An Encyclopedia of Keynesian Economics, Second Edition
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An Encyclopedia of Keynesian Economics, Second Edition

Edited by Thomas Cate

The comprehensive Encyclopedia features accessible, informative and provocative contributions by leading international scholars working in the tradition of Keynes. It brings together widely dispersed yet theoretically congruent ideas, presents concise biographies of economists who have contributed to the debate on Keynes and the Keynesian Revolution, and outlines the basic principles, models and tools used to discuss the economic consequences of The General Theory.
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Economics of Keynes and of his Revolution, Key Elements of the

A review of the writings of J.M. Keynes reveals that he had two primary goals in the General Theory, one theoretical, one political. The first was to explode the myth perpetuated by what he termed the ‘classical’ economists, that the perfectly competitive, self-adjusting, market-clearing model tends toward full employment. In this regard, Keynes’s reference to the ‘classical’ economist was primarily to the neoclassical economists that preceded or were contemporary to him. However, Keynes was surely referring as well to Marshall’s neoclassical version of Smith and Ricardo, since he centered his attack on Say’s Law as it came to be incorporated into the market-clearing, neoclassical orthodoxy. Keynes’s second goal was to provide understanding and guidance in trying to improve the average level of performance of the British economy as he saw its reality during the 1920s and 1930s.

In this effort, we believe that there are five key elements in Keynes’s attack on Say’s Law and the perfectly competitive, self-adjusting, market-clearing model. The first four elements relate to his theoretical criticisms, including: (1) his analysis of equilibrium; (2) his theory of probability: expectations and uncertainty; (3) his critique of the neoclassical loanable funds theory of interest rate determination; and (4) his theory of money, liquidity preference and interest rate determination. His concern for improving the economy’s performance is embodied in the final element: his public policy proposal.

Keynes’s equilibrium analysis

In the Treatise and the General Theory Keynes develops a very simple yet elegant model of a closed economic system. He divides the economic system into two sectors, consumers and producers. Consumers decide how to divide their stream of income into two parts: spending on consumption goods and saving. Simultaneously, and yet independently of consumers, producers decide how to divide the stream of output into two parts: consumption goods and investment goods. Three outcomes are possible. First, if the decisions made by the consumers are consistent with the decisions made by the producers, the economic system is in equilibrium. This consistency of decisions, however, in no way implies that the economic system is operating at full employment. Full employment is but one of an infinite number of possible equilibria. Second, if the amount of income allocated for spending on consumer goods is greater than the dollar value of consumer goods that the producers have decided to produce, the two decisions are not consistent and the economic system is in disequilibrium. This situation cannot persist because inventories will decline below some critical level and producers will respond by increasing the production of consumer goods. This positive feedback mechanism moves the economic system toward p. 168an equilibrium position, which may, or may not, be consistent with full employment. Third, if the amount of income allocated for spending on consumer goods is less than the dollar value of consumer goods that the producers have decided to produce, the two decisions are not consistent and the economic system is in disequilibrium. This situation cannot persist because inventories will rise above some critical level and producers will respond by decreasing the production of consumer goods. This negative feedback mechanism moves the economic system toward an equilibrium, which may, or may not, be consistent with full employment.

There are four aspects of Keynes’s equilibrium analysis that were both unique and sources of interpretive controversy. In part, this was because Keynes’s concept of equilibrium differed in its structure, content and purpose from that of his English orthodox predecessors. The first aspect of uniqueness and controversy was the ex ante–ex post analysis used by Keynes. While this approach may have been novel to mainstream British economists, such was not the case for Hayek or Myrdal. Neither could understand the undue attention being paid to this aspect of Keynes’s work since the ex ante–ex post sequence analysis, employed rather clumsily by Keynes, was an old friend to them.

The second aspect of uniqueness and controversy was the fact that the composition of national income and aggregate demand together determined the level of aggregate demand and, therefore, critically affected the determination of the equilibrium level of national income and employment (the very point that Domar elaborated in his theory of economic growth). With the direction of causation running from the labor market to the real goods market via aggregate supply, orthodox macroeconomics, using Say’s Law, was able to demonstrate that the economic system always operated at its full employment level of output. Since Keynes did not believe that Say’s Law was an accurate description of the way an economic system worked, he reversed the direction of causation established in orthodox macroeconomics. In his model, Keynes had causation running from aggregate demand and the real goods market to the labor market because he believed that the economic system rarely, if ever, operated at its full employment level of output.

