A Keynesian key insight

For me the key Keynesian insights are:

1. The economy can be in equilibrium at a high level of unemployment.

2. People can choose more goods and less money, or more money and less goods. If they choose the in a sufficiently dramatic and surprising way, then you can end up with a general glut.

Of course both these arguments predate Keynes and Keynesian economics but nevertheless.

Microeconomics has its own ways of explaining persistent unemployment beyond the "natural rate" without invoking irrationality. These explanations have to do with a lack of information. They aren't particularly new, either. Armen Alchian pioneered these models half a century ago.

Here's an example of how things could go.

Aggregate demand drops, and so the employer, whose demand has also gone down, tries to lower the wages of his employees, who do not know that aggregate demand has dropped. They only see that their employer's demand has dropped. They can rationally decide that it is worth quitting their job rather than taking they pay cut and looking for a job that will pay them what they think they are worth elsewhere. If this is happening in businesses all over the country, unemployment could get large quickly for entirely rational reasons.

Now, workers might realize their mistake and try to ask for lower wages. But this won't get them hired either, because stepping out of the crowd to ask for a lower wage just sends a signal that you're not worth very much and also that you're unusual in some way. Employers won't be interested in hiring a high-risk low-productivity worker. And furthermore, the workers know that employers will react in this way, so no individual will even bother trying.

Employers will see that people aren't willing to work at the wage necessary to make it profitable to hire them and that they're not budging on this. So they'll start restructuring their business, substituting capital for the labor that has gone. Now you have a skills mismatch where the workers can't do the sorts of things people are willing to pay them to do because the jobs they were trained for are now done by machines. And that can give you pretty persistent unemployment just with rational imperfect information microeconomics.

Keynesian models virtually always involve two key elements: (1) a monetary exchange economy, and (2) some kind of nominal price stickiness. (The simple income/expenditure model assumes no price adjustments at all; the full implications of imperfect price adjustment are only seen in AS/AD type models.) From a micro-economic perspective, there is no mystery: price stickiness is just like a binding price control, where the short side of the market determines quantity traded.

What the income/expenditure model adds is that, in the very short run, feedback loops can drive effective income/expenditure very far below their "notional" values (the values that would prevail in the absence of frictions), due to how desired expenditure depends on realized income.

Note that here, wage flexibility does not remove all frictions, because price stickiness also matters a lot. To a first approximation, adding wage flexibility would merely result in making wages sharply pro-cyclical (because labor demand also depends on realized income).

I don't think this captures the essence of macro economic theories. In my view, the key insight is that you must think about the money balances people hold (carefully distinguishing money from wealth here), how trade affects that balance and how they attempt to optimize it.

In particular with sticky prices, the 'hot potato effect' becomes important. You might also hear it called, 'monetary disequilibrium', 'excess cash balances mechanism' and probably some other things as well. The Keynesian concept of the “Paradox Of Thrift” is related, though less well developed. I've written more about it here.

consider an economy initially at equilibrium with a fixed quantity of money and prices that adjust to changes only after some time (sticky prices). Some people in the economy decide they want to hold higher money balances than they had in the past:

When people hold less money than they would like, they try to increase their holdings of money in two ways: 1) try to reduce their spending 2) try to increase their income. The quantity of money is fixed, so if one person holds a higher nominal quantity of money than before, all others must hold a lower quantity of money than before in aggregate. Prices are fixed, so this is also true for the real quantity of money. When one person reduces their spending, they reduce the income of others in the economy. Unless those others desire to hold less money than before, they now hold less money than they would like. Now those others also try to increase their money holdings by the same means. This is a vicious circle and aggregate spending and incomes decline. The circle ends when people no longer want to reduce their their spending to achieve higher money balances.

There are two effects which determine how far this process proceeds. 1) The quantity that people want to hold is positively related to the quantity people expect to spend, so as people expect to spend less they will need to hold somewhat less money. 2) As people reduce their spending, those reductions become more painful, so will be more reluctant to trade off consumption for increased money balances.

1. Keynesian models do not require irrationality. Unemployment can persist (in the model) even if every agent is completely rational.
2. Hence theoretical macroeconomics really is different from theoretical microeconomics.

Asking from ignorance here -- how does the second point follow from the first? Does theoretical microeconomics require irrationality?

The two key insights are:

Keynesian models do not require irrationality. Unemployment can persist (in the model) even if every agent is completely rational.
Hence theoretical macroeconomics really is different from theoretical microeconomics.

Could you elaborate and clarify the first insight? The insight can't be that people can be unemployed even when people are acting rationally, yet that is the way I read what you wrote.

Isn't income to shareholders also a source of money spent on goods? How is it possible for the system to move all of the money and all of the goods to the shareholders?

There's one expression of this idea I like because it uses the partial equilibrium supply & demand model that introductory microeconomics classes always use, and it's a reasonably easy formulation to follow if one knows that model. (It also illustrates a danger of doing back-of-a-napkin partial equilibrium analysis for a single market when that market's big enough to have a big knock-on effect on another market.)

I'm lifting this from Robin Hahnel (Journal of Economic Issues, 41(4), pp. 1139-1159), although he says he got it from Axel Leijonhufvud:

Consider a labor market and a goods market. Assume that if either market is out of equilibrium the excess supply or excess demand in that market will eventually lead to wage or price adjustments leading that market to its equilibrium. Now assume that while the goods market is initially in equilibrium, the labor market is not because the wage rate is temporarily higher than the equilibrium wage. While the excess supply in the labor market will generate equilibrating forces pushing the wage rate down toward its equilibrium, suppose it does not reach its equilibrium immediately, and in the meantime labor contracts are struck at a wage rate that is still higher than the equilibrium wage. If the labor demand curve is elastic this will result in lower labor income than would have been the case if the wage rate had reached its equilibrium. But the demand curve in the goods market was premised on the (implicit) assumption that the labor market was in equilibrium, and therefore that labor income was higher than it actually will be. When we reconstruct the demand curve in the goods market based on the actual outcome in the labor market, where labor income is lower than it would have been had the labor market been in equilibrium, we get an actual goods demand curve to the left of the one anticipated. No matter how quickly or slowly the price in the goods market adjusts to the resulting excess supply, we will get a drop in sales and revenues in the goods market.

But lower sales and revenues in the goods market will decrease the demand for labor in the labor market. The demand curve we originally drew in the labor market was premised on the (implicit) assumption that we had reached the equilibrium outcome in the goods market. Now that sales and revenues are lower in the goods market, when we reconstruct the demand for labor curve based on the new, actual outcome in the goods market, we get a new demand for labor curve to the left of the initial one. No matter how quickly or slowly the wage rate adjusts to the new excess supply, employment and labor income will drop, further depressing the actual demand for goods in the goods market. Instead of remaining in equilibrium in the goods market and moving toward the higher, equilibrium level of employment in the labor market, we move out of equilibrium in the goods market and even farther away from equilibrium levels of employment in the labor market.