Say's law

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In classical economics, Say's law, or the law of markets, is the claim that the production of a product creates demand for another product by providing something of value which can be exchanged for that other product. So, production is the source of demand. It is named after Jean-Baptiste Say. In his principal work, A Treatise on Political Economy "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." And also, "As each of us can only purchase the productions of others with his/her own productions – as the value we can buy is equal to the value we can produce, the more men can produce, the more they will purchase."

Some maintain that Say further argued that this law of markets implies that a general glut (a widespread excess of supply over demand) cannot occur. If there is a surplus of one good, there must be unmet demand for another: "If certain goods remain unsold, it is because other goods are not produced." However, according to Petur Jonsson, Say does not claim a general glut cannot occur and in fact acknowledges that they can occur. Say's law has been one of the principal doctrines used to support the laissez-faire belief that a capitalist economy will naturally tend toward full employment and prosperity without government intervention.

Over the years, at least two objections to Say's law have been raised:

• General gluts do occur, particularly during recessions and depressions.
• Economic agents may collectively choose to increase the amount of savings they hold, thereby reducing demand but not supply.

Say's law was generally accepted throughout the 19th century, though modified to incorporate the idea of a "boom-and-bust" cycle. During the worldwide Great Depression of the 1930s, the theories of Keynesian economics disputed Say's conclusions.

Scholars disagree on the question of whether it was Say who first stated the principle, but by convention, Say's law has been another name for the law of markets ever since John Maynard Keynes used the term in the 1930s.

History

Say's formulation

Say argued that economic agents offer goods and services for sale so that they can spend the money they expect to obtain. Therefore, the fact that a quantity of goods and services is offered for sale is evidence of an equal quantity of demand. Essentially Say's argument was that money is just a medium, people pay for goods and services with other goods and services. This claim is often summarized as "supply creates its own demand", although that phrase does not appear in Say's writings.

Explaining his point at length, Say wrote:

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products.

Say further argued that because production necessarily creates demand, a "general glut" of unsold goods of all kinds is impossible. If there is an excess supply of one good, there must be a shortage of another: "The superabundance of goods of one description arises from the deficiency of goods of another description."

To further clarify, he wrote: "Sales cannot be said to be dull because money is scarce, but because other products are so. ... To use a more hackneyed phrase, people have bought less, because they have made less profit."

Say's law should therefore be formulated as: Supply of X creates demand for Y, subject to people being interested in buying X. The producer of X is able to buy Y, if his products are demanded.

Say rejected the possibility that money obtained from the sale of goods could remain unspent, thereby reducing demand below supply. He viewed money only as a temporary medium of exchange.

Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another.

Early opinions

Early writers on political economy held a variety of opinions on what we now call Say's law. James Mill and David Ricardo both supported the law in full. Thomas Malthus and John Stuart Mill questioned the doctrine that general gluts cannot occur.

James Mill and David Ricardo restated and developed Say's law. Mill wrote, "The production of commodities creates, and is the one and universal cause which creates, a market for the commodities produced." Ricardo wrote, "Demand depends only on supply."

Thomas Malthus, on the other hand, rejected Say's law because he saw evidence of general gluts.

We hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of the new doctrine on profits and demand, that if one trade be overstocked with capital, it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital?

John Stuart Mill also recognized general gluts. He argued that during a general glut, there is insufficient demand for all non-monetary commodities and excess demand for money.

When there is a general anxiety to sell, and a general disinclination to buy, commodities of all kinds remain for a long time unsold, and those which find an immediate market, do so at a very low price... At periods such as we have described... persons in general... liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute... As there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence.

Mill rescued the claim that there cannot be a simultaneous glut of all commodities by including money as one of the commodities.

In order to render the argument for the impossibility of an excess of all commodities applicable... money must itself be considered as a commodity. It must, undoubtedly, be admitted that there cannot be an excess of all other commodities, and an excess of money at the same time.

Contemporary economist Brad DeLong believes that Mill's argument refutes the assertions that a general glut cannot occur, and that a market economy naturally tends towards an equilibrium in which general gluts do not occur. What remains of Say's law, after Mill's modification, are a few less controversial assertions:

• In the long run, the ability to produce does not outstrip the desire to consume.
• In a barter economy, a general glut cannot occur.
• In a monetary economy, a general glut occurs not because sellers produce more commodities of every kind than buyers wish to purchase, but because buyers increase their desire to hold money.

Say himself never used many of the later, short definitions of Say's law, and thus the law actually developed through the work of many of his contemporaries and successors. The work of James Mill, David Ricardo, John Stuart Mill, and others evolved Say's law into what is sometimes called law of markets, which was a key element of the framework of macroeconomics from the mid-19th century until the 1930s.

The Great Depression

The Great Depression posed a challenge to Say's law. In the United States, unemployment rose to 25%. The quarter of the labor force that was unemployed constituted a supply of labor for which the demand predicted by Say's law did not exist.

John Maynard Keynes argued in 1936 that Say's law is simply not true, and that demand, rather than supply, is the key variable that determines the overall level of economic activity. According to Keynes, demand depends on the propensity of individuals to consume and on the propensity of businesses to invest, both of which vary throughout the business cycle. There is no reason to expect enough aggregate demand to produce full employment.

Today

Steven Kates, although a proponent of Say's law, writes:

Before the Keynesian Revolution, [the] denial of the validity of Say's Law placed an economist amongst the crackpots, people with no idea whatsoever about how an economy works. That the vast majority of the economics profession today would have been classified as crackpots in the 1930s and before is just how it is.

Keynesian economists, such as Paul Krugman, stress the role of money in negating Say's law: Money that is hoarded (held as cash or analogous financial instruments) is not spent on products. To increase monetary holdings, someone may sell products or labor without immediately spending the proceeds. This can be a general phenomenon: from time to time, in response to changing economic circumstances, households and businesses in aggregate seek to increase net savings and thus decrease net debt. To increase net savings requires earning more than is spent—contrary to Say's law, which postulates that supply (sales, earning income) equals demand (purchases, requiring spending). Keynesian economists argue that the failure of Say's law, through an increased demand for monetary holdings, can result in a general glut due to falling demand for goods and services.

Many economists today maintain that supply does not create its own demand, but instead, especially during recessions, demand creates its own supply. Krugman writes:

Not only doesn't supply create its own demand; experience since 2008 suggests, if anything, that the reverse is largely true -- specifically, that inadequate demand destroys supply. Economies with persistently weak demand seem to suffer large declines in potential as well as actual output.

Olivier Blanchard and Larry Summers, observing persistently high and increasing unemployment rates in Europe in the 1970s and 1980s, argued that adverse demand shocks can lead to persistently high unemployment, therefore persistently reducing the supply of goods and services. Antonio Fatás and Larry Summers argued that shortfalls in demand, resulting both from the global economic downturn of 2008 and 2009 and from subsequent attempts by governments to reduce government spending, have had large negative effects on both actual and potential world economic output.

