# Results for “keynes's general theory” 20 found

## Keynes’s General Theory, chapter ten

The velocity of money can vary, aggregate demand matters, and the multiplier is real.  Let's get those preliminaries out of the way.  That all said, this is one of the least accurate chapters in Keynes's General Theory.  To pull out one key quotation (pp.116-117, in section II):

It follows, therefore, that, if the consumption psychology of the community is such that they will choose to consume e.g., nine-tenths of an increment of income, then the multiplier is 10; and the total employment caused by (e.g.) increased public works will be ten times the primary employment provided by the public works themselves…

AARRRGGHH!

Empirically a typical estimate of a multiplier might be 1.3 or 1.4, not 10, not even in a deep slump.  (Valerie Ramey points out that the key issue in estimating a multiplier is to determine when the fiscal innovation actually occurred; this is not easy.)  One theoretical problem in generating a high multiplier is this.  Say you have a debt-financed increase in government spending.  You can get some dollars out of low-velocity pools into high-velocity pools on the first round of redistributing the spending flow.  Do not expect complete crowding out and so nominal aggregate demand can increase, thus boosting output and employment.  But the second and third round effects of the redistributed money are usually a wash and the boost to velocity dwindles.  Why should it stay in a high-velocity sector of the economy?

It is common in the GT that Keynes confuses marginal and average effects and, for all of his explicit talk about average and marginal in this chapter, he is making one version of that error again.  Rothbard and Hazlitt are not in general reliable critics of Keynes, but
they do have a good reductio (see chapter XI) on crude interpretations of the multiplier and that is what Keynes is serving up here.  You can't just take a partial derivative of an accounting identity and call the result a causal relationship.

In addition to velocity/spending effects, there are also multiplier effects through real production.  The most insightful analysis of supply-side multipliers comes from the work of W.H. Hutt.

The multiplier is a legitimate concept but often it is overestimated in its import.  This chapter in Keynes is a step backwards from Richard Kahn, the father of the multiplier concept.

Don't forget Alex's comments on fiscal policy and velocity.

## Keynes’s General Theory, chapter six

Keynes does all this huffing and puffing about terms and finally he stumbles into his mention of Hayek.  Hayek had written some now-obscure articles about net investment and measures of the capital stock, reprinted in Profits, Interest, and Investment.  (Here is an excellent Lawrence H. White essay on this part of Hayek’s thought.)  Keynes wants to show he doesn’t have to worry about these debates.  Keynes is also trying to liberate himself from his previous (1930) two-volume Treatise on Money, a disappointing work.  At the end of section (i) you get the clincher: "For this reason, and also because I no longer require my former terms to express my ideas accurately, I have decided to discard them — with much regret for the confusion which they have caused."

Again, in part ii the bombshell comes, unannounced.  Keynes decides that he will declare savings to be a "mere residual."  Consumption and investment alone will determine income and savings is defined as whatever is left over to make the national income equations balance.

At the time this was considered by many to be an enormous sleight of hand. The Austrian and Swedish traditions focused on the question of whether planned savings was going to equal planned investment and what happens if not.  Keynes has just banished such questions to the woodshed and he has done so by a terminological maneuver.

Whether or not you think that the Austrian and Swedish traditions lead anywhere fruitful, Keynes is on shaky ground here.  He is using definitions to favor one causal account of macro over another.  That’s not right.  You can still make a plausible argument that Keynes is right on empirical grounds that planned savings is not an important force for understanding business cycles.  But so far no such empirical argument has been clinched.

In the second to last paragraph Keynes realizes that in his system savings does not and cannot constrain investment.  He notes that if animal spirits were wild enough, the price of output could fluctuate between zero and infinity.  Neither interest rates nor savings plans perform any of their traditional constraining or equilibrating functions.  At least Keynes realized how far out on a limb he was going.

Due to popular request, we’ll resume with the Keynes symposium in January but take a break for the close of the semester.

## Keynes’s General Theory, chapter five

Part i shows that Keynes had digested the Austrians, and especially the Swedes, far more than he let on.  He goes through considerable machinations to show that his main argument is consistent with the Swedish long vs. short-run, ex ante vs. ex post analysis that ruled Stockholm at the time, as found in Myrdal, Lindahl, Ohlin and others.  For all of Keynes’s periodic dismissiveness of his precursors, I read him as actually quite intimidated by them.  In this section he’s "looking for their approval," if only in his own mind.

