Deflation

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https://en.wikipedia.org/wiki/Deflation

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation increases it. This allows more goods and services to be bought than before with the same amount of currency. Deflation is distinct from disinflation, a slow-down in the inflation rate, i.e. when inflation declines to a lower rate but is still positive.

Economists generally believe that a sudden deflationary shock is a problem in a modern economy because it increases the real value of debt, especially if the deflation is unexpected. Deflation may also aggravate recessions and lead to a deflationary spiral.

Deflation usually happens when supply is high (when excess production occurs), when demand is low (when consumption decreases), or when the money supply decreases (sometimes in response to a contraction created from careless investment or a credit crunch) or because of a net capital outflow from the economy. It can also occur due to too much competition and too little market concentration.

Causes and corresponding types

In the IS–LM model (investment and saving equilibrium – liquidity preference and money supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services. This in turn can be caused by an increase in supply, a fall in demand, or both.

When prices are falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The way to reverse this quickly would be to introduce an economic stimulus. The government could increase productive spending on things like infrastructure or the central bank could start expanding the money supply.

Deflation is also related to risk aversion, where investors and buyers will start hoarding money because its value is now increasing over time. This can produce a liquidity trap or it may lead to shortages that entice investments yielding more jobs and commodity production. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

Deflation is the natural condition of economies when the supply of money is fixed, or does not grow as quickly as population and the economy. When this happens, the available amount of hard currency per person falls, in effect making money more scarce, and consequently, the purchasing power of each unit of currency increases. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods, and consequently, deflation has occurred, since purchasing power has increased.

Rising productivity and reduced transportation cost created structural deflation during the accelerated productivity era from 1870–1900, but there was mild inflation for about a decade before the establishment of the Federal Reserve in 1913. There was inflation during World War I, but deflation returned again after the war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s so that there is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Demand-side causes are:

• Growth deflation: an enduring decrease in the real cost of goods and services as the result of technological progress, accompanied by competitive price cuts, resulting in an increase in aggregate demand.

  A structural deflation existed from the 1870s until the cycle upswing that started in 1895. The deflation was caused by the decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. The mild inflation after 1895 was attributed to the increase in gold supply that had been occurring for decades. There was a sharp rise in prices during World War I, but deflation returned at the war's end. By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the 1960s, but no deflation.

  Historically not all episodes of deflation correspond with periods of poor economic growth.

  Productivity and deflation are discussed in a 1940 study by the Brookings Institution that gives productivity by major US industries from 1919 to 1939, along with real and nominal wages. Persistent deflation was clearly understood as being the result of the enormous gains in productivity of the period. By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression.

• Cash building (hoarding) deflation: attempts to save more cash by a reduction in consumption leading to a decrease in velocity of money.

Supply-side causes are:

• Bank credit deflation: a decrease in the bank credit supply due to bank failures or increased perceived risk of defaults by private entities or a contraction of the money supply by the central bank.

Debt deflation

Debt deflation is a complicated phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher (1933) to explain the deflation of the Great Depression.

Money supply side deflation

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity. This is to be expected because monetary base (M_B), velocity of base money (V_B), price level (P) and real output (Y) are related by definition: M_BV_B = PY. However, it is important to note that the monetary base is a much narrower definition of money than M₂ money supply. Additionally, the velocity of the monetary base is interest rate sensitive, the highest velocity being at the highest interest rates.

In the early history of the United States, there was no national currency and an insufficient supply of coinage. Banknotes were the majority of the money in circulation. During financial crises, many banks failed and their notes became worthless. Also, banknotes were discounted relative to gold and silver, the discount depending on the financial strength of the bank.

In recent years changes in the money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply.

Credit deflation

In modern credit-based economies, deflation may be caused by the central bank initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble. In a credit-based economy, a slow-down or fall in lending leads to less money in circulation, with a further sharp fall in money supply as confidence reduces and velocity weakens, with a consequent sharp fall-off in demand for employment or goods. The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production, or repaying debt levels incurred at the prior price level. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets that have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, and most recently America and Spain). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Historical examples of credit deflation

In the early economic history of the United States, cycles of inflation and deflation correlated with capital flows between regions, with money being loaned from the financial center in the Northeast to the commodity producing regions of the [mid]-West and South. In a procyclical manner, prices of commodities rose when capital was flowing in, that is, when banks were willing to lend, and fell in the depression years of 1818 and 1839 when banks called in loans. Also, there was no national paper currency at the time and there was a scarcity of coins. Most money circulated as banknotes, which typically sold at a discount according to distance from the issuing bank and the bank's perceived financial strength.