A minority of economists still support Say's law. Some proponents of real business cycle theory maintain that high unemployment is due to a reduced labor supply rather than reduced demand. In other words, people choose to work less when economic conditions are poor, so that involuntary unemployment does not actually exist.

While economists have abandoned Say's law as a true law that must always hold, most still consider Say's law to be a useful rule of thumb which the economy will tend towards in the long run, so long as it is allowed to adjust to shocks such as financial crises without being exposed to any further such shocks. The applicability of Say's law in theoretical long-run conditions is one motivation behind the study of general equilibrium theory in economics, which studies economies in the context where Say's law holds true.

Consequences

A number of laissez-faire consequences have been drawn from interpretations of Say's law. However, Say himself advocated public works to remedy unemployment and criticized Ricardo for neglecting the possibility of hoarding if there was a lack of investment opportunities.

Recession and unemployment

Say argued against claims that businesses suffer because people do not have enough money. He argued that the power to purchase can only be increased through more production.

James Mill used Say's law against those who sought to give the economy a boost via unproductive consumption. In his view, consumption destroys wealth, in contrast to production, which is the source of economic growth. The demand for a product determines the price of the product.

According to Keynes (see more below), if Say's law is correct, widespread involuntary unemployment (caused by inadequate demand) cannot occur. Classical economists in the context of Say's law explain unemployment as arising from insufficient demand for specialized labour—that is, the supply of viable labour exceeds demand in some segments of the economy.

When more goods are produced by firms than are demanded in certain sectors, the suppliers in those sectors lose revenue as result. This loss of revenue, which would in turn have been used to purchase other goods from other firms, lowers demand for the products of firms in other sectors, causing an overall general reduction in output and thus lowering the demand for labour. This results in what contemporary macroeconomics call structural unemployment, the presumed mismatch between the overall demand for labour in jobs offered and the individual job skills and location of labour. This differs from the Keynesian concept of cyclical unemployment, which is presumed to arise because of inadequate aggregate demand.

Such economic losses and unemployment were seen by some economists, such as Marx and Keynes himself, as an intrinsic property of the capitalist system. The division of labor leads to a situation where one always has to anticipate what others will be willing to buy, and this leads to miscalculations.

Assumptions and criticisms

Say's law did not posit that (as per the Keynesian formulation) "supply creates its own demand". Nor was it based on the idea that everything that is saved will be exchanged. Rather, Say sought to refute the idea that production and employment were limited by low consumption.

Thus Say's law, in its original concept, was not intrinsically linked nor logically reliant on the neutrality of money (as has been alleged by those who wish to disagree with it), because the key proposition of the law is that no matter how much people save, production is still a possibility, as it is the prerequisite for the attainment of any additional consumption goods. Say's law states that in a market economy, goods and services are produced for exchange with other goods and services—"employment multipliers" therefore arise from production and not exchange alone—and that in the process a sufficient level of real income is created to purchase the economy's entire output, due to the truism that the means of consumption are limited ex vi termini by the level of production. That is, with regard to the exchange of products within a division of labour, the total supply of goods and services in a market economy will equal the total demand derived from consumption during any given time period. In modern terms, "general gluts cannot exist", although there may be local imbalances, with gluts in some markets balanced out by shortages in others.

Nevertheless, for some neoclassical economists, Say's law implies that economy is always at its full employment level. This is not necessarily what Say proposed.

In the Keynesian interpretation, the assumptions of Say's law are:

• a barter model of money ("products are paid for with products");
• flexible prices—that is, all prices can rapidly adjust upwards or downwards; and
• no government intervention.

Under these assumptions, Say's law implies that there cannot be a general glut, so that a persistent state cannot exist in which demand is generally less than productive capacity and high unemployment results. Keynesians therefore argued that the Great Depression demonstrated that Say's law is incorrect. Keynes, in his General Theory, argued that a country could go into a recession because of "lack of aggregate demand".

Because historically there have been many persistent economic crises, one may reject one or more of the assumptions of Say's law, its reasoning, or its conclusions. Taking the assumptions in turn:

• Circuitists and some post-Keynesians dispute the barter model of money, arguing that money is fundamentally different from commodities and that credit bubbles can and do cause depressions. Notably, the debt owed does not change because the economy has changed.
• Keynes argued that prices are not flexible; for example, workers may not take pay cuts if the result is starvation.
• Laissez-faire economists argue that government intervention is the cause of economic crises, and that left to its devices, the market will adjust efficiently.

As for the implication that dislocations cannot cause persistent unemployment, some theories of economic cycles accept Say's law and seek to explain high unemployment in other ways, considering depressed demand for labour as a form of local dislocation. For example, advocates of Real Business Cycle Theory argue that real shocks cause recessions and that the market responds efficiently to these real economic shocks.

Krugman dismisses Say's law as, "at best, a useless tautology when individuals have the option of accumulating money rather than purchasing real goods and services".

Role of money

It is not easy to say what exactly Say's law says about the role of money apart from the claim that recession is not caused by lack of money. The phrase "products are paid for with products" is taken to mean that Say has a barter model of money; contrast with circuitist and post-Keynesian monetary theory.

One can read Say as stating simply that money is completely neutral, although he did not state this explicitly, and in fact did not concern himself with this subject. Say's central notion concerning money was that if one has money, it is irrational to hoard it.^{[citation needed]}

The assumption that hoarding is irrational was attacked by underconsumptionist economists, such as John M. Robertson, in his 1892 book, The Fallacy of Saving: where he called Say's law:

[A] tenacious fallacy, consequent on the inveterate evasion of the plain fact that men want for their goods, not merely some other goods to consume, but further, some credit or abstract claim to future wealth, goods, or services. This all want as a surplus or bonus, and this surplus cannot be represented for all in present goods.

Here Robertson identifies his critique as based on Say's theory of money: people wish to accumulate a "claim to future wealth", not simply present goods, and thus the hoarding of wealth may be rational.

For Say, as for other classical economists, it is possible for there to be a glut (excess supply, market surplus) for one product alongside a shortage (excess demand) of others. But there is no "general glut" in Say's view, since the gluts and shortages cancel out for the economy as a whole. But what if the excess demand is for money, because people are hoarding it? This creates an excess supply for all products, a general glut. Say's answer is simple: there is no reason to engage in hoarding money. According to Say, the only reason to have money is to buy products. It would not be a mistake, in his view, to treat the economy as if it were a barter economy. To quote Say:

Nor is [an individual] less anxious to dispose of the money he may get ... But the only way of getting rid of money is in the purchase of some product or other.

In Keynesian terms, followers of Say's law would argue that on the aggregate level, there is only a transactions demand for money. That is, there is no precautionary, finance, or speculative demand for money. Money is held for spending, and increases in money supplies lead to increased spending.