In Part ii Keynes presents two bombshells, more or less from out of nowhere:

a) For the short-run, the common default expectation is that "recently realized results will continue"; this precludes entrepreneurial creativity and creation as a way out of a bad situation.  You’ll note the influence of Cambridge epistemology here, namely that we do not recreate our entire basic picture of the world de novo every day.  G.L.S. Shackle is mostly a Keynesian but on this issue his emphasis on the creative imagination of the individual is a significant revision of Keynes.

b) Long-term expectations do not adjust smoothly but rather become more bullish or bearish in volatile leaps.

Furthermore a) and b) are held together, which implies at some margin a sharp disjunction between the short-run and long-run.  I do not regard Keynes’s two assumptions as absurd, but they are hardly a "general theory."  Note that you need a) to choke off various processes of recovery and you need b) to get investment demand to be so volatile in the first place.  Let’s say you think b) is reasonable, then in my view you should also believe in possible "cascade" effects which can pull you out of a downturn in the short run.  But for Keynes, no.

Here is a comment on last week’s session.  Chapter six will be going up this afternoon.  On short vs. long-term expectation, Felix Salmon has some good points.

## Keynes’s General Theory, chapter four, *The Choice of Units*

This chapter may seem cryptic but the key is the tiny footnote to Hayek; this chapter is Keynes obsessing over capital theory and the Austrians.

Hayek argued that an economic downturn should be understood as a discombobulation of the capital structure and here is Keynes arguing against that approach.  When you cut through the terminology, Keynes says that capital
heterogeneity isn’t needed to generate aggregate demand analysis and that
his core mechanisms will operate in any case.

Keynes admits that with economic development labor gets very specialized, or very closely connected to particular capital goods, so yes there are capital complementarities of the Austrian kind.  But Keynes thinks such fragilities will only help his argument, while rendering the analytics too messy.  He declares his intention to proceed with homogeneous magnitudes of capital and labor.

This chapter often fails to receive its proper due; it is very important for understanding the location of Keynes in the history of economic thought.

With this one chapter, Austrian capital theory falls off the map.

## Keynes’s General Theory, chapter three

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.

## Krugman’s introduction to Keynes’s General Theory

Krugman writes:

A reasonable man might well have concluded that capitalism had failed,
and that only…the nationalization of the means of production – could
restore economic sanity….Keynes argued that these failures had
surprisingly narrow, technical causes…

It is well-known that Keynes called for the socialization of investment and euthanasia of the rentier.  Although I do not think he meant it by the 1940s (for background read this paper, or Keynes’s preface to the German-language edition of GT, which is Department of Uh-Oh material), it is odd for Krugman to ignore these passages and present Keynes as an outright enemy of government control or ownership of investment.  Next, Krugman writes:

1. Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment
2. The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully
3. Government policies to increase demand, by contrast, can reduce unemployment quickly
4. Sometimes increasing the money supply won’t be enough to persuade
the private sector to spend more, and government spending must step
into the breach

To a modern practitioner of economic policy, none of this – except,
possibly, the last point – sounds startling or even especially
controversial. But these ideas weren’t just radical when Keynes
proposed them; they were very nearly unthinkable. And the great
achievement of The General Theory was precisely to make them
thinkable….

Arthur Marget and other historians of thought have shown that such ideas were commonplace in pre-1936 macroeconomics, albeit not in Hayek and Robbins.  The American tradition in particular pushed for activist fiscal policy, read for instance Jacob VinerSeveral books document the popularity of this approach, again before the General Theory.

## Keynes’s *General Theory*, chapter 12

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The
essence of this convention — though it does not, of course, work out
quite so simply — lies in assuming that the existing state of affairs
will continue indefinitely, except in so far as we have specific
reasons to expect a change. This does not mean that we really believe
that the existing state of affairs will continue indefinitely. We know
from extensive experience that this is most unlikely. The actual
results of an investment over a long term of years very seldom agree
with the initial expectation. Nor can we rationalise our behaviour by
arguing that to a man in a state of ignorance errors in either
direction are equally probable, so that there remains a mean actuarial
expectation based on equi-probabilities. For it can easily be shown
that the assumption of arithmetically equal probabilities based on a
state of ignorance leads to absurdities. We are assuming, in effect,
that the existing market valuation, however arrived at, is uniquely correct in
relation to our existing knowledge of the facts which will influence
the yield of the investment, and that it will only change in proportion
to changes in this knowledge; though, philosophically speaking it
cannot be uniquely correct, since our existing knowledge does not
provide a sufficient basis for a calculated mathematical expectation.
In point of fact, all sorts of considerations enter into the market
valuation which are in no way relevant to the prospective yield.

