The General Theory of Employment, Interest and Money

Keynes's aims in the General Theory

The central argument of The General Theory is that the level of employment is determined not by the price of labour, as in classical economics, but by the level of aggregate demand. If the total demand for goods at full employment is less than the total output, then the economy has to contract until equality is achieved. Keynes thus denied that full employment was the natural result of competitive markets in equilibrium.

In this he challenged the conventional ('classical') economic wisdom of his day. In a letter to his friend George Bernard Shaw on New Year's Day, 1935, he wrote:

I believe myself to be writing a book on economic theory which will largely revolutionize – not I suppose, at once but in the course of the next ten years – the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say, – in my own mind, I'm quite sure.

The first chapter of The General Theory (only half a page long) has a similarly radical tone:

I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

Summary of the General Theory

Keynes's main theory (including its dynamic elements) is presented in Chapters 2–15, 18, and 22, which are summarised here. A shorter account will be found in the article on Keynesian economics. The remaining chapters of Keynes's book contain amplifications of various sorts and are described later in this article.

Book I: Introduction

The first book of The General Theory of Employment, Interest and Money is a repudiation of Say's law. The classical view for which Keynes made Say a mouthpiece held that the value of wages was equal to the value of the goods produced, and that the wages were inevitably put back into the economy sustaining demand at the level of current production. Hence, starting from full employment, there cannot be a glut of industrial output leading to a loss of jobs. As Keynes put it on p. 18, "supply creates its own demand".

Say's law depends on the operation of a market economy. If there is unemployment (and if there are no distortions preventing the employment market from adjusting to it) then there will be workers willing to offer their labour at less than the current wage levels, leading to downward pressure on wages and increased offers of jobs.

The classics held that full employment was the equilibrium condition of an undistorted labour market, but they and Keynes agreed in the existence of distortions impeding transition to equilibrium. The classical position had generally been to view the distortions as the culprit and to argue that their removal was the main tool for eliminating unemployment. Keynes on the other hand viewed the market distortions as part of the economic fabric and advocated different policy measures which (as a separate consideration) had social consequences which he personally found congenial and which he expected his readers to see in the same light.

The distortions which have prevented wage levels from adapting downwards have lain in employment contracts being expressed in monetary terms; in various forms of legislation such as the minimum wage and in state-supplied benefits; in the unwillingness of workers to accept reductions in their income; and in their ability through unionisation to resist the market forces exerting downward pressure on them.

Keynes accepted the classical relation between wages and the marginal productivity of labour, referring to it on page 5 as the "first postulate of classical economics" and summarising it as saying that "The wage is equal to the marginal product of labour".

The first postulate can be expressed in the equation y'(N) = W/p, where y(N) is the real output when employment is N, and W and p are the wage rate and price rate in money terms (and hence W/p is the wage rate in real terms). A system can be analysed on the assumption that W is fixed (i.e. that wages are fixed in money terms) or that W/p is fixed (i.e. that they are fixed in real terms) or that N is fixed (e.g. if wages adapt to ensure full employment). All three assumptions had at times been made by classical economists, but under the assumption of wages fixed in money terms the 'first postulate' becomes an equation in two variables (N and p), and the consequences of this had not been taken into account by the classical school.

Book II: Definitions and ideas

Keynes sought to allow for the lack of downwards flexibility of wages by constructing an economic model in which the money supply and wage rates were externally determined (the latter in money terms), and in which the main variables were fixed by the equilibrium conditions of various markets in the presence of these facts.

Many of the quantities of interest, such as income and consumption, are monetary. Keynes often expresses such quantities in wage units (Chapter 4): to be precise, a value in wage units is equal to its price in money terms divided by W, the wage (in money units) per man-hour of labour. Therefore it is a unit expressed in hours of labour. Keynes generally writes a subscript w on quantities expressed in wage units, but in this account we omit the w. When, occasionally, we use real terms for a value which Keynes expresses in wage units we write it in lower case (e.g. y rather than Y).

As a result of Keynes's choice of units, the assumption of sticky wages, though important to the argument, is largely invisible in the reasoning. If we want to know how a change in the wage rate would influence the economy, Keynes tells us on p. 266 that the effect is the same as that of an opposite change in the money supply.

