The stark fact of inflationary recession violates the fundamental assumptions of Keynesian theory and the crucial program of Keynesian policy … Keynesian doctrine is, despite its algebraic and geometric jargon, breathtakingly simple at its core: recessions are caused by underspending in the economy, inflation is caused by overspending … When investors and consumers underspend, government can and should step in and increase social spending via deficits, thereby lifting the economy out of recession. When private animal spirits get too wild, government is supposed to step in and reduce private spending by what the Keynesians revealingly call “sopping up excess purchasing power” … What in blazes is government going to do if there is a steep recession (with unemployment and bankruptcies) and a sharp inflation at the same time? What can Keynesianism say? Step on both accelerator and brake at the same time? (Making Economic Sense, pg. 46-47).
- The Keynesian Cross cannot explain inflationary recessions (stagflation)
o Inflation and Recession are mutually exclusive in the Keynesian system
- The IS Curve is derived from the Keynesian Cross
o IS-LM cannot explain stagflation
- AS-AD is built upon two conflicting theories of inflation
o The AD Curve is derived from IS-LM where inflation and recession are mutually exclusive
o The AS Curve is derived from the Phillips Curve where there is a trade-off between inflation and unemployment
§ The AS Curve and the AD Curve do not belong on the same set of axis
The Keynesian categories of Y, C, and I are flows, that is, amounts measured over a period of time. If these flows are defined in relation to the stocks, then Y would be equal to the change in the value of the entire stock, C would be the change in the value of all consumption goods, and I the change in the value of all investment goods. As long as some stock of goods exists, the flow of consumption goods does not have to be less than the change of the stock. C could exceed Y, even for the entire economy, by consuming part of the existing stock. Also, if C were equal to Y, then I would be negative because of depreciation.
Three absurd cases exist, corresponding to three violations of Keynes's pronouncement that 0 <>
1. One absurdity exists when the MPC = 1 since, in this case, k (multiplier) is infinitely large. Thus, any additional expenditure on "public works" would end scarcity!
2. Even more damaging is the case where the MPC exceeds one. In this case, the multiplier is negative! But Keynes claimed that more spending always means more prosperity, not less.
3. The final case is no less absurd. If the MPC is negative then k will be a positive fraction. Thus, an increase in spending for "public works" gets partially consumed somewhere in the aggregate economy. But Keynes claimed that failure to spend leads to recession. His formula does not concur, nor can it be reconciled with his verbal pronouncements. Keynesians cannot have it both ways: either they must give up mathematical precision (rendering the theory null) or they must reconcile these absurdities with general economic theory (not possible)” (Dissent on Keynes, pg. 76-78).
- The Keynesian Cross falls apart if the MPC is not bound by 0<1
- The IS Curve is derived from the Keynesian Cross, so IS-LM analysis falls apart if the MPC is not bound by 0<1
- The AD Curve is derived from IS-LM, so AS-AD analysis falls apart if the MPC is not bound by 0<1
o Empirical evidence shows that the MPC is not bound by 0<1>
Liquidity Theory of Interest Rates:
If Keynes's theory were right, then short-term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual's reluctance to part with cash—to "reward" him for "parting with liquidity." But it is precisely in a depression, when everything is dragging bottom, that short-term interest rates are lowest. And if Keynes's liquidity-preference were right, short-term interest rates would be lowest in a recovery and at the peak of a boom, because confidence would be highest then, everybody would be wishing to invest in "things" rather than in money, and liquidity or cash preference would be so low that only a very small "reward" would be necessary to overcome it. But it is precisely in a recovery and at the peak of a boom that short-term interest rates are highest (The Failure of the New Economics, pg. 192).
“According to Keynes, since money has a systematic impact on employment, income, and interest, interest, in turn—quite consistently, for that matter—must be conceived of as a purely monetary phenomenon. I need not explain the elementary fallacy of this view. Suffice it to say here again that money would disappear in equilibrium, but interest would not, which demonstrates that interest must be considered a real, not a monetary phenomenon” (The Economics and Ethics of Private Property, pg. 162).
- The LM Curve is a liquidity preference theory of interest
o But the liquidity preference theory of interest is clearly wrong
o IS-LM analysis is wrong because it depends on an incorrect theory of interest
o The AD Curve is derived from IS-LM, so AS-AD analysis is wrong because it depends on an incorrect theory of interest
- The Supply and Demand for money determines the purchasing power of money, not the interest rate (Quantity Theory of Money)