The values of income, consumption and saving shown in Table 3.1 have been plotted in Figure 3.1. If the national income is increased by an amount of say Rs. It’s a long book, so if you’re in a hurry, you might prefer my shorter summary of the fundamental ideas. The desire to hold cash, however, is not an absolute desire; it can be easily overcome by offering sufficiently high reward in the form of interest. And there’s the issue that even at low rates of interest, banks still need to trust their borrowers and make enough to pay their expenses, which may require them to raise rates. In Keynes’s view, fluctuations in the marginal efficiency of capital are the fundamental cause of the business cycle. Keynes, the story goes, figured out the causes of the Great Depression and in doing so revolutionized the field of economics. 180 crores. the national dividend is that part of the objective income of the community including, of course, income derived from abroad, which can be measured in money.” According to Prof. Pigou, only those goods and services should be included (double counting being avoided) that are actually sold for money. It’s hard to convey the excitement I felt when reading this.] Instead, saving lowers demand and thus decreases employment. Use of the Wage Unit 4. In The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes argues that the belief that markets naturally tend towards full employment is a fallacy, and that state interventionism is therefore necessary to … (Since running a trade deficit with a country means sending them your precious metals instead of your exports.) That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. (Since savings=investment, incomes are reduced such that the amount left over for savings equals the lesser amount now invested. Since few of the readers of this book are likely to be well acquainted with the significance of Gesell, I will give to him what would be otherwise a disproportionate space. What changes how much they spend? But if you’ve been unemployed long enough, you might actually want to work. In this way, Keynes reduced the magnitude of employment to wage units and measured the various types of aggregative magnitudes in terms of wage units. 2 likes. Static Analysis: The ‘General Theory’ does not trace out the effect of the future on the present economic events clearly. But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. 1: This chapter cheekily consists of a single paragraph. According to Prof. Pigou :”…. 5: Businesses make production decisions not based on sales or anything solidly measurable, but on personal opinions: expectations. 60 crores. For in such matters it is rash to predict how the average man will react to a changed environment. The General Theory was Keynes’s last major written work. Let us study the concepts and relations one by one. Introduction to Keynesian Theory: Keynes was the first to develop a systematic theory of employment in his book. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. If people are unemployed, it must be because they’re refusing to take the job. The straight line labelled C shows the behaviour of consumption expenditure with respect to income. As the title of “The General Theory of Employment, Interest, and Money” would indicate, much of Keynes’ ideas focused on unemployment, inflation, and the supply of money. For the book is, indeed, truly brilliant, a definite work of genius. Before we do so, it will help us to know the general framework or apparatus of Keynes’s theory. Money can’t survive on its own. They keep doing what they did yesterday unless they have a reason to change. 10. And there are other problems: when the stock market crashes, rich people see themselves as less rich and decide to start spending less. And there must be a similar employment multiplier (k’) where for each person hired for a job, k’ people get hired in total. The main problem with the Keynesian model was that it was meant for the short run. THE GENERAL THEORY OF EMPLOYMENT SUMMARY 1. If consumption fell at the same rate as income, we’d fall into a downward spiral: lower consumption would mean lower income, which in turn would mean lower consumption, and soon we’d all be out of a job. But the side effect is that “the very long-run course of prices has almost always been upward.”. Supplementary costs are those costs which cannot be foreseen or are beyond the control of entrepreneurs, i.e. a central bank) under public control. Thus, through his theoretical contribution Keynes not only shook the Classical Theory in its roots but also demolished its policy implications completely. Still, the book isn’t exactly a smooth read. It would need a volume of a different character from this one to indicate even in outline the practical measures in which they might be gradually clothed. The equilibrium level of income is determined at Rs. “It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.” And since much new investment money is raised on the stock market, it’s these estimates which influence new investment. It’s because investment comes first. Yet he has scarcely established an equal claim to rank — a private, perhaps, but not a major in the brave army of heretics — with Mandeville, Malthus, Gesell and Hobson, who, following their intuitions, have preferred to see the truth obscurely and imperfectly rather than to maintain error, reached indeed with clearness and consistency and by easy logic, but on hypotheses inappropriate to the facts. I must not be taken to deny this, because I assert that a state of full investment in the strict sense has never yet occurred, not even momentarily.”