10.

2 The Principle of Effective Demand Keynes developed his principle of effective demand after a rather long time of gestation and controversies on central economic questions. One such question as su!"ected to a heated de!ate in the inter# ar period and it as on the economic consequences of pu!lic or$s. %n England& for e'ample& there ere t o ma"or vie s on the effects of pu!lic or$s on the overall level of employment. The first one as identified ith the Treasury department& hich is responsi!le for the 10.2 The Principle of Effective Demand 2() conduct of pu!lic policy& and attri!uted the causes of unemployment to the imper# fections of the mar$et system. %n these imperfections ere included government regulation& elfare institutions and& a!ove all& strong unions that did not allo the mar$et forces to operate properly& and rising unemployment as one of the dire consequences. %f government ere to intervene in the economy& this ought to !e directed to the lifting of all inhi!itions that prevent the efficient operation of mar$et forces. %n this vie & there as no room for the government to assume any active role investing in pu!lic or$s. The idea as that pu!lic or$s entailed investment spending hich ould !e financed through private savings. %n other ords& govern# ment& through ta'ation& ould divert the given amount of total savings from the private to the pu!lic sector to finance the additional employment. *ccording to the Treasury vie these efforts ould !e counter!alanced !y a reduction in the private savings and investment& hich is another ay to say that hat ould !e gained in terms of pu!lic employment& ould !e lost in terms of private employment. %n modern parlance private investment ould !e +cro ded out, !y pu!lic investment& and the net effect in the level of employment ould !e at !est nil. The -i!eral party that as led !y -loyd .eorge claimed that government intervention to undermine union po er and social institutions in general might create much more serious pro!lems than those that it intends to solve. The li!eral party proposed to e'pand the demand for la!our through pu!lic or$s. Keynes approved of these policies/ in his pamphlet 0co#authored ith 1enderson2 +3an -loyd .eorge do it4 *n E'amination of the -i!eral Pledge, 015252 argued that the reduction in unemployment through pu!lic or$s has further employment#generat# ing effects on the rest of the economy. The reason is that the ne ly employed or$ers spend the income that they earn on consumer goods& here employment should also increase and so forth. Keynes and 1enderson 015252& ho ever& did not clarify the e'act mechanism that leads to the e'pansion of employment and also did not give any precise mathematical formula to e'plaining these employment# generating effects. Keynes,s 0undergraduate2 student 6ichard Kahn 015712 in his article +The relation of home investment to unemployment, not only developed the theoretical argument favouring pu!lic or$s& !ut also gave its mathematical for# mulation through the concept of employment multiplier. Kahn,s idea as that in a depressionary situation the level of savings falls short of hat is required for the full employment of la!our. 3onsequently& as the level of activity increases through pu!lic investment& output increases and results in an increase in savings. 8ean# hile& in the investment goods sector the additional income is !eing spent on consumer goods and so output there increases as ell. 9o part of that output is also saved. :e o!serve that savings are not fi'ed ; as as assumed in the Treasury vie ; !ut rather a varia!le quantity& hich could !e affected !y government intervention. Once this employment#generating process sets in it or$s itself out until the economy reaches the full employment level of output. %n Kahn,s analysis the shortcoming in the Treasury,s vie as that in a

recessionary situation the level of savings falls short of hat is required for the full employment of la!our. Thus& for Kahn as the level of activity increases through pu!lic investment& output increases and ith that increases the amount of savings. 2(< 10 Keynes,s .eneral Theory The limit to this virtuous cycle#li$e process& here!y pu!lic investment e'pands employment and output& hich in turn increases savings and so forth& is until the economy reaches the full employment level of output. %t is interesting to note that Kahn as trapped to the old mode of thin$ing according to hich savings deter# mine investment and so his employment multiplier as cast in purely neoclassical terms and as such it as not entirely ne . The innovative element that Kahn contri!uted to economic theory as the mathematical formulation of the multiplier process as a sum of infinite terms of a declining geometric progression. The follo ing year :arming 015722 criticised constructively Kahn,s 015712 article !y introducing an e'plicit consumption function in the economic literature of the multiplier 09$idels$y 1552& p. ()12. Keynes adopted Kahn,s employment multiplier and he transformed it from a sheer description of changes that come from investment to a !asic component of the theory of income determination and employment. 8ore specifically& he ad"usted Kahn,s multiplier process to a relation !et een savings and investment. 8ore specifically& e $no that in classical economists1the central idea is that savings and investment are t o aspects of the same act& for classics +the money that is saved is automatically invested,. =y contrast& in the neoclassical theory the equality of savings and investment is esta!lished through variations in the rate of interest. Keynes re"ected the classical economists, vie as unrealistic for the modern mone# tary economies& hile he disagreed ith the neoclassical vie & here the interest rate plays the equili!rating role !et een savings and investment. >or Keynes the equality of these t o varia!les is !rought a!out !y variations in income 0output2? The novelty of my treatment of saving and investment consists& not in my maintaining their necessary aggregate equality& !ut in the proposition that it is& not the rate of interest& !ut the level of incomes hich 0in con"unction ith certain other factors2 ensures this equality. 0Keynes 157@!& p. 2)02 >urthermore& Keynes !y !orro ing Kahn,s formulation of the concept of multi# plier managed to develop an entirely ne idea of the relationship !et een savings and investment& here the t o varia!les are equalised through variations in the level of output produced. 10.7 The %ncome Determination 8odel %n terms of simple national accounts the a!ove can !e specified in the follo ing ay. The level of national income is determined !y consumption and investment e'penditures? AB3C% 1Keynes calls all the economists !efore him classical/ ho ever& he mainly means *lfred 8arshall& 3ecil Pigou& and Knut :ic$sell 0see 3hap. )2. 10.7 The %ncome Determination 8odel 2(@ 9imilarly& national income that is earned !y households is either consumed or saved? AB3C9 3onsequently in purely accounting terms it ill al ays !e true that? 9 B %? This is an accounting identity that holds independent of income.

