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. In fact, monetary unit (money) had been employed usually as the standard of measurement. 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 problematic as this is, Keynes points out that it’s a lot more realistic than the classical theory, which just seems to magically assume everyone is paid in proportion to their productivity. One is the amount of capital and equipment and so on you use up, which we’ll call the user cost. Reading Keynes’ General Theory of Employment, Money, and Interest then is a sobering experience. 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. 140. 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). But this clearly isn’t true — people can save money under their mattress and not get any interest. 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). 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. At the income level of Rs. 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. “An act of individual saving means — so to speak — a decision not to have dinner to-day.” But it is not a promise to have dinner tomorrow — it doesn’t replace current demand with future demand; it decreases demand altogether. No explanation of this is provided by the Keynesian Theory. inflation-adjusted) wage. 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. 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. It’s often said that the interest rate is the price people demand for saving money instead of spending it. And then what do we do? What happens isn’t so much excessive investment as misdirected investment. Perhaps the government should start buying and selling long-term bonds to address this. Liquidity preference means preference for liquidity or cash. It is an inevitable result of an investment market whose organization encourages these behaviors. Machines, workers and raw materials were available for production but were not being used simply because the employers feared losses in the production of goods. What this amounts to is Say’s Law: supply creates its own demand. And then those factories hire people to work there, who spend their wages on other things. It is in this respect that his definition differed from those of his predecessors. He writes: ”This simple yet powerful point doesn’t get the attention it ought to. The straight line through the origin (Y = C + S) makes an angle of 45′ with the two axes. Static Analysis: The ‘General Theory’ does not trace out the effect of the future on the present economic events clearly. Even if the entrepreneurs wished he could not avoid this loss. 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. Again we have a tradeoff between having a market (and thus volatility) or no market (and thus overcaution). [emphasis added], 11: Imagine you get a new widget-making machine. Thus they can’t even be approximately estimated. Consumption function is written as a schedule of various amounts of consumption expenditure that consumers will incur at different levels of income. Keynes. Since consumption expenditures in the short run remain stable, Keynes’s theory stated in simple terms maintains that employment depends upon investment. The points on this line fulfill the equilibrium condition in the economy: i.e. This isn’t a conspiracy, it’s just the natural outcome of a system that depends on rich people feeling good. at different points on this line total income is equal to total expenditure. 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.”. Money can’t survive on its own. Earlier we said people spend the money they get, but not all of it. It has a constant slope and therefore shows a functional relation between income and consumption. And even if they were willing to wait, why should they trust you? 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. He solved this problem in his own way. Instead, saving lowers demand and thus decreases employment. “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. 180 crores. 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. 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. Absence of Governmental Part in Economic Activity: The government is assumed to play no (significant) part either as a taxer or as a spender. 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 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. Thus if someone makes twice as much per hour as an unskilled laborer, we’ll count each hour they work as two unskilled hours. The General Theory of Employment, Interest and Money (1936). Content Guidelines 2. This considerably simplified his analysis, for he could thereby take employment and output as moving together in the same direction. Why should it be any different from a futures contract on wheat? We’ll define net income as just income minus supplementary costs, since people can’t really be blamed for the unforeseen events. Consumption C and Investment I further depend on a large number of other influences in the economy. According to Keynes, number of people to be employed (N) depends upon income (7) in this sense. We’ll call these hours labor-units and we’ll call the money that gets paid for them wage-units. 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 entrepreneur’s income is the value of his output less the prime cost — that’s what he tries to maximize. Modern equity markets undermine the necessity for long-term, stable investment. 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. But to assume that it actually does so is to assume our difficulties away. 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. 900 at the end of the year by incurring a small maintenance cost of Rs. Keynes: Long-term Expectations (Ch. Investment is either foreign or domestic. Keynes has found a crack in the classical theory. After all, a bond is just a promise to get some money in the future. ... 