Some classical economists did see that a loss of confidence in business or a collapse of credit will increase the demand for money, which will decrease the demand for goods. This view was expressed both by Robert Torrens and John Stuart Mill. This would lead demand and supply to move out of phase and lead to an economic downturn in the same way that miscalculation in productions would, as described by William H. Beveridge in 1909.

However, in classical economics, there was no reason for such a collapse to persist. In this view, persistent depressions, such as that of the 1930s, are impossible in a free market organized according to laissez-faire principles. The flexibility of markets under laissez faire allows prices, wages, and interest rates to adjust so as to abolish all excess supplies and demands; however, since all economies are a mixture of regulation and free-market elements, laissez-faire principles (which require a free market environment) cannot adjust effectively to excess supply and demand.

As a theoretical point of departure

The whole of neoclassical equilibrium analysis implies that Say's law in the first place functioned to bring a market into this state: that is, Say's law is the mechanism through which markets equilibrate uniquely. Equilibrium analysis and its derivatives of optimization and efficiency in exchange live or die with Say's law. This is one of the major, fundamental points of contention between the neoclassical tradition, Keynes, and Marxians. Ultimately, from Say's law they deduced vastly different conclusions regarding the functioning of capitalist production.

The former, not to be confused with "new Keynesian" and the many offsprings and syntheses of the General Theory, take the fact that a commodity–commodity economy is substantially altered once it becomes a commodity–money–commodity economy, or once money becomes not only a facilitator of exchange (its only function in marginalist theory) but also a store of value and a means of payment. What this means is that money can be (and must be) hoarded: it may not re-enter the circulatory process for some time, and thus a general glut is not only possible but, to the extent that money is not rapidly turned over, probable.

A response to this in defense of Say's law (echoing the debates between Ricardo and Malthus, in which the former denied the possibility of a general glut on its grounds) is that consumption that is abstained from through hoarding is simply transferred to a different consumer—overwhelmingly to factor (investment) markets, which, through financial institutions, function through the rate of interest.

Keynes' innovation in this regard was twofold: First, he was to turn the mechanism that regulates savings and investment, the rate of interest, into a shell of its former self (relegating it to the price of money) by showing that supply and investment were not independent of one another and thus could not be related uniquely in terms of the balancing of disutility and utility. Second, after Say's law was dealt with and shown to be theoretically inconsistent, there was a gap to be filled. If Say's law was the logic by which we thought financial markets came to a unique position in the long run, and if Say's law were to be discarded, what were the real "rules of the game" of the financial markets? How did they function and remain stable?

To this Keynes responded with his famous notion of "animal spirits": markets are ruled by speculative behavior, influenced not only by one's own personal equation but also by one's perceptions of the speculative behavior of others. In turn, others' behavior is motivated by their perceptions of others' behavior, and so on. Without Say's law keeping them in balance, financial markets are thus inherently unstable. Through this identification, Keynes deduced the consequences for the macroeconomy of long-run equilibrium being attained not at only one unique position that represented a "Pareto Optima" (a special case), but through a possible range of many equilibria that could significantly under-employ human and natural resources (the general case).

For the Marxian critique, which is more fundamental, one must start at Marx's initial distinction between use value and exchange value—use value being the use somebody has for a commodity, and exchange value being what an item is traded for on a market. In Marx's theory, there is a gap between the creation of surplus value in production and the realization of that surplus value via a sale. To realize a sale, a commodity must have a use value for someone, so that they purchase the commodity and complete the cycle M–C–M'. Capitalism, which is interested in value (money as wealth), must create use value. The capitalist has no control over whether or not the value contained in the product is realized through the market mechanism. This gap between production and realization creates the possibility for capitalist crisis, but only if the value of any item is realised through the difference between its cost and final price. As the realization of capital is only possible through a market, Marx criticized other economists, such as David Ricardo, who argued that capital is realized via production. Thus, in Marx's theory, there can be general overproductive crises within capitalism.

Given these concepts and their implications, Say's law does not hold in the Marxian framework. Moreover, the theoretical core of the Marxian framework contrasts with that of the neoclassical and Austrian traditions.

Conceptually, the distinction between Keynes and Marx is that for Keynes the theory is but a special case of his general theory, whereas for Marx it never existed at all.

Modern interpretations

A modern way of expressing Say's law is that there can never be a general glut. Instead of there being an excess supply (glut or surplus) of goods in general, there may be an excess supply of one or more goods, but only when balanced by an excess demand (shortage) of yet other goods. Thus, there may be a glut of labor ("cyclical" unemployment), but this is balanced by an excess demand for produced goods. Modern advocates of Say's law see market forces as working quickly, via price adjustments, to abolish both gluts and shortages. The exception is when governments or other non-market forces prevent price adjustments.

According to Keynes, the implication of Say's law is that a free-market economy is always at what Keynesian economists call full employment (see also Walras' law). Thus, Say's law is part of the general world view of laissez-faire economics—that is, that free markets can solve the economy's problems automatically. (These problems are recessions, stagnation, depression, and involuntary unemployment.)

Some proponents of Say's law argue that such intervention is always counterproductive. Consider Keynesian-type policies aimed at stimulating the economy. Increased government purchases of goods (or lowered taxes) merely "crowd out" the production and purchase of goods by the private sector. Contradicting this view, Arthur Cecil Pigou, a self-proclaimed follower of Say's law, wrote a letter in 1932 signed by five other economists (among them Keynes) calling for more public spending to alleviate high levels of unemployment.

Keynes versus Say

Keynes summarized Say's law as "supply creates its own demand", or the assumption "that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product" (from chapter 2 of his General Theory). See the article on The General Theory of Employment, Interest and Money for a summary of Keynes's view.

Although hoarding of money was not a direct cause of unemployment in Keynes's theory, his concept of saving was unclear and some readers have filled the gap by assigning to hoarding the role Keynes gave to saving. An early example was Jacob Viner, who in his 1936 review of the General Theory said of hoarding that Keynes' attaches great importance to it as a barrier to "full" employment' (p152) while denying (pp158f) that it was capable of having that effect.

The theory that hoarding is a cause of unemployment has been the subject of discussion. Some classical economists suggested that hoarding (increases in money-equivalent holdings) would always be balanced by dis-hoarding. This requires equality of saving (abstention from purchase of goods) and investment (the purchase of capital goods). However, Keynes and others argued that hoarding decisions are made by different people and for different reasons than are decisions to dis-hoard, so that hoarding and dis-hoarding are unlikely to be equal at all times, as indeed they are not. Decreasing demand (consumption) does not necessarily stimulate capital spending (investment).

Some have argued that financial markets, and especially interest rates, could adjust to keep hoarding and dis-hoarding equal, so that Say's law could be maintained, or that prices could simply fall, to prevent a decrease in production. But Keynes argued that to play this role, interest rates would have to fall rapidly, and that there are limits on how quickly and how low they can fall (as in the liquidity trap, where interest rates approach zero and cannot fall further). To Keynes, in the short run, interest rates are determined more by the supply and demand for money than by saving and investment. Before interest rates can adjust sufficiently, excessive hoarding causes the vicious circle of falling aggregate production (recession). The recession itself lowers incomes so that hoarding (and saving) and dis-hoarding (and real investment) can reach a state of balance below full employment.

