Orthodox economics in a non-orthodox world: developing Keynes' business cycle analysis

By Svein Lauvsnes

PKES Working Paper 1204

April 2012
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Orthodox economic theory fails to recognise fundamental driving forces of business cycles, and this theory is therefore insufficient as a guide in the pursuit of economic stability. This paper claims that Keynes’ ”supply and demand price” analysis of employment determination offers a more realistic alternative. Two essential points are emphasised, namely that a) Keynes’ ”supply price” can be understood in terms of minimum required revenues for a given profit maximising level of employment, corresponding to a growth rate of employment equal to zero (Keynes’ ”effective demand”), and b) it is necessary to include liquidity preference explicitly in the analysis in order to obtain adjustment for uncertainty. The analysis also discusses why booms and busts appear to be persistent, and assesses the relationship between financial markets and economic instability. An implication is stronger regulations of financial markets and a reduction of the size of financial markets relative to the real economy.

Keywords: Conventional expectations, rational expectations, shifting equilibrium, supply and demand prices, orthodox economic theory

JEL classification: D01 D84 E12 E24 E32