Nevertheless the above conventional method of calculation will be
compatible with a considerable measure of continuity and stability in
our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organised investment markets and if we can rely
on the maintenance of the convention, an investor can legitimately
encourage himself with the idea that the only risk he runs is that of a
genuine change in the news over the near future, as to the
likelihood of which he can attempt to form his own judgment, and which
is unlikely to be very large. For, assuming that the convention holds
good, it is only these changes which can affect the value of his
investment, and he need not lose his sleep merely because he has not
any notion what his investment will be worth ten years hence. Thus
investment becomes reasonably “safe” for the individual investor over
short periods, and hence over a succession of short periods however
many, if he can fairly rely on there being no breakdown in the
convention and on his therefore having an opportunity to revise his
judgment and change his investment, before there has been time for much
to happen. Investments which are “fixed” for the community are thus

It has been, I am sure, on the basis of some such procedure as this
that our leading investment markets have been developed. But it is not
surprising that a convention, in an absolute view of things so
arbitrary, should have its weak points. It is its precariousness which
creates no small part of our contemporary problem of securing
sufficient investment.

The insights here have yet to be fully mined.

## Keynes’s *General Theory*, chapter eleven

This chapter is a wild ride, often verging on incoherence but sometimes falling into brilliance.  In any case it is hard to follow.

The first page or two of this chapter presages Tobin's "q theory" and the notion that differential rates of return determine additions to the capital stock (or lack thereof).  The theory of irreversible investment, and the corresponding notion of option value, has made q theory obsolete although not in a way which damaged Keynesian theory.  Quite the contrary.

The end of section i notes that the rate of interest, as used to evaluate capitalized streams of future income, has to come in part from outside the market for capital goods themselves.  This whole section will make more sense once you've read the notorious chapter 17.  Maybe the claims are true as stated in this chapter (all relations are those of general equilibrium in the final analysis), but what Keynes actually meant here is not so obviously true.  He is hinting at the notion that a liquidity trap can halt new investment and that the rate of return on money can "rule the roost."  When and whether this can be true is a central question for contemporary macro and we will return to it.

Parts of section ii hint at the later "reswitching" debates in capital theory and in this section Keynes is drawing upon Irving Fisher's notes on the problem.  He's again getting at the claim that a purely "real" (non-monetary), partial equilibrium theory of interest won't carry much explanatory power.  I don't think he is wielding the right weapon here.

Section iii pokes a hole in the Fisher Effect.  Keynes points out that if expectations of inflation induce a higher nominal interest rate, why don't those same expectations cause prices to go up now?  This adjustment, by the way, would eliminate the nominal premium on the rate of interest.  This simple yet powerful point doesn't get the attention it ought to.  Storage costs for goods and services may eliminate this paradox but perhaps not completely.  It is striking how few economists have thought this problem through.

The chapter ends with a blizzard of arguments about the importance of expectations.

Whew!  Overall this chapter supports my view that Keynes was obsessed with capital theory and had deep ideas on the topic.  But in terms of understanding the overall argument of the GT, if you can follow chapter 17 (ha), you needn't worry too much about all the difficult arguments and passages here.

## Keynes’s *General Theory*, chapter seven

There's a lot of shadow boxing in this chapter.  Keynes is well aware that he just made a radical move in treating savings as a pure residual (see my discussion of chapter six).  Now he is looking to cover his tracks, make it sound reasonable, and show that other people don't really have a better approach.

Section I recaps.  When Keynes writes "It would certainly be very inconvenient and misleading not to mean this" you should be just a bit astonished.  He knew exactly what he was trying to cram in here and I suspect Keynes himself was smirking when he wrote that line.

Section II covers Hawtrey, an economist hardly discussed these days.  (But wait, the issue pops up here, today!  And here!  Fama I think is wrong but read his 1980 "Banking in the Theory of Finance," Journal of Monetary Economics, for his underlying model)

Section III says that there exists a contorted interpretation of Keynes's earlier Treatise on Money which is consistent with the GT.

Sections IV and V whack the Austrians (again), drawing heavily on Piero Sraffa's 1932 "Dr. Hayek on Money and Capital."  Keynes's basic point is that inflation can push around the redistribution of wealth, and expenditure flows, but that the new allocation of resources will be self-sustaining rather than self-reversing.  He was basically right, unless you are willing to adopt some ancillary doctrine of market failure when specifying how adjustment processes occur.

The first paragraph of Section V is interesting but I don't think it is a correct account of why the Austrians differ from Keynes on this point.  The Austrians had confusing terminology and here I think Keynes is taking them too literally.

The last two paragraphs of this chapter are a nice statement of what macroeconomics is all about.

Psychologically, Keynes feels he has neutralized the alternative approaches to savings and investment, and so he will proceed with the approach which we now call Keynesian.  This chapter is Keynes trying to reassure himself, and reassure the reader.  It's Keynes, the conscious revolutionary, trying to sound conservative.