Worse, a recession would hurt private real investment—by hurting profitability and business confidence—through what is called the accelerator effect. This means that the balance between hoarding and dis-hoarding would be pushed even further below the full-employment level of production.

Keynes treats a fall in marginal efficiency of capital and an increase in the degree of liquidity preference (demand for money) as sparks leading to an insufficiency of effective demand. A decrease in MEC causes a reduction in investment, which reduces aggregate expenditure and income. A decline in the interest rate would offset the decline in investment, and stimulate propensity to consume.

The General Theory of Employment, Interest and Money

From Wikipedia, the free encyclopedia

 https://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Money

 

The General Theory of Employment, Interest and Money

Author	John Maynard Keynes
Language	English
Genre	Non-fiction
Publisher	Palgrave Macmillan
Publication date	1936
Publication place	United Kingdom
Media type	Print paperback
Pages	472 (2007 edition)
ISBN	978-0-230-00476-4
OCLC	62532514

The General Theory of Employment, Interest and Money is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision-making.

Keynes denied that an economy would automatically adapt to provide full employment even in equilibrium, and believed that the volatile and ungovernable psychology of markets would lead to periodic booms and crises. The General Theory is a sustained attack on the classical economics orthodoxy of its time. It introduced the concepts of the consumption function, the principle of effective demand and liquidity preference, and gave new prominence to the multiplier and the marginal efficiency of capital.

Keynes's aims in the General Theory

The central argument of The General Theory is that the level of employment is determined not by the price of labour, as in classical economics, but by the level of aggregate demand. If the total demand for goods at full employment is less than the total output, then the economy has to contract until equality is achieved. Keynes thus denied that full employment was the natural result of competitive markets in equilibrium.

In this he challenged the conventional ('classical') economic wisdom of his day. In a letter to his friend George Bernard Shaw on New Year's Day, 1935, he wrote:

I believe myself to be writing a book on economic theory which will largely revolutionize – not I suppose, at once but in the course of the next ten years – the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say, – in my own mind, I'm quite sure.

The first chapter of The General Theory (only half a page long) has a similarly radical tone:

I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

Summary of the General Theory

Keynes's main theory (including its dynamic elements) is presented in Chapters 2–15, 18, and 22, which are summarised here. A shorter account will be found in the article on Keynesian economics. The remaining chapters of Keynes's book contain amplifications of various sorts and are described later in this article.

Book I: Introduction

The first book of The General Theory of Employment, Interest and Money is a repudiation of Say's law. The classical view for which Keynes made Say a mouthpiece held that the value of wages was equal to the value of the goods produced, and that the wages were inevitably put back into the economy sustaining demand at the level of current production. Hence, starting from full employment, there cannot be a glut of industrial output leading to a loss of jobs. As Keynes put it on p. 18, "supply creates its own demand".

Stickiness of wages in money terms

Say's law depends on the operation of a market economy. If there is unemployment (and if there are no distortions preventing the employment market from adjusting to it) then there will be workers willing to offer their labour at less than the current wage levels, leading to downward pressure on wages and increased offers of jobs.

The classics held that full employment was the equilibrium condition of an undistorted labour market, but they and Keynes agreed in the existence of distortions impeding transition to equilibrium. The classical position had generally been to view the distortions as the culprit and to argue that their removal was the main tool for eliminating unemployment. Keynes on the other hand viewed the market distortions as part of the economic fabric and advocated different policy measures which (as a separate consideration) had social consequences which he personally found congenial and which he expected his readers to see in the same light.

The distortions which have prevented wage levels from adapting downwards have lain in employment contracts being expressed in monetary terms; in various forms of legislation such as the minimum wage and in state-supplied benefits; in the unwillingness of workers to accept reductions in their income; and in their ability through unionisation to resist the market forces exerting downward pressure on them.

Keynes accepted the classical relation between wages and the marginal productivity of labour, referring to it on page 5 as the "first postulate of classical economics" and summarising it as saying that "The wage is equal to the marginal product of labour".

The first postulate can be expressed in the equation y'(N) = W/p, where y(N) is the real output when employment is N, and W and p are the wage rate and price rate in money terms (and hence W/p is the wage rate in real terms). A system can be analysed on the assumption that W is fixed (i.e. that wages are fixed in money terms) or that W/p is fixed (i.e. that they are fixed in real terms) or that N is fixed (e.g. if wages adapt to ensure full employment). All three assumptions had at times been made by classical economists, but under the assumption of wages fixed in money terms the 'first postulate' becomes an equation in two variables (N and p), and the consequences of this had not been taken into account by the classical school.

Keynes proposed a 'second postulate of classical economics' asserting that the wage is equal to the marginal disutility of labour. This is an instance of wages being fixed in real terms. He attributes the second postulate to the classics subject to the qualification that unemployment may result from wages being fixed by legislation, collective bargaining, or 'mere human obstinacy' (p. 6), all of which are likely to fix wages in money terms.

Outline of Keynes's theory

Keynes's economic theory is based on the interaction between demands for saving, investment, and liquidity (i.e. money). Saving and investment are necessarily equal, but different factors influence decisions concerning them. The desire to save, in Keynes's analysis, is mostly a function of income: the wealthier people are, the more wealth they will seek to put aside. The profitability of investment, on the other hand, is determined by the relation between the return available to capital and the interest rate. The economy needs to find its way to an equilibrium in which no more money is being saved than will be invested, and this can be accomplished by contraction of income and a consequent reduction in the level of employment.

In the classical scheme it is the interest rate rather than income which adjusts to maintain equilibrium between saving and investment; but Keynes asserts that the rate of interest already performs another function in the economy, that of equating demand and supply of money, and that it cannot adjust to maintain two separate equilibria. In his view it is the monetary role which wins out. This is why Keynes's theory is a theory of money as much as of employment: the monetary economy of interest and liquidity interacts with the real economy of production, investment and consumption.

Book II: Definitions and ideas

The choice of units

Main article: wage unit

Keynes sought to allow for the lack of downwards flexibility of wages by constructing an economic model in which the money supply and wage rates were externally determined (the latter in money terms), and in which the main variables were fixed by the equilibrium conditions of various markets in the presence of these facts.

Many of the quantities of interest, such as income and consumption, are monetary. Keynes often expresses such quantities in wage units (Chapter 4): to be precise, a value in wage units is equal to its price in money terms divided by W, the wage (in money units) per man-hour of labour. Therefore it is a unit expressed in hours of labour. Keynes generally writes a subscript w on quantities expressed in wage units, but in this account we omit the w. When, occasionally, we use real terms for a value which Keynes expresses in wage units we write it in lower case (e.g. y rather than Y).