:ith respect to the equality !et een savings and investment via the multiplier& let us suppose that investment increases !y 100 monetary units and the marginal propensity to consume is D0E and remains constant& hence e have Keynes,s +fundamental psychological la , according to hich menaredisposed&asaruleandontheaverage&toincreasetheirconsumptionastheirincome increases& !ut not !y as much as the increase in their income. 0.eneral Theory& p. 5<2 Empirically& e $no that in time series data the consumption e'penditures and disposa!le income are directly related. The same sta!le relationship& ho ever& does not seem to hold in cross section data& here the high income groups tend to consume a lo er proportion of their income& the converse is true for the lo income groups. *s a consequence& there has !een a voluminous literature on the character# istics of the propensity to consume in time series as ell as cross section data. 1o ever& these studies did not change any essential aspects of Keynes,s proposi# tion& according to hich income is the dominant determinant of consumption e'penditures& hereas the interest rate and other possi!le varia!les only play a secondary role. 1ence& e o!serve that the decisions to save 0i.e.& not to consume2 are not related in any direct ay to the decisions to invest. >rom introductory economics e $no that the increase in investment !y 100 monetary units leads to an equivalent increase in income A in the investment goods sector& from this income D0 ill !e consumed and 20 ill !e saved. %n the ne't period& these D0 monetary units !ecome income for the producers of consumer goods& ho in turn consume <( and save 1<. :e o!serve that in the third period total savings are 7< and are smaller than investment& hich are 100 monetary units. The purpose of the a!ove e'ample is to lead us from an identity 09 4 % 2 to a !ehavioural relation of saving and investment. %n other ords& the idea is that the pu!lic ad"usts the decisions for e'penditures ith regard to the planned 0normal2 e'penditures. The multiplier does not or$ instantaneously& so as the normal savings and income do not ad"ust automatically to investment. :e o!serve that in every particular moment there is equality !et een the actual investment and savings. *n equality hich is e' post and comes a!out from the un anted savings. Ta!le 10.1 sho s the difference of the e' post from the e' ante equality. :e o!serve that in the first period consumers save 100E of their income& hereas their normal !ehaviour indicates that only 20E of their income must !e 2(D 10 Keynes,s .eneral Theory saved& since the marginal propensity to save 0s2 is residually determined. 3onse# quently& normal !ehaviour requires that the pu!lic ad"usts its e'penditures ith respect to the desired savings& hich increase in each time period so as at some point total savings ould !e equal to total investment& that is % B 9uF 9dB 100. :ith the passage of time income ill tend to )00& hereas consumption and desired savings to (00 and 100& respectively. Thus& e have? A B1 s% B $% B ) 4 100 B )00 here $ B 1Gs is the ell#$no n formula for the investment multiplier& hich according to Keynes? 0%t2 tells us that& hen there is an increment of aggregate investment& income ill increase !y an amount hich is $ times the increment of investment. 0.eneral Theory& p. 11)2 The central idea of the .eneral Theory is that the level of production is ad"usted such that the normal 0planned2 savings is equal to the level of investment. 1ence& e have an entirely ne theoretical conception for the ay in hich savings are related to investment. :e $no that in neoclassical economics& savings are equal#

ised to investment through variations in the rate of interest. %n the .eneral Theory& ho ever& the equality !et een savings and investment comes a!out through varia# tions in the level of income. This ne conception is called principle of effective demand. 8ore specifically& according to the principle of effective demand the level of output in the economy is determined !y the level of monetary e'penditures. The corollary of this principle is that savings and investment are equalised through variations in the level of output. 1ence& e have t o questions? the first relates to the role of prices 0relative or a!solute2 and the analysis sho s that prices play no role hat so ever in the theory of effective demand. The second question relates to the causal relation !et een savings and investment. >or Keynes& the independent varia!le in his analysis is investment e'penditures hich determine savings and not the other ay around.2 Ta!le 10.1 The process of the multiplier Time % A 3 Hnplanned 0e' post2 9u Planned 0e' ante2 9d 1 100 100 100 0 2 D0 D0 D0 20 7 <( <( <( 7< Total 100 2(( 1(( 21ence e are assuming a super simple income determination model ith no government and foreign sector. Of course& the sum of monetary e'penditures 0 hich in the general case include investment e'penditures& government e'penditures and e'ports2 determine the amount of savings 0savings& ta'es and imports2. 10.7 The %ncome Determination 8odel 2(5 This is an entirely ne idea on the !asis of hich Keynes constructed an altogether ne theory. 9aving at the prior date cannot !e greater than the investment at that date. %ncreased investment ill al ays !e accompanied !y increased saving& !ut it can never !e preceded !y it. Dishoarding and credit e'pansion provides not an alternative to increased saving& !ut a necessary preparation for it. %t is the parent& not the t in& of increased saving. 0Keynes

