250 (Rs. It would be absurd to assert of the United States in 1929 the existence of over-investment in the strict sense. Since consumption depends upon net income, it is necessary that net income be calculated as accurately as possible.   Keynesians believe consumer demand is the primary driving force in an economy. Thus, if volume of employment (labour units) in the economy is increasing, it is clear that there is an increase in the national output. How does money influence demand? That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. The Middle Ages built cathedrals and sang dirges. Certain definite points on which the writer diverges from previous theories, 212. Therefore, it is important to understand what determines the amount of investment. Policy Recommendations of Keynes’s Theory 9. Fisher adopted consumption instead of production as the basis of measuring the national dividend. 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. They are “undoubtedly in the right [at present],” when investment is “unplanned and uncontrolled.” There’s no other way to raise employment. -The theory of interest restated, 215. Instead, you can give it to poor people, who will use it to buy useful things like food and clothing. The fact of the matter is that employment fluctuates on account of the fluctuations in investment. (Of course, this is only true until we hit full employment — then prices just inflate.). Keynes was writing about the short-period problem of depression. Keynes disputed the classical assumption of automaticity of full employment and the classical prescription that in the event of an economic depression wage cuts would bring about full employment in the economy. Absence of Governmental Part in Economic Activity: The government is assumed to play no (significant) part either as a taxer or as a spender. 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 analogy between this expedient and the goldmines of the real world is complete. At this point, expected return might be just enough to cover the costs of production, plus a little for risk and skill — just like other goods. 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. 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. Here, it means real investment in new capital goods Investment in Keynesian economics is that expenditure which should result in an increase of employment of the factors of production in new factories and consumption. If the rate of interest were so governed as to maintain continuous full employment, Virtue would resume her sway; — the rate of capital accumulation would depend on the weakness of the propensity to consume. 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). — III. But politics has triumphed over logic and we’ve forgotten all the crucial things he explained. 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. Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. It shows the simple process of income determination in an economy. 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 idea behind stamped money is sound. [AS: Obviously this accounting fiction isn’t particularly realistic since, in reality, the multiples people get paid change as the wage-unit goes up. But employment is kind of a more interesting number and it will have to do. So I thought I’d try my best at an explanation/summary. if the reward for parting with cash were diminished, the aggregate amount of cash which the public would wish to hold would exceed the available supply, and that if the rate of interest were raised, there would be a surplus of cash which no one would be willing to hold.” And if that’s true then the quantity of money is the other factor that determines interest rates. It would be the end of the rentier — the rich person who grows richer by using his wealth to exploiting others. All it can do is change the price of hoarding — the interest rate. 10) = Rs. 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. It has a constant slope and therefore shows a functional relation between income and consumption. Some conservative economists have forgotten or ignored his work, but society as a whole remembers his basic discovery: you get out of downturns by spending money. We can write this relation as C=f(Y). [AS: Keynes apparently has government investment — i.e. What changes how much they spend? Investment also includes additions to stocks of manufactured and semi-manufactured goods (inventories) as well as in fixed capital. 180 crores equals planned investment. Underemployment equilibrium was the result of private under-investment in relation to the savings available in the capitalist economy at the given income level. 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. 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. Static Analysis: The ‘General Theory’ does not trace out the effect of the future on the present economic events clearly. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. Of these ideas, unemployment and its repercussions have been given the most study.Keynes writes in one of the important quotes from “The General Theory of Employment, Interest, and Money” … the existing theory of unemployment nonsense. 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. Why should it be any different from a futures contract on wheat? ], 8: We return now to our main argument. … But there are many difficulties which Gesell did not face. He assumed that there is a fairly high degree of competition in the markets. The equation Y= C+I, expresses the relationship between C and Y. Limitations of the Keynesian Theory. Of course there’s lots of different things you can invest in; we’re assuming that you do whatever maximizes your expected return. And some of the money can “leak” out to other countries. 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. What happens isn’t so much excessive investment as misdirected investment. We have to select the more easily manageable factors influencing aggregate income and employment. Well, until you have full employment obviously. And when more efficient workers actually are paid more, he takes that into account as noted above. (Land can’t be grown either, but if we really needed to we could free some up by moving closer together. 