. That is, if management decides to pay people $4 an hour instead of $5, people might go on strike, but nobody ever goes on strike demanding a raise because the cost of milk has gone up. He observed that public works need to be undertaken only as long as private investment is deficient. In other words, it is the highest rate of return over cost expected from producing one more unit (marginal unit) of a particular type of capital asset. [AS: This is the first use of that suspicious definition.]) The distinction between consumption and investment is fundamental to Keynes’ General Theory. Two years later, though not completely recovered, he returned to teaching at Cambridge, wrote three influential articles on war finance entitled How to Pay for the War (1940; later reprinted as Collected Writings , vol. — Uncertainties and fluctuations of investment, 217. It may well be that the classical theory represents the way in which we should like our economy to behave. Therefore, Keynes called his treatise the General Theory Why is money so special? Well, until you have full employment obviously. At some point we just need to consume more stuff. 21: Traditional economics is divided between the theory of value (perfect competition, supply and demand, and all that good stuff) in the main spot and then over to the side has a separate theory of money (dealing interest rates and inflation), with no clear connection between the two. Further, the amount of wages received by ordinary labour for an hour’s work, Keynes called-wage unit. But the actual course of events is more complicated still. It’s basically been written out of economic history, in part, no doubt, because it was written in the form of a scandalous satirical epic poem. In other words, it shows that whatever people earn is being spent either on consumption or on investment. and measured them in wage units to be able to ignore the questions arising out of changes in relative prices of resources. At levels of income greater than Rs. Keynes’ concept of national income lies somewhat between the Gross National Product and the Net National Product. They’d much rather invest their money so that its valuation keeps going up and up and up. And this is especially true in the short-term — people’s habits take time to catch up with their incomes. In 1936, in the midst of the Great Depression, John Maynard Keynes forever transformed the field of macroeconomics with this classic and still controversial work. But this means that as national income increases, a smaller proportion of it will get spent, so more of it will have to be invested. But as interest rates get lower, it becomes profitable to invest in building things with smaller and smaller expected yields. Keynes also refers to this previous Treatise on Money, explaining the re-definition of terms in The General Theory to avoid the confusions which the previous book brought when his terms were adopted for general use, without considering the “special sense” that … Virtue and vice play no part. The classical school — including Keynes in earlier years — grew up mocking mercantilism (protectionism) as incoherent and absurd. But these all depend on other complicating factors. The bought and the un bought do not differ in kind from one another in any fundamental respect. Suppose in order to cure unemployment an investment of Rs. According to Keynes, this was the normal situation of a free-enterprise market economy and economists hailed this idea of Keynes as the most significant gift to economics. Keynes, therefore, adopted a new unit for measuring the changes in the national output, that is, the unit of the employment of labour. Except during the war, I doubt if we have any recent experience of a boom so strong that it led to full employment. A shorter account will be found in the article on Keynesian economics. The second half is filling it in. And while workers are obviously not all equivalent the way dollar bills are, we can take an hour of unskilled labor as our standard and count people with special skills as multiples of an hour of unskilled labor. Propensity to consume refers to the actual consumption that takes place at different levels of income. The conservative economists liked to wait for the free- economic system to correct its ailment itself but they could not specify for how long. Why does redistributing income work? In Keynesian Economics saving is defined as the excess of income over consumption, i.e., S = Y – C. The fundamental fact about saving is that its volume depends upon income. As a result, it seems likely that the State, which can calculate these things with an eye to the long-term and the social good, will take over more and more of the job of organizing long-term investment. As a result, the theory supports the expansionary fiscal policy. In order to carry daily transactions, to meet unforeseen contingencies and in order to take advantage of the market movements of bond prices, people want to hold cash; this constitutes the demand side of the Keynesian theory of the rate of interest. “There are advantages in some degree of flexibility in the wages of particular industries so as to expedite transfers from those which are relatively declining to those which are relatively expanding. Other traps are hyperinflation (where no one wants to hold onto money) and a financial crisis (where no one trusts the banks enough to let go of money). It would be absurd to assert of the United States in 1929 the existence of over-investment in the strict sense. Why is there a liquidity preference? And total consumption is just all the stuff that isn’t sold to other businesses. It’s also possible (although unlikely) that no one will believe the government can keep rates so low and so they begin hoarding all the new cash the government prints. stimulus — in mind here, although he never really comes out and says it.] But how do they know what future sales will be? It is striking how few economists have thought this problem through.”), 12: As we noted before, capitalists invest if they expect future sales to be high. First, people may refuse to work for a lower nominal wage when they’ll accept working for a lower real (i.e. I do not attempt an answer in this place. He assumed that there is a fairly high degree of competition in the markets. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a ‘purely monetary’ remedy have underestimated.”. But there’s two kinds of overinvestment: disappointing investments, where the investment would have made sense except the economy collapsed, and genuine overinvestment, where the investment could never have made money. Consumption function is written as a schedule of various amounts of consumption expenditure that consumers will incur at different levels of income. 