The third aspect of uniqueness and controversy was Keynes’s use of the term ‘unemployment’. For the advocates of the perfectly competitive, market-clearing model, involuntary unemployment was unimportant because either it was not possible or it was only possible out of equilibrium. In a model with completely flexible wages and prices unemployment is voluntary, or is a short-run disequilibrium phenomenon that cures itself. In the long run, the economy operates at its potential level of output. Keynes’s concept of involuntary unemployment was, therefore, foreign to the classical and neoclassical economists in the same sense that voluntary unemployment was foreign to him. Recent research has put forth the hypothesis that during the early stages of unemployment the individual p. 169feels that he or she is responsible for being unemployed, but as the duration of unemployment grows longer the blame for being unemployed is transferred from the individual to society (Goldsmith et al., 1994). That is to say, in the early stages of unemployment individuals behave according to ‘classical’ precepts and act as if they are voluntarily unemployed. As the duration of unemployment increases, however, they behave according to ‘Keynes’s’ precepts and act as if they are involuntarily unemployed.

The final aspect of uniqueness and controversy was the fact that Keynes’s concept of equilibrium reflected a purposive function, the ultimate purpose or goal pursued by practitioners of normal science, which differed in its maximand and normative content from the classical and neoclassical concepts of equilibrium (Johnson, 1980, 1983; Johnson and Ley, 1988). As used by the classical economists, Malthus and Marx excluded, the term ‘equilibrium’ implied that total social welfare measured in material terms (vendable commodities) was maximized with an ethically acceptable distribution of income. This reflected the fact that the classical purposive function was concerned with whether a perfectly competitive market–capitalist economic system was capable of maximizing total social welfare over time. As such, the classical conception of equilibrium reflected the fact that the basic economic concerns were centered on economic growth and the distribution of income. As used by the neoclassical economists, the term ‘equilibrium’ implied that individual welfare measured in terms of utility should be maximized given any distribution of income. This reflects the fact that the neoclassical purposive function was concerned with whether a perfectly competitive market–capitalist economic system was capable of maximizing individual welfare, defined subjectively in terms of utility, at any point in time. As such, the neoclassical conception of equilibrium reflected the fact that the basic economic concern was centered on allocative efficiency. As used by Keynes, the term ‘equilibrium’ was ethically neutral and did not imply that total social welfare, measured in terms of goods and services, should be maximized given any distribution of income. This reflected the fact that Keynes’s purposive function was concerned with whether a perfectly competitive, market–capitalist economic system was capable of increasing its average level of performance. As such, Keynes’s conception of equilibrium reflected that fact that his basic economic concerns were centered on economic stability, as measured by unemployment and, to a certain degree, the distribution of income (Johnson, 1980, 1983, 1984, 1988, 1991, 1992, 1993a, 1993b; Johnson, Gramm and Hoass, 1989, 1991; Johnson and Ley, 1988).

Keynes’s theory of probability: expectations and uncertainty

Keynes developed his theory of probability and ultimately his views regarding expectations and uncertainty in response to G.E. Moore’s Principia Ethica (1903) and refined it in light of Ramsey’s (1922, 1931) critique. This theory of p. 170probability describes three categories of logical propositions. These logical relationships may be expressed in the following manner: a/h = p, where a is the conclusion, h is premises and p is the resulting probability. The three categories of logical propositions that Keynes developed are universal induction, propositions that are either true (a/h = 1) or false (a/h = 0), statistical induction, propositions that are neither true nor false (0 < a/h < 1), and uncertainty, propositions where the probabilities are unknown. Keynes developed two versions of this theory, a subjective and an objective version.

In the objective version of his theory, Keynes argued that individuals were rational, pursued a single goal (that of maximizing the amount of good in the society), used induction to establish relationships between a and h, possessed objective degrees of belief in these relationships and were quite capable of deciding for themselves what is the best course of action. Keynes used this version of his theory of probability as a basis of attack on the idea that the quantity theory of money provided a reasonable guide for monetary policy. In his attack, Keynes examined the factors that affect the velocity of money, namely the ratio of cash to deposits and of reserves to deposits, and established the fact that the velocity of money is not stable over time. Given this conclusion, Keynes argued that monetary policy should be based on the discretion of the central bank and not on some rule association with the quantity theory of money (Keynes, 1924; Schumpeter, 1954).

