Thursday, December 03, 2015

Keynes On Rational Expectations And Policy Ineffectiveness

John Maynard Keynes' famous saying, "In the long run we are all dead", is from Chapter III of A Tract on Monetary Reform. He describes, in Chapter II of this 1924 book, how governments can obtain resources from their citizens through a deliberate policy of inflation. In this sense, inflation is like taxation. He also discusses how people might react to such a policy, making it difficult for the government to "tax" at the same rate without constantly raising the rate of inflation.

In Chapter III, Keynes states a general principle:

"...a large change in [the quantity of cash], which rubs away the initial friction, and especially a change in [the quantity of cash] due to causes which set up a general expectation of a further change in the same direction, may produce a more than proportionate effect on the [price level]. After the general analysis of Chapter I. and the narratives of catastrophic inflations given in Chapter II., it is scarcely necessary to illustrate this further, - it is a matter more readily understood than it was ten years ago. A large change in [the price level] greatly affects individual fortunes. Hence a change after it has occurred, or sooner in so far as it is anticipated, may greatly affect the monetary habits of the public in their attempt to protect themselves from a similar loss in future, or to make gains and avoid loss during the passage from the equilibrium corresponding to the old value of [the quantity of cash] to the equilibrium corresponding to its new value. Thus after, during, and (so far as the change is anticipated) before a change in the value of [the quantity of money], there will be some reactions on the values of [the parameters of the quantity equation in Keynes' Cambridge formulation], with the result that changes in the value of [the price level], at least temporarily and perhaps permanently (since habits and practices, once changed with not revert to exactly their old shape), will not be precisely in proportion to the change in [the quantity of cash]." -- J. M. Keynes, pp. 81-82.

It seems to me that the above is the Lucas critique, but with a more realistic understanding of human behaviour. What exactly did Lucas contribute again?


Blissex said...

I don't think that's the "Lucas critique", which is about the "pointlessness" of using empirical relationships for policy advice, because they can change, while microfoundations are necessarily and eternally true.

The argument that JM Keynes makes is different, and to me seems about path dependency, and in particular that balance-sheet effects are significant ("greatly affects individual fortunes"). To me this looks like the interesting concept of "reflexivity" named by G Soros.

There is an overlap: path dependency as for example from balance sheet effects may well look like shifting empirical relationships.

Note that later JM Keynes insisted to have developed a "General Theory", which however to me looked like more a parametric framework than a theory with fixed numbers in its coefficients.
As he famously said, when the facts changed, he changed his mind.

Emil Bakkum said...

"What exactly did Lucas contribute again?"
I do not feel qualified to judge if Keynes adresses the same phenomenon as Lucas. However, it is generally believed that the work of Lucas is original. So why question this?

Even more important: almost everything has been said before by someone. In science the criterion does not seem to be originallity, but the effort that has been made to advance a certain idea.

There is some justice in that. For the person who invest much of his time in promoting an idea is clearly most convinced of the importance of the idea.

Robert Vienneau said...

I can see something about path dependence at the end of the quote from Keynes. But I find him making the general point that people, perhaps with the same goals as before, will change their behavior in response to a policy change by the government. And that change may lead to the policy being less than effective if people were not to change their behavior. To me, this is an informal statement of the Lucas critque.

Emil, I was being somewhat sarcastic. I think Lucas' originality is not in the general ideas, but in casting the ideas into a formal/mathematical framework that his community of economists accepted. I'm not at all sure of the worth of that framework, although I used it for my latest paper at my SSRN site.

I am Responding to an Idiot said...

Ooh, your latest paper! I bet both of your readers will be super excited!

Robert Vienneau said...

One can only pity somebody so insecure.