As a result of Keynes's choice of units, the assumption of sticky wages, though important to the argument, is largely invisible in the reasoning. If we want to know how a change in the wage rate would influence the economy, Keynes tells us on p. 266 that the effect is the same as that of an opposite change in the money supply.

Expectations as determining output and employment

The key notion of expectations is introduced in Chapter 5.Short-term expectations are 'concerned with the price which a manufacturer can expect to get for his "finished" output at the time when he commits himself (sic) to starting the process which will produce it'. Long-term expectation 'is concerned with what the entrepreneur can hope to earn in the shape of future returns if he (sic) purchases (or perhaps manufactures) "finished" output as an addition to his capital equipment.'

Keynes note that:'It is sensible for producers to base their expectations on the assumption that the most recently realized results will continue, except in so far as there are definite reasons for expecting a change.' However (see Chapter 12) long-term expectations are liable to sudden revision. Thus the factor of long-term expectations cannot be even approximately eliminated or replaced by realized results.'

Briefly, short-run expectations are typically 'mathematical' in character, long-run expectations less so.

The identity of saving and investment

The relationship between saving and investment, and the factors influencing their demands, play an important role in Keynes's model. Saving and investment are considered to be necessarily equal for reasons set out in Chapter 6 which looks at economic aggregates from the viewpoint of manufacturers. The discussion is intricate, considering matters such as the depreciation of machinery, but is summarised on p. 63:

Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumption... the equality of saving and investment necessarily follows.

This statement incorporates Keynes's definition of saving, which is the normal one.

Book III: The propensity to consume

Keynes's propensities to consume and to save as functions of income Y

Book III of the General Theory is given over to the propensity to consume, which is introduced in Chapter 8 as the desired level of expenditure on consumption (for an individual or aggregated over an economy). The demand for consumer goods depends chiefly on the income Y and may be written functionally as C(Y). Saving is that part of income which is not consumed, so the propensity to save S(Y) is equal to Y–C(Y). Keynes discusses the possible influence of the interest rate r on the relative attractiveness of saving and consumption, but regards it as 'complex and uncertain' and leaves it out as a parameter.

His seemingly innocent definitions embody an assumption whose consequences will be considered later. Since Y is measured in wage units, the proportion of income saved is considered to be unaffected by the change in real income resulting from a change in the price level while wages stay fixed. Keynes acknowledges that this is undesirable in Point (1) of Section II.

In Chapter 9 he provides a homiletic enumeration of the motives to consume or not to do so, finding them to lie in social and psychological considerations which can be expected to be relatively stable, but which may be influenced by objective factors such as 'changes in expectations of the relation between the present and the future level of income' (p. 95).

The marginal propensity to consume and the multiplier

The marginal propensity to consume, C'(Y), is the gradient of the purple curve, and the marginal propensity to save S'(Y) is equal to 1–C'(Y). Keynes states as a 'fundamental psychological law' (p. 96) that the marginal propensity to consume will be positive and less than unity.

Chapter 10 introduces the famous 'multiplier' through an example: if the marginal propensity to consume is 90%, then 'the multiplier k is 10; and the total employment caused by (e.g.) increased public works will be ten times the employment caused by the public works themselves' (pp. 116f). Formally Keynes writes the multiplier as k=1/S'(Y). It follows from his 'fundamental psychological law' that k will be greater than 1.

Keynes's account is not clear until his economic system has been fully set out (see below). In Chapter 10 he describes his multiplier as being related to the one introduced by R. F. Kahn in 1931. The mechanism of Kahn's multiplier lies in an infinite series of transactions, each conceived of as creating employment: if you spend a certain amount of money, then the recipient will spend a proportion of what he or she receives, the second recipient will spend a further proportion again, and so forth. Keynes's account of his own mechanism (in the second para of p. 117) makes no reference to infinite series. By the end of the chapter on the multiplier, he uses his much quoted "digging holes" metaphor, against laissez-faire. In his provocation Keynes argues that "If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the banknotes up again" (...), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. 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".

Book IV: The inducement to invest

The rate of investment

Keynes's schedule of the marginal efficiency of capital

Book IV discusses the inducement to invest, with the key ideas being presented in Chapter 11. The 'marginal efficiency of capital' is defined as the annual revenue which is expected to be yielded by an extra increment of capital as a proportion of its cost. The 'schedule of the marginal efficiency of capital' is the function which, for any rate of interest r, gives us the level of investment which will take place if all opportunities are accepted whose return is at least r. By construction this depends on r alone and is a decreasing function of its argument; it is illustrated in the diagram, and we shall write it as I (r).

This schedule is a characteristic of the current industrial process which Irving Fisher described as representing the 'investment opportunity side of interest theory'; and in fact the condition that it should equal S(Y,r) is the equation which determines the interest rate from income in classical theory. Keynes is seeking to reverse the direction of causality (and omitting r as an argument to S()).

He interprets the schedule as expressing the demand for investment at any given value of r, giving it an alternative name: "We shall call this the investment demand-schedule..." (p. 136). He also refers to it as the 'demand curve for capital' (p. 178). For fixed industrial conditions, we conclude that 'the amount of investment... depends on the rate of interest' as John Hicks put it in 'Mr. Keynes and the "Classics"'.

Long-term expectations

In Chapter 12, Keynes writes:

It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. [Footnote: By “very uncertain’ I do not mean the same thing as improbable”. Cf. my Treatise on Probability, chap. 6, on “The Weight of Arguments”.] It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.

He goes on thus: ‘In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention ’. He notes that ‘our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation.’ ‘Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.’

He notes a practical problem: ‘Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.’ He suggests that: ‘The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.’

To account for the apparent ‘foolishness’ on which economic progress seemed to rely, Keynes suggests that:

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Interest and liquidity preference

Keynes proposes two theories of liquidity preference (i.e. the demand for money): the first as a theory of interest in Chapter 13 and the second as a correction in Chapter 15. His arguments offer ample scope for criticism, but his final conclusion is that liquidity preference is a function mainly of income and the interest rate. The influence of income (which really represents a composite of income and wealth) is common ground with the classical tradition and is embodied in the Quantity Theory; the influence of interest had also been noted earlier, in particular by Frederick Lavington (see Hicks's Mr Keynes and the "Classics"). Thus Keynes's final conclusion may be acceptable to readers who question the arguments along the way. However he shows a persistent tendency to think in terms of the Chapter 13 theory while nominally accepting the Chapter 15 correction.

Chapter 13 presents the first theory in rather metaphysical terms. Keynes argues that:

It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.

To which Jacob Viner retorted that:

By analogous reasoning he could deny that wages are the reward for labor, or that profit is the reward for risk-taking, because labor is sometimes done without anticipation or realization of a return, and men who assume financial risks have been known to incur losses as a result instead of profits.

Keynes goes on to claim that the demand for money is a function of the interest rate alone on the grounds that:

The rate of interest is... the "price" which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.

