Keynes's theory of potentially destabilizing bond markets, part I: AS falls when AD falls
Keynes presented a two-pronged attack on the classical theory of the role played by the bond market in the restoration of full employment. The first prong was his insistence that AS depends on and quickly reacts to changes in AD.
As all students of economics know, this is a cornerstone of his theory. If AD or sales decline substantially, Y and employment will fall in response. Seeing sales fall, firms will lower production by laying off workers in order to prevent an excessive inventory buildup. If Y falls because AD falls, Say's Law is a fairy-tale and there are multiple potential equilibrium positions. "The traditional analysis has been aware that saving depends on income, but it has overlooked the fact that income depends on investment" (CW 7, p. 184). Keynes argued repeatedly that the classical theory had to assume its conclusion that competitive markets keep AS close to YF even in the face of shocks and shifts in AD in order to prove it. But once AS (or Y) is allowed to become endogenous and a function of AD, the whole classical financial market story losses credibility and coherence.Consider once again our classical story of how bond markets stabilize the equilibrium value of income via the example used above in which there is a negative exogenous shock to the investment function. This will cause AD and Y to fall. The initial fall in Y caused by the shift in the parameters of the investment function I(r, Y) - the exogenous shock - will induce a
Disequilibrium processes in bond markets 225 further decline in I as well as drop in C(r, Y), causing AD and Y to fall even farther. "If the investment demand-schedule shifts... income will, in general, shift also." But the classical theory can "not tell us what its new value will be" because it assumes income is constant (CW 7, p. 181).
With both the demand for bonds (S) and the supply of bonds (I) falling due to the fall in Y, there is no guarantee that r will even decline, never mind fall to the point that its impact on AD would be as large as the negative impact of the fall in Y on the level of I. Indeed, if the decline in I is large and unexpected, panic in financial markets might cause interest rates to spike, accelerating the decline. This is what happened in the early 1930s.Keynes argued in chapter 8 that the interest elasticity of consumption with respect to a decline in the interest rate was likely to be small and possibly even zero. The influence of a decline in the interest rate:
on the rate of spending out of a given income is open to a good deal of doubt. For the classical theory of the rate of interest, which was based on the idea that the rate of interest was the factor which brought the supply and demand for savings into equilibrium, it was convenient to suppose. that any rise in the rate of interest would appreciably diminish consumption. It has long been recognized, however, that the total effect of changes in the interest rate on the readiness to spend on present consumption is complex and uncertain, being dependent on conflicting tendencies, since some of the subjective motives towards saving will be more easily satisfied if the rate of interest rises, whilst others will be weakened. Over a long period substantial changes in the rate of interest probably tend to modify social habits considerably, thus affecting the subjective propensity to spend - though in which direction in would be hard to say. The usual type of shortperiod fluctuation in the rate of interest is not likely, however, to exercise much direct influence on spending either way. [T]he main conclusion, suggested by experience is, I think, that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant, except, perhaps, where unusually large changes are in question.
(CW 7, pp. 93-94)
We know that the elasticity of consumption with respect to a fall in income is large. We also know that consumption is much larger than investment. Therefore, even if the interest declined significantly - which is highly unlikely - any positive impact of a fall of the interest rate on AD through an increase in investment would be swamped by the negative impact on both consumption and investment caused by the fall in Y. The key point is that by allowing Y to become an endogenous function of AD, Keynes made the classical demonstration of the efficient, stabilityenhancing character of financial markets irrelevant. It simply does not
apply to the real world in which a substantial fall in investment will typically lead to a multiplied fall in AD and therefore in output, income, and employment, and the response of the bond market could make the collapse even greater.