70 crores while their income is only Rs. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. and measured them in wage units to be able to ignore the questions arising out of changes in relative prices of resources. This is a depressing thought, especially since Keynes throughout seems optimistic that once he’s explained everything so clearly, economics will be back on the right track. Keynes in his general theory dealt with aggregates like the national income, saving, investment, etc. Sorry.] In fact, monetary unit (money) had been employed usually as the standard of measurement. Investment multiplier (Income multiplier) expresses the relationship between an initial investment and the ultimate increase in national income. ... x The Economics of Keynes: A New Guide to The General Theory Hayes’s subsequent explanations of the analysis and contributions of The General Theory are built on these basic, central, core foundations. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis. “Never in history was there a method devised of such efficacy for setting each country’s advantage at variance with its neighbours’!”. There’s an asymmetry in the system that workers will resist falling wages, but not rising ones. You might think that this just means someone who actually does sit down and calculate expected yields could make vast profits from all the speculators playing Snap. It simply lays down that as our incomes increase; consumption will also increase though not in the same proportion as the increase in income. Since it seemed unlikely that society had run out of money-making jobs, it was assumed that unemployment was caused either by people not knowing where the jobs were (frictional unemployment) or insisting on being paid more than they could make (voluntary unemployment). We’ve said it doesn’t have much effect on people’s propensity to consume, but a higher interest rate means it’s more expensive to borrow money, which means companies invest less, which means incomes are reduced. Indeed the world is ruled by little else. The equation Y= C+I, expresses the relationship between C and Y. And thus, just as capital investment was driven by stock market speculation, interest rates are driven by bond market speculation. But calculating expected yields is much harder than guessing what everyone else will do; there’s no reason to think spending the same amount of time doing that is any more profitable. Under the classical theory, the wage rate is determined by the marginal productivity of labour , and as many people are employed as are willing to work at that rate. We have to accept them as an inevitable result of applying to the conduct of the State the maxims which are best calculated to “enrich” an individual by enabling him to pile up claims to enjoyment which he does not intend to exercise at any definite time. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. Effective demand manifests itself in the spending of income. Thus gold-mines are of the greatest value and importance to civilisation. Pigou’s definition is precise, convenient, elastic and workable because it did away with the difficulty of measuring the national dividend inherent in Marshall’s definition. The horizontal axis of Figure 4.1 shows the levels of income and the vertical axis shows the levels of consumption, saving and investment in the economy. Policy Recommendations of Keynes’s Theory 9. If you can’t increase investment, you have to increase consumption. Since the former is a direct approach while the latter is an indirect approach, the two approaches are called the Front- Door Approach and the Back-Door Approach respectively. 250 (Rs. Keynes also discusses Bernard Mandeville’s incredible book, The Fable of the Bees. We can add it to the various levels of consumption shown by the consumption function and get the C +I (total expenditure) line. They got it in their head that they were going to build a railroad, and by Jove they did. It is judged from the total expenditure in the economy. The more virtuous we are, the more determinedly thrifty, the more obstinately orthodox in our national and personal finance, the more our incomes will have to fall when interest rises relatively to the marginal efficiency of capital. [emphasis added], 11: Imagine you get a new widget-making machine. Obstinacy can bring only a penalty and no reward. Or perhaps between the stationary economy and the shifting one, for money’s power “flows from its being a link between the present and the future.”. “We have all of us become used to finding ourselves sometimes on the one side of the moon and sometimes on the other, without knowing what route or journey connects them, related, apparently, after the fashion of our waking and our dreaming lives.” The right split is between the theory of the individual industry and the theory of the economy as a whole. So we’ll use only two types of counts: those of actual currency (money-values) and those of people (employment). For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;—a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts. 17: Let’s step back for a second. If electing FDR gets them depressed, they might pull back their investments and send the economy into a slump. In a country where most of the goods and services are not exchanged for money, i.e. This dual approach to income determination has proved of great help in theoretical model building on the one side and national income accounting on the other. We conclude by observing that the nature of economic problems of more developed economies has changed so much that Keynesian policies alone are not so much relevant. 2: The classical theory of employment says the labor market is just another market: people get paid what they make and people only work if they get paid enough to make it worth it. There were a few direct policy implications of Keynes’ theory. Bonds are for wusses. 