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. Instead, saving lowers demand and thus decreases employment. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. The General Theory of Employment, Interest and Money (1936). As a result, the theory supports the expansionary fiscal policy. People seem to recognize this when it comes to government making stuff. National Income Definition 3. It is the cost of using capital equipment rather than of leaving it idle. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. Welcome to EconomicsDiscussion.net! The other component is investment. And getting money for it is much harder — people don’t like it when you tell them “Yes, the stocks you bought are worthless now but just wait! Introduction to Keynes’s General Theory 2. If people are out of work now, the time they’re wasting will never be recovered. He advocated the policy of starting public works and financing them with fiat money with an unbalanced budget. Consumption is only one, though major, component of expenditure. 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 all depends on how far the rate of interest is favourable to investment, after taking account of the marginal efficiency of capital. 13: We said before that businesses keep investing until their expected return reaches the interest rate (so lower interest rates mean more investment), but what determines the interest rate? It seemed clear that there was something seriously wrong with the capitalist way of economic organisation. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. This isn’t a conspiracy, it’s just the natural outcome of a system that depends on rich people feeling good. The solution, they propose, is redistributing money to the poor to promote jobs. 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. Privacy Policy3. The demand in the economy is ordinarily for two types of goods – consumption goods and investment goods. Fourthly, Keynesian model has been criticised on the ground that it tends to understate the influence of money on the real variables (like consumption and investment) in the economy. There’s an asymmetry in the system that workers will resist falling wages, but not rising ones. “In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.”. Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York. Everyone has seen bits and pieces of wit quoted from the book, but Keynes weaves them into a beautiful tapestry that explains the whole of the modern economy. “Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.”. Keynes further assumed that the economy under analysis is a closed one; that is, he did not explicitly recognise in his analysis the influence of exports and imports. Prof. Fisher’s definition was better than both Dr. Marshall’s and Prof. Pigou’s in as much as it was nearer the concept of economic welfare because welfare depends upon the goods and services made available to the individuals of the community. Interest today rewards no genuine sacrifice, any more than does the rent of land. 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? But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. Think about the dot-com bubble where everyone was blowing money on useless fiber-optic cable. The result is that saving, which is income not spent on consumption, goes on increasing. 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. Liquidity preference means preference for liquidity or cash. Estimates are at best estimates and they can at times differ from the actual. The Two Approaches to Income Determination 8. It may turn out that the propensity to consume will be so easily strengthened by the effects of a falling rate of interest, that full employment can be reached with a rate of accumulation little greater than at present. Multiplier is the key concept of Keynes. However, it may be noted that the suitability of any particular definition depends upon the purpose for which it is to be used. It shows that an initial increase in investment increases the national income by a multiple of it. 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. To arrive at this seemingly simple conclusion, however, Keynes developed a highly complex argumentation brimming with new economic terms and concepts of his own devising, such as “multipliers,” “consumption and saving functions,” “the marginal efficiency of capital,” “liquidity preference,” “I-S curve,” and many others. 5 crores is made in public works, the effect of this original investment would be to increase the national income several fold. 20: We’ve said that employment ultimately comes from demand. 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. 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.”. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce. But it’s not easy to think of useful things to make for the future. If the minimum wage is doubled to $10 an hour, I’m not suddenly going to get paid $600 an hour, even though my relative productivity hasn’t changed. Nevertheless, the way in which modern economists view macro-economic problems owes much to the Keynesian framework. 60 crores. 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. Keynes wanted to choose the most suitable definition for this particular purpose. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Keynes’ concept of national income lies somewhat between the Gross National Product and the Net National Product. Then as some workers receive better wages other workers will demand it and, since business is booming, receive it. At levels of income greater than Rs. When recovery picks up, it feeds on itself in the opposite way. 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. 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 … Keynes’s first proposition was that total income depends upon the volume of total employment, which depends upon effective demand (D), which in turn, depends upon consumption expenditure (D1) and investment expenditure (D2): therefore, Effective Demand D = D1 + D2. But this is totally consistent with there being unemployment — if people aren’t buying, businesses aren’t selling, so they fire people (who then buy less). Operation of the Law of Diminishing Returns: Further, directly flowing from his assumption of unchanging techniques was his assumption of the operation of diminishing returns to productive resources or increasing cost. Experience in the 1970’s in particular has shown that high rates of inflation can co-exist with high rates of unemployment. Further as income rises, saving also rises. Keynes’ General Theory tries to tackle exactly this problem. 