notwithstanding the optimality of an economy with equilibrium market prices, in either the Walrasian or the Marshallian versions, cannot explain either how that set of equilibrium prices is, or can be, found, or how it results automatically from the routine operation of free markets.

The assumption made implicitly by both Keynesians and neoclassicals was that, in an ideal perfectly competitive free-market economy, prices would adjust, if not instantaneously, at least eventually, to their equilibrium, market-clearing, levels so that the economy would achieve an equilibrium state. Not all Keynesians, of course, agreed that a perfectly competitive economy would reach that outcome, even in the long-run. But, according to neoclassical theory, equilibrium is the state toward which a competitive economy is drawn.

Keynesian policy could therefore be rationalized as an instrument for reversing departures from equilibrium and ensuring that such departures are relatively small and transitory. Notwithstanding Keynes’s explicit argument that wage cuts cannot eliminate involuntary unemployment, the sticky-prices-and-wages story was too convenient not to be adopted as a rationalization of Keynesian policy while also reconciling that policy with the neoclassical orthodoxy associated with the postwar ascendancy of the Walrasian paradigm.

The Walrasian ascendancy in neoclassical theory was the culmination of a silent revolution beginning in the late 1920s when the work of Walras and his successors was taken up by a younger generation of mathematically trained economists. The revolution proceeded along many fronts, of which the most important was proving the existence of a solution of the system of equations describing a general equilibrium for a competitive economy — a proof that Walras himself had not provided. The sophisticated mathematics used to describe the relevant general-equilibrium models and derive mathematically rigorous proofs encouraged the process of rapid development, adoption and application of mathematical techniques by subsequent generations of economists.

Despite the early success of the Walrasian paradigm, Kenneth Arrow, perhaps the most important Walrasian theorist of the second half of the twentieth century, drew attention to the explanatory gap within the paradigm: how the adjustment of disequilibrium prices is possible in a model of perfect competition in which every transactor takes market price as given. The Walrasian theory shows that a competitive equilibrium ensuring the consistency of agents’ plans to buy and sell results from an equilibrium set of prices for all goods and services. But the theory is silent about how those equilibrium prices are found and communicated to the agents of the model, the Walrasian tâtonnement process being an empirically empty heuristic artifact.

In fact, the explanatory gap identified by Arrow was even wider than he had suggested or realized, for another aspect of the Walrasian revolution of the late 1920s and 1930s was the extension of the equilibrium concept from a single-period equilibrium to an intertemporal equilibrium. Although earlier works by Irving Fisher and Frank Knight laid a foundation for this extension, the explicit articulation of intertemporal-equilibrium analysis was the nearly simultaneous contribution of three young economists, two Swedes (Myrdal and Lindahl) and an Austrian (Hayek) whose significance, despite being partially incorporated into the canonical Arrow-Debreu-McKenzie version of the Walrasian model, remains insufficiently recognized.

These three economists transformed the concept of equilibrium from an unchanging static economic system at rest to a dynamic system changing from period to period. While Walras and Marshall had conceived of a single-period equilibrium with no tendency to change barring an exogenous change in underlying conditions, Myrdal, Lindahl and Hayek conceived of an equilibrium unfolding through time, defined by the mutual consistency of the optimal plans of disparate agents to buy and sell in the present and in the future.

In formulating optimal plans that extend through time, agents consider both the current prices at which they can buy and sell, and the prices at which they will (or expect to) be able to buy and sell in the future. Although it may sometimes be possible to buy or sell forward at a currently quoted price for future delivery, agents planning to buy and sell goods or services rely, for the most part, on their expectations of future prices. Those expectations, of course, need not always turn out to have been accurate.

The dynamic equilibrium described by Myrdal, Lindahl and Hayek is a contingent event in which all agents have correctly anticipated the future prices on which they have based their plans. In the event that some, if not all, agents have incorrectly anticipated future prices, those agents whose plans were based on incorrect expectations may have to revise their plans or be unable to execute them. But unless all agents share the same expectations of future prices, their expectations cannot all be correct, and some of those plans may not be realized.

The impossibility of an intertemporal equilibrium of optimal plans if agents do not share the same expectations of future prices implies that the adjustment of perfectly flexible market prices is not sufficient an optimal equilibrium to be achieved. I shall have more to say about this point below, but for now I want to note that the growing interest in the quiet Walrasian revolution in neoclassical theory that occurred almost simultaneously with the Keynesian revolution made it inevitable that Keynesian models would be recast in explicitly Walrasian terms.

What emerged from the Walrasian reformulation of Keynesian analysis was the neoclassical synthesis that became the textbook version of macroeconomics in the 1960s and 1970s. But the seemingly anomalous conjunction of both inflation and unemployment during the 1970s led to a reconsideration and widespread rejection of the Keynesian proposition that output and employment are directly related to aggregate demand.