The key notion of expectations is introduced in Chapter 5.Short-term expectations are 'concerned with the price which a manufacturer can expect to get for his "finished" output at the time when he commits himself to starting the process which will produce it'. Long-term expectation 'is concerned with what the entrepreneur can hope to earn in the shape of future returns if he purchases (or perhaps manufactures) "finished" output as an addition to his capital equipment.'

Keynes note that:'It is sensible for producers to base their expectations on the assumption that the most recently realized results will continue, except in so far as there are definite reasons for expecting a change.' However (see Chapter 12) long-term expectations are liable to sudden revision. Thus the factor of long-term expectations cannot be even approximately eliminated or replaced by realized results.'

Briefly, short-run expectations are typically 'mathematical' in character, long-run expectations less so.

Book III: The propensity to consume

Book III of the General Theory is given over to the propensity to consume, which is introduced in Chapter 8 as the desired level of expenditure on consumption (for an individual or aggregated over an economy). The demand for consumer goods depends chiefly on the income Y and may be written functionally as C(Y). Saving is that part of income which is not consumed, so the propensity to save S(Y) is equal to Y–C(Y). Keynes discusses the possible influence of the interest rate r on the relative attractiveness of saving and consumption, but regards it as 'complex and uncertain' and leaves it out as a parameter.

His seemingly innocent definitions embody an assumption whose consequences will be considered later. Since Y is measured in wage units, the proportion of income saved is considered to be unaffected by the change in real income resulting from a change in the price level while wages stay fixed. Keynes acknowledges that this is undesirable in Point (1) of Section II.

In Chapter 9 he provides a homiletic enumeration of the motives to consume or not to do so, finding them to lie in social and psychological considerations which can be expected to be relatively stable, but which may be influenced by objective factors such as 'changes in expectations of the relation between the present and the future level of income' (p. 95).

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' (p. 96) that the marginal propensity to consume will be positive and less than unity.

Chapter 10 introduces the famous 'multiplier' through an example: if the marginal propensity to consume is 90%, then 'the multiplier k is 10; and the total employment caused by (e.g.) increased public works will be ten times the employment caused by the public works themselves' (pp. 116f). Formally Keynes writes the multiplier as k=1/S'(Y). It follows from his 'fundamental psychological law' that k will be greater than 1.

Keynes's account is not clear until his economic system has been fully set out (see below). In Chapter 10 he describes his multiplier as being related to the one introduced by R. F. Kahn in 1931. The mechanism of Kahn's multiplier lies in an infinite series of transactions, each conceived of as creating employment: if you spend a certain amount of money, then the recipient will spend a proportion of what he or she receives, the second recipient will spend a further proportion again, and so forth. Keynes's account of his own mechanism (in the second para of p. 117) makes no reference to infinite series. By the end of the chapter on the multiplier, he uses his much quoted "digging holes" metaphor, against laissez-faire. In his provocation Keynes argues that "If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the banknotes up again" (...), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing".

Book IV: The inducement to invest

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 is expected to be yielded by an extra increment of capital as a proportion of its cost. The 'schedule of the marginal efficiency of capital' is the function which, for any rate of interest r, gives us the level of investment which will take place if all opportunities are accepted whose return is at least r. By construction this depends on r alone and is a decreasing function of its argument; it is illustrated in the diagram, and we shall write it as I (r).

This schedule is a characteristic of the current industrial process which Irving Fisher described as representing the 'investment opportunity side of interest theory'; and in fact the condition that it should equal S(Y,r) is the equation which determines the interest rate from income in classical theory. Keynes is seeking to reverse the direction of causality (and omitting r as an argument to S()).

He interprets the schedule as expressing the demand for investment at any given value of r, giving it an alternative name: "We shall call this the investment demand-schedule..." (p. 136). He also refers to it as the 'demand curve for capital' (p. 178).

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"'.

In Chapter 12, Keynes writes:

It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. [Footnote: By “very uncertain’ I do not mean the same thing as improbable”. Cf. my Treatise on Probability, chap. 6, on “The Weight of Arguments”.] It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.

The Keynesian economic system

In Chapter 14 Keynes contrasts the classical theory of interest with his own, and in making the comparison he shows how his system can be applied to explain all the principal economic unknowns from the facts he takes as given. The two topics can be treated together because they are different ways of analysing the same equation.

Keynes's presentation is informal. To make it more precise we will identify a set of 4 variables – saving, investment, the rate of interest, and the national income – and a parallel set of 4 equations which jointly determine them. The graph illustrates the reasoning. The red S lines are shown as increasing functions of r in obedience to classical theory; for Keynes they should be horizontal.