24: The two great economic problems are unemployment and inequality. There must be an investment multiplier — call it k — such that an extra $1 invested leads to $k increase in income. The result is “a gradual crescendo in the level of employment, rising to a peak and then declining to the new long-period level.” This can happen even if you don’t expect to sell more things, but just a slightly different thing: you “overhire” to get up to speed on the new model, but then fire people until you’re back down to your previous level. But to assume that it actually does so is to assume our difficulties away. National Income Definition 3. It shows the simple process of income determination in an economy. Instead, you can give it to poor people, who will use it to buy useful things like food and clothing. In practical life the exact line of demarcation between investment and consumption is easily drawn; for example, expenditures on food and clothing are clearly consumption while those on buildings, factories and transportation facilities are easily investment. So it’s how much people spend that determines employment. In The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes argues that the belief that markets naturally tend towards full employment is a fallacy, and that state interventionism is therefore necessary to overcome economic slumps. According to him what actually existed in the capitalist society was under-employment and not full employment. Not all protectionism promotes the balance of trade, of course — mid-1800s Britain probably would have done best with complete free trade. In which case, “a decreased readiness to spend will be looked on in quite a different light.”, [AS: And so this is the famous paradox of thrift. Let us imagine these policies are implemented. Keynes’s General Theory of Employment, Interest and Money (1936) is surely the most influential book of recent times. The higher the liquidity preference i.e., the desire of the people to hold cash, the higher the rate of interest which must be offered to overcome their liquidity preference. Liquidity preference is a new concept used by Keynes. In 1937 he suffered a severe heart attack . The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object. Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative. Think about the dot-com bubble where everyone was blowing money on useless fiber-optic cable. Since we are taking each commodity in turn as the standard, the returns on each commodity must be reckoned in this context as being measured in terms of itself. In other words, as employment goes up and we run out of skilled truck-builders, we say the truck factory is getting less efficient. Saving, of course, is just income minus consumption. He solved this problem in his own way. 16: OK, so we’re in a liquidity trap. 15 crores then investment multiplier is 15/5 = 3. He gave practically useful policy. Keynes's main theory (including its dynamic elements) is presented in Chapters 2-15, 18, and 22, which are summarised here. The only solution would be to force everyone to either to buy goods or capital assets with everything they own. (p.181), were inserted by Keynes … And the stock market depends on “what is, in truth, a convention” — namely that the current valuation of a company is an accurate assessment of its expected yield — that stock prices will only change if there’s new evidence suggesting the yield will be different. As is often the case with imperfectly analysed intuitions, their significance only became apparent after I had reached my own conclusions in my own way. It is because of this that Keynesians have put more faith in fiscal rather than monetary policy. And “it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. Inequality has been addressed somewhat by government redistribution, but some are hesitant to go further because they believe that growth is promoted by savings and so taking away the savings of the rich will retard growth. Saving doesn’t lower the interest rate and thus increase investment — an increase in money does that. It has a constant slope and therefore shows a functional relation between income and consumption. But the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.”. And, if our theory does work and we end up with full employment, then we return to the world of the classical economic theory, whose only flaw was assuming that full employment was the only possible state of affairs. For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him. That means, Keynesians wanted the government to go on raising aggregate demand to reduce unemployment to the acceptable level. The more open our stock markets get, the more speculators predominate, and the worse things get for us. (If, indeed, there’s nobody left who can build the trucks, we say the truck factory’s efficiency has gone to zero.). To conclude, Keynes uses the term income in two senses: (1) Gross Income (A-U) on which the volume of employment depends. That said, one wouldn’t want to get rid of money altogether: [D]angerous human proclivities can be canalised into comparatively harmless channels by the existence of opportunities for money-making and private wealth, which, if they cannot be satisfied in this way, may find their outlet in cruelty, the reckless pursuit of personal power and authority, and other forms of self-aggrandisement. | Keynes’s General Theory. 180 crores, planned saving is more than planned investment so that income falls to correct the disequilibrium. It conveys the impression that there are several factors on which employment depends. Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society. But it was found that Keynes’s policies tended to create inflationary pressures to control which the government had to reduce aggregate spending. The Income-Expenditure Approach (Y = C + 1): Keynes defined the equilibrium of the economy as that situation in which total income (Y) equals the total expenditure (C + I). And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. [Tyler Cowen: “This is the best chapter in the book and one of the most important economics essays of all time. So why should the government promote investment instead of demand? We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. Then as some workers receive better wages other workers will demand it and, since business is booming, receive it. at different points on this line total income is equal to total expenditure. It will be useful for us to understand the two approaches at the outset. TOS4. The problem is that capitalists aren’t buying capital per se, they’re buying an expected yield. “A full explanation is complex and must wait for Chapter 15.” But we can see one reason now: uncertainty about the expected [AS: there’s that word again] rate of interest. The General Theory of Employment, Interest and Money is a highly significant work that marked a turning point in the development of modern economic theory. But if effective demand is adequate, average skill and average good fortune will be enough. The book has proved revolutionary in the sense that it has left its imprint on all branches of economic theory. Summary. And then what do we do? 140. As income increases, consumption also increases but not so much as the increase in income. They didn’t sit down and calculate whether they could have made more money buying bonds instead. The ‘General Theory’ does not trace out the effect of the future on the present economic events clearly. But how much they sell is exactly dependent on how much people spend. Community saving is simply an aggregate of individual saving. People can either be put to work making things for people to use today or making things for people to use tomorrow, but that tomorrow “cannot be pushed indefinitely into the future.” After all, an hour of labor cannot be “saved” and put into a bank for a rainy day! Investment is just the amount of current output that isn’t consumed. We’ll call these hours labor-units and we’ll call the money that gets paid for them wage-units. But since no one really knows what they’re doing, especially not the speculators, it’s understandable that “when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.” Everyone gets freaked out that they’re not going to make money anymore and stops investing and raises their liquidity preference, raising interest rates and lowering investment further. Fleshing out the GT with tools not available to Keynes, Marglin exposes the fundamental failure of markets to self-regulate and draws lessons for fiscal and monetary policies. Thus the interest rate depends on people’s desire to hoard cash — their liquidity preference (L) — and the quantity of money (M). For example, if the economy is in a deflationary gap situation but is also suffering from a 15 per cent rate of inflation, an increase in government spending or a cut in taxation designed to reduce the unemployment is likely to worsen the rate of inflation. But in this case the value of the machine has been maintained at Rs. Here, the idea of ‘net Income’ assumes special significance. Thus, the user cost would be Rs. But this is good, because otherwise wages would fall to zero in any downturn and the entire economy would shut down. Absence of Governmental Part in Economic Activity: The government is assumed to play no (significant) part either as a taxer or as a spender. Presumably this means that interest rates will become very low (although you don’t want them so low that nobody’s making things to sell today). — The theory of interest restated, 215. are on the right track. With the publication of the General Theory in February 1936, the scene shifted somewhat to new matters of defence, exposition and further development. And some of the money can “leak” out to other countries. Like “The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. (Maybe large changes in interest rates, but those are rare.). To simplify his theory considerably, Keynes employed a few assumptions which must be noted to avoid any confusion or misunderstanding. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. His theory of interest depends upon it. Obviously a lot more in absolute terms, but far less proportionately.) Prices in Keynes’s model use only after full employment. And, in practice, people don’t calculate their expectations from scratch each morning. Finally we come to Major Douglas, who led the unorthodox Social Credit movement in the UK: Major Douglas is entitled to claim, as against some of his orthodox adversaries, that he at least has not been wholly oblivious of the outstanding problem of our economic system. Demand and Supply for output as a whole, 219. “If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.”. You might think (as Keynes once did) that the best solution is to just force people to hold on to what they buy, so they have to figure out what it’s really worth beforehand, but this will just push people to hold on to their money. Thirdly, Keynes spelt out the specific form which state intervention has to take to counter economic depression. 10) = Rs. And the process of adjusting can have some odd effects: if you need to quickly ramp up production, you might keep hiring until you have more employees than you really need in the long-run. If venture capitalists are spending all their money on useless cable, the solution is to take their money away. A labour unit may be taken to mean one hour of work by ordinary, unskilled or common worker. It was a passion with the young economists and a problem with the traditional economists. Everyone builds houses thinking they’ll all sell for lots and lots, then they find they aren’t actually selling for so much and the economy collapses. The other component is investment. For the result is inevitable. But now people invest their money in the stock market, which revises its profitability estimates minute-by-minute. Secondly, he could very nicely provide reasons for departures from the policy of balanced budgets. THE GENERAL THEORY 2. … But there are many difficulties which Gesell did not face. … The insights here have yet to be fully mined.”]