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. The same level of income gets determined whether we have the Y = C +I approach or the S=I approach. Keynes defined saving as that part of income which is not spent on consumption, S = Y – C. He defined investment as expenditure on goods and services not meant for consumption, i.e., I = Y = C. When equilibrium prevails in the economy, income equals expenditure and since S and I are both equal to Y- C, saving must equal investment. In a country where most of the goods and services are not exchanged for money, i.e. Demand and Supply for output as a whole, 219. The first half of this book will be dedicated to prying it open. Instead, you can give it to poor people, who will use it to buy useful things like food and clothing. According to Prof. Pigou :”…. However, it may be noted that the suitability of any particular definition depends upon the purpose for which it is to be used. Not much, Keynes argues. 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. 12 of Interest Rate Theory) Page 1 John Maynard Keynes The General Theory of Employment, Interest and Money Chapter 12. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. It’s only the second kind that’s an actual waste of resources, and the solution to it isn’t raising interest rates “which would probably deter some useful investments and might further diminish the propensity to consume, but in taking drastic steps, by redistributing incomes or otherwise, to stimulate the propensity to consume.”. But you can’t jump-start it just by lowering interest rates, since the real problem is expected return. 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. Quite the contrary. If this happens, then it seems likely that within a generation expected return will reach zero [AS: !!] Disclaimer Copyright, Share Your Knowledge
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). So why should the government promote investment instead of demand? Call that the supply cost. It was this theory of demand and supply of output as a whole which was neglected for more than 100 years and which Keynes analysed. The demand in the economy is ordinarily for two types of goods – consumption goods and investment goods. 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. Have they insufficient roots in the motives which govern the evolution of political society? 4: The next three chapters aren’t so much part of the argument as attempts to clear up some basic concepts and objections. Keynes’ concept of national income lies somewhat between the Gross National Product and the Net National Product. Its main tools are government spending on infrastructure, unemployment benefits, and education. 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. Keynes, therefore, adopted a new unit for measuring the changes in the national output, that is, the unit of the employment of labour. Recall that the classical theory said people needed to be paid enough to compensate them for their distaste for working. 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 the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.”. A hefty tax on each trade might be the best way to discourage speculation and thus improve the functioning of the market. 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. 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. As income increases, consumption also increases but not so much as the increase in income. But how much? He wanted to know the considerations that weigh with entrepreneurs when they decide to employ certain number of men. He observed that public works need to be undertaken only as long as private investment is deficient. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. Not all protectionism promotes the balance of trade, of course — mid-1800s Britain probably would have done best with complete free trade. If interest rates go up, it no longer becomes possible for them to make money, even though the machine remains unchanged. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Bonds are for wusses. Indeed, it so scandalized its readers at the time that it was “convicted as a nuisance by the grand jury of Middlesex in 1723, which stands out in the history of the moral sciences for its scandalous reputation.”. Thus gold-mines are of the greatest value and importance to civilisation. 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. Propensity to consume refers to the actual consumption that takes place at different levels of income. Keynes’s work has left a deep mark on modern macro-economics. Are the interests which they will thwart stronger and more obvious than those which they will serve? 2 likes. Therefore, point E shows equilibrium in the economy. vi The Economics of Keynes: A New Guide to The General Theory 3. In Table 3.1, planned saving at the levels of income 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. (2) net Income (A-U-V) on which Consumption of the community depends. Nevertheless, the way in which modern economists view macro-economic problems owes much to the Keynesian framework. Keynes’ economic thinking and economic policy at once became popular. 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; 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. But maybe it makes some sense: Growth depends on the inducements to new investment. And when more efficient workers actually are paid more, he takes that into account as noted above. … But there are many difficulties which Gesell did not face. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. 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. Saving doesn’t lower the interest rate and thus increase investment — an increase in money does that. The total income of the community is just the amount sold minus the user cost. [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 the worst part of the international gold system is the way it sets countries against one another. Then the money can’t go to hire more people so it just goes to bid up the prices of things, creating inflation. The policy recommendations he made were not entirely new but the theoretical justification he gave for them was remarkable. There’s no math, but there’s still a lot to chew on. 