The first equation asserts that the reigning rate of interest r̂ is determined from the amount of money in circulation M̂ through the liquidity preference function and the assumption that L(r̂)=M̂.

The second equation fixes the level of investment Î given the rate of interest through the schedule of the marginal efficiency of capital as I(r̂).

The third equation tells us that saving is equal to investment: S(Y)=Î. The final equation tells us that the income Ŷ is the value of Y corresponding to the implied level of saving.

All this makes a satisfying theoretical system.

Three comments can be made concerning the argument. Firstly, no use is made of the 'first postulate of classical economics', which can be called on later to set the price level. Secondly, Hicks (in 'Mr Keynes and the "Classics"') presents his version of Keynes's system with a single variable representing both saving and investment; so his exposition has three equations in three unknowns.

And finally, since Keynes's discussion takes place in Chapter 14, it precedes the modification which makes liquidity preference depend on income as well as on the rate of interest. Once this modification has been made the unknowns can no longer be recovered sequentially.

Dynamic aspects of Keynes's theory

Chapter 5 makes some common-sense observations on the role of expectation in economics. Short-term expectations govern the level of production chosen by an entrepreneur while long-term expectations govern decisions to adjust the level of capitalisation. Keynes describes the process by which the level of employment adapts to a change in long-term expectations and remarks that:

The level of employment at any time depends... not merely on the existing state of expectation but on the states of expectation which have existed over a certain past period. Nevertheless past expectations, which have not yet worked themselves out, are embodied in to-day's capital equipment... and only influence [the entrepreneur's] decisions in so far as they are so embodied.

The main role of expectation in Keynes's theory lies in the schedule of the marginal efficiency of capital which, as we have seen, is defined in Chapter 11 in terms of expected returns. Keynes differs here from Fisher whom he largely follows, but who defined the 'rate of return over cost' in terms of an actual revenue stream rather than its expectation. The step Keynes took here has a particular significance in his theory.

Keynes differed from his classical predecessors in assigning a role to the schedule of the marginal efficiency of capital in determining the level of employment. Its effect is mentioned in his presentations of his theory in Chapters 14 and 18 (see above).

Chapter 12 discusses the psychology of speculation and enterprise.

Most, probably, of our decisions to do something positive ... can only be taken as a result of animal spirits .. Thus if the animal spirits are dimmed and spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.

Keynes's picture of the psychology of speculators is less indulgent.

In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield... The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

The writing of the General Theory

Keynes drew a lot of help from his students in his progress from the Treatise on Money (1930) to the General Theory (1936). The Cambridge Circus, a discussion group founded immediately after the publication of the earlier work, reported to Keynes through Richard Kahn, and drew his attention to a supposed fallacy in the Treatise where Keynes had written:

Thus profits, as a source of capital increment for entrepreneurs, are a widow's curse which remains undepleted however much of them may be devoted to riotous living.

The Circus disbanded in May 1931, but three of its member – Kahn, Austin and Joan Robinson – continued to meet in the Robinsons' house in Trumpington St. (Cambridge), forwarding comments to Keynes. This led to a 'Manifesto' of 1932 whose ideas were taken up by Keynes in his lectures. Kahn and Joan Robinson were well versed in marginalist theory which Keynes did not fully understand at the time (or possibly ever), pushing him towards adopting elements of it in the General Theory. During 1934 and 1935 Keynes submitted drafts to Kahn, Robinson and Roy Harrod for comment.

There has been uncertainty ever since over the extent of the collaboration, Schumpeter describing Kahn's "share in the historic achievement" as not having "fallen very far short of co-authorship" while Kahn denied the attribution.

Keynes's method of writing was unusual:

Keynes drafted rapidly in pencil, reclining in an armchair. The pencil draft he sent straight to the printers. They supplied him with a considerable number of galley proofs, which he would then distribute to his advisers and critics for comment and amendment. As he published on his own account, Macmillan & Co., the 'publishers' (in reality they were distributors), could not object to the expense of Keynes' method of operating. They came out of Keynes' profit (Macmillan & Co. merely received a commission). Keynes' object was to simplify the process of circulating drafts; and eventually to secure good sales by fixing the retail price lower than would Macmillan & Co.

