Keynes’s General Theory, chapter three

by on December 11, 2008 at 7:36 am in Books | Permalink

The material on Say’s Law is good but J.S. Mill understood similar points as early as the 1840s. 

In section ii Keynes wrote: "This particular relationship, which corresponds to the
assumptions of the classical theory, is in a sense an optimum
relationship.  But it can only exist when, by accident or design,
current investment provides an amount of demand just equal to the
excess of the aggregate supply price of the output resulting from full
employment over what the community will choose to spend on consumption
when it is fully employed."

That is one of the most important passages in the book.  Consumption
is stable and investment is the volatile variable.  For equilibrium to
obtain, C + I (forget about G for now) must absorb Y.  But "I" is ruled
by fickle forces and there is no guarantee it will play its required
role.  Consider this one of Keynes’s basic models.

Garett Jones suggested to me that Keynes is postulating a vertical
curve in this chapter.  The question is why Say’s Law doesn’t
have more force, namely why supply increases don’t translate into
aggregate demand.  Keynes thought it was the liquidity trap –receipts
get soaked up in hoards rather than spent — but I think the key
problem has to be a broken banking system.  Holdings of currency just
aren’t large enough and otherwise the held money
would end up being invested through intermediation.  In the model
Keynes is often looking for ways to "break the circular flow" but he
didn’t always succeed.

Section iii has some lovely prose.

1 sboschi December 11, 2008 at 7:47 am


a couple of thoughts I had when reading Chapters 3 and 4 in Book 1.

Chapter 3 describes how a rigid labour market works.
In many countries it still works like that: take Italy, a case that I know: there is a very low rotation between employed and unemployed workers. In many other countries or in specific sectors instead a large unemployment force would push money wages down because outsider have really the chance to enter into the labour market.
As it was written before, Keynes is presenting a special case.

When Keynes says that “fortunately” workers don’t accept lower wages, I would have rather said that
“unfortunately” labour market is in some cases very rigid. I accept Keynes description of the rigid labour market with entrance barriers, but I would add that I would like to see a labour market that is more competitive. Pigou’s labour market is more an ideal labour market.

I’ve always thought that neoclassical economics was a nice simplification. If you use it, you have to know its limits, as for any model. More or less like Black & Scholes equation (sorry for the diversion to the field of finance) that you can certainly use bearing in mind that the stock price is not continuous.
You can try to use more sophisticate models that are in principle more realistic, but you not necessarily to get better results for a variety of reasons. On the other hand, if a neoclassical economist uses perfect competition for a rigid labour market is erring twice: firstly because any model is an approximation, secondly because he has chosen the wrong model among those available in the neoclassical paradigm. I think that other neoclassical models can provide a better description of labour markets if, instead of using a perfect competition model, we were using a monopoly model or a duopoly model (can we call these models, neoclassical models? I never read of a model using imperfect competition for the labour market, though).

A recent example again from finance, the investment banking job market.
Bankers wages are very flexible, total compensation (base salary + bonus) for 2008 is going to be probably 30% lower than in 2007. And Investment Bankers can be fired quite easily. This job market is very fluid, so why don’t we have full employment? Are both Keynes and the neoclassical missing something ?
Maybe we are at a point where marginal utility of employing the marginal banker is close to zero ( you always have fixed costs when you hire someone, no big expectations in terms of profits).
Or maybe also the banker job market is not as fluid as I think: It’s always difficult to reduce the salary of an employee but a bank could fire one and probably find an unemployed banker would accept to work for 80% of its old salary. But I suspect that this is illegal in the UK.


2 sboschi December 11, 2008 at 8:31 am

Sorry my previous post was for Chapter 2. Too late.


3 Steve Botha December 11, 2008 at 9:39 am

As you said, section iii has some lovely prose. It starts like this –

“The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.”

Apart from the beauty of the prose, this is interesting for how Keynes is positioning himself in the tradition of Malthus – remembering that (as Markwell shows) he had been an admirer of Malthus from at least 1914, and was involved in the 1930s “rehabilitation” of him.

It’s interesting, though, that although (as Skidelsky and Markwell show) Keynes was strongly opposed to Marxism, and describes Marx as belonging to an “underworld”, Keynes at least credits Marx with grappling with “the great puzzle of Effective Demand with which Malthus had struggled”.

4 Vangel December 11, 2008 at 10:42 am

Is everyone reading the same material here? As Henry Hazlitt pointed out, most of Keynes’, General Theory, seems to be an, “exercise in obfuscation.” Keynes states a precise relationship where one clearly does not exist and makes all kinds of assumptions so that he can apply mathematical tools to situations where such tools are not appropriate. In this chapter he proposes an, ‘Aggregate Demand Function,’ which is written in precise mathematical terms that cannot pass scrutiny. As Hazlitt points out in his critique of Keynes, there is no “constant, precise, determinate, and predictable relationship between the number of men a manufacturer employs and either his costs or his gross receipts.”