. [AS: Keynes apparently has government investment — i.e. What happens isn’t so much excessive investment as misdirected investment. The total income of the community is just the amount sold minus the user cost. 3: When people get money, they spend some of it — but not all of it. 4. In 1987, Greenwald and Stiglitz accused Keynes’s summary of the "General Theory" in chapter 18 of relying upon “neoclassical and Marshallian tools.” (The details of how the remainder gets invested has to do with interest and will be addressed later.). — II. (If you make $50K a year, you might spend $40K of it. All industries employ labour and their outputs can be expressed in terms of employment that they offer. inflation-adjusted) wage. Saving in that case equals intended or planned investment. The demand in the economy is ordinarily for two types of goods – consumption goods and investment goods. And yet, the book is a necessary now as it was then: economics has not learned a single one of his lessons. But this doesn’t effect the long-term rates, which depend on people’s expectations of what the government will do to short-term rates. An uninterrupted process of transition, such as the above, to a new long-period position can be complicated in detail. As I said, that’s the naive view — there are a couple complications. Even if the machine were not put to use, it would have suffered a loss of value on account of say rusting etc. So even lowering interest rates isn’t enough to recover from the crash. Indeed, this problem will be worse in richer countries, since the more people make the less of it they need to spend and thus less money is used to hire people. ‘“What will you do,” it is asked, “when you have built all the houses and roads and town halls and electric grids and water supplies and so forth which the stationary population of the future can be expected to require?”’ But the same logic applies to private investment. Thus in the absence of money and in the absence — we must, of course, also suppose — of any other commodity with the assumed characteristics of money, the rates of interest would only reach equilibrium when there is full employment. Such public investment, he said, best achieves the multiplier effects. It is not the ownership of the instruments of production which it is important for the State to assume. Is the fulfilment of these ideas a visionary hope? It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution. And businesses choose whether to hire people based on how much they expect to sell. The General Theory of Employment, Interest and Money [full text]. “Moreover, this situation might be reached comparatively soon—say within twenty-five years or less. Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. But how much? Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. This may be great simplification of facts but it brings forth the crucial importance of investment in Keynesian theory of employment. He wanted to know the considerations that weigh with entrepreneurs when they decide to employ certain number of men. Then the money can’t go to hire more people so it just goes to bid up the prices of things, creating inflation. It tells us that there is a direct relation between income and consumption. This isn’t a conspiracy, it’s just the natural outcome of a system that depends on rich people feeling good. Privacy Policy3. Keynes’ argument is based on the idea that the level of employment is not determined by the price of labour, but by the spending of money. It forgets that there is no such thing as liquidity of investment for the community as a whole. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. etc. 750 at the end of the year having suffered a reduction in the value worth Rs. These are supplementary costs. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. As there is disequilibrium, income will have to rise. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York. User Cost is the difference between the depreciation in the value of the machine when it is put to use and the depreciation which would occur if not in use plus the expenditure incurred on its maintenance and upkeep. If, however, it should prove easy to secure an approximation to full employment with a rate of accumulation not much greater than at present, an outstanding problem will at least have been solved. The mercantilists perceived the existence of the problem without being able to push their analysis to the point of solving it. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Even if you hire people for investment, the money those people get paid in turn gets spent on additional consumption, increasing employment indirectly as well. Since this seems so basic, Keynes is puzzled at how it’s been so ignored: The completeness of the [classical] victory is something of a curiosity and a mystery. The same level of income gets determined whether we have the Y = C +I approach or the S=I approach. Why should it be any different from a futures contract on wheat? Investment depends upon the marginal efficiency of capital on the one hand and the rate of interest on the other. It seemed clear that there was something seriously wrong with the capitalist way of economic organisation. Keynesian economics is a theory that says the government should increase demand to boost growth. Let us make an in-depth study of the Keynes’s General Theory in Macroeconomics:- 1. The General Theory of Employment, Interest and Money transformed economics and changed the face of modern macroeconomics. Having discussed the factors which determine the level of economic activity (income, output and employment) in the economy, Keynes went on to build a simple model of income determination at a particular time. No explanation of this is provided by the Keynesian Theory. (Of course, this is only true until we hit full employment — then prices just inflate.). Therefore, point E shows equilibrium in the economy. Keynes, the story goes, figured out the causes of the Great Depression and in doing so revolutionized the field of economics. In the post-war years his devotees bombarded me with copies of his works; yet, owing to certain palpable defects in the argument, I entirely failed to discover their merit. It is straight line rising upwards to the right intersecting the 45° line where the whole of income is spent on consumption. Thus we are so sensible, have schooled ourselves to so close a semblance of