## We resume with Keynes’s *General Theory*

We'll do chapter seven for Thursday.  If you need to get up to speed, here are previous installments in the series.

By the way, what do you all want for the *next* book club?

## New MR book club – Keynes’s *General Theory*

Greg Mankiw wrote:

If you were going to turn to only one economist to understand the
problems facing the economy, there is little doubt that the economist
would be John Maynard Keynes. Although Keynes died more than a
half-century ago, his diagnosis of recessions and depressions remains
the foundation of modern macroeconomics. His insights go a long way
toward explaining the challenges we now confront.

I will go through the book, chapter by chapter, with an eye toward a deeper understanding of what Keynes wrote and why it is, as Greg says, so important.  I’m not yet sure what kind of pace I can maintain but order your copy here, nowThe Kindle version is only \$3.96.  We’ll do chapters 1 and 2 by next Monday, eight days from now.

## General Theory, chapters one and two

I am repeatedly struck by Keynes’s skill as a literary stylist.  Usually this praise is denied the General Theory but I consider the book his Finnegans Wake; the most difficult passages are often the most charming but of course they are not for everyone.

I see three main themes in the book as a whole:

1. Income effects are more important than substitution effects.

2. Expectations matter.

3. The private and social returns to liquidity are very different.

#1
(as applied to macro) and #3 were most original in his time.  The book
as a whole circles around these themes and repeats them in varying
combinations, not always coherently or consistently.  You could also
add the claims that 4. monetary factors render a "natural rate of
interest" problematic and 5. labor markets are special.  Chapter two is

Keynes did go beyond the classics,
even if he did often caricature them.  (Keynes is brilliant as a
historian of thought when praising but almost always wrong when
criticizing.)  Since Keynes never gives us a truly coherent model —
not even verbally — it is easy to pick holes in the GT.
Keynes had so many exciting new ideas that he never decided what his
main point was or exactly under which conditions it would hold.

Much
of chapter two is devoted to establishing the proposition that workers
cannot in any direct way choose a lower real wage.  For Keynes nominal
wage flexibility doesn’t solve the
main problem.  If nominal wages fall across the board in an economy,
prices will fall and real wages will remain high.  Unemployment will
continue while the economy enters a downward spiral.  I’ve already
discussed that point here but to sum up my view Keynes is presenting a special case not a general case.

p.9 puts forward a version of the doctrine of money illusion.

p.15
defines involuntary unemployment, namely if the economy can be inflated
into a higher level of employment.  This pragmatic definition reflects
that Keynes was never sure why workers minded inflation, and a cut in
the real wage, less than they minded a cut in the nominal wage.  But
that is one of his behavioral postulates and it has survived into macro
to this day.

The "neo-Keynesian" models are not so loyal to Keynes.  Keynes held sticky nominal wages to be a policy prescription, but not necessarily a good description of the world.

Chapters
one and two are stunning, as they announce that we are now living on a
different economic terrain.  But we’ve yet to see whether the main
arguments are truly sound.

On Thursday we’ll be doing chapters
three and four — be ready!  And I encourage other bloggers to follow
along and offer their own commentaries.

## The General Theory on-line

Here it is, that maddening yet brilliant book.

The worst part is the talk about the socialization of investment.  My favorite parts — not the same as the best parts — are the notorious chapter 17 (remember all that talk of "own-rates of interest"?), the discussions of "animal spirits," and the short notes at the end about mercantilism and Silvio Gesell.  This book is more poetic, and more image-rich, than just about any other economics tract.  That is one reason why it it has been read in so many contradictory ways.

What is, after all, the central message?  That aggregate demand matters?  That wages and prices are sticky?  That wages and prices are not always sticky but ought to be, to prevent an ever-worsening downward spiral?  That monetary factors prevent the rate of interest from equilibrating ex ante savings and investment, thereby requiring income adjustments to equilibrate them ex post?  That the rate of interest is simply too high?  That the stock market can screw everything up?  That expectations are the key to the macroeconomy?  All of those?

Keynes’s great contribution was to create an economics in which a persistent Great Depression was possible.  But on policy recommendations, I would stick with Milton Friedman, or for that matter Keynes’s earlier Tract on Monetary Reform.  We can recognize the dangers of deflation without embracing Keynes’s seductive yet unworkably byzantine analytical framework.

Thanks to Brad DeLong for the pointer.

## Robert J. Barro on aggregate demand

There has been a recent kerfluffle over whether Robert Barro rejects the notion of aggregate demand, which he had written with quotation marks as “aggregate demand.”  Scott Sumner surveys the back and forth.