Indeed, supporters of the Monetarist views of Milton Friedman argued that the high inflation and unemployment of the 1970s amounted to an empirical refutation of the Keynesian system. But Friedman’s political conservatism, free-market ideology, and his acerbic criticism of Keynesian policies obscured the extent to which his largely atheoretical monetary thinking was influenced by Keynesian and Marshallian concepts that rendered his version of Monetarism an unattractive alternative for younger monetary theorists, schooled in the Walrasian version of neoclassicism, who were seeking a clear theoretical contrast with the Keynesian macro model.

The brief Monetarist ascendancy following 1970s inflation conveniently collapsed in the early 1980s, after Friedman’s Monetarist policy advice for controlling the quantity of money proved unworkable, when central banks, foolishly trying to implement the advice, prolonged a needlessly deep recession while central banks consistently overshot their monetary targets, thereby provoking a long series of embarrassing warnings from Friedman about the imminent return of double-digit inflation.


[1] Hayek, both a friend and a foe of Keynes, would chide Keynes decades after Keynes’s death for calling his theory a general theory when, in Hayek’s view, it was a special theory relevant only in periods of substantially less than full employment when increasing aggregate demand could increase total output. But in making this criticism, Hayek, himself, implicitly assumed that which he had himself admitted in his theory of intertemporal equilibrium that there is no automatic equilibration mechanism that ensures that general equilibrium obtains.

16 Responses to “The Rises and Falls of Keynesianism and Monetarism”


  1. 1 LAL January 9, 2022 at 9:18 pm

    Struggling with the following sentence:

    “ But unless all agents share the same expectations of future prices cannot all be correct, and some of those plans may not be realized.”

    Like

  2. 2 David Glasner January 10, 2022 at 12:27 pm

    Good catch, LAL. The words “their expectations” should be inserted (which I have done) between “prices” and “cannot.” Thanks for your careful reading.

    Like

  3. 3 Benjamin Cole January 11, 2022 at 4:36 pm

    I am a regular reader. What am I, chopped liver?

    Like

  4. 4 David Glasner January 11, 2022 at 6:44 pm

    Benjamin, You’ve been a regular since I started blogging. You’re definitely not chopped liver. I hate repeating something TFG once said, but you’re not just regular, you’re very special.

    Like

  5. 5 Henry Rech January 12, 2022 at 12:43 pm

    David,

    “The explanatory barrier that Keynes struggled, not quite successfully, to overcome in the dire circumstances of the 1930s…”

    I would say he did explain it successfully.

    Keynes explained it by arguing that at below full employment adjustment was by changes in income/spending.

    At full employment, adjustment was by changes in relative prices.

    Like

  6. 6 Henry Rech January 12, 2022 at 12:58 pm

    David,

    “Ever since, the notion that unemployment can be involuntary has remained a contested issue between Keynesians and neoclassicists, a contest requiring resolution in favor of one or the other theory or some reconciliation of the two.”

    Neoclassicists strictly speaking assume full employment prevails which is clearly against all experience.

    So why does unemployment exist”?

    The neoclassicists will concede that there is frictional unemployment. Keynes did not dispute this.

    But there a clear examples of non-frictional umemployment.

    If a heavily indebted and illiquid firm is told by its bank it wants its money back, the firm has not option but to retrench. If the bank has been forced to pull in loans by the prudential authorities then this kind of thing will be economy wide.

    If central banks decide that inflation is or financial markets are out of control and that a substantial interest rate rise is necessary, then same thing happens. There is economy wide retrenchment.

    No amount of wage cutting will mitigate the situation firms find themselves in.

    Like

  7. 7 Henry Rech January 12, 2022 at 1:02 pm

    David,

    “Initial steps toward a reconciliation were provided when a model incorporating the quantity of money and the interest rate into the Keynesian analysis was introduced, soon becoming the canonical macroeconomic model of undergraduate and graduate textbooks.”

    Keynes himself, as opposed to what came after him, did have a prices theory – which everyone seems to ignore.

    Like

  8. 8 Henry Rech January 12, 2022 at 1:17 pm

    David,

    “What both Keynesian and neoclassical economists failed to see is that, notwithstanding the optimality of an economy with equilibrium market prices, in either the Walrasian or the Marshallian versions, cannot explain either how that set of equilibrium prices is, or can be, found, or how it results automatically from the routine operation of free markets.”

    Theoretical prices theory assumes that prices are at equilibrium. The conditions at equilibrium can be described and formulated.

    In the real world, price is a signal. It tells the firm what it can profitably produce at that price. The consumer decides, given his income, on the basis of his tastes and preferences what he will consume at this price. If the quantity supplied does not equal the quantity demanded then the firm will either see its stock rise or be depleted very quickly. This will encourage the firm to change price until a his stock levels remain at an acceptable level.