1575& p. )@22 Keynes,s idea is counterintuitive& since common sense ould indicate that in order to invest one must secure first the necessary savings. Keynes argued that this conceptualisation no longer holds in modern economies& here there is a ell# developed and highly sophisticated financial system. =usinesses first ma$e their investment plans and then they are loo$ing for the required financing. %n other ords& it is not necessary for !usinesses !efore they invest to have accumulated the corresponding amount of savings& hich they ill have to reduce latter on in order to finance their investment. 9aving& in Keynes,s theory of effective demand is not a stoc$ !ut rather a flo varia!le. 9aving is output that has !een produced and has not !een consumed yet. %n this sense& savings although a real magnitude& and& therefore& constituent component of total output produced can ta$e on monetary e'pression. 9aving is generated through the demand from the part of the pu!lic. 8ore specifically& the pu!lic orders an amount of output through its e'penditures. * part of the output produced is a!sor!ed through consumer e'penditures& hich are equal to the marginal propensity to consume times the income. :ith regard to savings& that is the goods that are produced !ut are not consumed yet& the question is hether or not they ill !e a!sor!ed from normal investment. 3onsequently& total e'penditures 0or in"ections2 are those that determine the volume of outputproduced. Demand& overall& determines the general activity in the total economy. This appears also to !e true in neoclassical economics. %n 3hap. <& e sho ed that relative prices change in a ay so as to ad"ust the demand to the level of endo ment. The level of demand determines the supply and that demand is a function of relative prices. The neoclassical analysis is !ased on 9ay,s la / !y contrast& in Keynes there is the idea that demand determines output and& at the same time& the overthro n of 9ay,s la as this is sho n in the reversal of the causal relationship !et een savings and investment. %n other ords& only in Keynes e find the idea of investment as the independent varia!le of the system. The independence of investment from savings is due& according to Keynes& to the character of modern economies characterised !y a ell#developed credit system that ma$es possi!le the separation of finance from saving. The notion of finance refers to money& hereas savings refer to output that has !een produced and has not !een consumed yet. %nvestment does not require the reduction in the accumulated saving it only requires additional finance. There are no additional savings/ there is only additional financing. Entrepreneurs ith their investment e'penditures may increase their income and their savings until the point that they equate savings to investment. 9o long as e'penditures increase savings !ecome profits and the entrepreneurs pay !ac$ the amount of money that they !orro ed and so there is no increase in de!t. 2)0 10 Keynes,s .eneral Theory 10.( The 8arginal Efficiency of 3apital %n the Keynesian analysis in its simple version& that is& of a closed economy ithout government and foreign sector e $no that in equili!rium savings are equal to investment and that variations in investment lead to variations in savings. =ut hat determines investment4 Keynes argues that investment& the ma"or component of his theory of effective demand& depends on the marginal efficiency of capital 0hence# forth& 8E32 in relation to the interest rate. 9pecifically& Keynes 0157<2 argues that hen an entrepreneur !uys investment goods in reality& he !uys the right to a series of future incomes that e'pects to earn 0during the useful lifetime of the capital good2 selling the product after the su!traction of current e'penditures. 8ore specifically& Keynes notes?

% define the marginal efficiency of capital as !eing equal to that rate of discount hich ould ma$e the present value of the series of annuities given !y the returns e'pected from the capital asset during its life "ust equal to its supply price. 0.eneral Theory& p. 17)2 -et us suppose an entrepreneur ho purchases an additional unit of a capital good 0e.g.& a machine2 and let us further suppose that the e'pected returns sym!o# lised !y Ii& here i J 1& 2& ...& n are the years. =y Ps e sym!olise the supply price of the capital good& hich should not !e confused ith the current price of the capital good& !ut rather as Keynes notes? The price hich ould "ust induce a manufacturer ne ly to produce an additional unit of such assets& i& hat is sometimes called its replacement cost. 0.eneral Theory& p. 17)2 The 8E3 in Keynes,s definition is equal to the discount rate r that satisfies the follo ing condition? PsB I1 1 C rC I2 K1 C rL2C...C In K1 C rLnB M n iB1 Ii K1 C rLi here Psand Iiare given& as a result e have an equation of the n#th degree hich solves for r.7%f e suppose that I1B I2B 444 B InB I& then the a!ove sum forms a geometric series ith IG01 F r2 as the first term and ratio the term 1G01 C r2 N 1. 9u!sequently& e su!stitute in the ell#$no n formula of the sum of n terms of geometric progression& hich gives? PsB I 1Cr 1 4 K1 C rL4n 1 4 K1 C rL41 O P BI r 14 1 K1 C rLn 4 4 7%t is interesting to note that in the a!ove relation there are so many r,s as the roots of the equation that is !eing formed. >rom these roots& ho ever& one and only one corresponds to the 8E3 and this might !e an interesting e'ercise for the mathematically oriented reader. 10.( The 8arginal Efficiency of 3apital 2)1 %f e no suppose that n Q 1& e get? PsBI r and rsBI