prudent financiers, taking careful thought before we add to the “financial” burdens of posterity by building them houses to live in, that we have no such easy escape from the sufferings of unemployment. But this just weakens the multiplier, it doesn’t eliminate it. The effective demand in turn depends upon: (2) Investment, which depends upon marginal efficiency of capital and the rate of interest. Keynes, however, called it a social vice, as more saving on the part of an individual will mean less saving on the part of another individual, leaving the total savings of the community unaffected. Another way to look at it is the more stuff we make for tomorrow, the less stuff we need to make tomorrow. These two combined are the prime cost. It’s difficult to get people to realize that investing money doesn’t actually lead to an increase in investments. But if the ideas are correct — an hypothesis on which the author himself must necessarily base what he writes — it would be a mistake, I predict, to dispute their potency over a period of time. He writes: ”This simple yet powerful point doesn’t get the attention it ought to. In short, increasing interest rates to kill booms “belongs to the species of remedy which cures the disease by killing the patient.”, What would the world of the permanent boom look like? It is an inevitable result of an investment market whose organization encourages these behaviors. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. When we deduct the aggregate user cost from the Gross National Product, we shall get national income of the economy in the Keynesian sense represented by A-U (where A is the Gross National Product, being the total product or value of goods and services obtained in a year and U represents the total user cost). This incredible work of economic thought described the division of labor and the invisible hand in 1705, a full seventy years before Adam Smith. Well, the naive view is that it doesn’t — the additional money gets used to buy more things which hires more people — until everyone is hired. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. Limitations of the Keynesian Theory. He divided effective demand into two components – consumption and investment. In Keynesian economics, investment does not mean financial investment i.e., investing money in buying existing stocks and shares, bonds or equities. He did not draw any diagram in his ‘General Theory’ but his ideas can be better understood with the help of such a simple diagram as is given below. The Saving-Investment Approaches (S=I): The second approach to income determination given in the ‘General Theory’ is based on the Keynesian definitions of Saving and Investment. But you can’t jump-start it just by lowering interest rates, since the real problem is expected return. In this event a scheme for the higher taxation of large incomes and inheritances might be open to the objection that it would lead to full employment with a rate of accumulation which was reduced considerably below the current level. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. (And when everyone follows the stock market, like in the US, this applies to everyone.) But I think this is entirely due to a difference in philosophies: the General Theory was the first book on economics I could really understand. ], And as for some people being better at some jobs than others, we just pretend that’s an artifact of the equipment they use. It works, it’s just slow — if you want to get people employed quickly, you’re better off starting with building the factories. “The fundamental psychological law,” he says, is that, on average, the amount people spend increases as the amount they make increases, but not as quickly. Marginal prime costs and labor costs increase as industry is forced to use more expensive equipment and laborers, resulting in higher prices. “The idea behind stamped money is sound. money) is something which cannot be produced and the demand for which cannot be readily choked off. It means disserving or accumulated-wealth consumption. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. 16 quotes from The General Theory of Employment, Interest, and Money: ... ― John Maynard Keynes, The General Theory of Employment, Interest, and Money. To mention a detail, the tendency in slumps for the price of gold to rise in terms of labour and materials aids eventual recovery, because it increases the depth at which gold-digging pays and lowers the minimum grade of ore which is payable. [AS: This is truly brilliant. The points on this line fulfill the equilibrium condition in the economy: i.e. And when national income falls, a larger proportion gets spent as people dip into savings and governments go into deficit.   Keynesians believe consumer demand is the primary driving force in an economy. Then there’s the cost of creating one more new widget-making machine. Keynesian economics is a macroeconomic economic theory of total spending in the economy and its effects on output, employment, and inflation. For there would obviously be a natural tendency towards the optimum employment of resources in a society which was functioning after the manner of the classical postulates. 51, No. Keynes begins the General Theory with a summary of the classical theory of employment, which he encapsulates in his formulation of Say's Law as the dictum "Supply creates its own demand". The only thing that could work is a one-time decrease in everyone’s wages to a new level, but that a) is never going to happen in a democracy and b) unfairly penalizes wage-earners over everyone else. He advocated the policy of starting public works and financing them with fiat money with an unbalanced budget. 