finalexam

History of Economic Thought

Notes for Weeks 13 & 14

Keynes’s Critique

Keynes had difficulty with almost every part of the Neoclassical’s claim that free

competitive markets are forever moving toward a full and efficient use of resources. He didn’t

accept Say’s law, thought the Neoclassicals had a flawed theory of the labor market, disagreed

with their theory of saving and investment, and did not see the interest rate as determined by the

loanable funds market.

One of his more important critiques, which in turn revolutionized the way in which

economists interpret capitalism, involved his alternative conception of money. He was among the

first mainstream economists to point out that money is held as an asset, even though it earns no

interest. The basic idea is that he saw money as a vehicle that allows individuals to bridge the

gap between the future and the present. People hold onto money not because they’re unaware of

the interest they could be earning from buying a financial asset, but because it’s the one asset that

can be used to buy things in the future. Unlike other assets, money has the advantage of being

liquid, i.e., easily used for transaction purposes. As a result, people tend to hold onto money,

even though it earns no interest, because they want to be sure they’ll have the liquidity needed to

purchase goods sometime in the future. To be sure, the extent to which people held onto money

for this purpose depends on the level of economic uncertainty and conditions in the financial

markets. But, for the moment, it’s enough to know that he saw the asset demand for money

growing whenever economic uncertainty was heightened. If the public is uncertain about the

future (say because of declining economic activity and rising unemployment), then people will

tend to hold onto money, causing the overall level of spending to fall. He did not believe that

people could be counted on to purchase goods whose value is equal to the value of what they

offer for sale. They may instead decide to hold onto a portion of the money they earn from

selling goods and not buy an amount whose value is equal to the value of what they offered for

sale. In other words, from Keynes’s perspective, it is not irrational to hold onto money beyond

the amount needed for transactions purposes.

Keynes’s rejection of Say’s Law carried with it a rejection of the Neoclassical insistence

that all economic decisions are made in real terms. As was noted in the notes on Say’s Law, the

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Neoclassicals see the decision to offer work or saving (or the decision to hire workers or borrow

money for investment purposes) as being carried out in terms of the real wage or the real interest

that could be earned from offering labor or saving. The same is true with regard to every other

decision. In short, Say’s Law assumes a barter economy or, perhaps more appropriately, one in

which money and finance play a minor role. But Keynes argued that finance and money are

actually at the core of what it means to have a capitalist economy. Rather than playing a minor

role, money is central to the operation of the system; and not simply because money serves as a

medium of exchange (the transactions function of money), but because it is the medium through

which future plans are connected to current decisions. What’s more, in the real world, decisions

are seldom made in real terms, not because people are unaware of the real value of their wages or

saving, but because the average price is beyond their control.

Thus, for example, the Neoclassicals claim that workers will offer less labor when the real

wage falls. In the context of unemployment this argument seems reasonable, so long as one stays

within the context of their theory of human behavior. A reduction in nominal wages, due to

unemployed workers competing against employed workers, would seem to cause real wages to

fall, which in turn would motivate workers to either cut back on the offer of labor or drop out of

the market. But this is much more difficult to imagine when we consider real wages falling as a

result of an increase in the general price level, while nominal wages remain unchanged. That is,

one would not expect fully employed workers to cut back on their offer of employment, or drop

out of the labor market, when real wages fall due to an increase in the price level. Indeed, in the

real world, they don’t. The reason for this is not because workers are unaware of the declining

real value of their nominal wages, but because they have no control over the prices of the things

they purchase (i.e., no control over the price level). What workers do respond to and try to have

some control over is the nominal wage, since there’s not much they can do about the price level.

It’s for this reason that the labor market doesn’t work quite the way Neoclassicals claim. In

the context of labor unemployment, workers do their best to hold onto their real wage by

resisting reductions in their nominal wage. Rather than there being a fall in the nominal wage,

and consequently a fall in the real wage, what happens is that the nominal wage remains

stagnant. While workers may not be able to influence the price level, they do try to influence

nominal wages. And they do this not by offering their labor at a lower nominal wage, but by

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searching for employment at the same nominal wage. Those who lose out in that competition and

remain unemployed were referred to as involuntarily unemployed by Keynes.

