Wednesday, September 24, 2014

Investment versus Consumption in the Keynesian Business Cycle Theory

This is one of those issues which causes critics of Keynesianism to make all sorts of ignorant statements. For example, it is frequently charged that Keynesianism ignores or neglects the investment function, and focuses too much on consumption.

In reality, the investment function was seen by Keynes as the “prime mover” or “driving force” of most business cycles, and fiscal stimulus is all about (1) filling the gap created when private investment falls by means of public investment and (2) inducing private investment to rise again.

A business cycle will, generally speaking, be led by a contraction in private investment spending (Arestis and Karakitsos 2013: 111; Hansen 1941: 49). Of course, consumption will also fall, usually after a lag, as private income falls, and negative feedback effects will probably reduce investment even further.

Because of government countercyclical fiscal policy such as automatic stabilisers and deficit-financed fiscal stimulus (involving public investment, or social spending, R&D, a greater level of transfer payments, and so on), in the recovery we should usually see such government spending lead the upswing, with (1) consumption and then investment, or (2) investment and then consumption or (3) consumption and investment simultaneously following.

If we look at the graphs below showing an index of US personal consumption and gross private domestic investment expenditures with shaded areas showing recessions, we see that investment does indeed seem to lead the downturn in recessions. Exactly what happens in recoveries is unclear. Some Post Keynesians seem to argue that investment leads the recovery too (Arestis and Karakitsos 2013: 111), and, in regard to some US cycles before 1939, Hansen (1941: 49) reports that investment was leading the recovery. In the graphs below, it appears that consumption often seems to lead the recovery.



After WWII and in the period down to the 1970s, US recessions seem to have been characterised by “inventory recessions”: they were caused by business accumulating excessive inventories which they could not sell (that is, when expected demand failed to materialise or did not grow at a sufficiently high rate), and, when these inventories were liquidated, the fall in investment was a major cause of recessions (Sorkin 1997: 569). In this sense, then, the investment decisions were obviously affected by demand for final output.

BIBLIOGRAPHY
Arestis, Philip and Elias Karakitsos. 2013. Financial Stability in the Aftermath of the ‘Great Recession’. Basingstoke, UK.

Hansen, Alvin H. 1941. Fiscal Policy and Business Cycles. W.W. Norton & Co., New York.

Sorkin, A. L. 1997. “Recessions after World War II,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 566–569.

7 comments:

  1. "In the graphs below, it appears that consumption often seems to lead the recovery."
    -Uh, LK, that's because you're using monthly data for consumption and quarterly data for investment.

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    1. Yes, on closer inspection, you are right. Thank for pointing that out.

      Unfortunately, FRED does not seem to have a monthly series for gross private domestic investment.

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    2. Hmmm. You used wrong data, it was pointed out, and you conceded immediately without waffling. Now when Bob Murphy used bogus Canadian numbers and you pointed it out ...
      Maybe he'll concede according to Major_Freedom's definition of immediately, but I wouldn't hold my breath.

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    3. Well, bob's silence on his latest "Canadian austerity on the 1990s" post is rather telling.

      In my defence, I think even the quarterly data for investment, if you look carefully at some of the recessions, is clearly still flat even after consumption rises. Whether the month data proves my point about recoveries, I'll leave as an open question.

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  2. Hey you know Murphy banned Philippe now. Can't have obstacles if you want a working echo chamber.

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    Replies
    1. Did he really? I expect I'll be next!

      Delete
  3. "A business cycle will, generally speaking, be led by a contraction in private investment spending (Arestis and Karakitsos 2013: 111; Hansen 1941: 49). Of course, consumption will also fall, usually after a lag, as private income falls, and negative feedback effects will probably reduce investment even further."

    Economists often get this wrong. That's a positive feedback effect. At least you're not confusing stability with equilibrium as mainstream economics does. If the gain is negative, then a feedback signal that pushes the gain further into negative (i.e. in the same direction) is a positive feedback signal. Stabilisers are negative feedback. Counter cyclical economic policies aim to create a stability of non equilibrium. Positive feedback is inherently unstable and tends to cause oscillations. A typical metaphor is the oscillating amplifier. The business cycle oscillation is caused by positive feedback effects, therefore negative feedback must be an oscillating signal which is out of phase by 180% (antiphase). If animal spirits weren't a positive feedback effect then there would be a system of dynamic equilibrium. It doesn't matter that economic activity may not be negative in the sense of being destructive. A positive bias can be expressed as an offset. There can also be 2nd order feedbacks, etc.

    http://en.wikipedia.org/wiki/Negative_feedback

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