P The a!ove relation indicates that the 8E3 can !e vie ed as the annual yield that is e'pected to accrue to the entrepreneur from the additional investment of a unit of capital goods. O!viously& there is an inverse relation !et een the 8E3 and Ps. 10.(.1 The >alling 8E3 3learly& the definition of the 8E3 depends on e'pected and not on current or past profits and also these e'pected profits of a pro"ect are not evaluated against a stoc$ of capital !ut rather against the flo of capital& that is& the increment of the e'isting capital stoc$& in particular the price of ne equipment investment.(Thus Keynes argues that the 8E3 depends on the rate of return e'pected to !e o!taina!le on money if it ere invested in a ne ly produced asset/ not on the historical result of hat an investment has yielded on its original cost if e loo$ !ac$ on its record after its life is over. 0.eneral Theory& p. 17)2 %t is interesting to note that the assumption of e'pected returns is a!solutely necessary to Keynes in order to !e consistent ith his overall theory of effective demand& according to hich the decisions to invest determine saving. %f Keynes had assumed current or past profits instead of e'pected ones in his definition of the 8E3& then he ould have essentially accepted the idea that saving determines investment. *lthough the 8E3 depends on e'pected and not realised profits& hich of course are fraught ith uncertainty& Keynes as& nevertheless& a!solutely certain a!out the falling 8E3 schedule& that he did not feel that there is a need for any detailed analysis. The gist of his argument on the falling 8E3 is contained in "ust a single paragraph? %fthere isan increased investment in any given type ofcapital duringany period of time& the marginal efficiency of that type of capital ill diminish as the investment in it is increased& partly !ecause the prospective yield ill fall as the supply of that type of capital is increased and partly !ecause& as a rule& pressure on the facilities for producing that type of capital ill cause its supply price to increase/ the second of these factors !eing usually the more important in producing equili!rium in the short run& !ut the longer the period in vie the more does the first factor ta$e its place. Thus for each type of capital e can !uilt up a schedule& sho ing !y ho much investment in it ill have to increase ithin the period& in (This is the reason hy Pasinetti 0155@& p. 20@2 approves *!!a -erner,s use of the term marginal efficiency of investment instead of capital. Eisner 0155@& p. 15<2 although in agreement ith -erner& nevertheless prefers to maintain !oth terms. %n this paper e opted for the term 8E3 although e $no thatKeynes refersto the flo ofinvestment and not thestoc$ of capital 0see also 3hic$& 15D7& 3hap. </ -e6oy& 15D7/ *sima$opoulos& 1551& 3hap. (2. 2)2 10 Keynes,s .eneral Theory order that its marginal efficiency should fall to any figure. :e can then aggregate these schedules for the different types of capital R...S. :e shall call this the investment demand;schedule of the marginal efficiency of capital. 0.eneral Theory& p. 17<2 %n the a!ove succinctly ritten paragraph there are t o intert ined arguments concerning the falling profita!ility. The first refers to short#run and the supply side of the mar$et& here the investment e'penditures of a firm imply that competition ith other firms over resources gets more intense. 1o ever& the supply of resources is given in the short run/ as a consequence& their price increases and profits decrease for each of the competing firms. 1ence& Keynes assumes inverted -#shape unit cost curves& hich imply that as competition gets more intense firms are !ound to operate at the increasing part of their unit cost curves. >or e'ample& he notes R...S in the short period supply price usually increases ith increasing output& on account either of the physical fact of diminishing returns or the tendency of the cost#unit to rise in

terms of money hen output increases. 0.eneral Theory& p. 72D2 This argument& as Keynes notes& or$s more effectively in the short#run and ea$ens ith the passage of time inasmuch as investment e'pands the capacity to produce. The long#run argument refers to the demand side of the economy. 1ence& Keynes,s idea is that as a firm increases its investment and e'pands its output& it ould !ecome e'tremely difficult to $eep its sales gro ing at the going price. %ts sales can gro pari passu ith its productive capacity only if the firm reduces its selling price.3onsequently&e'pectedprofitsfalland sodoesthe 8E3.%tisimportant to stress& once again& that the supply and demand arguments in Keynes are not mutually e'clusive/ on the contrary& they may complement each other there!y reinforcing his overall argument for a falling 8E3 0Eat ell 15D52. >or the total economy& e simply add the !ehaviour of individual firms. 9ince for each particular firm there is an inverse relationship !et een the 8E3 and investment it follo s that this is true for the economy as a hole. %t is important to point out that for Keynes the fall of the 8E3& in and of itself& does not automatically imply a reduction in investment e'penditures. Everything depends on hether or not the rate of interest on loans is lo er than the 8E3. %f for some reason the rate of interest is $ept !elo the 8E3& then there al ays e'ists an investment motive despite the falling 8E3. This is the reason hy Keynes& in 3hap. 2( of the .eneral Theory& argues for the +euthanasia of rentiers,& hich can !e achieved as the rate of interest appro'imates Tero. Keynes,s analysis of falling profita!ility is too !rief and certainly does not contain the su!tleties that one finds& for e'ample& in the classical economists.) This& ho ever& !y no means implies that there are no important insights and innovations. %n fact& Keynes in 3hap. 11 of the .eneral Theory has some origi# nal contri!utions such as that the 8E3 is !ased on e'pected profits from current )>or a succinctly ritten summary of the vie s of the ma"or economists on the falling rate of profit see Eltis 015D52. 10.( The 8arginal Efficiency of 3apital 2)7 investment and the notion of uncertainty& a vie hich is consistent ith the idea that the arro of causality is running from investment to saving. The importance of these points& ho ever& has passed unnoticed even !y Keynes,s ma"or commentators 0e.g.& Dillard 15(D& 3hap. @/ 1ansen 15)7& 3hap. )/ *sima$opoulos 1551& 3hap. (2. Keynes must also !e !lamed for that since he underestimates& in at least t o instances& his o n contri!utions !y crediting the definition of the 8E3 to %rving >isher. The first is in the .eneral Theory 0p. 1(02 and the second in 157@& in >isher,s >estschrift 03ollected :ritings& 'iv& 1012. The similarity& ho ever& is only superficial and reminiscent of Keynes,s style to find precursors of his vie s. >or e'ample& Keynes 0.eneral Theory& 3hap. 272 refers to 8althus as the precursor of the theory of effective demand& and to >isher as the precursor of the 8E3. :e $no that neither 8althus nor >isher share Keynes,s vie of investment determin# ing saving and that the equality of saving and investment comes a!out through variations in output. Keynes,s vie is characteristically different to >isher,s and the neoclassical economists, ho posited that the equality of full employment saving and investment is !rought a!out !y variations in the rate of interest. >urthermore& an identification of Keynes,s theory of the 8E3 ith that of >isher,s& as .aregnani 015@D;15@52 has pointed out& leads to t o inconsistencies? first >isher,s e'pected profits are determined !y marginal productivities of capital and la!our/ and second >isher,s +8E3, presupposes full employment of !oth capital and la!our. *n argument that prima facie contradicts the quintessence of the .eneral Theory