10: We’ve established that an increase in investment leads to an increase in income. It was in this type of situation that Keynes was provoked to bring out his ‘General Theory’ (So nicknamed popularly) to justify taking up some new economic measures to tackle the situation. If they expect to do a cash transaction in the future, they’ll need to sell a bond then — but if the interest rate has risen in the meantime, they’ll be selling the bond at a loss. Since consumption expenditures in the short run remain stable, Keynes’s theory stated in simple terms maintains that employment depends upon investment. It is interesting to notice that the characteristic which has been traditionally supposed to render gold especially suitable for use as the standard of value, namely, its inelasticity of supply, turns out to be precisely the characteristic which is at the bottom of the trouble. Have they insufficient roots in the motives which govern the evolution of political society? That said, today’s decisions are based on the conditions of today and expectations about tomorrow — not on past expectations or the conditions of the past. As such it is called Consumption Function. Thus all ‘go’ periods tended to be followed by ‘stop’ periods and it became difficult to achieve long-term economic growth. Thus the total amount spent on wages equals the wage-unit times the number of labor-units. At the income level of Rs. During depression he would advocate a deficit budget to stimulate effective demand and in times of inflation, he wanted the government to have a surplus budget to restrict effective demand. These can be either short-term expectations (the barrista will be given the day off if management doesn’t expect any customers) or long-term expectations (Starbucks won’t open up a new story if they expect coffee consumption to start going down). It is better that a man should tyrannise over his bank balance than over his fellow-citizens; and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative. The general apparatus of the Keynesian theory of employment can be briefly summarised in the following form: We start explaining the concepts from the top of the format given above. The Two Approaches to Income Determination 8. Net income is found by deducting supplementary costs V from the income (A-U). Entrepreneurs can also lose capital due to unavoidable events — a market crash, an earthquake, the passage of time. ], 7: Keynes spends the chapter defending his decision to define savings as equal to investment. Dr. Marshall in his Principles of Economics had defined national income as follows: “The labour and capital of a country, acting on its natural resources, produce annually a certain net aggregate of commodities, material and immaterial, including services of all kinds… and net income due on account of foreign investments must be added in this is the true net annual income or revenue of the country, or the national dividend.”. [AS: I think he only ends up in making things more confusing, but maybe I’m missing something. 2.4 Summary 83 APPENDIX TO CHAPTER 2 86 . For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions. The only thing that can save us is if “millionaires find their satisfaction in building mighty mansions to contain their bodies when alive and pyramids to shelter them after death, or, repenting of their sins, erect cathedrals and endow monasteries or foreign missions.” That’s no way to run a country. Again, in Pigou’s definition, one could find the total amount of national dividend because we are to include where most of the goods and services are not exchanged for money. Not only is income equal to expenditure, Y = C +I, but saving also equals investment, S = I. There’s no math, but there’s still a lot to chew on. 9: How does raising interest rates affect consumption? If you give people money to buy more (say) iPods, then first all the existing iPods get sold. […]. Another thing the classical economists long mocked were laws against usury. If you make $1M, you might spend $500K of it. Further as income rises, saving also rises. Domestic investment is encouraged by the interest rate and foreign investment by the balance of trade. But I now read these discussions as an honest intellectual effort to keep separate what the classical theory has inextricably confused together, namely, the rate of interest and the marginal efficiency of capital. Keynes rejected classical theories based on the idea that production creates its own demand, that is, that the economy always recovers to full employment after a shock. (So inflation might actually be a better solution than wage cuts.). You use the extra people to get you up to speed, then you lay them off. In the Keynesian model, a change in money supply only affects national income through its effect on the rate of interest. Keynes does not deduct the whole of depreciation from the Gross National Product, he subtracts a little less than the whole amount of depreciation called ‘User Cost’. Keynesian demand management policies were used by the governments of most Western countries in the attempt to keep the unemployment levels down. Some industries hit “bottlenecks” first, causing their prices to rise and demand to be funneled into industries that are faster to respond. We start by observing it’s impossible to measure things like “net output” or “price level” accurately — you’re always trying to compare qualitatively different things and run into no end of difficulties. The Middle Ages built cathedrals and sang dirges. All this requires detailed study of Keynes’s General Theory. Keynes: Long-term Expectations (Ch. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. If there are people around willing to work, jobs will spring up to make use of them. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority. It’s often said that the interest rate is the price people demand for saving money instead of spending it. 1. Keynes assumed that the techniques of production and the amount of fixed capital used remain constant in the model of his theory. There are a large number of short-run and long-run influences which affect the marginal efficiency of capital. Others say the problem is that the country is so unequal that poor people can’t spend enough. We could imagine paying the future wheat contracts in terms of wheat, resulting in a wheat interest rate. 22: Why are there trade cycles, aka business cycles, aka booms and busts? And there are some, I believe, who practise the fourth, fifth and higher degrees.
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