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. Thus, through his theoretical contribution Keynes not only shook the Classical Theory in its roots but also demolished its policy implications completely. 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. 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. Moreover, the lives of durable goods which last beyond one year are very difficult to measure. Indeed, the basic model assumed that wages and prices are fixed as long as the government is reducing unemployment. Thus the total amount spent on wages equals the wage-unit times the number of labor-units. For that may enable the so-called boom to last. Is the fulfilment of these ideas a visionary hope? - III. 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. According to Prof. Fisher, “…….. the national dividend or income consists solely of services received by ultimate consumers, whether from their material or from their human environment. Finally, with the additional demand equipment and so on will have to be replaced, raising marginal costs. Deflation does the opposite. (And when everyone follows the stock market, like in the US, this applies to everyone.) [Tyler Cowen: “This is the best chapter in the book and one of the most important economics essays of all time. 15 crores then investment multiplier is 15/5 = 3. Policy Recommendations of Keynes’s Theory 9. 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. They keep doing what they did yesterday unless they have a reason to change. Effective demand is the demand for goods and services in the economy as a whole which is fully satisfied by the supply of the output as a whole. 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? […]. But the side effect is that “the very long-run course of prices has almost always been upward.”. are on the right track. Introduction to Keynesian Theory: Keynes was the first to develop a systematic theory of employment in his book. Eventually they begin to run out of iPods and start investing in additional factories to make more. - I. (Maybe large changes in interest rates, but those are rare.). The government lowers interest rates so that there’s full employment. But in this case the value of the machine has been maintained at Rs. 1. 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. Consumption is only one, though major, component of expenditure. 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. OK, so we have the following model: more money reduces the interest rate (as long as liquidity preference doesn’t go up faster), lower interest rates increase investment (as long as expected return doesn’t fall faster), more investment leads to more employment (as long as the propensity to consume doesn’t fall faster), and if employment increases prices will rise which can increase liquidity preference and thus require more money. The effective demand in turn depends upon: (2) Investment, which depends upon marginal efficiency of capital and the rate of interest. 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 it is more difficult to have an idea of net consumption than net production. I must not be supposed to deny the possibility, or even the probability, of this outcome. Further as income rises, saving also rises. According to Prof. Hansen, Consumption Function is the most important contribution of J.M. It may well be that the classical theory represents the way in which we should like our economy to behave. 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… But it’s not easy to think of useful things to make for the future. It says the book is an attempt to show that classical economics (basically that summarized by Alfred Marshall, including Ricardo, Mill, Edgeworth, and Pigou) addresses only a special case of the economy, while this book outlines a more general theory. (If, indeed, there’s nobody left who can build the trucks, we say the truck factory’s efficiency has gone to zero.). I. 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. (The details of how the remainder gets invested has to do with interest and will be addressed later.). and measured them in wage units to be able to ignore the questions arising out of changes in relative prices of resources. This is to say that total expenditure constitutes aggregate demand while total income is the aggregate supply. 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. 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. The point £ where the aggregate expenditure line intersects the 45° line shows that income is equal to total expenditure, Y= C + I. And when national income falls, a larger proportion gets spent as people dip into savings and governments go into deficit. And businesses choose whether to hire people based on how much they expect to sell. Obviously a lot more in absolute terms, but far less proportionately.) It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. Wherever these policies were adopted, recovery was remarkably rapid. THE PRINCIPLE OF EFFECTIVE DEMAND There must be an investment multiplier — call it k — such that an extra $1 invested leads to $k increase in income. If the national income is increased by an amount of say Rs. These propositions contain the essentials of the general theory’ of employment. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. You use the extra people to get you up to speed, then you lay them off. Marginal prime costs and labor costs increase as industry is forced to use more expensive equipment and laborers, resulting in higher prices. It means disserving or accumulated-wealth consumption. His theory is built up on the basic idea that ‘Effective Demand’ determines employment. 250 (Rs. 