according to hich the cause of unemployment is the lac$ of adequate effective demand and that the price system left to its o n devices cannot generate enough output to fully employ la!our. *s for the marginal productivity theory of value and distri!ution& Keynes ruled out such a theory from his overall perspective of the ay in hich the actual capitalist economy or$s. >or e'ample& in the 1577 draft of several chapters of the .eneral Theory Keynes 03ollected :ritings& 'iii2 introduces the distinction !et een a real e'change economy and a monetary economy. %n the latter the presence of fiat money changes the la of production in a characteristically different ay ith respect to the former/ that is& the real e'change or !arter economy of classical and neoclassical economics. 8ore specifically& Keynes resorts to the distinction& that as initially introduced !y 8ar' 03hap. <2& !et een the simple commodity production 0Keynes,s real e'change economy2 in hich pro# ducts are e'changed for the sa$e of consumption and a capitalist 0Keynes,s monetary2 economy& here production of commodities is for the sa$e of profit in monetary terms. This transition to the monetary economy involves the presence of fiat money hich changes& in a fundamental ay& the la s of production of the classical theory? The classical theory supposes that the readiness of the entrepreneur to start up a productive process depends on the amount of value in terms of product hich he e'pects to fall to his share/ i.e.& that only an e'pectation of more product for himself ill induce him to offer more employment. =ut in an entrepreneur economy this is a rong analysis of the nature of !usiness calculation. *n entrepreneur is interested& not in the amount of product& !ut in the amount of money hich ill fall to his share. 1e ill increase his output if !y so doing he 2)( 10 Keynes,s .eneral Theory e'pects to increase his money profit& even though this profit represents a smaller quantity of product than !efore. The e'planation of this is evident. The employment of factors of production to increase output involves the entrepreneur in the dis!ursement& not of product& !ut of money. 03ollected :ritings& ''i'& p. D22 Keynes& a fe years later& in the .eneral Theory& continues to assume a monetary economy and e'plicitly rules out the marginal productivity theory of income distri!ution as this can !e "udged from the follo ing? %f capital !ecomes less scarce& the e'cess yield ill diminish& ithout its having !ecome less productive ; at least in the physical sense R...S the only reason hy an asset offers a prospect of yielding during its life services having an aggregate value greater than its initial price is !ecause it is scarce R...S. 0.eneral Theory& p. 2172< %t has !een argued 0Dimand 155)2 that Keynes perhaps as not a are of all the details of >isher,s analysis and that may!e he "ust did not find it appropriate to e'plain their conceptual differences in a !oo$ honouring >isher,s contri!utions. :e $no that Keynes disregarded >isher,s notion of the +8E3, in his lectures& at a time as early as 157( 0Dimand 155)& 2)@2 and that he admitted& in his correspondence ith 1arrod 0*ugust& 2@ and 70& 157<2& that his definition of the 8E3 is quite different from the or$s of classical economists and that it as +vital for his analysis, a concept that he devised +last of all& after an immense lot of muddling and many drafts, 03ollected :ritings& 'iv& D)2. Thus& although Keynes did not really present an analytically coherent argument& his desire for pragmatism led him to the conclusion that the 8E3 schedule as much lo er in the 1570s than in the nineteenth century. There is no dou!t that Keynes thought of the falling 8E3 as an already accomplished fact? Today and presuma!ly for the future the schedule of the marginal efficiency of capital is& for a variety of reasons& much lo er than it as in the nineteenth century. 0.eneral Theory&

p. 70D2 1ence& Keynes essentially adopts 9mith,s idea that the rate of interest& as a rule of thum!& can give us an appro'imate idea of !oth the level of the rate of profit and the direction of its long#term movement. 9ince in Keynes,s time there ere no national income accounts and certainly no time series data on profits and invest# ment&@it seems that he as led to this conclusion !y o!serving the evolution of the <.aregnani 015@@;15@D2 argued that the 8E3 is the +Tro"an 1orse, of the price of capital goods through hich the marginal productivity theory of distri!ution ill undermine the statement? +capital is getting no its marginal productivity 0in some sense or other2& is only valid in a stationary state. The aggregate current return to capital has no direct relationship to its marginal efficiency/ hilst its current return at the margin of production 0i.e. the return to capital hich enters into the supply price of output2 is its marginal user cost& hich also has no close connection ith its marginal efficiency, 0.eneral Theory& 1752. >or a related vie see 8ins$y 015@)& p. 5<2& hile Pasinetti 0155@& p. 21D2 argues that .aregnani,s critique of the 8E3 is misplaced. @The national income and product accounts data for the years up until the first decades of the t entieth century ere created mostly retrospectively and after the pu!lication of the .eneral Theory& hich essentially created !oth the need for such data as ell as the conceptual frame or$ for the estimation of varia!les such as income& investment& consumption& saving& etc. 10.( The 8arginal Efficiency of 3apital 2)) rate of interest& as 9mith did in his o n time.D>or e'ample& in the .eneral Theory 03hap. 1<& p. 2152 Keynes presents estimates of the long run average interest rate in the range of 2;2.)E& hich is in fact equal to our estimates of the average interest rate on consols for the period 1500;157<& hereas for the entire nineteenth century the average interest rate on consols as around (E.5There is no dou!t that Keynes as a are of !oth the limitations of his theoretical analysis and the need to !e !ac$ed up !y empirical evidence. >or e'ample he notes? +To develop the thesis 0on the falling 8E32 ould occupy a !oo$ rather than a chapter& and ould require a close e'amination of facts, 0.eneral Theory& p. 7172. %t is interesting to note that the 8E3 refers to relations !et een prices and quantities. 1ence& e have a demand function for investment that relates invest# ment and the 8E3. Keynes notes? The rate of investment ill !e pushed to the point on the investment demand#schedule here the marginal efficiency of capital in general is equal to the mar$et rate of interest. 0.eneral Theory& pp. 17<;17@2 9uch a relation does not appear in the theory of effective demand here prices do not play any role. The 8E3 schedule& ho ever& refers to prices since it associates the level of investment e'penditures to the internal rate of return and interest rate. %f there is such a relationship& then a series of questions arise that challenge Keynes,s position of chronic unemployment equili!rium. >or e'ample& hat level of investment leads the economy to full employment4 :hy the economy does not succeed in achieving this level of investment4 :hat are the factors that determine the level of investment4 >rom the point that Keynes accepts the notion of the 8E3& then there is the pro!lem of determination of the rate of interest. Keynes,s theory of unemployment equili!rium must also e'plain the reason hy the rate of interest does not fall so as to lead investment to the level that is necessary for the full employment of la!our. This is an issue that e deal ith in the ne't section. 10.) The -iquidity Preference Theory Keynes,s third ma"or component of his .eneral Theory is the determination of the rate of interest in order to e'plain the volume of investment spending. :e $no that& according to Keynes& investment depends on the 8E3 in relation to the rate of

