Monday, May 13, 2013

Reconciling Keynes and Hayek within the simple Keynesian cross model

The Keynesian cross model is, of course, a highly simplified abstraction of Keynes's work. Even so, it is not hard to add Hayek to the model, and thus to illustrate how their work is complementary, rather than contradictory.

Although highly simplified, of course, we can instruct undergrads as follows: Keynes was theorizing about the portion of the cross below where the aggregate demand line crosses the income equals output line, i.e. where savings exceeds intended investment. Hayek was theorizing about the portion of the cross above that equilibrium point, where intended investment exceeds savings. This is exactly the point made in the Shackle quote offered a few weeks ago on this blog. And, of course, the first region is characterized by the money rate of interest being above the Wicksellian natural rate, while the second region is characterized by the money rate being below the natural rate.

And note: Both the Keynesian story and the Hayekian story rely upon disequilibrium in the loanable funds market, albeit opposite cases of disequilibrium. Do the followers of either thinker really want to insist that while savings might exceed intended investment, or intended investment exceed savings, the opposite case never can occur? That strikes me as similar to someone who contends that while shortages can arise in the market, surpluses never can, or vice versa.


  1. While Hayek clearly thought that if the money rate was artificially reduced below its natural rate then bad things would happen its not clear to me that Keynes really saw a similar connection between too high a natural rate and economic health.

    In the General Theory Keynes said:

    "I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment"

    I take this to mean that in periods where the economy is below full employment it may actually be at (and not above) one of these natural rates and the solution is to increase the money supply to move to a different natural rate where the employment level would be higher.

    Hayek was extremely critical of Keynes because he felt he had an extremly short-term focus, by which he meant Keynes ideas on the use of money supply changes and of interest rates to achieve short-term policy goals.

    While Hayek is rather unfair in these accusations I do think it highlights a key difference. Keynes saw the economy as not self-correcting and in constant need of fine-tuning to keep it healthy, while Hayek saw it as fundamentally sound if bad policy could be avoided. I think this difference is fundamental and undermines any attempt to see them as different sides of the same Wicksellian coin as Goodspeed claims.

    Beyond this shared heritage (and the interesting fact that they both devised the same solution to the own rates issue) they really don't have that much in common in my opinion.

  2. Great post. I've never been able to come up with a simple way of making this point. This is the first simple way I've seen that works.


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