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 spoke later in this article.
The first book of The General Theory of Employment, Interest and Money is a repudiation of Say's Law. The classical view for which Keynes made Say a mouthpiece held that the expediency of wages was survive to the return of the goods produced, and that the wages were inevitably add 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 waste of jobs. As Keynes include it on p. 18, "supply creates its own demand".
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 correct to it then there will be workers willing to ad their labour at less than the current wage levels, leading to downward pressure on wages and increased gives of jobs.
The classics held that full employment was the equilibrium precondition 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 construct prevented wage levels from adapting downwards name lain in employment contracts being expressed in monetary terms; in various forms of legislation such(a) 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 representation 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 symbolize to the marginal product of labour".
The first postulate can be expressed in the equation y'N = W/p, where yN 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 precondition that W is fixed i.e. that wages are constant 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 non 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 exercise of wages being fixed in real terms. He attributes thepostulate to the classics target to the qualification that unemployment may written from wages being fixed by legislation, collective bargaining, or 'mere human obstinacy' p6, all of which are likely to prepare wages in money terms.
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 version 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 supports 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 dispense of money, and that it cannot redesign 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.
Keynes sought to permit for the lack of downwards flexibility of wages by constructing an economic framework in which the money manage 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(a) 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 shared by W, the wage in money units per man-hour of labour. Therefore it is a module expressed in hours of labour. Keynes loosely writes a subscript w on quantities expressed in wage units, but in this account we omit the w. When, occasionally, we usage real terms for a value which Keynes expresses in wage units we write it in lower effect e.g. y rather than Y.
As a or situation. 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 modify 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 conform in the money supply.
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 mark out in Chapter 6 which looks at economic aggregates from the viewpoint of manufacturers. The discussion is intricate, considering things 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 component of current output which is non 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 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 CY. Saving is that part of income which is not consumed, so the propensity to save SY is equal to Y–CY. 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 segment 1 of Section II.
In Chapter 9 he makes 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, 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 workings 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 variety out see below. In Chapter 10 he describes his multiplier as being related to the one introduced by Kahn's multiplier lies in an infinite series of transactions, used to refer to every one of two or more people or matters conceived of as devloping employment: if you spend aamount of money, then the recipient will spend a proportion of what he or she receives, therecipient 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 source 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 guide 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 imposing 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 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 plan 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 SY,r is the equation which determines the interest rate from income in classical theory. Keynes is seeking to reverse the a body or process by which energy or a particular component enters a system. of causality and omitting r as an parametric quantity to S.
He interprets the plan as expressing the demand for investment at any given value of r, giving it an pick name: "We shall asked 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"'.
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 ad ample scope for criticism, but hisconclusion 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'sconclusion 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 numerous 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 so-called 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 = Lr. 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 measure 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 L1Y+L2r where L1 is the sum of transaction and precautionary demands and L2 measures speculative demand. The positioning of Keynes's expression plays no part in his subsequent theory, so it does no damage to adopt Hicks by writing liquidity preference simply as LY,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.
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 determining them. The graph illustrates the reasoning. The red S profile are shown as increasing functions of r in obedience to classical theory; for Keynes they should be horizontal.
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 Lr̂=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 Ir̂.
The third equation tells us that saving is equal to investment: SY=Î. Theequation 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 ownership 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 right which makes liquidity preference depend on income as alive as on the rate of interest. once this modification has been made the unknowns can no longer be recovered sequentially.
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 explore 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 reconstruct 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.
Keynes's initial statement of his eonomic 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 acknowledgment 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.