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. And the fact that people aren’t spending further decreases expected returns. “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. But spending can have negative effects as well. In Keynes’s view, fluctuations in the marginal efficiency of capital are the fundamental cause of the business cycle. … It tells us that there is a direct relation between income and consumption. my shorter summary of the fundamental ideas, The General Theory of Employment, Interest and Money. However, this period was relatively short because Keynes's heart attack in 1937 meant that he was out of action … Thus all ‘go’ periods tended to be followed by ‘stop’ periods and it became difficult to achieve long-term economic growth. Generally these policies were successful in preventing heavy unemployment like that experienced during the days of the Great Depression. According to Keynes, number of people to be employed (N) depends upon income (7) in this sense. The only solution would be to force everyone to either to buy goods or capital assets with everything they own. Besides the concept of income, another concept which continued to bother Keynes was the choice of units for the purpose of macroeconomic analysis and measurement in the absence of which he could never go along conveniently. It may well be that the classical theory represents the way in which we should like our economy to behave. […]. But how do they know what future sales will be? Keynesian economics is a theory that says the government should increase demand to boost growth. Thirdly, the coincidence of inflation and unemployment makes the Keynesian policy recommendation very questionable. It means disserving or accumulated-wealth consumption. But this just weakens the multiplier, it doesn’t eliminate it. For example, a machine worth Rs. 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. In particular, he was unaware that money was not unique” — if people didn’t hoard it, there’s lots of other things they could hoard. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available, our wealth suffers stagnation or decline. 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. — II. Propensity to consume, also called the consumption function, is a key concept to Keynesian theory of employment. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. Others say the problem is that the country is so unequal that poor people can’t spend enough. For the result is inevitable. So the government will print money to keep the interest rate at a level corresponding to full employment. Consumption function is written as a schedule of various amounts of consumption expenditure that consumers will incur at different levels of income. 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. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. And since future demand is estimated based on present demand, it tends to decrease investment as well. Another way to look at it is the more stuff we make for tomorrow, the less stuff we need to make tomorrow. Keynes has found a crack in the classical theory. Investment depends upon the marginal efficiency of capital on the one hand and the rate of interest on the other. Nothing real has changed, you just need to hold on and see if I’m right in the long run.” People don’t like it when their stocks go down. It was a man-made calamity, a situation of poverty amidst plenty. Thus gold-mines are of the greatest value and importance to civilisation. Marginal efficiency of capital refers to the expected profitability of an additional capital asset; it may be defined as the highest rate of return over cost accruing from an additional unit of a capital asset. In Keynesian economics, investment does not mean financial investment i.e., investing money in buying existing stocks and shares, bonds or equities. In general, if more people are working then more stuff is getting made, although this obviously isn’t a perfect connection. Reading this, you might think the solution is to raise interest rates to prevent overinvestment during booms, since lowering them doesn’t get you out of slumps. The main problem with the Keynesian model was that it was meant for the short run. - III. In olden days, what happened was that rough-riding men of business thought taking risks was manly and invested their money as a way of life. Share Your PDF File 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. Keynes argues that there is a paradox between the object of liquidity for the individual and the illiquidity of investment for the community (this is also where Keynes mentions “time and ignorance” [p. 155]). This considerably simplified his work. 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.”. 180 crores, planned saving is more than planned investment so that income falls to correct the disequilibrium. And then what do we do? But the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.”. The first half of this book will be dedicated to prying it open. Modern equity markets undermine the necessity for long-term, stable investment. 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. Content Guidelines 2. Its main tools are government spending on infrastructure, unemployment benefits, and education. The points on this line fulfill the equilibrium condition in the economy: i.e. 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. At the same time we must recognise that only experience can show how far the common will, embodied in the policy of the State, ought to be directed to increasing and supplementing the inducement to invest; and how far it is safe to stimulate the average propensity to consume, without foregoing our aim of depriving capital of its scarcity-value within one or two generations. 