Keynesian economics vs. Austrian economics

Before I begin, I want to give a useful definition of "Keynesian Economics." I will not define "Austrian Economics" and will instead allow my opponent to provide his own definition. Keynesian Economics is generally treated as a set of models that give us a useful idea of what causes some recessions, we are going to treat it as a set of propositions that can be true or false. The proposition we will discuss is that short-term fluctuations in economic growth are caused by reduced aggregate demand, and that increased aggregate demand, either through expansionary monetary policy, or expansionary fiscal policy, can dampen or cure these sorts of recessions. An important point of Keynesian economics is that it only explains short-run fluctuations in the economy and why some of an economy's resources, it's labor and capital, would go unused. Many critiques of Keynesian economics rest upon a confused notion of what Keynesian economics tries to explain. Keynesian economics does not try to explain most long-term (several years or more) unemployment. Keynesian economics also does not explain economic growth or even wage determination. Keynesian economics explains why, for a short period of time, large amounts of a nation's resources would go unused, despite the productive capacity being almost unaffected. We will start with a basic proposition of macroeconomics, the quantity theory of money. The quantity theory of money is expressed in the accounting truism MV=PY. "M" is the money supply. "V" is the velocity of money, or the amount of times a dollar changes hands in a given year. "P" is the price level, the average price of any given good sold in the economy. "Y" is the amount of transactions. Another basic proposition of Keynesian economics is "price stickiness", or the tendency for prices and wages to not adjust to clear markets. Many of the models of Keynesian economics are built upon this assumption and model the behavior of the macroeconomy when prices are unable to adjust to clear the market. The assumption is that, instead of adjusting prices, firms and wage earners will change output instead. The evidence for this is numerous empirical studies by Alan Blinder and others during the rise of the so-called "New Keynesian" school of economics, which sought to examine the "microfoundations" or the behavior of individual firms, workers, and investors that would explain the behavior in the macroeconomy. In surveying businesses, Blinder found that most businesses adjust their prices as often as twice a year, and many businesses do not adjust their prices even once per year. There are numerous reasons for this, but the basic reason given by business managers is a failure of price coordination. This failure can be illustrated with the following thought experiment. Imagine an economy with two firms that both charge enough to make a profit 30$. Now imagine that demand for their products falls by one half. Without adjusting nominal prices, they only make a 15$ profit. Now if both firms reduce their nominal prices, the supply of real money balances (the money supply divided by the price level) will increase and both firms can make a real profit of 30$. However, if only one of them reduces their prices then the supply of real money balances does not increase, and therefore the firm will only make 8$ profit. This failure of price coordination can cause firms to not adjust their prices. This can also cause unions to not reduce their own wage demands, for they realize that only if other unions reduce their own nominal wage demands can their real wages increase. Now what happens if aggregate demand falls, given price stickiness? Recall the quantity theory of money, MV=PY. Necessarily, If "P" is fixed, and either M or V are reduced, then "Y" will have to fall as well. So another obvious question is can aggregate demand fall throughout the economy? It absolutely can. To see how, consider a rational consumer. Our consumer has a choice of consumption today vs. consumption tomorrow. His choices are constrained by what economists call a "budget constraint", which is determined by factors such as wage income, asset income, and wealth. He also has a choice of what kind of assets to hold, either bonds (which we will define as any non-liquid, interest bearing assets) or liquid money. If his wage income increases today, he will consume more today, but he will not consume everything, he will save some in the form of increased assets. If his asset income increases tomorrow, he will spend some tomorrow but borrow from banks against this expected asset income. Now what would happen if our consumer's wealth were to suddenly decrease? His debts are denominated in currency, and so if his wealth decreases (like if the value of his home were to suddenly plummet, or the value of his stock portfolio were to decrease), he will still have to pay the same nominal amount of debt but his real income will have suddenly decreased. Therefore, our consumer will either default or will increase his demand for liquid money. Now this is not a problem at the individual level. However, at any given time the amount of money in the economy is fixed. If suddenly everyone's demand for liquid money were to increase, then necessarily the velocity of money would decrease, and therefore total output would decrease. There are many government policies that could solve this problem, by increasing aggregate demand. The most common way is for central banks to increase the money supply, thereby reducing interest rates and therefore making businesses more likely to borrow money to purchase capital, hire workers, etc. There are, however, some exceptions to this rule. When nominal interest rates are near zero, then bonds and cash become perfect substitutes for individuals and banks. They yield the exact same return, namely zero. When this happens, any increase in the money supply will mean that banks will simply hold the cash rather than invest in bonds as they become perfect substitutes. At this point, the government needs to increase planned expenditures somehow. This will cause the amount of income at any given interest rate and given money supply to increase by increasing the velocity of money. In conclusion, we have seen that Keynesian economics provides an empirically plausible and theoretically sound explanation of recessions and provides many useful remedies to said recessions.