When banks failed their notes were redeemed for bank reserves, which often did not result in payment at par value, and sometimes the notes became worthless. Notes of weak surviving banks traded at steep discounts. During the Great Depression, people who owed money to a bank whose deposits had been frozen would sometimes buy bank books (deposits of other people at the bank) at a discount and use them to pay off their debt at par value.

Deflation occurred periodically in the U.S. during the 19th century (the most important exception was during the Civil War). This deflation was at times caused by technological progress that created significant economic growth, but at other times it was triggered by financial crises – notably the Panic of 1837 which caused deflation through 1844, and the Panic of 1873 which triggered the Long Depression that lasted until 1879. These deflationary periods preceded the establishment of the U.S. Federal Reserve System and its active management of monetary matters. Episodes of deflation have been rare and brief since the Federal Reserve was created (a notable exception being the Great Depression) while U.S. economic progress has been unprecedented.

A financial crisis in England in 1818 caused banks to call in loans and curtail new lending, draining specie out of the U.S. The Bank of the United States also reduced its lending. Prices for cotton and tobacco fell. The price of agricultural commodities also was pressured by a return of normal harvests following 1816, the year without a summer, that caused large scale famine and high agricultural prices.

There were several causes of the deflation of the severe depression of 1839–1843, which included an oversupply of agricultural commodities (importantly cotton) as new cropland came into production following large federal land sales a few years earlier, banks requiring payment in gold or silver, the failure of several banks, default by several states on their bonds and British banks cutting back on specie flow to the U.S.

This cycle has been traced out on a broad scale during the Great Depression. Partly because of overcapacity and market saturation and partly as a result of the Smoot-Hawley Tariff Act, international trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition.

Scarcity of official money

The United States had no national paper money until 1862 (greenbacks used to fund the Civil War), but these notes were discounted to gold until 1877. There was also a shortage of U.S. minted coins. Foreign coins, such as Mexican silver, were commonly used. At times banknotes were as much as 80% of currency in circulation before the Civil War. In the financial crises of 1818–19 and 1837–41, many banks failed, leaving their money to be redeemed below par value from reserves. Sometimes the notes became worthless, and the notes of weak surviving banks were heavily discounted. The Jackson administration opened branch mints, which over time increased the supply of coins. Following the 1848 finding of gold in the Sierra Nevada, enough gold came to market to devalue gold relative to silver. To equalize the value of the two metals in coinage, the US mint slightly reduced the silver content of new coinage in 1853.

When structural deflation appeared in the years following 1870, a common explanation given by various government inquiry committees was a scarcity of gold and silver, although they usually mentioned the changes in industry and trade we now call productivity. However, David A. Wells (1890) notes that the U.S. money supply during the period 1879-1889 actually rose 60%, the increase being in gold and silver, which rose against the percentage of national bank and legal tender notes. Furthermore, Wells argued that the deflation only lowered the cost of goods that benefited from recent improved methods of manufacturing and transportation. Goods produced by craftsmen did not decrease in price, nor did many services, and the cost of labor actually increased. Also, deflation did not occur in countries that did not have modern manufacturing, transportation and communications.

By the end of the 19th century, deflation ended and turned to mild inflation. William Stanley Jevons predicted rising gold supply would cause inflation decades before it actually did. Irving Fisher blamed the worldwide inflation of the pre-WWI years on rising gold supply.

In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce (or unusually unreliable), commerce can still continue (e.g., most recently in Zimbabwe). Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as a protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, because one easy way to make money in such an economy is to dig it out of the ground.

Market liberalisation

Increasing competition by internal or external economic liberalisation generally has a price-cutting effect. Measures of deregulation like the abolition of (e.g. state-owned) monopolies or the elimination of price maintenance as well as increased free trade can therefore cause deflation as far as a multitude of sectors is affected.

Currency pegs and Monetary unions

If a country pegs its currency to the one of another country that features a higher productivity growth or a more favourable unit cost development, it must – to maintain its competitiveness – either become equally more productive or lower its factor prices (e.g. wages). Cutting factor prices fosters deflation. Monetary unions have a similar effect to currency pegs.