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. Keynes’s work has left a deep mark on modern macro-economics. At various levels of income and employment, there will be different levels of aggregate demand, but all the levels of demand are not effective. Column 3 in the table shows that at the level of income of 50 crores, saving is negative, that is, minus 10 crores. But the actual course of events is more complicated still. Keynesian economics was founded by economist John Maynard Keynes. Let us consider what the various commodity-rates of interest over a period of (say) a year are likely to be for different types of assets. Consumption depends upon the size of income and the propensity to consume while investment depends upon marginal efficiency of capital and the rate of interest. 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. The classical view is that we are kept poor by our impatience — we insist on spending money now instead of saving it for later, when it will grow into more. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. 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". stimulus — in mind here, although he never really comes out and says it.] 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. Use of the Wage Unit 4. 10. Thus decreased consumption leads to decreased employment. For in such matters it is rash to predict how the average man will react to a changed environment. So how does printing money affect prices? So why should the government promote investment instead of demand? As such it is called Consumption Function. The remaining chapters of Keynes's book contain amplifications of various sorts and are described later in this article. 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. The point £ where the aggregate expenditure line intersects the 45° line shows that income is equal to total expenditure, Y= C + I. Perhaps the government should start buying and selling long-term bonds to address this. 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. Summary. He observed that public works need to be undertaken only as long as private investment is deficient. The C +I line lies parallel to and above C, the vertical distance between them showing investment For determining the equilibrium level of income we need the total expenditure (C + 7) line and the 45° line (Y= C+S). Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. If we expect interest rates to go up, we might want to hold on to our cash and use it to buy higher-yield bonds later. In ease of disequilibrium, planned or intended or ex-ante saving is more than or less than planned investment. But it was found that Keynes’s policies tended to create inflationary pressures to control which the government had to reduce aggregate spending. The values of income, consumption and saving shown in Table 3.1 have been plotted in Figure 3.1. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Share Your Word File Keynes’ economic thinking and economic policy at once became popular. [AS: I’ve been saying businesses because I find it clearer, but Keynes actually says entrepreneurs. 70 crores while their income is only Rs. The government lowers interest rates so that there’s full employment. Prices in Keynes’s model use only after full employment. Otherwise, our only relief comes from printing more money. If the national income is increased by an amount of say Rs. A shorter account will be found in the article on Keynesian economics. He writes: ”This simple yet powerful point doesn’t get the attention it ought to. Disclaimer Copyright, Share Your Knowledge With the publication of the General Theory in February 1936, the scene shifted somewhat to new matters of defence, exposition and further development. 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. Another thing the classical economists long mocked were laws against usury. And even if they were willing to wait, why should they trust you? In the Keynesian model, a change in money supply only affects national income through its effect on the rate of interest. “One of the chief social justifications of great inequality of wealth is, therefore, removed.”. 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. So business is booming and everyone’s optimistic — even though costs of production (and maybe interest rates) are rising, sales are too, so expected profits are looking good. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. Not much, Keynes argues. Lerner, a disciple of Keynes, called it the policy of Functional Finance. We can’t measure net output, but we can count the number of people employed. His theory is built up on the basic idea that ‘Effective Demand’ determines employment. I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. If interest rates go up, it no longer becomes possible for them to make money, even though the machine remains unchanged. [emphasis added], 11: Imagine you get a new widget-making machine. If venture capitalists are spending all their money on useless cable, the solution is to take their money away. The straight line through the origin (Y = C + S) makes an angle of 45′ with the two axes. 4. 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. Thus, even though we actually have no clue what the yield might be, we all agree that the current stock price is our best guess and instead of worrying about the fact we actually have no clue what the “right” stock price is whatsoever, we only have to worry about those things which will affect it (the stock price). So it’s how much people spend that determines employment. Or if there is some monopoly clement somewhere, then its degree remains unchanged. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The extraordinary achievement of the classical theory was to overcome the beliefs of the ‘natural man’ and, at the same time, to be wrong. 