In the subjective version of his theory, Keynes argued that individuals were irrational, pursued many goals, held subjective degrees of belief about a and h that were subject to sudden and violent shifts, and recognized the need to maintain certain conventions and rules (Bateman, 1990, 1991, 1995). With this version of his theory, Keynes concluded that consumption and saving are stable functions of disposable income and that the speculative demand for money and gross private domestic investment are unstable owing to the presence of uncertainty.

Even though individuals are confronted by uncertainty, they still must decide what to do. In these instances individuals fall back on conventions and rules. Embedded in these conventions and rules are expectations about the next occurrence of an event that form the basis of subjective probabilities about this event. These expectations, and hence the probabilities on which they rest, are subject to sudden and violent shifts. The existence of these factors led Keynes to conclude that gross private domestic investment and the speculative demand for money are unstable, with the result that the average level of performance of the British economy was below what it could be. The question, then, is what to do about this state of affairs. The answer to this question is discussed below in the section on Keynes’s public policy proposals.

p. 171Keynes’s critique of the loanable funds theory of interest rate determination

Among the many points of disagreement that Keynes had with the orthodox tradition, two dealt with consumption, saving and investment. According to the orthodox tradition, consumption, saving and investment are functions of the rate of interest. As such the loanable funds theory states that the rate of interest is determined in the loanable funds market where new financial assets for new investment projects are bought and sold. Saving is a direct function of the rate of interest because of consumers’ positive time preferences, consumption is an indirect function of the rate of interest because of the dominant substitution effect between savings and consumption, and investment is an indirect function of the rate of interest because investment projects are ranked according to their expected rates of return that are governed by the value of the marginal product of capital and diminishing returns. The operation of perfect competition and Say’s Law ensures that the supply of (saving) and demand for (investment) loanable funds is in long-run equilibrium with full employment as long as interest rates are flexible. Moreover, in such a theory, saving is automatically transformed into investment. This led the British neoclassical orthodoxy toward a positive view of saving that has its origin in the work of Adam Smith and his theory of growth. However, Keynes saw saving as a leakage from the income stream, hence it reduced aggregate demand, output and employment.

With respect to consumption and saving, Keynes agreed with the neoclassical economists that, upon the receipt of an increment of income, consumers decided how much to spend on consumption and how much to save. Keynes disagreed, however, with the neoclassical economists that consumption and saving were functions of the rate of interest and argued instead that consumption and saving are stable functions of disposable income. After postulating the relationship between consumption expenditures and disposable income, Keynes examines thoroughly the factors that affect this relationship and establishes the fact that a stable pattern exists. This is important because the marginal propensity to consume plays an important role in Keynes’s investment multiplier, which is vital to his public policy proposals and the goal of the General Theory of increasing the average level of performance in the British economy. This line of reasoning led some economists to investigate more thoroughly the exact nature of the consumption function, including the issue of proportionality between consumption and disposable income. Moreover, Keynes saw that changes in consumption, including changes in the distribution of income that could result from fiscal and non-fiscal policy changes, would affect changes in aggregate demand and equilibrium level of national income and employment. However, the primary reason for the unstable nature of aggregate demand was changes in investment.

While Keynes agreed with the neoclassical economists that investment was an indirect function of the rate of interest, he disagreed with their contention p. 172that the rate of interest was determined in the loanable funds market according to the principles set forth in the loanable funds theory. Instead, he argued that the rate of interest was determined in the secondary money market where existing financial assets were bought and sold, and that the rate of interest in question was the long-term rate on gilt-edged securities. Furthermore, Keynes argued that the level of output is less than optimal because investment is less than optimal. Investment is less than optimal because of the uncertainty associated with the future rate of return on invested capital. In the General Theory and in his critique of Tinbergen’s work on investment activity, Keynes argues that a careful examination of the factors that affect investment activity yields establishes the existence of an unstable pattern in the underlying factors that affect gross private domestic investment. This result can be used as a partial explanation of the cyclical movements in employment, output and income (Keynes, 1936, 1939; Tinbergen, 1939)

As was the case with Keynes’s consumption decision-making process, Keynes’s hypothesis about the rate of interest and its relation to investment has stimulated a great deal of theoretical and empirical research. One aspect of this research involves the question of the stability of investment. Empirical research concludes that investment, especially investment in capital goods, is very volatile. Why is that the case? As we have indicated above, Keynes’s theories of expectations and uncertainty offer one explanation.