Keynes also rejected the idea that wages are set in the labor market. That is, he did not

accept the idea that wages are determined endogenously, from the interaction of supply and

demand in the national market for labor. Now, it’s important to note that he was not referring to

relative wages, but rather the average wage for labor as a whole. Like the Classicals, he saw the

average wage determined by exogenous factors. But while the Classicals saw the average real

wage as being determined by subsistence, Keynes, while not rejecting this idea, put greater

emphasis on the legal and institutional context of the economy (minimum wage laws, existence

of labor unions, labor laws, the international context, etc.). In short, Keynes assumes that the

average wage rate is given by exogenous factors.

In addition, Keynes rejected the Neoclassical interpretation of saving, investment and

interest. Keynes argued that saving (i.e. non consumption) is determined by the level of income,

and not the interest rate. He did this by introducing a theory of consumption that argued

consumption grows at a diminishing rate with respect to income (another way of saying this is

that saving grows at an increasing rate with respect to income). The amount by which

consumption changes due to a change in income, Keynes referred to as the marginal propensity

to consume, and it tends to diminish as the level of income increases. But since saving is the

counterpart to consumption, this is equivalent to saying that the marginal propensity to save

increases as the level of income grows. What’s important about this is that Keynes divorces the

decision to save (and consume) from the kind of utility maximizing calculus that’s central to the

Neoclassical way of thinking. Saving doesn’t occur because individuals are comparing the going

rate of interest to their marginal disutility of abstaining from current consumption, it instead

occurs because individuals have attained a level of income that allows them to save.

It’s important to note that, in this regard Keynes is implicitly introducing the concept of

necessity. While the Classicals took for granted the reality of necessary income and necessary

consumption, these notions died out with the coming of Neoclassical economics. Indeed, to this

day, Neoclassical economics shies away from this notion since it implies that alternatives or

substitutes are unavailable or difficult to find, a position that’s in direct contradiction to the core

of the Neoclassical paradigm. By reintroducing this notion, Keynes was able to depict saving as

an activity that is carried out after necessary consumption is taken care of. But, in addition, this

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same notion of necessity is implicit in the way Keynes characterizes the behavior of workers

with respect to the real wage. Workers, he argued, resist offering less labor when the real wage

falls, not because they’re unaware of the declining real value of wages, but because there’s a

minimum threshold below which necessities become unattainable. And in their effort to avoid

that outcome, workers do not cut back on their offer of labor when real wages fall; they instead

offer the same, or more, labor.

Keynes also rejected the notion that investment is determined by the relationship between

the marginal productivity of capital and the interest rate. He argued that the decision to invest is

determined by the relationship between what he called the marginal efficiency of capital and the

interest rate. His discussion of the marginal efficiency of capital is quite involved, but the basic

idea is that it represents an estimate made by capitalists of the rate of return that will be captured

in the future from investing in capital goods now. It is, in short, a guess of future profitability

and, as such, subject to all kinds of conjectures and capable of changing at a moment’s notice.

That is, the decision to invest in new productive capacity is not dependent on the relationship

between the marginal product of capital and the real interest rate, but rather on the relationship

between estimates of future profitability (the marginal efficiency of capital) and the nominal

interest rate.

The key idea here, as with his conception of money, is that capitalists have no way of

knowing the future. This is true even if the capitalist hires statisticians, accountants and

economists to estimate the flow of future profits from a potential investment. In the end, all such

estimates are nothing more than a guess, regardless of how sophisticated that guess might be.

The reason for this is that the future is unknowable. To be sure, we make plans and try to

safeguard future outcomes, but there is never any guarantee that our best-laid plans will work as

anticipated. Because of this, investment is subject to an enormous amount of uncertainty, and

capitalists will only invest if they’re reasonably confident that the marginal efficiency of capital

is greater than or equal to the going rate of interest. But confidence can easily vanish, and a

change of heart is all that’s needed to go from assuming that investment will be profitable to

imagining that it might entail a loss. Investment, in short, is quite volatile and tends to exhibit a

kind of herd mentality, rising when other capitalists seem confident about the future and falling

or stagnating when others are uncertain and leery.

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Because of the above, Keynes did not believe that the interest rate was determined in what

the Neoclassicals call the loanable funds market. He instead argued that it was determined by the

demand and supply for money. This was another major innovation on the part of Keynes. Instead

of thinking of the interest rate as a real magnitude, as imagined by Neoclassicals, Keynes thought

it was more appropriate to understand the interest rate as a nominal, monetary, magnitude. This

part of his theory is also quite involved and complex, but the basic idea is that Keynes saw the

rate of interest as a measure of what he called liquidity preference.