Frank Knight commented that this seems to assume that demand is simply an inverse function of price. The upshot from these reasonings is that:

Liquidity-preference is a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L(r). This is where, and how, the quantity of money enters into the economic scheme.

And specifically it determines the rate of interest, which therefore cannot be determined by the traditional factors of 'productivity and thrift'.

Chapter 15 looks in more detail at the three motives Keynes ascribes for the holding of money: the 'transactions motive', the 'precautionary motive', and the 'speculative motive'. He considers that demand arising from the first two motives 'mainly depends on the level of income' (p. 199), while the interest rate is 'likely to be a minor factor' (p. 196).

Keynes treats the speculative demand for money as a function of r alone without justifying its independence of income. He says that...

what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level...

but gives reasons to suppose that demand will nonetheless tend to decrease as r increases. He thus writes liquidity preference in the form L₁(Y)+L₂(r) where L₁ is the sum of transaction and precautionary demands and L₂ measures speculative demand. The structure of Keynes's expression plays no part in his subsequent theory, so it does no harm to follow Hicks by writing liquidity preference simply as L(Y,r).

'The quantity of money as determined by the action of the central bank' is taken as given (i.e. exogenous – p. 247) and constant (because hoarding is ruled out on page 174 by the fact that the necessary expansion of the money supply cannot be 'determined by the public').

Keynes does not put a subscript 'w' on L or M, implying that we should think of them in money terms. This suggestion is reinforced by his wording on page 172 where he says "Unless we measure liquidity-preference in terms of wage-units (which is convenient in some contexts)... ". But seventy pages later there is a fairly clear statement that liquidity preference and the quantity of money are indeed "measured in terms of wage-units" (p. 246).

The Keynesian economic system

Keynes's economic model

In Chapter 14 Keynes contrasts the classical theory of interest with his own, and in making the comparison he shows how his system can be applied to explain all the principal economic unknowns from the facts he takes as given. The two topics can be treated together because they are different ways of analysing the same equation.

Keynes's presentation is informal. To make it more precise we will identify a set of 4 variables – saving, investment, the rate of interest, and the national income – and a parallel set of 4 equations which jointly determine them. The graph illustrates the reasoning. The red S lines are shown as increasing functions of r in obedience to classical theory; for Keynes they should be horizontal.

Graphical representation of Keynes's economic model, based on his own diagram at page 180 of the General Theory

The first equation asserts that the reigning rate of interest r̂ is determined from the amount of money in circulation M̂ through the liquidity preference function and the assumption that L(r̂)=M̂.

The second equation fixes the level of investment Î given the rate of interest through the schedule of the marginal efficiency of capital as I(r̂).

The third equation tells us that saving is equal to investment: S(Y)=Î. The final equation tells us that the income Ŷ is the value of Y corresponding to the implied level of saving.

All this makes a satisfying theoretical system.

Three comments can be made concerning the argument. Firstly, no use is made of the 'first postulate of classical economics', which can be called on later to set the price level. Secondly, Hicks (in 'Mr Keynes and the "Classics"') presents his version of Keynes's system with a single variable representing both saving and investment; so his exposition has three equations in three unknowns.

And finally, since Keynes's discussion takes place in Chapter 14, it precedes the modification which makes liquidity preference depend on income as well as on the rate of interest. Once this modification has been made the unknowns can no longer be recovered sequentially.

Keynesian economic intervention

The state of the economy, according to Keynes, is determined by four parameters: the money supply, the demand functions for consumption (or equivalently for saving) and for liquidity, and the schedule of the marginal efficiency of capital determined by 'the existing quantity of equipment' and 'the state of long-term expectation' (p. 246). Adjusting the money supply is the domain of monetary policy. The effect of a change in the quantity of money is considered at p. 298. The change is effected in the first place in money units. According to Keynes's account on p. 295, wages will not change if there is any unemployment, with the result that the money supply will change to the same extent in wage units.

We can then analyse its effect from the diagram, in which we see that an increase in M̂ shifts r̂ to the left, pushing Î upwards and leading to an increase in total income (and employment) whose size depends on the gradients of all 3 demand functions. If we look at the change in income as a function of the upwards shift of the schedule of the marginal efficiency of capital (blue curve), we see that as the level of investment is increased by one unit, the income must adjust so that the level of saving (red curve) is one unit greater, and hence the increase in income must be 1/S'(Y) units, i.e. k units. This is the explanation of Keynes's multiplier.

It does not necessarily follow that individual decisions to invest will have a similar effect, since decisions to invest above the level suggested by the schedule of the marginal efficiency of capital are not the same thing as an increase in the schedule.

The equations of Keynesian and classical economics

Keynes's initial statement of his economic model (in Chapter 14) is based on his Chapter 13 theory of liquidity preference. His restatement in Chapter 18 doesn't take full account of his Chapter 15 revision, treating it as a source of 'repercussions' rather than as an integral component. It was left to John Hicks to give a satisfactory presentation. Equilibrium between supply and demand of money depends on two variables – interest rate and income – and these are the same two variables as are related by the equation between the propensity to save and the schedule of the marginal efficiency of capital. It follows that neither equation can be solved in isolation and that they need to be considered simultaneously.

The 'first postulate' of classical economics was also accepted as valid by Keynes, though not used in the first four books of the General Theory. The Keynesian system can thus be represented by three equations in three variables as shown below, roughly following Hicks. Three analogous equations can be given for classical economics. As presented below they are in forms given by Keynes himself (the practice of writing r as an argument to V derives from his Treatise on money).

Classical		Keynesian
y'(N) = W/p	The 'first postulate'	d(W·Y/p)/dN = W/p
i (r) = s(y(N),r)	Determination of the interest rate	I (r) = S(Y)	Determination of income
M̂ = p·y(N) /V(r)	Quantity theory of money	M̂ = L(Y,r)	Liquidity preference
y, i, s in real terms; M̂ in money terms		Y, I, S, M̂, L in wage units

Here y is written as a function of N, the number of workers employed; p is the price (in money terms) of a unit of real output; V(r) is the velocity of money; and W is the wage rate in money terms. N, p and r are the 3 variables we need to recover. In the Keynesian system income is measured in wage units and is therefore not a function of the level of employment alone since it will also vary with prices. The first postulate assumes that prices can be represented by a single variable. Strictly it should be modified to take account of the distinction between marginal wage cost and marginal prime cost.

The classics took the second equation as determining the rate of interest, the third as determining the price level, and the first as determining employment. Keynes believed that the last two equations could be solved together for Y and r, which is not possible in the classical system. He accordingly concentrated on these two equations, treating income as 'almost the same thing' as employment on p. 247. Here we see the benefit he has gained by simplifying the form of the consumption function. If he had written it (slightly more accurately) as C(Y,p/W), then he would have needed to bring in the first equation to get a solution.

The classical theory of employment for wages fixed in money terms (The three curves have different vertical scales.)