interest. The latter according to Keynes depends on the relation !et een the stoc$ of monetary assets and their demand. The monetary assets are issued !y the D3learly& Keynes regarded the rate of interest and the rate of profit 0or the 8E32 as distinct and strictly separate economic categories. %n fact& Keynes criticised those economists 0li$e 8ises and 1aye$2 of Uconfusing the marginal efficiency of capital ith the rate of interestV 0.eneral Theory& pp. 151;157 for a related analysis see also pp. 1@7;1@(2. 5Data on the real interest rate on consols come from .lo!al >inancial Data 0 . glo!alfinancialdata.com2. 2)< 10 Keynes,s .eneral Theory government according to its !orro ing needs and the regulations of the money mar$ets. There is no dou!t that the monetary assets e'ceed the annual flo of money !y far. Turning no to the liquidity preference or demand for money Keynes distinguished three motives? l The demand for money for transaction purposes l The demand for money for precautionary purposes l The demand for money for speculative purposes >rom the a!ove three motives only the demand for money for speculation depends on the rate of interest& hereas the other types of demand for money depend mainly on income. The crucial element in the analysis of the interest rate determination is the relationship !et een preference of the pu!lic for cash and for other less liquid assets. 3learly& the pu!lic considers that the advantage of holding cash is the fle'i!ility in transactions& hereas its disadvantage is that no interest is earned. The converse is true for less liquid assets such as !onds& hich they offer interest !ut are not liquid enough. %f e suppose an individual ho could possess either cash or !onds& his decision ould !e !ased on the current interest rate in comparison to that e'pected in the long run. %f the current interest rate is a!ove than the e'pected one in the long run& naturally the pu!lic anticipates falling interest rates and the price of !onds& ceteris pari!us& increases. The pu!lic therefore prefers to !uy !onds no in the hope of !enefiting from their anticipated appreciation. %f all the indivi# duals in the mar$ets are rational ith perfect information the ad"ustment ould !e instantaneous and the mar$et under investigation ould !e too volatile. Keynes& ho ever& assumed that the mar$et consists of a large num!er of heterogeneous individuals that each has all the money either in cash or in !onds and the e'act proportion depends on e'pectations on the rate of interest. The demand for money is formed from all the individuals that each and every one of them chooses one of the t o e'treme !ehaviours. %n >ig. 10.1a& here the current interest rate& i& together ith the e'pected in the long run& iW& are on the vertical a'is& hereas the quantity of money is on the horiTontal a'is. The demand for money is inversely related of the rate of interest& as this is depicted in >ig. 10.1a. %f the current interest rate e'ceeds the long run interest rate 0i2X iW2& the pu!lic e'pects that the rate of interest ill fall and so& ceteris pari!us& reduces its cash holdings and increase the amount of !onds in the hope of ma$ing capital gains from their appreciation. %f the current interest rate falls short of the long run 0i1N iW2& it follo s that the current interest rate is e'pected to rise and thus the price of !onds to fall. 3onsequently& the pu!lic prefers the sale of !onds no since their price is e'pected to fall and so the demand for money ill !e increasing. %t is orth stressing that the demand for money in Keynes is a function of t o interest rates the current and the future e'pected one. 9o there is no single demand for money !ut rather many hich depend on the e'pected interest rate and volatility in the current interest rate derives from volatility in the e'pected interest