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. “— which implies that if the rate of interest were lower, i.e. Hayek economics was founded by famous economist Friedrich August von Hayek. A labour unit may be taken to mean one hour of work by ordinary, unskilled or common worker. 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. 180 crores equals planned investment. As soon as private investment is stimulated and the economy is well on its way to recovery, public works need no more be carried on. Its importance lies in the fact that in a private enterprise economy investment depends upon it. 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. Most people think that as the interest rate goes up, spending goes down and saving goes up, but this shows that saving and spending both decrease. 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. In 1937 he suffered a severe heart attack . Let us make an in-depth study of the Keynes’s General Theory in Macroeconomics:- 1. But if you’ve been unemployed long enough, you might actually want to work. 9, 1972), and served once more in the Treasury as an all-purpose adviser. 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. Since consumption depends upon net income, it is necessary that net income be calculated as accurately as possible. 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. 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. 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. Its analysis remains comparatively static, though at times Keynes introduced expectations in his analysis. Why don’t people just invest all their money? And, in practice, people don’t calculate their expectations from scratch each morning. 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. He divided effective demand into two components – consumption and investment. 4. … Nor was there over-investment in the sense that the standard and equipment of housing was so high that everyone, assuming full employment, had all he wanted at a rate which would no more than cover the replacement cost, without any allowance for interest, over the life of the house; and that transport, public services and agricultural improvement had been carried to a point where further additions could not reasonably be expected to yield even their replacement cost. [AS: Keynes apparently has government investment — i.e. […]. The public can’t control the amount of hoarding, since that’s necessarily equal to the amount of cash. An important fact about the consumption function is that it is stable in the short run because the consumption habits of the community remain more or less stable in the short run. 24: The two great economic problems are unemployment and inequality. 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. Thirdly, the coincidence of inflation and unemployment makes the Keynesian policy recommendation very questionable. Further, the amount of wages received by ordinary labour for an hour’s work, Keynes called-wage unit. His theory of interest depends upon it. Second, if wages go down, then the cost of making things goes down, which means that prices go down, which means that in real terms wages end up staying about the same. It is straight line rising upwards to the right intersecting the 45° line where the whole of income is spent on consumption. Keynesian economics is a theory that says the government should increase demand to boost growth. They are “undoubtedly in the right [at present],” when investment is “unplanned and uncontrolled.” There’s no other way to raise employment. Such costs have to be deducted from gross income to get net income on which the consumption of the community depends. Except during the war, I doubt if we have any recent experience of a boom so strong that it led to full employment. Indeed the world is ruled by little else. 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. “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.”. In his ‘General Theory’ Keynes used two approaches to the determination of income: Both these approaches lead to the determination of the same level of income. 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. “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! Why is there a liquidity preference? “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. For the state of expectation is liable to constant change, a new expectation being superimposed long before the previous change has fully worked itself out; so that the economic machine is occupied at any given time with a number of overlapping activities, the existence of which is due to various past states of expectation. - Uncertainties and fluctuations of investment, 217. Underemployment equilibrium was the result of private under-investment in relation to the savings available in the capitalist economy at the given income level. “Never in history was there a method devised of such efficacy for setting each country’s advantage at variance with its neighbours’!”. "THE GENERAL THEORY OF EMPLOYMENT" by John Maynard Keynes. Some industries hit “bottlenecks” first, causing their prices to rise and demand to be funneled into industries that are faster to respond. Domestic investment is encouraged by the interest rate and foreign investment by the balance of trade. He advocated the policy of starting public works and financing them with fiat money with an unbalanced budget. If people are out of work now, the time they’re wasting will never be recovered. 100 + Rs. Thus the government must step in. 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. He laid down the policy of starting public works financed from deficit financing through direct throw of additional currency or via credit creation. Therefore, Keynes called his treatise the General Theory The fact of the matter is that employment fluctuates on account of the fluctuations in investment. Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. It may be called ‘Income = Expenditure’ line. As a result, the theory supports the expansionary fiscal policy. (So inflation might actually be a better solution than wage cuts.). Some of these are controllable by policy, others are not so. Only the services, rendered to use during this year by these things are income.”. 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. 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. 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. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow. The values of income, consumption and saving shown in Table 3.1 have been plotted in Figure 3.1. In ease of disequilibrium, planned or intended or ex-ante saving is more than or less than planned investment. etc. Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York. And this is especially true in the short-term — people’s habits take time to catch up with their incomes. THE GENERAL THEORY 2. Secondly, he could very nicely provide reasons for departures from the policy of balanced budgets. This raises the price, which makes Apple richer but doesn’t help any employees — and Apple likes to save its money much more than its employees do. It conveys the impression that there are several factors on which employment depends. 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. Distinguished British economist John Maynard Keynes (1883-1946) set off a series of movements that drastically altered the ways in which economists view the world. Keynesians believe consumer demand is the primary driving force in an economy. TOS4. 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. | Keynes’s General Theory. Investment multiplier (Income multiplier) expresses the relationship between an initial investment and the ultimate increase in national income. 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. “Moreover, this situation might be reached comparatively soon—say within twenty-five years or less. 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. (Since running a trade deficit with a country means sending them your precious metals instead of your exports.) Keynes defined income in such a manner as enabled him to determine employment in the community. 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. 15: The central bank can lower the short-term interest rate through open-market operations: printing money and using it to buy short-term government debt. OK, so you promote investment, but how much investment? Let us presume (with Keynes) that the level of investment is not related to income. 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. 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. Virtue and vice play no part. 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. — Uncertainties and fluctuations of investment, 217. How does money influence demand? It’s conceivable that it might lead not just to full employment, but full investment — a world with so much plenty that you couldn’t expect to make a profit on any kind of durable good. 10) = Rs. In his view, short period is that in which new investments do not change the technique, the organisation and equipment. 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 is the cost of using capital equipment rather than of leaving it idle. He assumed that there is a fairly high degree of competition in the markets. So I thought I’d try my best at an explanation/summary. The main problem with the Keynesian model was that it was meant for the short run. A shorter account will be found in the article on Keynesian economics. A Project Gutenberg of Australia eBook Title: The General Theory of Employment, Interest and Money Author: John Maynard Keynes eBook No. 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. 9: How does raising interest rates affect consumption? 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.”. 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. 70 crores while their income is only Rs. 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. • Hayek economic theory and Keynesian economic theory are both schools of thought that employ different approaches to defining economic concepts. Moreover, this behavior is not the outcome of a wrong‐headed propensity. A man’s saving is that part of his money income that is not spent on consumption goods. (p.181), were inserted by Keynes … Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omen (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward. If you make $1M, you might spend $500K of it. And there are other problems: when the stock market crashes, rich people see themselves as less rich and decide to start spending less. This may be great simplification of facts but it brings forth the crucial importance of investment in Keynesian theory of employment. This is known as stagflation. Another way to look at it is the more stuff we make for tomorrow, the less stuff we need to make tomorrow. 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). We have to select the more easily manageable factors influencing aggregate income and employment. Thus focusing on the balance of trade serves both purposes — and, at a time we didn’t know how to control interest rates, was the only direct means of controlling them. 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. 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. 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. — II. And the fact that people aren’t spending further decreases expected returns. Storage costs for goods and services may eliminate this paradox but perhaps not completely. Limitations of the Keynesian Theory. Keynes was writing about the short-period problem of depression. 2. The equilibrium level of income is determined at Rs. 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. Primarily thru the rate of interest, which depends on liquidity preferences, marginal efficiencies, and investment multipliers. Keynes’s view was that money offers ready purchasing power for commodities and bonds. 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. 7. Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. 