Effects

Deflation was present during most economic depressions in US history Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency, and because confused pricing signals cause malinvestment, in the form of under-investment.

In this sense, it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders (savers) and use the proceeds to subsidize borrowers, including governments, and to cause malinvestment as overinvestment. Thus inflation encourages short term consumption and can similarly over-stimulate investment in projects that may not be worthwhile in real terms (for example the housing or Dot-com bubbles), while deflation retards investment even when there is a real-world demand not being met. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with economic depression, as occurred in the Great Depression and the Long Depression.

Nobel laureate Friedrich Hayek, a libertarian Austrian Economist, stated about the Great Depression deflation:

I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.

— Interview with Diego Pizano (1979)

While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as an effective increase in a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even an interest-free loan is unattractive as it must be repaid with money worth 10% more each year.

Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate – the overnight federal funds rate in the U.S. – and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.

In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to borrowers has grown larger. Deflation can discourage private investment, because there is reduced expectations on future profits when future prices are lower. Consequently, with reduced private investments, spiraling deflation can cause a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent for institutions to hold on to money, and not to spend or invest it (burying money). They are therefore rewarded by holding money. This "hoarding" behavior is seen as undesirable by most economists, as Hayek points out:

It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.

— Hayek (1932)

Some believe that, in the absence of large amounts of debt, deflation would be a welcome effect because the lowering of prices increases purchasing power.

Since deflationary periods disfavor debtors (including most farmers), they are often periods of rising populist backlash. For example, in the late 19th century, populists in the US wanted debt relief or to move off the new gold standard and onto a silver standard (the supply of silver was increasing relatively faster than the supply of gold, making silver less deflationary than gold), bimetal standard, or paper money like the recently ended Greenbacks.

Deflationary spiral

A deflationary spiral is a situation where decreases in the price level lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in the price level. Since reductions in general price level are called deflation, a deflationary spiral occurs when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. In science, this effect is also known as a positive feedback loop. Another economic example of this situation in economics is the bank run.

The Great Depression was regarded by some as a deflationary spiral. A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is Irving Fisher's theory that excess debt can cause a continuing deflation.

Counteracting deflation

During severe deflation, targeting an interest rate (the usual method of determining how much currency to create) may be ineffective, because even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers. In the 21st-century negative interest rate has been tried, but it can't be too negative, since people might withdraw cash from bank accounts if they have negative interest rate. Thus the central bank must directly set a target for the quantity of money (called "quantitative easing") and may use extraordinary methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves (such as mortgage-backed securities). Before he was Chairman of the United States Federal Reserve, Ben Bernanke claimed in 2002, "...sufficient injections of money will ultimately always reverse a deflation", although Japan's deflationary spiral was not broken by the amount of quantitative easing provided by the Bank of Japan.

Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.

This view was challenged in the 1930s during the Great Depression. Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased money supply by simply reducing the reserve requirements and through open market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–02, respectively. Austrian economists worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can cause higher asset prices and excessive debt accumulation. Therefore, lowering rates may prove to be only a temporary palliative, aggravating an eventual debt deflation crisis.

With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.

Special borrowing arrangements

When the central bank has lowered nominal interest rates to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to lend money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to artificially increase the money supply.

Capital

Although the values of capital assets are often casually said to deflate when they decline, this usage is not consistent with the usual definition of deflation; a more accurate description for a decrease in the value of a capital asset is economic depreciation. Another term, the accounting conventions of depreciation are standards to determine a decrease in values of capital assets when market values are not readily available or practical.

Historical examples

EU countries

The inflation rate of Greece was negative during three years from 2013 to 2015. The same applies to Bulgaria, Cyprus, Spain and Slovakia from 2014 to 2016. Greece, Cyprus, Spain and Slovakia are members of the European monetary union. The Bulgarian currency lev is pegged to the Euro with a fixed exchange rate. In the entire European Union and the Eurozone a disinflationary development was to be observed in the years 2011 to 2015.

