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Lekachman, Robert. The Age of Keynes. New York: Random House, 1966.

“Supply creates its own demand,” or so says Say’s Law which encompassed the reasoning of classical economists prior to Keynes’s General Theory. Since sellers are also buyers, supply and demand in an economy should always equal. Marshall clarified this logic slightly by indicating that all income is used to “consume” in that some of it was spent on goods/services while the rest was saved and thereby reinvested into the economy. As such, there could be no such thing as involuntary unemployment. Workers simply needed to accept lower wages for their labor in order to have full employment. Unemployment arose as a result of monopoly interference, sticky wages caused by labor unions, immobility of labor/capital, or inappropriate government policy. In the long run, these factors would no longer be consequential. However, such lack of policy recommendations and assumption of long run equilibrium dissatisfied Keynes, who wrote, “In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

In a 1924 work entitled Banking Policy and the Price Level, Keynes helped his good friend and colleague D.H. Robertson investigate the relationship between savings (S) and investment (I). Classical economists had previously concluded that interest rates adjusted so S = I. However, Robertson argued that savings, which are voluntarily made by individuals, need not apply to new investment and that excess savings do not necessarily translate into higher consumption. Keynes would later recognize the phenomenon of oversaving as adverse to employment and output during times of economic recession. During depressions, if S > I, S represented potential production which never materialized due to lack of investment and consumption, thereby exacerbating unemployment. In Keynes’s Treatise on Money, he concludes that investment is more important than saving.

While teaching at Cambridge, Keynes was also highly influenced by R.F. Kahn, who developed the concept of the multiplier in 1931. Keynes described the function of the multiplier in his series of articles entitled Means to Prosperity (1933), composing a scenario in which the government employs one man for a public works project. That man would spend part of his income on goods/services, thereby increasing demand and requiring more people to be hired to make and sell these items. In turn, these newly employed people would use their income to buy more goods and so on. This process is not infinite, since at each stage a proportion of new income is saved, spent on imports, or taxed. Keynes conservatively estimated that in his contemporary England the multiplier would equal at least 1.5.

R.F. Kahn’s findings gave Keynes the theoretical foundation for an argument promoting economic policy to pull an economy out of recession. In his General Theory of Employment, Interest, and Money (1936), he first defines involuntary unemployment as a condition in which both the aggregate supply of labor willing to work at current wages and demand for work at that wage exceeded the employment available. Thus, it was not that workers were unwilling to work for lower wages; it was firms who were unwilling to hire additional labor, because they did not desire to produce more output. Keynes argued that if all firms cut all wages to induce full employment, this fall in income would cause aggregate demand for consumer goods to also fall. This in turn causes prices to fall, lowering marginal revenue and the value of a worker’s marginal product, thus requiring another cut in wages. Through this analysis, Keynes derived the theory of aggregate demand.

Keynes’s aggregate demand function measures the volume of sales which corresponds to each possible level of income and output. The actual level of employment will be where aggregate demand and aggregate supply intersect. However, equilibrium is possible at any level of employment, and no theoretical reason exists to assume that full employment is inevitable. Ultimately, aggregate demand for goods/services determines employment. As such, Keynes defined three influences on consumption: 1) disposable income; 2) objective factors- changes in cost of living, interest rates, etc.; and 3) subjective factors. He determined that disposable income was the most important determinant of short-run consumption, and that as a rule, people increase their consumption as their income increases but not by as much as their increase in income (marginal propensity to consume).

Keynes’s consumption function could not explain the size of national income and employment, since aggregate demand also relied on investment. He identified three investment characteristics: 1) investments are made by businessmen, not consumers; 2) all investments are risky; and 3) investments are postponable. What determines the level of investment? Expectations. The expected return on an investment must exceed the interest charges on the money borrowed to make the investment (marginal efficiency of capital).

Knowing that the marginal efficiency of capital must be greater than the interest rate in order to invest, what determines the rate of interest? As opposed to classical economists, Keynes argued that the rate of interest did not depend on the time preferences of savers or on the marginal productivities of capital assumed by investors. Interest rates were a function of preferences for perfectly liquid assets over less liquid assets. As such, expectations play a large role in the direction of interest rates. Speculators buy stocks in the expectation that they will rise. This drives up stock prices, causing interest rates to fall since the dividend is a smaller percentage of the now higher-priced stock. The implications of this are enormous, considering that changes in the interest rate can drive up stock prices and investment. If this is the case, Keynes argued that central banks can engage in open market operations to manipulate interest rates, which in turn can induce greater investment. This increase in investment can trigger the multiplier effect, increasing the nation’s income by a greater amount than the initial amount of the new investment. From this analysis, Keynes emphasized the ability of both fiscal and monetary policy to increase both output and employment.

Blaug, Mark. Economic Theory in Retrospect, 5^th Edition, Chapter 15, “The Neo-Classical theory of Money, Interest and Prices,”613-628.

