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Why Keynesians Don't Understand the Macro Economy

April 7, 2014
Frank Hollenbeck, in “Why Keynesian Economists Don’t Understand Inflation”  argues that a fundamental shift in macro theorizing, shifting from the transaction version of the equation of exchange to the income form  of the equation, particularly in theorizing about the demand for money is wrong theory and hence leads to bad policy and a inherent inability to understand inflation and its consequences properly.  He summarizes:
Yet, the original, non-Keynesian quantity theory of money clearly shows that the demand for money is to conduct all possible transactions, and not just those that make up nominal income. Money is linked to prices of anything that money can buy, consumer goods, stocks, bonds, stamps, land, etc. From this, an average price cannot be measured since appropriate weights are not obtainable. The use of the simplified, Keynesian version in economic textbooks and by the professional economist has caused immense damage. When your theory is wrong, your policy prescriptions will likely also be wrong.
[caption id="attachment_7943" align="alignright" width="72"]glahe Fred Glahe[/caption] One of the few textbooks to highlight problems with macroeconomic modeling based on the income form of the quantity equation’s was my mentor Fred R. Glahe’s Macroeconomics Theory and Policy. The discussion is around p. 221 in the linked 3rd edition. This edition was one of the few (only) texts that had a section on Austrian business cycle theory. The text was also one of the best in highlighting hidden assumptions in Keynesian analysis. The problems with the simplified Keynesian version is foundational, and is the result of basing macroeconomics on national income product concepts as Hayek attempted to show beginning in the late 1920s. Fred and I discuss the implications of the use of the income form of quantity equation (almost all ‘modern’ macro) in our book The Hayek-Keynes Debate pages 114-117. We conclude:
These models [Keynesian and modern macro] focus on aggregates. Hayek’s model [capital structure] cannot be expressed or understood in terms of such aggregates. All the key features of Hayek’s analysis are absent in models that use the national income concept as a starting point for macroeconomic analysis.
Roger Garrison (Natural Rates of Interest and Sustainable Growth) provides an excellent discussion highlighting the “variations on a the theme” (ABCT) that was evident in the two most recent boom-bust cycles, the dot.com and housing, that he attributes to the Fed’s ‘learning by doing’ policy of the Great Moderation. He highlights how the use of aggregate data lead Fed policy makers to have a blind eye toward the how interest rate manipulation generates  malinvestments, overconsumption, and capital consumption and impedes sustainable recovery:
The inattention to the effect of manipulating interest rates on the allocation of resources traces to the high level of aggregation that dominates the thinking of today’s macroeconomists. Hayek’s earliest work in monetary theory (Hayek [1928] 1975) is an extended demonstration that the whole process of a credit-driven boom and subsequent bust is concealed within the macroeconomic aggregates that populate the equation of exchange.
For more detail see Mark Skousen’s The Structure of Production with a New Introduction. pp. xi–xxxix or  How Measuring GDP Encourages Government Meddling.

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