Keynes argued that the demand for money consisted of a transactions and an asset demand

for money. The transactions demand for money represents the demand to hold money for

transactions purposes. This part of his theory was compatible with the Neoclassical emphasis on

money as a medium of exchange. An increase in the volume of transactions, other things equal,

will induce an increase in the transactions demand for money, and vice versa. But the asset

demand form money involved a way of looking at money that is alien to, or rejected by, the

Neoclassical tradition. The asset demand for money consisted of what he called the

precautionary and the speculative motive. The precautionary demand for money involved the

straightforward notion that people often hold onto money not because it allows them to engage in

current transactions, but because they are cautious about the future. The speculative demand for

money involved the use of money for purposes of financial speculation. The idea here was that

wealthy individuals use money as a hedge against the vagaries of the financial markets, using it

as a fund from which to buy or sell financial assets for speculative purposes.

The combined impact of these different motivations led Keynes to the conclusion that

the interest rate is determined by what he called the liquidity premium. Since money is the most

liquid asset, people will be reluctant to part with it unless the rate of interest is sufficiently high

to ally their concerns. The degree to which people are willing to part with liquidity will depend

on the general state of confidence, or certainty, regarding the future behavior of the economy

and, more specifically, financial assets. If people become increasingly uncertain about the future,

they’ll increase the premium they attach to holding money and, as a result, will demand a higher

rate of interest to cover the higher premium they’re now attaching to liquidity. If, instead, people

are increasingly confident about the future, they’ll reduce the premium attached to holding

money and willingly accept a lower rate of interest before parting with it.

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The last critique implicit in Keynes’s theory involved the quantity theory of money and the

average price. Keynes did not see the supply of money as being exogenously determined, as do

the Neoclassicals. He instead saw the supply of money as being endogenously determined,

responsive to the needs of business and financiers. So, it’s not that the price level increases

because of an increase in the supply of money, it’s rather that the supply of money is increased

as a result of rising price level. What’s more, he thought of the price level as being determined

by some multiple (a markup) of the going wage rate.

Note that this last point leads to a theory of inflation that focuses on the struggle for

income on the part of capitalists and workers. That is, inflation, rather than being a result of too

much money in circulation, is instead thought of as a symptom of class struggle; where

capitalists increase the price of their output as a way of holding onto the profit margins that get

squeezed when wages rise. This has the effect of increasing the demand (and thus supply) of

money. If the spiral of rising wages and prices, in an effort to safeguard profits, grows faster than

output, then the net effect is inflation. The money supply does indeed grow under these

circumstances, but not because the central bank pushed more money into the system, but because

capitalists are demanding more money to safeguard their profits.

Keynes’s concept of effective demand

Given the above critiques, Keynes set out to create an entirely different framework to

explain the employment of labor. The basic idea was that the demand for labor was not

determined by the marginal productivity of labor in something called the labor market. Instead,

the demand for labor was determined by the effective demand for business’s output. The

effective demand for output represented that level of spending (aggregate demand) which could

effectuate the capitalist’s sales, and consequently profit, expectations. That is, at any moment in

time there exists a going wage rate and technology, and consequently a cost of production, as

well as a markup over cost that business owners customarily expect from the sale of their

product. Given that context, the number of workers capitalists hire depends on whether or not the

revenue they earn from selling the product generated by those workers is enough to cover their

cost plus anticipated profits. If sales revenue is greater than anticipated, capitalists will hire more

workers; if sales revenue is less than anticipated, capitalists will hire fewer workers; and if sale

revenue is consistent with expectations, capitalists will leave their hiring decisions unchanged.

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The effective demand for output represents that level of sales which meets capitalist’s

expectations.

Keynes referred to the effective demand for output as being that point at which aggregate

supply is matched by aggregate demand. Aggregate supply was thought of as the relationship

that exists between expected sales and employment. It represents the relationship introduced in

the previous paragraph, where the number of workers hired by capitalists depends on anticipated

sales (and thus profits). Aggregate demand represents the level of overall spending, both

consumption and investment spending, that both workers and capitalists engage in at various

levels of employment, given existing wages and markups. The consumption function makes up

the largest component of aggregate demand and grows at a diminishing rate as the level of

income and employment grows. The investment function makes up the other part of aggregate

demand. It is the more volatile component of aggregate demand, rising or falling in response to

changing profit expectations on the part of the capitalist class.

