Blog o’ Burns

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.