If we wish to examine the classical system our task is made easier if we assume that the effect of the interest rate on the velocity of circulation is small enough to be ignored. This allows us to treat V as constant and solve the first and third equations (the 'first postulate' and the quantity theory) together, leaving the second equation to determine the interest rate from the result. We then find that the level of employment is given by the formula

${\displaystyle \frac{y^{\prime }(N)}{y(N)}=\frac{W}{\hat{M}V}}$.

The graph shows the numerator and denominator of the left-hand side as blue and green curves; their ratio – the pink curve – will be a decreasing function of N even if we don't assume diminishing marginal returns. The level of employment N̂ is given by the horizontal position at which the pink curve has a value of ${\displaystyle W/(\hat{M}V)}$, and this is evidently a decreasing function of W.

Chapter 3: The principle of effective demand

The theoretical system we have described is developed over chapters 4–18, and is anticipated by a chapter which interprets Keynesian unemployment in terms of 'aggregate demand'.

The aggregate supply Z is the total value of output when N workers are employed, written functionally as φ(N). The aggregate demand D is manufacturers' expected proceeds, written as f(N). In equilibrium Z=D. D can be decomposed as D₁+D₂ where D₁ is the propensity to consume, which may be written C(Y) or χ(N). D₂ is explained as 'the volume of investment', and the equilibrium condition determining the level of employment is that D₁+D₂ should equal Z as functions of N. D₂ can be identified with I (r).

The meaning of this is that in equilibrium the total demand for goods must equal total income. Total demand for goods is the sum of demand for consumption goods and demand for investment goods. Hence Y = C(Y) + S(Y) = C(Y) + I (r); and this equation determines a unique value of Y given r.

Samuelson's Keynesian cross is a graphical representation of the Chapter 3 argument.

Dynamic aspects of Keynes's theory

Chapter 5: Expectation as determining output and employment

Chapter 5 makes some common-sense observations on the role of expectation in economics. Short-term expectations govern the level of production chosen by an entrepreneur while long-term expectations govern decisions to adjust the level of capitalisation. Keynes describes the process by which the level of employment adapts to a change in long-term expectations and remarks that:

The level of employment at any time depends... not merely on the existing state of expectation but on the states of expectation which have existed over a certain past period. Nevertheless past expectations, which have not yet worked themselves out, are embodied in to-day's capital equipment... and only influence [the entrepreneur's] decisions in so far as they are so embodied.

Chapter 11: Expectation as influencing the schedule of the marginal efficiency of capital

The main role of expectation in Keynes's theory lies in the schedule of the marginal efficiency of capital which, as we have seen, is defined in Chapter 11 in terms of expected returns. Keynes differs here from Fisher whom he largely follows, but who defined the 'rate of return over cost' in terms of an actual revenue stream rather than its expectation. The step Keynes took here has a particular significance in his theory.

Chapters 14, 18: The schedule of the marginal efficiency of capital as influencing employment

Keynes differed from his classical predecessors in assigning a role to the schedule of the marginal efficiency of capital in determining the level of employment. Its effect is mentioned in his presentations of his theory in Chapters 14 and 18 (see above).

Chapter 12: Animal spirits

Main article: Animal spirits (Keynes)

See also: Keynesian beauty contest

Chapter 12 discusses the psychology of speculation and enterprise.

Most, probably, of our decisions to do something positive ... can only be taken as a result of animal spirits .. Thus if the animal spirits are dimmed and spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.

Keynes's picture of the psychology of speculators is less indulgent.

In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield... The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

(Work in behavioural economics has since empirically supported Keynes' assertion; businesses which are extremely seasonal do indeed see notably higher valuations in the season in question, even if their results are consistent in that quarter from year to year).

Keynes considers speculators to be concerned...

...not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of mass psychology, three months or a year hence...

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional;– it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs – a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

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. 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. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

Chapter 21: Wage behaviour

Keynes's theory of the trade cycle is a theory of the slow oscillation of money income which requires it to be possible for income to move upwards or downwards. If he had assumed that wages were constant, then upward motion of income would have been impossible at full employment, and he would have needed some mechanism to frustrate upward pressure if it arose in such circumstances.

His task is made easier by a less restrictive (but nonetheless crude) assumption concerning wage behaviour:

let us simplify our assumptions still further, and assume... that the factors of production... are content with the same money-wage so long as there is a surplus of them unemployed... ; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand.

Chapter 22: The trade cycle

Keynes's theory of the trade cycle is based on 'a cyclical change in the marginal efficiency of capital' induced by 'the uncontrollable and disobedient psychology of the business world' (pp. 313, 317).

The marginal efficiency of capital depends... on current expectations... But, as we have seen, the basis for such expectations is very precarious. Being based on shifting and unreliable evidence, they are subject to sudden and violent changes.

Optimism leads to a rise in the marginal efficiency of capital and increased investment, reflected – through the multiplier – in an even greater increase in income until 'disillusion falls upon an over-optimistic and over-bought market' which consequently falls with 'sudden and even catastrophic force' (p. 316).

There are reasons, given firstly by the length of life of durable assets... and secondly by the carrying-costs of surplus stocks, why the duration of the downward movement should have an order of magnitude... between, let us say, three and five years.

And a half cycle of 5 years tallies with Jevons's sunspot cycle length of 11 years.

Income fluctuates cyclically in Keynes's theory, with the effect being borne by prices if income increases during a period of full employment, and by employment in other circumstances.

Wage behaviour and the Phillips curve

Keynes's assumption about wage behaviour has been the subject of much criticism. It is likely that wage rates adapt partially to depression conditions, with the consequence that effects on employment are weaker than his model implies, but not that they disappear.

Lerner pointed out in the 40s that it was optimistic to hope that the workforce would be content with fixed wages in the presence of rising prices, and proposed a modification to Keynes's model. After this a succession of more elaborate models were constructed, many associated with the Phillips curve.

Keynes's optimistic prediction that an increase in money supply would be taken up by an increase in employment led to Jacob Viner's pessimistic prediction that "in a world organized in accordance with Keynes' specifications there would be a constant race between the printing press and the business agents of the trade unions".

Models of wage pressure on the economy needed frequent correction and the standing of Keynesian theory suffered. Geoff Tily wrote ruefully:

Finally, the most destructive step of all was Samuelson's and [Robert] Solow's incorporation of the Phillips curve into 'Keynesian' theory in a manner which traduced not only Phillips but also Keynes's careful work in the General Theory, Chapter 21, substituting for its subtlety an immutable relationship between inflation and employment. The 1970s combination of inflation and stagnating economic activity was at odds with this relationship, and therefore 'Keynesianism', and by association Keynes were rejected. Monetarism was merely waiting in the wings for this to happen.

Keynes's assumption of wage behaviour was not an integral part of his theory – very little in his book depends on it – and was avowedly a simplification: in fact it was the simplest assumption he could make without imposing an unnatural cap on money income.

