Macroeconomic theory
The principle of effective demand Keynes’s contemporaries were used to thinking that at the aggregate level demand could not be distinguished from supply: whatever was produced would generate an equal demand to absorb that output (“You will not find [aggregate demand] mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou”; GT, Keynes 1936 [1973]: 32).
Keynes saw empirically that aggregate supply did not create its own demand and provided the theoretical justification for treating supply and demand as independent of each other. He also saw that in real time producers must form expectations about the future level of demand to combine with their (known) cost structure to determine the profit-maximizing level of output and thus employment. If the result for the economy as a whole was less than full employment, there was nothing labour could do about it. This “Principle of Effective Demand”, as Keynes called it, was perhaps the most important contribution of the GT: it asserted the independence of demand from supply at the aggregate level, showed the importance of producers’ expectations and established the systemic dependence of employment on producers’ output decisions: the labour market should not be analysed in isolation.If expectations are not fulfilled, profits are larger or smaller than expected, and firms may alter their expectations, and their output decisions, but only in future (GT, Keynes 1936 [1973]: ch 5). Current employment is determined by those earlier expectations, whether or not they are correct (ibid.: ch 3). If expectations are fulfilled, the output and employment decisions are likely to be repeated unchanged. This result is called an equilibrium, whether full employment or not.
Aggregate demand If the level of activity is stable, it is assumed that firms’ expectations of demand will converge to the actual level of aggregate demand expressed in expenditure.
Keynes continued the convention of dividing aggregate demand into consumption and investment, but in the GT he made much more of that distinction than earlier theory had done. Consumption, he argued, was mainly responsive to changes in income and thus could not drive changes in income by itself. Consumption moved in the same direction as income but not to the full amount, because some income is saved: the marginal propensity to consume (mpc) is hypothesized to be less than one. This assumption gave Keynes powerful ammunition, for it put a stop to the automatic expansion of economic activity independently of (and most likely before) full employment, contrary to the classical idea of self-adjustment to full-employment equilibrium.Investment, the purchase of real productive capital, was, by contrast, not determined by current income, for two reasons: the purpose of investment is to expand the capacity to meet expected future, not current, demand; and (in Keynes’s time) much investment was initially financed by bank loans. The first point is the source of Keynes’s stress on long-term expectations as the main driving force of investment: expectations of future profits must be made for the entire life of the equipment. The second point overturns the classical causality between saving and investment. Bank loans are independent of current or prior saving; therefore investment can take place without prior saving (Chick 1983: ch. 9). Investment raises income and desired saving, but realized saving includes new bank deposits created when investment expenditure is made. (“The investment market can be congested through shortage of cash. It can never be congested through shortage of saving”; Keynes 1937b [1973]: 222). (Any change in expenditure not dependent on current income will be amplified according to the multiplier.)
The rate of interest Along with long-term expectations, the other major factor influencing investment was the rate of interest. This represented the cost of obtaining funds to carry out the projects.
Here, again, Keynes departed from conventional wisdom, which had treated interest and returns on real capital as synonymous. The rate of interest in GT is a purely monetary phenomenon, mainly determined by the degree of preference for liquid over illiquid financial assets. This preference will depend not only on the need for cash for routine transactions with a cushion for the unexpected but will also, sometimes largely, be determined by the expectations of future capital gains and losses on the part of speculators (GT, Keynes 1936 [1973]: ch. 12), the bulls and bears introduced in TM. The capital value of securities is inversely related to the rate of interest. Keynes framed liquidity preference in terms of expected interest rates and showed that an excessive preference for liquidity could keep rates too high to stimulate enough investment to provide full employment. The root cause of unemployment was not high wages but high rates of interest.Liquidity preference and unemployment equilibrium gave Keynes the means finally to escape the quantity theory. He showed (GT, Keynes 1936 [1973]: ch. 21) that only at full employment and with zero preference for liquidity would the quantity theory hold.
Both the speculators and those investing in real capital were subject to sudden changes in their expectations of an uncertain future, periods of optimism and pessimism which they often shared. This made investment potentially volatile. However, investment was also the economy’s engine of growth. A rise in investment would cause consumption to rise, in accordance with the mpc, as the new income circulated around the economy. If the process were to work its way out in full, the extent to which the change in income exceeded the rise in investment would be given by the “multiplier”, which depended on the mpc. With Keynes’s new methodological perspective, such a boom was no longer seen as a deviation from long-run equilibrium, and thus deplored, but something to be welcomed and, if possible, prolonged.
Far from the classical economist’s instinct to raise interest rates to choke off a boom, Keynes would lower interest rates to facilitate it as long as unemployment prevailed. Indeed, he favoured a general policy of low interest rates, as these would stimulate investment and, by making loans easier to pay off, prevent debt from accumulating. This is his characteristic policy conclusion (Tily 2009), far more than the policy usually associated with his name: fiscal stimulus. The latter policy might be the only thing to take an economy out of a slump, but it was not a policy for all seasons.The long run The bulk of GT is occupied with short-period analysis, but the long-run effects of capital accumulation do claim Keynes’s attention, mainly in chapters 16 and 17. Although he looked forward to the time when capital was no longer scarce, he saw that the existence of money as an alternative store of value presented a problem: that as capital accumulates, its diminishing scarcity value reduces the marginal efficiency of capital (mec, or expected return) - even to zero if scarcity ceases altogether. But the liquidity premium commanded by money, which is cheap to store and does not require any effort to generate the return that liquidity affords, will prevent the rate of interest from falling to zero. If the mec falls to zero but the desire to save is still positive at full employment, the only way to reduce saving to zero, to match investment, is for income (and employment) to fall. A zero rate of new investment and saving at just full employment would be a fluke: the classical theorem that full employment characterizes the long run is refuted.