Year	Bulgaria	Greece	Cyprus	Spain	Slovakia	EU	Eurozone
2011	3,4	3,1	3,5	3,0	4,1	3,1	2,7
2012	2,4	1,0	3,1	2,4	3,7	2,6	2,5
2013	0,4	−0,9	0,4	1,5	1,5	1,5	1,4
2014	−1,6	−1,4	−0,3	−0,2	−0,1	0,6	0,4
2015	−1,1	−1,1	−1,5	−0,6	−0,3	0,1	0,2
2016	−1,3	0,0	−1,2	−0,3	−0,5	0,2	0,2
2017	1,2	1,1	0,7	2,0	1,4	1,7	1,5

Table: Harmonised index of consumer prices. Annual average rate of change (%) (HICP inflation rate). Negative values are highlighted in colour.

Hong Kong

Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th quarter of 2004. Many East Asian currencies devalued following the crisis. The Hong Kong dollar however, was pegged to the US dollar, leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap exports from Mainland China, and "weak Consumer confidence" in Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.

Ireland

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.

Japan

Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates and 'quantitative easing', but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

• Tight monetary conditions. The Bank of Japan kept monetary policy loose only when inflation was below zero, tightening whenever deflation ends.
• Unfavorable demographics. Japan has an aging population (22.6% over age 65) which has been declining since 2011, as the death rate exceeds the birth rate.
• Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in stocks and especially real estate in Japan in the 1980s (peaking in late 1989).
• Insolvent companies:  Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested as methods to speed this process and thus end the deflation.
• Insolvent banks:  Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.
• Fear of insolvent banks:  Japanese people are afraid that banks will collapse so they prefer to buy (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.
• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages and fast growth in those countries) and inexpensive raw materials, many of which reached all time real price minimums in the early 2000s. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.
• Stimulus spending: According to both Austrian and monetarist economic theory, Keynesian stimulus spending actually has a depressing effect. This is because the government is competing against private industry, and usurping private investment dollars. In 1998, for example, Japan produced a stimulus package of more than 16 trillion yen, over half of it public works that would have a quashing effect on an equivalent amount of private, wealth-creating economic activity. Overall, Japan's stimulus packages added up to over one hundred trillion yen, and yet they failed. According to these economic schools, that stimulus money actually perpetuated the problem it was intended to cure.

In November 2009, Japan returned to deflation, according to The Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near-record 2.2%. It was not until 2014 that new economic polies laid out by Prime Minister Shinzo Abe finally allowed for significant levels of inflation to return. However, the Covid-19 recession once again led to deflation in 2020, with consumer good prices quickly falling, prompting heavy government stimulus worth over 20% of GDP.

As a result, it is likely that deflation will remain as a long term economic issue for Japan.

United Kingdom

During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.

The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.

United States

Annual inflation (in blue) and deflation (in green) rates in the United States since 1666

 

US CPI-U starting from 1913; Source: U.S. Department Of Labor

Major deflations in the United States

There have been four significant periods of deflation in the United States.

The first and most severe was during the depression in 1818–1821 when prices of agricultural commodities declined by almost 50%. A credit contraction caused by a financial crisis in England drained specie out of the U.S. The Bank of the United States also contracted its lending. The price of agricultural commodities fell by almost 50% from the high in 1815 to the low in 1821, and did not recover until the late 1830s, although to a significantly lower price level. Most damaging was the price of cotton, the U.S.'s main export. Food crop prices, which had been high because of the famine of 1816 that was caused by the year without a summer, fell after the return of normal harvests in 1818. Improved transportation, mainly from turnpikes, and to a minor extent the introduction of steamboats, significantly lowered transportation costs.

The second was the depression of the late 1830s to 1843, following the Panic of 1837, when the currency in the United States contracted by about 34% with prices falling by 33%. The magnitude of this contraction is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money. Despite the deflation and depression, GDP rose 16% from 1839 to 1843.

The third was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

The Great Sag of 1873–96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation's worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.

—  (Note: David A. Wells (1890) gives an account of the period and discusses the great advances in productivity which Wells argues were the cause of the deflation. The productivity gains matched the deflation. Murray Rothbard (2002) gives a similar account.)

The fourth was in 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression occurred partly because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and when the Federal Reserve was supposed to accommodate that demand, it instead contracted the money supply by 30% in enforcement of its new real bills doctrine, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash – see fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a concomitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

Minor deflations in the United States

Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time. This was quite common in the 19th century, and in the 20th century until the permanent abandonment of the gold standard for the Bretton Woods system in 1948. In the past 60 years, the United States has only experienced deflation two times; in 2009 with the Great Recession and in 2015, when the CPI barely broke below 0% at -0.1%.