These relationships are depicted in the following figure. Note that sales revenue is depicted

in nominal terms along the vertical axis, while employment is measured on the horizontal axis.

That is, this graph provides a visual image of the relationship Keynes is establishing between the

nominal value of sales and the level of real employment. This is one of the ways in which

Keynes is underscoring the role of money, and nominal magnitudes, in the economic behavior of

capitalists, consumers and workers.

Z

D

d

N

d

Z, D

d

Ne

d

Ze

d

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The upward slopping curve labeled Z is the aggregate supply curve. It is upward slopping

to account for the existence of diminishing returns. And since it is expressed in nominal terms

the whole curve can rotate up or down depending upon whether wages and/or markups rise or

fall. If, for example, wages increase, then the Z curve would rotate upward. And if wages

decrease, then the Z curve would rotate downward. Similarly, if capitalists were to increase their

markups, with a stable wage rate, then the Z curve would rotate upward; and if they were to

decrease their markups, then the Z curve would rotate downward.

The curve labeled D represents the aggregate demand for output. It too is represented in

nominal, not real, terms. It captures the nominal value of spending the public at large will engage

in at various levels of employment, given existing wages and markups. As the level of

employment increases, consumption spending also increases but a diminishing rate. This is due

to the fact that the marginal propensity to consume decreases as the level of income and

employment increases. At the same time, the aggregate demand curve (D) also incorporates the

role of investment spending and it’s this latter component that makes aggregate demand

somewhat volatile. Keynes imagined aggregate demand moving up and down in response to

changes in investment spending which in turn is responding to changes in capitalist’s

expectations of future profitability and/or interest rates. Like the Z curve, aggregate demand can

move up or down, not only because of changing profit expectations and/or interest rates, but

because of changes in wages and/or markups. If the wage rate were to increase, other things

equal, then the D curve would shift up, and if the wage rate were to fall, then the D curve would

shift down; likewise for changes in the markup, though the impact would be less dramatic than

changes in the wage rate since it captures a smaller proportion of national income.

The effective demand for output is the point at which aggregate demand matches up with

aggregate supply. The equilibrium level of employment is determined by the effective demand

for output. If aggregate demand is greater than aggregate supply, then employment will be

growing, and if aggregate demand is less than aggregate supply, then employment will be falling.

It is only when aggregate demand is equal to aggregate supply that employment remains stable.

Note however, that this equilibrium level of employment need not correspond to the full

employment of labor. The number of workers seeking employment may very well exceed the

equilibrium level of employment. But, since sales and profit expectations are being met, there is

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no is no incentive motivating capitalists to hire the extra workers. They have no reason to change

their employment decisions.

The Neoclassicals argued that in the presence of unemployment, competition among

workers would cause the wage rate to fall, helping to eliminate unemployment by restoring full

employment at a lower real wage. Keynes used his theory of effective demand to explain why

this would probably not happen. He noted that if wages were indeed to fall, as Neoclassicals

suggest, then all that would happen is that both aggregate supply and aggregate demand would

fall, reducing the value of the effective demand for output, without necessarily changing the

equilibrium level of employment. In terms of the above figure, both the Z and the D curve would

fall, bringing about a lower level of effective demand but at the same level of employment. The

system as a whole will experience deflation but the level of unemployment will remain

unchanged. Indeed, it’s possible that, in the face of considerable deflation, aggregate demand

falls faster than aggregate supply bringing about drop in the equilibrium level of employment.

Under these more dramatic circumstances, the reduction in wages would actually increase the

level of unemployment, not reduce it.

Keynes, in short, did not believe that free markets automatically move the economy toward

the full employment of labor. Given this, society really has no other option, assuming that it’s

concerned about unemployment, but to rely on government to nudge the private sector toward

the full employment of labor. And the only way this can be accomplished, within the parameters

of a capitalist economy, is through fiscal and monetary policy. Keynes was convinced that his

theory implied that, from now on, capitalist societies would have to assign a much larger role to

government. Indeed, he believed that there was no other option but to accept the socialization of

investment, so as to maintain full employment over the long term.