The advantages of self-publication can be seen from Étienne Mantoux's review:

Chronology

Keynes's work on the General Theory began as soon as his Treatise on Money had been published in 1930. He was already dissatisfied with what he had written and wanted to extend the scope of his theory to output and employment. By September 1932 he was able to write to his mother: 'I have written nearly a third of my new book on monetary theory'.

In autumn 1932 he delivered lectures at Cambridge under the title 'the monetary theory of production' whose content was close to the Treatise except in giving prominence to a liquidity preference theory of interest. There was no consumption function and no theory of effective demand. Wage rates were discussed in a criticism of Pigou.

In autumn 1933 Keynes's lectures were much closer to the General Theory, including the consumption function, effective demand, and a statement of 'the inability of workers to bargain for a market-clearing real wage in a monetary economy'. All that was missing was a theory of investment.

By spring 1934 Chapter 12 was in its final form.

His lectures in autumn of that year bore the title 'the general theory of employment'. In these lectures Keynes presented the marginal efficiency of capital in much the same form as it took in Chapter 11, his 'basic chapter' as Kahn called it. He gave a talk on the same subject to economists at Oxford in February 1935.

This was the final building block of the General Theory. The book was finished in December 1935 and published in February 1936.

Observations on its readability

Many economists found General Theory difficult to read, with Étienne Mantoux calling it obscure, Frank Knight calling it difficult to follow, Michel DeVroey commenting that "many passages of his book were almost indecipherable"., and Paul Samuelson calling the analysis "unpalatable" and incomprehensible.

However Raúl Rojas dissents, saying that "obscure neo-classical reinterpretations" are "completely pointless since Keynes' book is so readable".

Reception

Keynes did not set out a detailed policy program in The General Theory, but he went on in practice to place great emphasis on the reduction of long-term interest rates and the reform of the international monetary system as structural measures needed to encourage both investment and consumption by the private sector. Paul Samuelson said that the General Theory "caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea islanders."

Praise

Many of the innovations introduced by The General Theory continue to be central to modern macroeconomics. For instance, the idea that recessions reflect inadequate aggregate demand and that Say's law (in Keynes's formulation, that "supply creates its own demand") does not hold in a monetary economy. President Richard Nixon famously said in 1971 (ironically, shortly before Keynesian economics fell out of fashion) that "We are all Keynesians now", a phrase often repeated by Nobel laureate Paul Krugman (but originating with anti-Keynesian economist Milton Friedman, said in a way different from Krugman's interpretation). Nevertheless, starting with Axel Leijonhufvud, this view of Keynesian economics came under increasing challenge and scrutiny and has now divided into two main camps.

Prior to the financial crises of 2007-9, the majority new consensus view, still found in most current text-books and taught in all universities, was New Keynesian economics, which (in contrast to Keynes) accepts the neoclassical concept of long-run equilibrium but allows a role for aggregate demand in the short run. New Keynesian economists pride themselves on providing microeconomic foundations for the sticky prices and wages assumed by Old Keynesian economics. They do not regard The General Theory itself as helpful to further research. The minority view is represented by post-Keynesian economists, all of whom accept Keynes's fundamental critique of the neoclassical concept of long-run equilibrium, and some of whom think The General Theory has yet to be properly understood and repays further study.

In 2011, the book was placed on Time's top 100 non-fiction books written in English since 1923, almost 400 universities are teaching a revised curriculum that takes instability seriously and Keynes's notion of uncertainty has become more familiar as 'radical uncertainty'.

Criticisms

From the outset there has been controversy over what Keynes really meant. The success of what came to be known as "neoclassical synthesis" Keynesian economics owed a great deal to the Harvard economist Alvin Hansen and MIT economist Paul Samuelson as well as to the Oxford economist John Hicks. Hansen and Samuelson offered a lucid explanation of Keynes's theory of aggregate demand with their 45° Keynesian cross diagram while Hicks created the IS-LM diagram. Both of these diagrams can still be found in textbooks.

Just as the reception of The General Theory was encouraged by the 1930s experience of mass unemployment, its fall from favour was associated with the 'stagflation' of the 1970s. Although Keynes explicitly addresses inflation, The General Theory does not treat it as an essentially monetary phenomenon or suggest that control of the money supply or interest rates is the key remedy for inflation, unlike neoclassical theory.

Post-Keynesians argue that the neoclassical Keynesian model is completely distorting and misinterpreting Keynes' original meaning, at least in so far as it largely rests on an assumed long-term equilibrium.