Keynes’s theories of liquidity preference, money and interest rate determination

Having disposed of the neoclassical notion that the rate of interest is determined according to the principles embodied in the loanable funds theory, Keynes explains the role of the secondary money market and the determination of the rate of interest. Of the three functions that money performs, Keynes focused his attention on the store of value function of money. Why would anyone want to hold money, a non-income-earning asset? Money, as Keynes patiently points out, is the bridge between the dead hand of the past and an unforeseen and less than certain future. Apart from the need for day-to-day transactions, individuals can be persuaded to part with their money – if the price is right. Keynes’s liquidity preference theory of the rate of interest provides an explanation of what is necessary to get individuals to part with their money. According to Keynes, the rate of interest is determined in the secondary money market through the equilibrating forces of the demand for and supply of money. In Keynes’s theory, money then becomes an integral part of the modern economic system.

Keynes’s theory of the determination of the rate of interest accomplished four objectives. First, his theory attacks the neoclassical notion of full employment as being a real phenomenon determined completely by the interaction of saving p. 173and investment. In an economic system ‘with a past as well as a future and in which contracts are made in terms of money, no equilibrium may exist’ (Arrow and Hahn, 1971, p.361). Moreover, even if the economy did achieve equilibrium, there was certainly no assurance – or even a strong likelihood – that the resulting equilibrium would occur at full employment. Second, his theory introduces the concept of money into the economic system. Money is no longer a veil that covers the operation of the real sectors of the economic system. Third, his theory redefines the demand for money to include three component parts: a transaction component, a precautionary component and a speculative component. Keynes’s examination of the factors that affect the speculative demand for money establishes the existence of an unstable pattern in these factors due mainly to the existence of uncertainty. The implications of the impact of uncertainty on the speculative demand for money have been discussed above. Fourth, his theory is a direct attack on the quantity theory of money. The principal role for monetary policy in the quantity theory of money as it was presented at that time was dealing with inflation. In the Tract (1924) Keynes distinguished between the equation of exchange and the assumptions necessary for the long-run conclusions of the quantity theory. After a careful examination of the factors that affect these assumptions, Keynes concluded that the quantity theory is not a useful guide for monetary policy. Rather, given his theory of interest rate determination, monetary policy in conjunction with government investment projects can be used to combat involuntary unemployment. Appropriate expansions of the money supply will reduce the interest rate, thereby increasing investment. The increase in investment and the resulting increase in aggregate demand will expand income and employment as long as the secondary money market is not caught in the ‘liquidity trap’.

Keynes’s public policy proposals

The goal of the General Theory is to increase the average level of performance of the economic system. To achieve this goal the government must implement public policies that establish and/or maintain conventions or rules acceptable to the business community (Bateman, 1995). Why the business community? This group of individuals undertakes gross private domestic investment and, as we have shown above, Keynes argued that gross private domestic investment is unstable. Two such conventions and rules are balanced budgets and the idea that investment is related to the rate of interest. These conventions and rules guide Keynes’s public policy proposal, which, if implemented, will increase the stability of gross private domestic investment and achieve the goal of the General Theory.

There are four aspects of Keynes’s public policy proposal. First, the government must use monetary policy to reduce the rate of interest. Such a policy will promote more gross private domestic investment. Second, the government must p. 174subdivide its budget into two parts, a current expenditures budget and a capital expenditures budget. Third, the current expenditures portion of the budget must be in balance, or in surplus, at the end of each fiscal year. The capital expenditures portion underwrites self-liquidating capital projects. Fourth, Keynes states that gross domestic investment is equal to the sum of gross private and gross public domestic investment and that these two components are complements and not substitutes. Keynes argues that problems associated with gross private domestic investment can be overcome if the government increases gross public domestic investment. To do this the government must develop an investment inventory needs assessment mechanism that permits the government to identify what investments are in progress or scheduled to begin, by whom, for what purpose and how they are to be funded. Keynes’s public policy proposal implies that the government must put the interests of the nation ahead of the pleadings of special interest groups and that the government must be comprised of leaders and statesmen and not politicians.

Tom Cate

L.E. Johnson

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