rate. %n >ig. 10.1!& here e have depicted the long run interest rate and the current interest rate hich is the result of the intersection of the supply of money and the 10.) The -iquidity Preference Theory 2)@ demand for money. 9uppose that the i N iW so the current interest rate is e'pected to increase a result that !rings a lot of volatility in the money mar$et and shifts the hole demand for money to the right. %n spite of the fact that e'pected interest rate& hich is so crucial in the analysis of Keynes and yet one does not get definitive ans ers reading the .eneral Theory or other Keynes,s ritings in the main& ho ever& he argues that the long run interest rate depends on hat the !an$ing community considers accepted or natural long#run interest rate. %n this sense& the determination of the long run rate of interest has many similarities& for instance& ith the determination of the real age in classical economics. %t is important to point out the e'istence of a natural interest rate is a hotly de!ated issue even today. *s e ill see central !an$s decide a!out the supply of money on the !asis of a natural interest rate hose e'istence is in question. :e do $no though that 8ar' and 9raffa& for instance& argued against the e'istence of a natural interest rate. Keynes,s position on this issue is am!ivalent.10 The demand for money displayed in >ig. 10.1! is compared ith the supply of money 0802& a varia!le hich is ithin the control of the central !an$ and thus the equili!rium rate of interest is determined. 1ence& the rate of interest is purely a monetary varia!le and operates as a centre of gravity for a hole spectrum of interest rates that are around it. The rate of interest then is compared to the 8E3 in the effort to determine the volume of investment 0see >ig. 10.2& !elo 2. 8ore specifically& entrepreneurs ran$ all their possi!le investment pro"ects starting from the most profita!le to the less profita!le and then they decide ho much to invest on i 80 iW iW -0i2 a - 0i2 i1 i1 i2 ! -Y 0i2 i >ig. 10.1 %nterest rate determination 10%n neoclassical economics the natural rate of interest ould !e associated ith full employment. %n Keynes& underemployment may coe'ist ith macroeconomic equili!rium. Thus& Keynes in the .eneral Theory 0pp. 202;207& 2(2;2(72 re"ected the idea of a unique natural interest rate. %t might !e remar$ed in passing that Keynes in the Treatise of 8oney 015702 had adopted :ic$sell 01D5D2 notion of a single natural interest rate identified ith the marginal productivity of capital 0see also Dillard 15(D& pp. 15@;15D2. 2)D 10 Keynes,s .eneral Theory the point here their 8E3 from the most recent investment pro"ect is at least equal

to the rate of interest. 3onsequently& e see that there is a relation !et een the rate of interest& investment and savings ho ever the arro of causality runs in the opposite direc# tion from that in the neoclassical analysis. 8ore specifically& economists !efore Keynes argued that the equality !et een savings and investment is due to variations in the rate of interest& as e sho in the ne't equation. 9Ki/ AL B %Ki/ AL %n this sense& neoclassical economists could support this relation on the assump# tion of full employment output H B A. Keynes argued that investment is a function of the interest rate& hereas saving is a function of !oth the interest rate and income. This description might give the impression that nothing is really ne in Keynes. The ne element that Keynes contri!uted to the analysis is the arro of the causal relationship. %n Keynes the rate of interest ith given 8E3 determines the level of investment& hich in turn determines the level of savings and su!sequently via the multiplier the level of income. %n Keynes e have the follo ing chain of events? i/8EK K LQ%Q9Q 1 sKiLQ A The issue here is hy the automatic forces in the economy do not set in motion the rate of interest so as to move to ards the level hich is consistent ith the full employment of la!our4 3learly& this possi!ility e'ists in the .eneral Theory and Keynes had to sho that this is only a theoretical possi!ility& !ecause the rate of interest cannot fall to the required level& so as to stimulate investment spending to such an e'tent& so as to !ring forth the full employment of la!our. 0 %nvestment %nterest rate i& 8E3 >ig. 10.2 %nvestment decisions 10.) The -iquidity Preference Theory 2)5 Keynes argued that in reality the fall in the rate of interest may require su!stan# tial changes in the supply or in the demand for money and for Keynes only moderate changes in some varia!les may have an effect to the desired direction& hich nevertheless are not strong enough to !ring a!out full employment. %f& !y contrast& the changes in some varia!les are su!stantial& then the normal relations among the varia!les are no longer valid and so one cannot predict the final outcome. %n order to illustrate Keynes,s thesis let us suppose that !ecause of the idespread unemployment the price level falls& and& therefore& the real supply of money increases and the transactions demand for money falls and so the interest rate falls stimulating investment spending and increasing employment. This is true& Keynes argued& to the e'tent that the deflation process is slo / if& !y contrast& the deflation process is su!stantial& then the pu!lic feels insecure a!out the value of real assets and turns instead to the possession of money. -iquidity increases and the ensuing chaos ould !rea$ do n the a!ove descri!ed favoura!le for the employ# ment chain reaction of varia!les that restores equili!rium in the economy ith full employment. >urthermore& Keynes considered the case of an active monetary policy& here the supply of money increases through the purchase of securities and interest rates fall& investment increases and unemployment decreases& and so forth. This effect can or$ so long as the changes in the money supply are