Some economists believe the United States may have experienced deflation as part of the financial crisis of 2007–10; compare the theory of debt deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due to a steep decline in energy prices. Consumer prices dropped 1 percent in October 2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November 2008 with a 1.7% decline. In response, the Federal Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008.

In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral. Economist Nouriel Roubini predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it. It is the opposite of stagflation, which was the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily decreasing from the first measured deflation of -0.38% in March, to July's deflation rate of -2.10%. On the wage front, in October 2009 the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first time a state has cut its minimum wage since 1938.

General glut

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/General_glut 

 

Unemployed men, marching for jobs during the Great Depression.

In macroeconomics, a general glut is an excess of supply in relation to demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume (purchase) said production. This exhibits itself in a general recession or depression, with high and persistent underutilization of resources, notably unemployment and idle factories. The Great Depression is often cited as an archetypal example of a general glut.

The term dates to the beginnings of classical economics in the late 18th century, and there is a long-running debate on the existence, causes, and solutions of a general glut. Some classical and neoclassical economists argue that there are no general gluts, advocating a form of Say's law (conventionally but controversially phrased as "supply creates its own demand"), and that any idling is due to misallocation of resources between sectors, not overall, because overproduction in one sector necessitates underproduction in others, as is demonstrable in severe price falls when such alleged 'malinvestment' in gluts clear; unemployment is seen as voluntary, or a transient phenomenon as the economy adjusts. Others cite the frequent and recurrent economic crises of the economic cycle as examples of a general glut, propose various causes and advocate various solutions, most commonly fiscal stimulus (government deficit spending), a view advocated in the 19th and early 20th century by underconsumptionist economists, and in the mid to late 20th and 21st century by Keynesian economics and related schools of economic thought.

One can distinguish between those who see a general glut (greater supply than demand) as a supply-side issue, calling it overproduction (excess production), and those who see it as a demand-side issue, calling it underconsumption (deficient consumption). Some believe that both of these occur, such as Jean Charles Léonard de Sismondi, one of the earliest modern theorists of the economic cycle.

Classical economic theory

Introduction

The general glut problem is identified within the classical political economy of the era of Adam Smith and David Ricardo. The problem is that, as labor becomes specialized, if people want a higher standard of living, they must produce more. However, producing more lowers prices and leads to the need to produce yet more in response. If those who have money choose not to spend it, then it is possible for a national economy to become glutted with all of the goods it produces, and still be producing more in hopes of overcoming the deficit. While Say's Law supposedly dealt with this problem, successive economists came up with new scenarios which could throw an economy out of general equilibrium, or require expansion through conquest, which became termed imperialism.

The nature of the general glut

In Classical Economics, the chief economic concern of all economists according to Thomas Sowell (On Classical Economics, 2006, pp. 22) was how to generate and sustain stable economic growth on a national level. Each factory-producer's basic concern is of maximizing return on investment through sales. Yet, concern was also expressed that savings (and not spending money by the wealthy classes) or production of the wrong items contrary to market demand would produce a nationwide economic glut (a.k.a. recession/depression) because of the un-purchased (unconsumed) products which result in unemployment, idle factories, low national output, and wealth fleeting from the nation. Some theorized that a general glut is then (in the basic case over time) avoidable and not inevitable. Say's Law says, Since "savings equals investment" in a bank or other wise, money is always spent and ultimately reinvested into more or newer production activities which generates demand (both for the production resources and the items produced). Say's Law: Since "demand is always present," then, "production generates its own demand." Then if a glut exists, producers must react to market demand liquidating glut items and produce the items the market desires. Demand will return and any remaining glut will then be distributed by the market. A company/country only needs to keep producing, or produce more wisely, or respond to market conditions with products that meet consumer's demands to avoid a (national recession/depression) glut.

Say's law

According to French economist Jean-Baptiste Say, the concentration of wealth into resources dedicated to savings and re-investment simply adds to the ability of consumption to consume more. And so, he states, there can be no general glut because investment in "production creates its own demand." A producer/country only need liquidate the glut items and redirect its production activities to items the market demands to eliminate the glut and prosperity will return.

