Lecture Notes: Business Cycles and Keynesian Economics

Introduction

• Business cycles and recessions lead to lower output and higher unemployment.
• Four major schools of thought in macroeconomics regarding business cycles:
  • Keynesians
  • Monetarists
  • Real business-cycle theorists
  • Austrians
• This series will explore each theory and its application to the Great Recession of 2008.

Keynesian Economics

• Named after John Maynard Keynes, based on his 1936 book "The General Theory of Employment, Interest and Money."
• Key Concept: Aggregate Demand - different from real business-cycle theory which focuses on supply.

Aggregate Demand Components

• C: Consumption
• I: Investment
• G: Government spending
• Net Exports: Exports minus imports
• These components drive labor hiring and economic activity.

Sticky Wages

• Nominal wages are considered sticky (do not adjust quickly to demand changes).
• Sticky wages lead to layoffs instead of wage cuts when aggregate demand falls.
• Causes of sticky wages:
  • Long-term contracts
  • Minimum wage laws
  • Worker morale

Historical Context

• Great Depression:
  • Banks failed, money supply fell by a third, stock market crash.
  • Led to decreased consumer spending and investment, high unemployment.
• Great Recession of 2008:
  • Significant Keynesian elements, covered in a separate video.

Government Response in Keynesian Model

• Falling consumption/investment leads to reduced tax revenue and government spending unless borrowing occurs.
• Negative shocks to aggregate demand.
• Graphically: Aggregate demand curve shifts back/left, output decreases.
• Second-order effects: Lower productivity due to demoralized workers.

Keynesian Remedies

• Activist monetary and fiscal policies:
  • Expand money supply, lower interest rates.
  • Government deficit spending (e.g., Public Works programs).
• Purpose: Restore aggregate demand flow.

Critiques of Keynesian Economics

• Does not always explain why aggregate demand falls initially.
• Aggregate demand issues may mask deeper economic problems.
• Monetary Policy: Often enough to stabilize nominal expenditures, leading to monetarism.
• Government Efficiency: Concerns about timely and effective fiscal policy.
• Stagflation: High inflation and unemployment in the 1970s contradicted Keynesian predictions.
• Public-Choice Critique: Asymmetry in deficit spending; potential for fiscal crises.

Conclusion

• Keynesian economics is crucial for modern macroeconomics but has limitations and criticisms.

• Encouragement to practice questions and explore more videos for mastering economics.