An Introduction to the Quantity Theory of Money

Until the 1930s, the dominant theory used by economists to explain shifts in price levels was the quantity theory of money: MV = PT

M = quantity of money in circulation; V = velocity that a unit of money is transacted; P = price level; T = real value of aggregate transactions

For this equation to hold true, three assumptions are made: 1) MV must cause PT rather than the opposite; 2) changes in V and T cannot be due to monetary factors; and 3) the nominal stock of money must be determined by an exogenous force (such as a central bank) as opposed to public demand for money.

The theory assumes a stable value for V, which means that price levels (P) vary in exact proportion to changes in the money supply (M). If they are in disequilibrium, two transmission mechanisms exist to balance them: 1) the direct mechanism- people use additional money to buy more goods, which drives up prices; and 2) the indirect mechanism- an increase in the money supply drives down interest rates, which increases consumption, which in turn drives up prices until interest rates return to equilibrium.

Though every classical economist (Malthus, Thornton, Bentham, McCulloch, John Stuart Mill, and Torrens) except for Ricardo and James Mill acknowledged that changes in the money supply could impact economies in the short-run, classical economists emphasized the “neutrality of money,” implying that changes in the money supply have no influence on real economic variables (output, employment, etc.) in the long-run. This is what ultimately distinguished classical economists from neoclassical economists in terms of quantity theory. By the mid-20th century, the strict long-run neutrality of money had all but disappeared. Quantity theory would transform from an explanation of changes in purchasing power to a theory of how the money supply influenced aggregate demand (represented by MV), prices, and output.

The Evolution of Quantity Theory

Fisher and Marshall– In Fisher’s Purchasing Power of Money, he acknowledged that the equation of exchange only held in long-run equilibrium and that transition periods occurred in which the value of V would change. However, he argued that such changes were due to frictions in the economic system. Ultimately, he over-emphasized the concept of money to spend (motion theory) rather than to hold (rest theory).

Marshall moved the theory of money demand more toward ordinary demand analysis rather than treating it only as a unit of exchange. Money related to national income rather than to the value of goods transacted. Marshall also shifted focus from money’s annual rate of turnover to the proportion of income that people hold in the form of money.

Wicksell– Wicksell carefully restated the indirect mechanism which had only been touched upon by Marshall. He intended to account for the Gibson Paradox while also defending quantity theory. The Gibson Paradox was first observed by Thomas Tooke between 1838 to 1857, indicating that price levels and interest rates moved in the same direction which contradicted monetary theory. Wicksell approaches the issue by first conceptualizing a pure cash system in which only coins and paper currency are used. In such a regime, a fall in interest rates would raise the volume of investment per unit of time and prices of capital would rise. In the economy were fully employed, the entire wage-price level would rise and this inflationary upsurge would cause a drain in the circulation of money. Since banks cannot issue more loans due to reserve requirements, they must raise interest rates to cut off inflation. Wicksell next conceptualizes a pure credit system in which there are no limits to bank reserves. Under such a regime, monetary authorities would be free to determine price levels at will.

He argued that if interest rates were lower than the expected yield of investments, this would create a disequilibrium that would be inflationary unless this money were saved and not used for consumption. He developed three criteria of monetary equilibria: 1) loan rates must equal the expected yield of newly created capital; 2) demand for loans must equal the supply of savings; and 3) the general level of commodity prices must be stable.

There were several shortcomings to Wicksell’s model. Firstly, he did not consider how economic growth involves increased productivity, which impacts price levels. For stable prices, the money supply must increase with the rate of increase in productivity, because higher output causes prices to fall. He also did not incorporate changing expectations into his model. In static equilibrium, producers would assume that increases in the price of capital are only temporary and will come back down. As such, they would wait until prices fell to invest, causing investment to sink below normal levels. Wicksell also failed to include cost or yield variables in his money demand function, and he only considered an economy at full employment without considering monetary impacts on employment and output.

Keynes– In criticism of Wicksell, Keynes argued that when there are unused resources in an economy, changes in spending are more likely to impact employment and output rather than prices. In addition, he reversed the assumptions of quantity theory, by making prices fixed and output flexible while also denying the stability of V. He demonstrated that an increase in the money supply could be offset by a fall in V, causing spending and income to stay the same. He also separated demand for money into active cash balances and inactive cash balances, which for the first time included the opportunity cost of holding cash. Replacing the direct mechanism with the multiplier, Keynes’s main policy implication promoted fiscal policy as a superior tool to monetary policy in fighting economic downturn.

Friedman– Milton Friedman countered Keynes’s analysis with a complete specification of relevant constraints and opportunity cost variables for his money demand function. His independent variables included a broad definition of wealth which consisted of the present value of expected future receipts from all sources. He considered all types of wealth as possible substitutes for cash holdings.

Questions and Comments

I am having trouble fully understanding the cumulative process described by Wicksell.

How did Wicksell ultimately explain the Gibson Paradox?  Was the positive correlation between inflation and interest rates due to the fact that Tooke only looked at nominal interest rates?

If we lump together classical and neoclassical economists and compare them with Keynesian economists, I suppose two main differences are demonstrated in this article: 1) classical economists tend to favor monetary policy while Keynesian economists favor fiscal policy; and 2) classical economists focus on long term equilibria while Keynesian economists emphasize short term equilibria.