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. Simple Income Determination 7. Certain definite points on which the writer diverges from previous theories, 212. etc. And there are some, I believe, who practise the fourth, fifth and higher degrees. THE POSTULATES OF THE CLASSICAL ECONOMICS 3. In the analysis of trade cycle, theory of multiplier is an important tool Keynes’s policy of public works was based on his belief in the working of the multiplier vigorously in the depression phase. We’ll define net income as just income minus supplementary costs, since people can’t really be blamed for the unforeseen events. and measured them in wage units to be able to ignore the questions arising out of changes in relative prices of resources. Keynes in his general theory dealt with aggregates like the national income, saving, investment, etc. No, the interest rate is the “price” people demand for parting with their cash. 22: Why are there trade cycles, aka business cycles, aka booms and busts? [AS: This is truly brilliant. It was a passion with the young economists and a problem with the traditional economists. They keep doing what they did yesterday unless they have a reason to change. But these all depend on other complicating factors. If the expected rate of profitability (MEC) of an additional unit of capital asset is high, private investors would be prepared to invest, otherwise not. … The insights here have yet to be fully mined.”]. Let’s start by thinking about the end of the boom. The entrepreneur’s income is the value of his output less the prime cost — that’s what he tries to maximize. And if the interest rate falls, the economy will grow and people will need more cash for these sorts of transactions. It’s because investment comes first. Well, recovery can’t come until old equipment is used up and has to be replaced and old stocks of goods that were produced get sold off and have to be replenished. 3) It’s very easy to store — it doesn’t spoil. But since saving is just the amount of income that isn’t consumed and income is just output (output is always output to someone), savings necessarily equals investment. The equilibrium level of income is determined at Rs. Entrepreneurs can also lose capital due to unavoidable events — a market crash, an earthquake, the passage of time. money) is something which cannot be produced and the demand for which cannot be readily choked off. 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. As there is disequilibrium, income will have to rise. There are other reasons people might want to hold cash. And when national income falls, a larger proportion gets spent as people dip into savings and governments go into deficit. Most governments were helpless spectators to the deepening economic crisis because the economic advisers would not suggest any economic measures of state intervention in the economy. There are three attributes which different types of assets possess in different degrees; namely, as follows: (i) Some assets produce a yield or output q, measured in terms of themselves, by assisting some process of pro… Such public investment, he said, best achieves the multiplier effects. As I said, that’s the naive view — there are a couple complications. Earlier definitions did not throw any light on the factors which go to determine income or its relation with employment; this purpose was amply achieved in the definition adopted by Keynes. 24: The two great economic problems are unemployment and inequality. An uninterrupted process of transition, such as the above, to a new long-period position can be complicated in detail. at different points on this line total income is equal to total expenditure. Community saving is simply an aggregate of individual saving. ... 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. they are simply bartered away; Pigou’s definition was of no use. Its importance lies in the fact that in a private enterprise economy investment depends upon it. Why don’t people just invest all their money? There are two obvious problems with this. 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.” “We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.”, Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! 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. | Keynes’s General Theory. But how much? Finally, with the additional demand equipment and so on will have to be replaced, raising marginal costs. But unfortunately they tended to give rise to the phenomenon known as ‘stop-go’. We have seen that it’s quite the opposite — that redistribution, by increasing effective demand, promotes growth. For a country could only keep its citizens employed if it had gold, and the only way to get gold was by taking it from another country (and thus throwing them out of work). 250 as a result of depreciation. There are a large number of short-run and long-run influences which affect the marginal efficiency of capital. “Moreover, this situation might be reached comparatively soon—say within twenty-five years or less. [AS: This sounds pretty ridiculous, I know, but give it a minute.]. Keynes's main theory (including its dynamic elements) is presented in Chapters 2-15, 18, and 22, which are summarised here. Thus the total amount spent on wages equals the wage-unit times the number of labor-units. A hefty tax on each trade might be the best way to discourage speculation and thus improve the functioning of the market. And businesses choose whether to hire people based on how much they expect to sell. The limitations of Keynes’s theory and policy became obvious when the policies advocated by the Keynesians were implemented after the Second World War. Perhaps this is why it has a reputation for being a very tough book — so difficult that even economists can’t follow it. Effective demand manifests itself in the spending of income. Are the interests which they will thwart stronger and more obvious than those which they will serve? Classical economists always believed that the economy was in equilibrium at full employment level only, but in his general theory Keynes could show successfully that the free enterprise market economy could be in equilibrium at less than full employment-to this, he gave the name of underemployment equilibrium. Before publishing your Articles on this site, please read the following pages: 1. And we return to the problem that many of our economic decisions depend on our “spontaneous optimism,” our “animal spirits,” our “urge to action rather than inaction,” not “the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” This means not only that slumps get exaggerated (since they depress animal spirits, worsening the slump) but that economic performance depends to a large degree on keeping businessmen happy. 