    This will be the equilibrium price. This is how real free markets work.

    Time may be required for equilibrium to eventuate or the process may not operate quickly enough because it can’t keep up with changes in the firm’s cost structure or changes in consumer’s preferences and tastes (and income).

    The system is constantly hunting the equilibrium price.

    And this process is at work in intertemporal markets.

    I can’t see what the problem is.

    Like

  9. 9 Henry Rech January 12, 2022 at 1:24 pm

    David,

    “Besides rejecting the neoclassical theory of employment, Keynes also famously disputed the neoclassical theory of interest by arguing that the rate of interest is not, as in the neoclassical theory, a reward for saving, but a reward for sacrificing liquidity.”

    This is not exactly accurate.

    Perhaps you might like to consider the following.

    From page 178 of the GT:

    “All these points of agreement can be summed up in a proposition which the classical school would accept and I should not dispute; namely, that, if the LEVEL OF INCOME IS ASSUMED TO BE GIVEN (my capitalization), we can infer that the current rate of interest must lie at the point where the demand curve for capital corresponding to different rates of interest cuts the curve of the amounts saved out of the GIVEN INCOME (my capitalization) corresponding to different rates of interest.”

    Here Keynes is saying that the loanable funds theory applies when income is fixed.

    He then proceeds to discuss what happens when the level of income is not fixed and concludes that the loanable funds theory does not apply.

    And from page 378 of the GT;

    “But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards.”

    Now, at full employment, the level of income is no longer variable and is fixed and presumably the classical theory applies.

    Like

  10. 10 Henry Rech January 12, 2022 at 1:34 pm

    David,

    “But the seemingly anomalous conjunction of both inflation and unemployment during the 1970s led to a reconsideration and widespread rejection of the Keynesian proposition that output and employment are directly related to aggregate demand.”

    The silly Keynesians of the time capitulated too easily to Lucas’ diatribes and critiques.

    The 1970s stagflation was the result of two shocks, not one as is commonly considered.

    The inflation part of the stagflation was initiated by the large oil price increases as we all know – the supply side shock.

    The stagnation part of the stagflation was due to the massive transfer of income to the oil producers – the demand side shock.

    The adjustment process was inevitably going to be grim and painful.

    Like

  11. 11 David Glasner January 12, 2022 at 4:44 pm

    Henry, I explained myself that theoretical price theory assumes that all prices are equilibrium prices when deriving conditional predictions about the effects of parameter changes on endogenous variables. Theoretical price theory does not assume that all prices are equilibrium prices in every context.

    Real markets do adjust prices in response to perceived excess demands and supplies, but, as I explain, that automatic adjustment of individual markets doesn’t ensure that relative prices are at their equilibrium levels inasmuch as interactions between markets cause demands and supplies in other markets to change which have further feedback effects on other markets, which means that there is no automatic tendency for relative prices to be equilibrium relative prices. And that doesn’t even begin to take into account the role of expectations of future prices as equilibrating variables that must adjust appropriately to achieve an equilibrium state.

    Like

  12. 12 David Glasner January 12, 2022 at 4:49 pm

    I agree, and actually wrote, that Keynes described the neoclassical full-employment equilibrium as a special case of his more general theory, so his concession that the rate of interest at a full employment equilibrium would correspond to that described by the neoclassical theory is consistent with what I wrote. But Keynes’s point was that changes in the rate of interest were driven by the excess demand for money not by relationship between savings and investment.

    Like

  13. 13 David Glasner January 12, 2022 at 4:53 pm

    Henry, I agree with much, but not all, of this comment, but I would have phrased it rather differently.

    Like

  14. 14 Henry Rech January 12, 2022 at 8:27 pm

    David,

    “But Keynes’s point was that changes in the rate of interest were driven by the excess demand for money not by relationship between savings and investment.”

    But only at less then full employment.

    Like

  15. 15 Henry Rech January 13, 2022 at 10:07 am

    David,

    “…..which means that there is no automatic tendency for relative prices to be equilibrium relative prices.”

    Does it mean this? This statement seems to strong.

    Markets might find it difficult to equilibrate under these conditions but surely the tendency is there.

    Equilibrium may never be attained but as long as firms have stock levels which are not optimal they will endeavour to change production levels/price until they are.

    Like

  16. 16 David Glasner January 13, 2022 at 11:02 am

    Henry, The point is that every change in one market has repercussions on other markets, so the process of adjustment never comes to a rest point because the repercussions are endless. That’s what Walrasian tatonnement was designed to avoid by stopping all activity pending the discovery the equillibrium set of relative prices..

    Like


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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