moderate. %f& ho ever& the supply of money increases !y much& Keynes argued that the liquidity preference function !ecomes particularly unsta!le11and so the direction of variation in the interest rates is uncertain 0.eneral Theory& p. 20)2. 10.).1 8oney 6ate of %nterest and 6eturns on *ssets Thus& Keynes ruled out the case of price variations to affect the rate of interest to a direction that ould !ring full employment. Keynes focused on the liquidity preference and the associated ith it money interest rate. %n this section& e e'amine the relation !et een the money rate of interest and the rate of return on other assets 0.eneral Theory& 3hap. 1@2.12Our focus on the money rate of interest is "ustified from the vie that in the final analysis it determines the level of the other interest rates. %n conditions of equili!rium& all the interest rates tend to !e equal to each other& a result that follo s from the foregoing discussion on the 8E3 and the idea that the volume of investment is determined at the point here the 8E3 is equal to the rate of interest. Keynes in the analysis of the rate of interest notes that this is !ased on an idea that he !orro ed from 9raffa in his de!ate ith 1aye$ in 1572 0.eneral Theory& 11The volatility in the liquidity preference function depends upon degrees of e'pectations and it cannot !e predicted to move in any particular direction. 121ansen contends Uthat not too much ould have !een lost had it 03hap. 1@2 not !een rittenV 015)7& p. 1)52 and Keynes himself admitted Uthe o!scurity of this chapterV 03:& M%Z& p. )152. 2<0 10 Keynes,s .eneral Theory p. 2272. *ccording to this idea the returns of every asset i 0denoted !y ri2 is equal to the sum of the three elements? 012 The interest that is paid for this asset& ri. 022 The rate of change of the value of the asset& ai. 072 The e'penditures for the possession of liquidity premium& li. %f e e'amine the various assets e o!serve that all of them display more or less the a!ove characteristics. >or e'ample& let us suppose an asset such as !onds hich display high liquidity& since there is a mar$et for them and so they can !e easily converted into cash.178oreover& !onds pay interest 0e'plicitly through a coupon or implicitly !y their appreciation in the maturity date2 and their price is su!"ect to changes. >or e'ample& the same !ond has different prices in different time periods. Other assets such as houses are characterised !y high illiquidity since there is no mar$et in hich they could !e sold relatively easily and ith no loss of value. 3onsequently& the o ners of such assets must loo$ for higher returns in order to compensate themselves for their lo liquidity. 8oreover& assets of this $ind are su!"ect to capital gains or losses. The return of money 0rm2 equals to its liquidity only& that is& rmB li. The value of money remains constant riB aiB 0& since money is the unit of account to evaluate all the other assets. The return on money 0i.e.& the interest rate2 can rise at a very high level !ut it cannot fall past a certain possi!le minimum& hile the returns on other assets vary much easier in any direction and !ecome even Tero. %n conditions of equili!rium the returns of all assets ill !e equal to each other& that is& riB rm. This equality comes from the operation of competition and e'plains the reason hy the rate of interest on money determines the interest rate on all other assets& the money rate of interest& as Keynes says& +rules the roost,& that is& the money rate of interest determines the level of the other interest rates for its t o unique properties 0.eneral Theory& pp. 270;2712? l [ero or negligi!le elasticity of production 0.eneral Theory& p. 2702. l [ero or negligi!le elasticity of su!stitution 0.eneral Theory& p. 2712. -et us suppose an asset hose returns e'ceeds the money rate of interest& that is&

riX rm. Hnder these circumstances one ould e'pect the e'pansion of production of good i& hose increased supply ill lo er its returns to the point that riB rm. %f e no suppose the converse that is riN rm& then it does not follo that there ill !e e'pansion of +production, of money so as rmto fall. This is !ecause of the first property of money& hich is the Tero 0or negligi!le2 elasticity of production. %n other ords& money is not a privately produced good& and& therefore& its stoc$ in the economy is fi'ed.1(3onsequently& the rate of interest or the returns on money constitutes the lo er limit of money for the returns of other assets. 17Of course there are restrictions such as that mar$ets do not operate round the cloc$& there are holidays& etc. 1(%f money could !e produced privately then as Dillard 015(D& p. 2012 claims the courses of depressions ould !e different& as indeed they are to some e'tent in gold#producing countries. 10.) The -iquidity Preference Theory 2<1 %t is true that there is no asset that can replace money/ this is the meaning of the Tero elasticity of su!stitution of money. %f& for e'ample& there is a shortage of money& then it follo s 0in a monetary economy2 that everyone ill see$ to find su!stitutes for money and there is no asset that appro'imates& in any satisfactory ay& the properties of money. %n such a situation& since monetary economies cannot function ithout money it follo s that the rate of return on money ill tend to increase ithout limits. This means that there is no asset that has lo er returns from money& that is riN rmsince this is a disequili!rium situation. The returns on money rmform the ma'imum returns 0ceiling2 for the returns of the other assets hich must approach the level of rm. 3onsequently& the returns of money !ecause of the Tero elasticity of su!stitution operates for the other assets as a ceiling and a Tero elasticity of production operates as a floor& hich means that all other interest rates vary ithin these t o !ounds determined !y the returns on money. This analysis is in 3hap. 1@ of the .eneral Theory and it is a long run analysis& after all a uniform interest rate 0return2 !y definition requires a long run analysis. Keynes from the moment that he !rought in his analysis of the determination of the volume of investment through the 8E3 schedule and the rate of interest had to create some $ind of infle'i!ility in his theoretical system in order to maintain his main proposition of unemployment equili!rium. %n other ords& Keynes had to fi' one crucial price so as the varia!ility of the other prices ould not restore full employment. The fi'ed price he chose as the money rate of interest. The latter derives its characteristics firstly from the speculative demand for money& hich is a short#run argument and secondly from the peculiar qualities of money hich clearly is a long run argument. The short run and the long run arguments seem that they cannot !e reconciled to a consistent theory for the determination of the rate of interest. The pro!lem is in Keynes,s analysis of the determination of the equili!rium level of output hich is accompanied !y the unemployment of la!our. Equili!rium implies that all the necessary ad"ustments have already ta$en place and there are no centripetal forces. %f& ho ever& the economy is in long#run equili!rium& then there is a pro!lem in the foundations of the theory since the long#run interest rate remains une'plained. Keynes further argues that if there ere not an asset such as money ith the dual character then the interest rate on commodities ould vary until the restoration of full employment. %n other ords& the presence of money 0 ith its t o attri!utes2 prevents the rates of returns from falling and encouraging investment& and then Keynes argues that the price mechanism ould drive the economy !ac$ to full employment. This argument is inconsistent ith Keynes,s overall analysis

!ecause he claims that the interest rate on money o!structs the rates of return of other assets to fall and to increase investment to the full employment level of output. 9o Keynes creates infle'i!ility in his analysis. 1e uses a fi'ed price to stop varia!le prices pushing the economy to ards full employment. This fi'ed price is the money rate of interest. *nd the money rate of interest derives its characteristics from the speculative demand for money& hich is a short run argument and the peculiar qualities of money hich is a long run argument.