Keynes and Modern Economics by Kuroki Ryuzo;

Author:Kuroki, Ryuzo;
Language: eng
Format: epub
Publisher: Taylor & Francis Group

5 Stagnation dynamics and Keynes’ General Theory

Yoshiyasu Ono*

1 Introduction

The US subprime loan problem triggered a financial crisis in 2008 and its effect has immediately spread all over the world. It has induced a shortage of aggregate demand and has worsened business conditions in many countries. Thus, Keynesian economics has suddenly been focused on, instead of neoclassical economics.

Typical Keynesian models, such as the IS-LM analysis and New Keynesian models, regard a demand shortage as generated by price/wage rigidities. Such a view is essentially the same as that of neoclassical economics, since it considers that a demand shortage never arises as long as prices and wages adjust. Consequently, Keynesian theory is widely taken as a neoclassical general equilibrium model with price/wage rigidities. However, it does not seem that the current stagnation can be solved simply by adjusting prices. Also, under Japan's long-run stagnation, deflation lasts for a decade and hence prices should already have declined enough to recover full employment if the conventional logic were right. However, a shortage of aggregate demand still continues.

In The General Theory of Employment, Interest, and Money (1936), Keynes states that price/wage rigidities are not causes of a shortage of aggregate demand and that more rapid adjustments worsen stagnation. He theoretically discusses various reasons that neither investment nor consumption can be large enough to attain full employment although prices and wages decline, and obtains a shortage of aggregate demand by assuming a liquidity trap and the consumption function. However, it is rather a tautology than a theoretical result since the consumption function ignores the effect of price changes on consumption. If the real balance effect were taken into account, a persistent shortage of aggregate demand would not obtain.

This chapter reviews Keynes’ theory of stagnation and discusses primary factors that create a shortage of aggregate demand. After showing that his logic crucially relies on price/wage rigidities, it applies the idea of the liquidity trap to households’ consumption-saving choices instead of the portfolio choice between money and bonds. It is shown that excessive liquidity preference absorbs purchasing power that would otherwise be directed toward consumption. Consequently, a shortage of aggregate demand is shown to last even though prices and wages continue to decline. In this framework the consumption function is not necessary to obtain a shortage of aggregate demand. Moreover, most properties that Keynes mentions in The General Theory are found to be valid in steady state.

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