2. 100 + Rs. The General Theory of Employment, Interest and Money Written: 1935; Source: The General Theory of Employment, Interest and Money by John Maynard Keynes, Fellow of the King's College, Cambridge, published by Harcourt, Brace and Company, and printed in the U.S.A. by the Polygraphic Company of America, New York; Not all protectionism promotes the balance of trade, of course — mid-1800s Britain probably would have done best with complete free trade. And that’s because, unlike most economics books, it makes sense — the theories it proposes comport with the real world, instead of taking place in some fantasyland of perfect competition. Therefore, he made the specific assumption of short-period so as to concentrate on the problem at hand. These two combined are the prime cost. Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. If people lose “confidence” because of all the spending, they may decide to hold onto their money. A.C. Pigou has tried to limit down the concept so as to make it practicable. Not only is income equal to expenditure, Y = C +I, but saving also equals investment, S = I. It is an inevitable result of an investment market whose organization encourages these behaviors. In Table 3.1, planned saving at the levels of income of Rs. Keynes. Introduction to Keynesian Theory: Keynes was the first to develop a systematic theory of employment in his book. 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. Indeed, the basic model assumed that wages and prices are fixed as long as the government is reducing unemployment. So stock traders don’t sit down and try to calculate the long-term expected yield; they try to guess the short-term change in the stock price and trade base on that. … Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.” [AS: The US, however, is in this situation right now (2009).]. Keynes seems to suggest this can be modeled as “a rapid liability to change in the supply of labor;” I guess that’s possible. 1) You can’t just go ahead and make it — it can’t be “grown like a crop or manufactured like a motor-car.” 2) You can’t reclaim it from use for other purposes — it doesn’t have any. Because these things go together, they’re sometimes mistaken as the cause, but note that it’s the expected return which falls first, then interest rates rise. It is not always possible to predict the effects of policy changes adopted in the short run. It is very necessary to measure the aggregative quantities like saving, investment, consumption, income output etc. 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. 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! The General Theory was Keynes’s last major written work. Thus the interest rate depends on people’s desire to hoard cash — their liquidity preference (L) — and the quantity of money (M). 23: Now that Keynes has outlined his revolutionary theory, it’s time to look back at other economists the classical school dismissed. 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. Call that the supply cost. Reading Keynes’ General Theory of Employment, Money, and Interest then is a sobering experience. 900 at the end of the year by incurring a small maintenance cost of Rs. 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. If you can’t increase investment, you have to increase consumption. 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. But the classical school ignored the problem, as a consequence of introducing into their premisses conditions which involved its non-existence; with the result of creating a cleavage between the conclusions of economic theory and those of common sense. Saving money for the future is not the same as making things for the future — it’s only the latter that’s useful. Liquidity preference is a new concept used by Keynes. 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). This gets rid of the most objectionable features of capitalism — people could still become rich by saving money, but there would be nothing left to invest it in, so their money wouldn’t ever grow. Comments on the four discussions in the previous issue of points in the General Theory, 209. (Since running a trade deficit with a country means sending them your precious metals instead of your exports.) For it now seems clear that the disquisitions of the schoolmen were directed towards the elucidation of a formula which should allow the schedule of the marginal efficiency of capital to be high, whilst using rule and custom and the moral law to keep down the rate of interest.” After all, “individual savings may be absorbed either by investment or by debts, and that there is no security that they will find an outlet in the former.” Laws against usury help ensure they do. Saving in that case equals intended or planned investment. There’s no math, but there’s still a lot to chew on. Now in general the interest rate is governed by the quantity of money and “in an age in which substantial foreign loans and the outright ownership of wealth located abroad are scarcely practicable” (not to mention the international gold standard), money equals precious metals which equals the balance of trade. Classical economists believed that saving was a great private and social virtue. But this is good, because otherwise wages would fall to zero in any downturn and the entire economy would shut down. TOS4. Let investment be 20 crores of rupees whatever the level of income. 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. Net income is found by deducting supplementary costs V from the income (A-U). 16 quotes from The General Theory of Employment, Interest, and Money: ... ― John Maynard Keynes, The General Theory of Employment, Interest, and Money. 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. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated. In it, he argues vigorously for strong government action to correct the excesses of laissez-faire capitalism. The General Theory of Employment, Interest and Money transformed economics and changed the face of modern macroeconomics. OK, so you promote investment, but how much investment? It’s the best book on the economy I’ve ever read; indeed, it’s one of the best books I’ve ever read. According to him what actually existed in the capitalist society was under-employment and not full employment. 