Hazlitt’s critique should be required reading by anyone who wants to understand Keynes’, General Theory. It can be downloaded for free at It is a very thorough, chapter by chapter review that provides clear arguments against each significant point that is made by Keynes. Hazlitt also points out that many of the things that are attributed to Keynes were developed later by his misguided and confused followers. The bottom line is that Keynesian thought is a total failure. Its popularity in political circles is due to Keynes’ praise of reckless spending and budget deficits. While such an approach can keep reality from asserting itself in the short term in the long term we have to deal with it and pay for our sins.

5 Current December 11, 2008 at 2:29 pm

“Keynes is simply providing an overview. The key is the link between money,
interest and output. Keynes interest is liquidity–not time–preference, therefore
interest does not channel savings directly into investment. Higher interest rates
can lead to a reduction of investment, income and saving.Intermediation
transfers savings to borrowers and allocates from risk adverse to risk takers relecting
savers’ liquity preference. If we peek at chap 5 both liquidity
preference and irr are volatile.”

Just because liquidity demands may change for a while doesn’t mean that liquidity not time-preference determines interest. Demanding money is a plan, like any other business plan, it is just a short term one. Anyone who demands it obviously does so with a view to doing something with it in the future.

Interest does not channel savings directly into investment straight away. It is not a clean process. It is though what happens.

Lots of the things Keynes talks about in this chapter he mistakes as being functions of short-term aggregate variables. The Classical and Austrian economists never intended them to be that, they do not use aggregates.

6 bob mcmanus December 11, 2008 at 3:34 pm

“Actually, as regards the policy most associated with Keynes’s
name, deficit spending by the central government, his views were
relatively consistent over time: the fact is that he rarely explicitly
supported such a policy. What Keynes supported during the last two
decades of his life was the use of public works projects to stimu-
late aggregate demand.” …Bradley Bateman, “Keynes & Keynesianism” Cambridge Companion to Keynes, 2006, p. 275

Keynes advocated deficit spending once, argued against many times. Keynes real preference was for a self-financing gov’t capital budget.

Deficits? Abba Lerner

7 gnat December 11, 2008 at 3:54 pm

I think Keynes would respond that time preference implies that you can assess future risk/returns. If we cannot and the future is uncertain then risk adversion and liquity preference may be significant.

As to short run, we are always making choices in the present that reflect partial adaptions to past decisions and revised choices based on expectations about the future planning period.

8 mickslam December 13, 2008 at 11:01 am

The important part about this phrase:

“”This particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.”

Is not:

“Consumption is stable and investment is the volatile variable”

It is that it relies on full employment to make the relationship work. The sentence before makes this clear.

Check the sentence before:

“The effective demand associated with full employment is a special case, only realized when the propensity to consume and the inducement to invest stand in a particular relationship to one another.”

He is stating that the relationship that you describe here:

“Consumption is stable and investment is the volatile variable. For equilibrium to obtain, C + I (forget about G for now) must absorb Y. But “I” is ruled by fickle forces and there is no guarantee it will play its required role”

is more complex, and that C is also volatile.

Importantly, , the rest of the chapter is devoted to demonstrating that, we cannot ignore effective demand, and when D1 (consumption) falls, D2 must take up the slack to maintain full employment!

This is why he wants to have the govt deficit spend to take up investment slack. This is why classical economists hate him, and the Austrians hate him. First, he demonstrates that consumption can fall, then gives a solution that makes sense that unfortunately involves the govt.

Also, there is something extremely important you might want to comment on as well…in Chapter 4

9 Current December 14, 2008 at 12:38 pm

mickslam: “First, he demonstrates that consumption can fall, then gives a solution that makes sense that unfortunately involves the govt.”

Consumption can fall, but only in the short term. As Oskar Lange and W.H.Hutt demonstrated “Say’s law” is true. Once the “rush to liquidity” is over it will take over and the economy will grow once more.

Keynes gives a method of accelerating this. One that has high long term costs because it distorts the time structure of production.

We Austrians disagree with him because he is wrong.

10 Ralph Musgrave December 30, 2008 at 1:07 pm

I suspect Tyler Cowen is wrong to say that Keynes claimed that Says Law doesnt work because of the liquidity trap. As I understand it ( and I’m far from infallible ) Keynes stated correctly that Says law works via the Pigou effect. I.e. 1, new source of supply (including associated labour) starts producing stuff, 2, price of stuff, and price of labour drops in money terms because aggregate supply exceeds aggregate demand, 3, as a result, the real value of money balances rises (or to be more exact the value of the monetary base rises), 4, this increased value of the monetary base induces additional spending.

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