Malthus's solution

Thomas Malthus proposed that a glut of production localised in time rather than by industry or field of production would meet the requirement of Say's Law that general gluts cannot exist and yet would constitute just such a general glut. The consequences then are worked out by Malthus, although Simond de Sismondi first proposed this problem before him. Malthus is more famous for his earlier writings which tried to prove the opposite problem, a general over-consumption, as an inevitability to be lived with rather than solved.

Keynesian

Keynesian economics, and underconsumptionism before it, argue that fiscal stimulus in the form of government deficit spending can solve general gluts.

This is a demand side theory, rather than the supply-side theory of classical economics; the fundamental ideas are that savings in a recession or depression causes the paradox of thrift (excess saving, or more pejoratively, "hoarding"), causing a deficit of effective demand, yielding a general glut. Keynes locates the cause in sticky wages and liquidity preference.

Marxian

Karl Marx's critique of Malthus started from a position of agreement. Marx's idea of capitalist production, however, is characterized by his concentration on the division of labor and his notion that goods are produced for sale and not for consumption or exchange. In other words, goods are produced simply for the intention of transforming output into money. The possibility of a lack of effective demand, therefore, is held only in the possibility that there might be a time lag between the sale of a commodity (the acquisition of money) and the purchase of another (its disbursement). This possibility, also originally crafted by Sismondi (1819), endorsed the idea that the circularity of transactions was not always complete and immediate. If money is held, Marx contended, even if for a little while, there is a breakdown in the exchange process and a general glut can occur.

For Marx, since investment is part of aggregate demand, and the stimulus for investment is profitability, accumulation will continue unhindered as far as profitability is high. However, Marx saw that profitability had a tendency to fall, which would lead to a crisis in which insufficient investment generates an insufficiency of demand and a glut of markets. The crisis itself would operate to raise profitability, which would start a new period of accumulation. This would be the mechanism for crisis occurring repeatedly.

Post-Keynesian

Some Post-Keynesian economists see the cause of general gluts in the bursting of credit bubbles, particularly speculative bubbles. In this view, the cause of a general glut is the shift from private sector deficit spending to private sector savings, as in the debt-deflation hypothesis of Irving Fisher and the Financial Instability Hypothesis of Hyman Minsky, and locate the paradox of thrift in paying down debt. The shift from spending more than one earns to spending less than one earns (in the aggregate) causes a sustained drop in effective demand, and hence a general glut.

Austrian

Austrian economics do not see "general glut" as a meaningful way of describing an economy, indeed Austrian Economists do not believe it is possible to have too much of everything. In the Austrian analysis, it is the misallocation of resources that should be avoided. Producing too much of the wrong things, and not enough of the right things, is what Austrians believe to be truly wrong with an economy

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
Country	United Kingdom
Language	English
Genre	Nonfiction
Publisher	Palgrave Macmillan
Publication date	1936
Media type	Print paperback
Pages	472 (2007 edition)
ISBN	978-0-230-00476-4
OCLC	62532514

The General Theory of Employment, Interest and Money of 1936 is a book by English economist John Maynard Keynes. 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 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' (p6), 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

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. 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.

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' (p95).

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' (p96) 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' (pp116f). 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 will 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..." (p136). He also refers to it as the 'demand curve for capital' (p178). 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"'.

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' (p199), while the interest rate is 'likely to be a minor factor' (p196).

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" (p246).

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' (p246).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

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

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

Chapter 12 discusses the psychology of speculation and enterprise.

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over 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 quantified benefits... 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.

(Henry Hazlitt examined some railway share prices and found that they did not bear out Keynes's assertion.)

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' (pp313, 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' (p316).

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

Keynes was an associate of Lytton Strachey and shared much of his outlook. 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. Raúl Rojas dissents, saying that "obscure neo-classical reinterpretations" are "completely pointless since Keynes' book is so readable".

Inessential chapters

Chapter 16: Sundry observations on the nature of capital

§I: Say's Law

Keynes reiterates his denial that an act of saving constitutes an act of investment. A formulation of classical macroeconomics in three equations was given above as follows:

• y'(N) = W/p        i (r) = s(y(N),r)        M̂ = p·y(N) / V(r)

The role of Say's Law in Keynes's interpretation of them can be seen if we split the second equation into two components:

• i (r) = i_d(y(N),r)        i_d(y(N),r) = s(y(N),r)

the first of which asserts the equilibrium between investment and its corresponding demand, and the second of which identifies the demand for investment with the desired level of saving. In rejecting the second component Keynes denies that the total demand for goods in an economy is identical with its total income – i.e. that supply creates its own demand – and is therefore able to make their equality an equilibrium condition.