The writing of the General Theory

Keynes drew a lot of help from his students in his progress from the Treatise on Money  (1930) to the General Theory  (1936). The Cambridge Circus, a discussion group founded immediately after the publication of the earlier work, reported to Keynes through Richard Kahn, and drew his attention to a supposed fallacy in the Treatise  where Keynes had written:

Thus profits, as a source of capital increment for entrepreneurs, are a widow's cruse which remains undepleted however much of them may be devoted to riotous living.

The Circus  disbanded in May 1931, but three of its member – Kahn, Austin and Joan Robinson – continued to meet in the Robinsons' house in Trumpington St. (Cambridge), forwarding comments to Keynes. This led to a 'Manifesto' of 1932 whose ideas were taken up by Keynes in his lectures. Kahn and Joan Robinson were well versed in marginalist theory which Keynes did not fully understand at the time (or possibly ever), pushing him towards adopting elements of it in the General Theory. During 1934 and 1935 Keynes submitted drafts to Kahn, Robinson and Roy Harrod for comment.

There has been uncertainty ever since over the extent of the collaboration, Schumpeter describing Kahn's "share in the historic achievement" as not having "fallen very far short of co-authorship" while Kahn denied the attribution.

Keynes's method of writing was unusual:

Keynes drafted rapidly in pencil, reclining in an armchair. The pencil draft he sent straight to the printers. They supplied him with a considerable number of galley proofs, which he would then distribute to his advisers and critics for comment and amendment. As he published on his own account, Macmillan & Co., the 'publishers' (in reality they were distributors), could not object to the expense of Keynes' method of operating. They came out of Keynes' profit (Macmillan & Co. merely received a commission). Keynes' object was to simplify the process of circulating drafts; and eventually to secure good sales by fixing the retail price lower than would Macmillan & Co.

The advantages of self-publication can be seen from Étienne Mantoux's review:

When he published The General Theory of Employment, Interest and Money last year at the sensational price of 5 shillings, J. M. Keynes perhaps meant to express a wish for the broadest and earliest possible dissemination of his new ideas.

Chronology

Keynes's work on the General Theory began as soon as his Treatise on Money had been published in 1930. He was already dissatisfied with what he had written and wanted to extend the scope of his theory to output and employment. By September 1932 he was able to write to his mother: 'I have written nearly a third of my new book on monetary theory'.

In autumn 1932 he delivered lectures at Cambridge under the title 'the monetary theory of production' whose content was close to the Treatise except in giving prominence to a liquidity preference theory of interest. There was no consumption function and no theory of effective demand. Wage rates were discussed in a criticism of Pigou.

In autumn 1933 Keynes's lectures were much closer to the General Theory, including the consumption function, effective demand, and a statement of 'the inability of workers to bargain for a market-clearing real wage in a monetary economy'. All that was missing was a theory of investment.

By spring 1934 Chapter 12 was in its final form.

His lectures in autumn of that year bore the title 'the general theory of employment'. In these lectures Keynes presented the marginal efficiency of capital in much the same form as it took in Chapter 11, his 'basic chapter' as Kahn called it. He gave a talk on the same subject to economists at Oxford in February 1935.

This was the final building block of the General Theory. The book was finished in December 1935 and published in February 1936.

Observations on its readability

Many economists found General Theory difficult to read, with Étienne Mantoux calling it obscure, Frank Knight calling it difficult to follow, Michel DeVroey commenting that "many passages of his book were almost indecipherable", and Paul Samuelson calling the analysis "unpalatable" and incomprehensible. However Raúl Rojas dissents, saying that "obscure neo-classical reinterpretations" are "completely pointless since Keynes' book is so readable".

Reception

Keynes did not set out a detailed policy program in The General Theory, but he went on in practice to place great emphasis on the reduction of long-term interest rates and the reform of the international monetary system as structural measures needed to encourage both investment and consumption by the private sector. Paul Samuelson said that the General Theory "caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea islanders."

Praise

Many of the innovations introduced by The General Theory continue to be central to modern macroeconomics. For instance, the idea that recessions reflect inadequate aggregate demand and that Say's law (in Keynes's formulation, that "supply creates its own demand") does not hold in a monetary economy. President Richard Nixon famously said in 1971 (ironically, shortly before Keynesian economics fell out of fashion) that "We are all Keynesians now", a phrase often repeated by Nobel laureate Paul Krugman (but originating with anti-Keynesian economist Milton Friedman, said in a way different from Krugman's interpretation). Nevertheless, starting with Axel Leijonhufvud, this view of Keynesian economics came under increasing challenge and scrutiny and has now divided into two main camps.

Prior to the financial crises of 2007-9, the majority new consensus view, still found in most current text-books and taught in all universities, was New Keynesian economics, which (in contrast to Keynes) accepts the neoclassical concept of long-run equilibrium but allows a role for aggregate demand in the short run. New Keynesian economists pride themselves on providing microeconomic foundations for the sticky prices and wages assumed by Old Keynesian economics. They do not regard The General Theory itself as helpful to further research. The minority view is represented by post-Keynesian economists, all of whom accept Keynes's fundamental critique of the neoclassical concept of long-run equilibrium, and some of whom think The General Theory has yet to be properly understood and repays further study.

In 2011, the book was placed on Time's top 100 non-fiction books written in English since 1923, almost 400 universities are teaching a revised curriculum that takes instability seriously and Keynes's notion of uncertainty has become more familiar as 'radical uncertainty'.

Criticisms

From the outset there has been controversy over what Keynes really meant. Many early reviews were highly critical. The success of what came to be known as "neoclassical synthesis" Keynesian economics owed a great deal to the Harvard economist Alvin Hansen and MIT economist Paul Samuelson as well as to the Oxford economist John Hicks. Hansen and Samuelson offered a lucid explanation of Keynes's theory of aggregate demand with their elegant 45° Keynesian cross diagram while Hicks created the IS-LM diagram. Both of these diagrams can still be found in textbooks. Post-Keynesians argue that the neoclassical Keynesian model is completely distorting and misinterpreting Keynes' original meaning, at least in so far as it largely rests on an assumed long-term equilibrium.

Just as the reception of The General Theory was encouraged by the 1930s experience of mass unemployment, its fall from favour was associated with the 'stagflation' of the 1970s. Although few modern economists would disagree with the need for at least some intervention, policies such as labour market flexibility are underpinned by the neoclassical notion of equilibrium in the long run. Although Keynes explicitly addresses inflation, The General Theory does not treat it as an essentially monetary phenomenon or suggest that control of the money supply or interest rates is the key remedy for inflation, unlike neoclassical theory.

Lastly, Keynes' economic theory was criticized by Marxian economists, who said that Keynes ideas, while well intentioned, cannot work in the long run due to the contradictions in capitalism. A couple of these contradictions to which Marxians point are the idea of full employment, which is seen as impossible under private capitalism; and the idea that government can encourage capital investment through government spending, when in reality government spending could be a net loss on profits.