I say use The Google to find out what Barro really thinks and indeed he has written a whole piece on the topic (jstor), namely “The Aggregate-Supply/Aggregate Demand Model,” from the mid 1990s, and here is the abstract:

In recent years, many macroeconomic textbooks at the principles and intermediate levels have adopted the aggregate-supply/aggregate-demand (AS-AD) frame- work [Baumol and Blinder, 1988, Ch. 11; Gordon, 1987, Ch. 6; Lipsey, Steiner, and Purvis, 1984, Ch. 30; Mankiw, 1992, Ch. 11]. The objective was to allow for supply shocks in a Keynesian framework and to generate more satisfactory predictions about the behavior of the price level. The main point of this paper is that the AS-AD model is unsatisfactory and should be abandoned as a teaching tool.

In one version of the aggregate-supply curve, the components of the AS-AD model as usually used are contradictory. An interpretation of the model to eliminate the logical inconsistencies makes it a special case of rational-expectations macro models. In this mode, the model has no Keynesian characteristics and delivers the policy prescriptions that are familiar from the rational-expectations literature.

An alternative version of the aggregate-supply curve leads to what used to be called the complete Keynesian model: the goods market clears but the labor market has chronic excess supply. This model was rejected long ago for good reasons and should not be resurrected now.

If you read the paper, you will see three things.  First, Barro is fully aware of “AD-like” phenomena and does not reject that notion.  Second, Barro seems to prefer the IS-LM model to AS-AD, albeit with some caveats about possible false predictions of IS-LM and also noting in footnote two that he prefers his own presentation in his 1993 text.  Third, Barro’s criticism is (whether you agree or not) that AD-AS collapses too readily into standard rational expectations models and doesn’t really provide an independent foundation for sticky price macroeconomics.  In a nutshell “The AS-AD model is logically flawed as usually presented because its assumption that the price level clears the goods market is inconsistent with the Keynesian underpinnings for the aggregate-demand curve.”

If you read Barro’s piece, what you see is a blithe dismissal of the whole notion that economies can ever suffer from am inadequate level of “aggregate demand” — the scare quotes are his, not mine, meant to suggest that this is a silly, bizarre notion, in conflict with “regular economics.”

I believe that is not a good characterization of Barro’s views and it is also an object lesson in the importance of the Ideological Turing Test.  I would cite not only this piece, but also forty years of journal articles, many of which study the importance of nominal shocks and demand, albeit without (in general) using textbook AD-AS terminology.  Indeed, Barro working with Herschel Grossman is one of the founding fathers of quantity-constrained Keynesian sticky-price macro and he is still citing this work favorably in his mid-1990s piece; see for instance Barro and Grossman (1971, 1974) and also their book from 1976: “This is a textbook on macroeconomic theory that attempts to rework the theory of macroeconomic relations through a re-examination of their microeconomic foundations. In the tradition of Keynes’s General Theory of Employment, Interest and Money…”

On the UI issue, I would note that the multiplier from transfers is likely unimpressive relative to the multiplier from government consumption.

## Hayek in the 1930s

Paul Krugman on Hayek’s influence in the 1930s:

…back in the 30s nobody except Hayek would have considered his views a serious rival to those of Keynes…

Alvin Hansen reviewing Hayek’s Prices and Production in 1933 in the American Economic Review.

The present volume is, it seems to me, the only book of recent years which at all approaches Keynes’s A Treatise on Money in the impetus it has given to renewed interest and discussion of business-cycle theory.
This in itself is high praise. Altogether aside from the soundness of its
conclusions, the value of the book and its important place in the recent
literature of cycle theory is unquestioned.

von Hayek’s contributions in the field of economic theory are both profound and original. His scientific books and articles in the twenties and thirties aroused widespread and lively debate. Particularly, his theory of business cycles and his conception of the effects of monetary and credit policies attracted attention and evoked animated discussion. He tried to penetrate more deeply into the business cycle mechanism than was usual at that time. Perhaps, partly due to this more profound analysis, he was one of the few economists who gave warning of the possibility of a major economic crisis before the great crash came in the autumn of 1929.

To be clear, it is true that Keynes’s General Theory eclipsed Hayek but to say that Hayek was not a serious rival to Keynes in the 1930s is a Whiggish misreading of the history of economic thought.

Addendum: Don Boudreaux also comments noting that Hicks specifically referred to the great Hayek-Keynes rivalry of the 1930s. See also Greg Ransom’s citations from Hicks and Coase in the comments.

Do note that reading Hayek out of the debate diminishes Hayek but perhaps even more it diminishes Keynes who clearly won over the profession.

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