Chapter 16 contains a few statements in support of the view that saving does not necessarily add to the demand for capital goods.

An act of individual saving means – so to speak – a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date.

... an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order.

He adds that:

The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy... that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.

It is in this chapter that Keynes mentions "the ownership of money and debts" as "an alternative to the ownership of real capital-assets" (p212). On the same page he draws attention to what he considers to be the error of...

... believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield.

§II–IV: The declining yield of capital

Keynes argues that the value of capital derives from its scarcity and sympathises with 'the pre-classical doctrine that everything is produced by labour' (p213). The preference for direct over roundabout processes will depend on the rate of interest.

He wonders what would happen to 'a society which finds itself so well equipped with capital that its marginal efficiency is zero' while money provides a safe outlet for savings. He does not consider this hypothesis far-fetched: on the contrary...

... a properly run community... ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation...

He asserts that...

... the position of equilibrium, under conditions of laissez-faire, will be one in which employment is low enough and the standard of life sufficiently miserable to bring savings to zero'.

The misery does not depend on any assumption of static wages. If the return to capital falls to zero then according to Keynes's theory there will be no investment, and income must collapse to the point at which the propensity to save disappears. However his conclusions are not pessimistic because he postulates that steps may be taken to adjust the interest rate to ensure full employment (p220), that 'enormous social changes would result' and that 'this may be the most sensible way of getting rid of many of the objectionable features of capitalism' (p221).

Chapter 17: The essential properties of interest and money

Keynes begins by defining 'own rates of interest'. If the market price for purchasing the commitment to supply a bushel of wheat every year in perpetuity was the price of 50 bushels, then the 'wheat rate of interest' would be 2%. He then tries to find the property which justifies us in regarding the money rate as the true rate. His arguments didn't satisfy his supporters who accepted Pigou's contention that it makes no difference which rate is used.

Hazlitt went further, considering the very concept of an own rate of interest to be 'one of the most incredible' of the 'confusions in the General Theory.

Book V: Money-wages and prices

Chapter 23: Notes on mercantilism

In §I–IV Keynes gives a sympathetic notice to the 17th century mercantilists who, like himself, believed interest to be a monetary phenomenon and saw high interest rates as harmful. He accepts their conclusion that in principle export restrictions may prevent the flow of money abroad and lead to economic advantages at home.

For similar reasons Keynes sees justice in scholastic prohibitions of usury. He remarks in §V that Adam Smith had supported a maximum legal rate of interest. Smith's reasoning – certainly surprising from the proponent of the 'invisible hand' of markets – was based on a fear that a high rate of interest would lead to loans being cornered by spendthrifts and get-rich-quick 'projectors'.

§VI is devoted to the theories of 'the strange, unduly neglected prophet Silvio Gesell' who had proposed a system of 'stamped money' to artificially increase the carrying costs of money. 'The idea behind stamped money is sound', says Keynes, but subject to technical difficulties, one of which is the existence of other outlets for liquidity preference such as jewellery and formerly land. It is interesting that Keynes considered durable assets to be as much a problem as banknotes: even when they satisfy the same motives for ownership, they lack the property that wages are fixed in terms of them.

Keynes's final brief survey in §VII is of theories of underconsumption. Bernard Mandeville in the early 18th century and Hobson and Mummery in the late 19th were amongst those who believed that private thrift was the source of public poverty rather than riches.

Chapter 24: Concluding notes on social philosophy

Saving does not, in Keynes's view, engender investment, but rather impedes it by reducing the likely return to capital: "One of the chief social justifications of great inequality of wealth is, therefore, removed" (p373).

It would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure... [This] would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital... it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce... And it would remain for separate decision on what scale and by what means it is right and reasonable to call on the living generation to restrict their consumption, so as to establish in course of time, a state of full investment for their successors.

In some other respects the foregoing theory is moderately conservative in its implications... Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before.

... the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back... But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

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.

The majority new consensus view, found in most current text-books and taught in all universities, is New Keynesian economics, which 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.

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.

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 good intentioned, cannot work in the long run due to the contradictions in capitalism. A couple of these, that Marxians point to 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.