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. No doubt Dr. Marshall’s definition was theoretically sound, simple and comprehensive; even then it had serious practical limitations; for example, it is not easy to make statistically correct estimates of the total production of goods and services in a country, besides the difficulties of double counting and the portion of the produce that is retained for personal consumption. They got it in their head that they were going to build a railroad, and by Jove they did. 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. 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. It is not the ownership of the instruments of production which it is important for the State to assume. 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. And total consumption is just all the stuff that isn’t sold to other businesses. 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. I. It simply lays down that as our incomes increase; consumption will also increase though not in the same proportion as the increase in income. This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. It forgets that there is no such thing as liquidity of investment for the community as a whole. “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. Only the services, rendered to use during this year by these things are income.”. They’d much rather invest their money so that its valuation keeps going up and up and up. Keynes uses some archaic language and is trying to communicate some complicated ideas. - Uncertainties and fluctuations of investment, 217. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. But how much they sell is exactly dependent on how much people spend. The mercantilists perceived the existence of the problem without being able to push their analysis to the point of solving it. are on the right track. That means, Keynesians wanted the government to go on raising aggregate demand to reduce unemployment to the acceptable level. And there must be a similar employment multiplier (k’) where for each person hired for a job, k’ people get hired in total. a central bank) under public control. The big problem is that money is the one thing market processes can’t adjust. The policy recommendations he made were not entirely new but the theoretical justification he gave for them was remarkable. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. “It is in determining the volume, not the direction, of actual employment that the existing system has broken down.”. It may be called ‘Income = Expenditure’ line. Hayek economics was founded by famous economist Friedrich August von Hayek. It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly “wasteful” forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict “business” principles. Thus they can’t even be approximately estimated. 140. 3. The effective demand in turn depends upon: (2) Investment, which depends upon marginal efficiency of capital and the rate of interest. [Tyler Cowen: “This is the best chapter in the book and one of the most important economics essays of all time. The public can’t control the amount of hoarding, since that’s necessarily equal to the amount of cash. The General Theory of Employment, Interest and Money [full text]. Bonds are for wusses. It conveys the impression that there are several factors on which employment depends. And there’s our trap: if we don’t make things for tomorrow and we don’t make things for today, people are forced out of work since there’s nothing for them to make. “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. The State of Long-Term Expectation I WE have seen in the previous chapter that the scale of investment … Again we have a tradeoff between having a market (and thus volatility) or no market (and thus overcaution). Keynes’ multiplier is investment multiplier in the sense that a small increase in investment (A1) is expected to lead to a much higher increase in income (Ay). Thus, if you ignore direct investment by the government (as people had), these are the two things to be concerned about. John Maynard Keynes' The State of Long‐Term Expectation, From the General Theory Page 3 of 4 months or a year hence. — The theory of interest restated, 215. 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. And, in practice, people don’t calculate their expectations from scratch each morning. But to assume that it actually does so is to assume our difficulties away. Keynes, the story goes, figured out the causes of the Great Depression and in doing so revolutionized the field of economics. Keynes, the story goes, figured out the causes of the Great Depression and in doing so revolutionized the field of economics. 2.4 Summary 83 APPENDIX TO CHAPTER 2 86 . While each person thinks they’ll do better off by saving money instead of spending it, if a whole country decides to save their money, they’re all worse off, since nobody will have a job. Deflation does the opposite. 3: When people get money, they spend some of it — but not all of it. 12 of Interest Rate Theory) Page 1 John Maynard Keynes The General Theory of Employment, Interest and Money Chapter 12. When most countries of the world were experiencing the gravest depression of the last two hundred years – that is, the so- called Great Depression of 1929-36-economists of the time faced a challenge in the problem of increasing unemployment, shrinking national income, falling prices and failing firms. Therefore, Keynes called his treatise the General Theory Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society. Keynes, however, felt that the concept of income in terms of A-U is of little use when the community has to decide how much to spend on consumption. Thus the government must step in. After all, a bond is just a promise to get some money in the future. (2) net Income (A-U-V) on which Consumption of the community depends. But as interest rates get lower, it becomes profitable to invest in building things with smaller and smaller expected yields. 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.