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. They’d much rather invest their money so that its valuation keeps going up and up and up. It forgets that there is no such thing as liquidity of investment for the community as a whole. 2.4 Summary 83 APPENDIX TO CHAPTER 2 86 . The solution, they propose, is redistributing money to the poor to promote jobs. And yet, the book is a necessary now as it was then: economics has not learned a single one of his lessons. ), Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth, in that it possessed two activities, namely, pyramid-building as well as the search for the precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance. 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. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. And there are some, I believe, who practise the fourth, fifth and higher degrees. 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. But if effective demand is adequate, average skill and average good fortune will be enough. The General Theory of Employment, Interest, and Money By John Maynard Keynes Feburary 1936 Table of Contents • PREFACE • PREFACE TO THE GERMAN EDITION • PREFACE TO THE JAPANESE EDITION • PREFACE TO THE FRENCH EDITION Introduction 1. and measured them in wage units to be able to ignore the questions arising out of changes in relative prices of resources. But we could increase investment: “the wisest course is to advance on both fronts at once.” Not just so that the people we give money to can buy the new products investment creates, but so that they have enough money to buy even more, and thus spark growth themselves! 3: When people get money, they spend some of it — but not all of it. Thus, net income = A – U – V. In other words, both user costs (U) and supplementary costs (V) have to be subtracted from Gross National Product (A) to obtain the net national income. “Consumption — to repeat the obvious — is the sole end and object of all economic activity.” What are we making things for if not to use them? Effective demand manifests itself in the spending of income. Long-term expectations can’t be easily checked, so when they do change, they often change suddenly. It was a passion with the young economists and a problem with the traditional economists. Firstly, it was clear that a laissez-faire capitalist economy will not be able to maintain full employment even if it is attained. Keynes in his general theory dealt with aggregates like the national income, saving, investment, etc. Which is why the suggestion of making it spoil (by printing money with expiration dates, etc.) Therefore, it is important to understand what determines the amount of investment. In the short period, employment, income and aggregate output are interrelated. It simply lays down that as our incomes increase; consumption will also increase though not in the same proportion as the increase in income. 750 at the end of the year having suffered a reduction in the value worth Rs. 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. Use of the Wage Unit 4. Investment is just the amount of current output that isn’t consumed. 10. In 1987, Greenwald and Stiglitz accused Keynes’s summary of the "General Theory" in chapter 18 of relying upon “neoclassical and Marshallian tools.” The demand for consumption goods forms a major part of the total demand and it goes on increasing with increase in income and employment. But politics has triumphed over logic and we’ve forgotten all the crucial things he explained. What will we do when we’ve built all the factories the people of the future can be expected to use? 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. Of course there’s lots of different things you can invest in; we’re assuming that you do whatever maximizes your expected return. “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 result is that saving, which is income not spent on consumption, goes on increasing. 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. … The insights here have yet to be fully mined.”]. And obviously you’ll keep borrowing money and investing it until your expected return reaches the market rate of interest. The distinction between consumption and investment is fundamental to Keynes’ General Theory. There’s the value of the widgets you expect [AS: there’s that word again] it to produce, less the cost of its inputs and maintenance. Then as some workers receive better wages other workers will demand it and, since business is booming, receive it. Before publishing your Articles on this site, please read the following pages: 1. 10: We’ve established that an increase in investment leads to an increase in income. 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]). Introduction to Keynes’s General Theory 2. 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. We can write this relation as C=f(Y). Entrepreneurs can also lose capital due to unavoidable events — a market crash, an earthquake, the passage of time. 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. Prices in Keynes’s model use only after full employment. 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. But now people invest their money in the stock market, which revises its profitability estimates minute-by-minute. 23: Now that Keynes has outlined his revolutionary theory, it’s time to look back at other economists the classical school dismissed. 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. Or if there is some monopoly clement somewhere, then its degree remains unchanged. “I was brought up to believe that the attitude of the Medieval Church to the rate of interest was inherently absurd, and that the subtle discussions aimed at distinguishing the return on money-loans from the return to active investment were merely Jesuitical attempts to find a practical escape from a foolish theory. 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. Apparatus of Keynes’s General Theory 6.