Thursday, August 11, 2005

What was so "general" about Keynes' General Theory ?

I once had a teacher in college who told me that he had taken a final exam in his own university days where his professor had asked students the following question: What was so "general" about Keynes' General Theory? That's a great question. Now let me try to answer it.

Keynes argued that Classical macroeconomic theory was full of special assumptions--assumptions which he felt were not at all realistic. Classical thought, according to Keynes, assumed that adjustment in three variables would generate economic recovery from recessions. Classical economists asserted that during times of inventory recession wages, interest rates, and prices would all fall and return the economy to high production and full employment. Keynes said this might be true sometimes, but a more general theory would have to consider cases where this would not occur. Let's look at each variable separately.

First, it is certainly true that wages will fall with high unemployment, but this fall might well be accompanied by expectations of a further fall in wages. If firms expect a further fall in wages, they might very well hold off on their investment plans. The reason is simple. Falling wages and prices in the future meant that the medium to long term stream of nominal profits from investment would also be lower. This would lower the nominal MEC and hence reduce investment. Only if the nominal interest rate fell sufficiently would there be any reason for investment to increase. In general, falling wages accompanied by an expectation of further falls in wages would dampen investment and lead to a reduction in aggregate demand. Falling wages would not lead to increased employment and general. Only in the special case where the fall in wages was expected to halt or reverse its course, or the nominal interest rate fell sufficiently, would there be a rise in investment and an increase in production and employment. (See Chapter 11 and 19 of the GT)

Second, a reduction in the interest rate, due to excessive household saving and an "over-production" of consumer goods, was thought by Classical theorists to raise investment demand and revive the economy by increasing the production of capital goods, machines, structures, and the like. Keynes asserted that this was only true if saving and investment alone determined the interest rate. He pointed out that this was a special and unrealistic assumption. It was more likely that output would adjust downwards, rather than the interest rate, if there were excessive saving. Furthermore, investment demand would most likely shrink even as the interest rate fell, with the result that the quantity of investment might also fall. (See Chapter 14 and Keynes' only use of a graph in the GT)

Finally, falling prices during an inventory recession might not increase spending and return the economy to a position of full employment. Certainly falling prices increase the real stock of money and thus place pressure on the interest rate to fall. However, Classical economists made the special assumption that the rate of interest would always fall sufficiently to restore full employment. Keynes declared that if there was a liquidity trap or if investment demand collapsed due to falling prices and a loss of confidence, it might be impossible for the interest rate to fall below a certain level. Arthur Cecil Pigou later countered Keynes theory by declaring that falling prices would generate a real balance effect which would stimulate consumption and hence aggregate demand. (See Chapter 17 of GT for Keynes on the liquidity trap)

According to Keynes, Classical theory was not illogical. For him, the trouble with Classical thought was that it relied too heavily on very special and unrealistic assumptions, thus rendering it largely irrelevant.


At Wednesday, November 30, 2005 8:17:00 AM, Anonymous Street Strategist said...

Let me share my view: The general theory is general because for the first time one theory accounts for non-monetary factors and monetary factors.

At Thursday, December 01, 2005 4:30:00 AM, Blogger David Kleykamp said...

Thanks to the Street Strategist for his input. However, I don;t believe that this was what made the General Theory general.

Donald Patinkin believed that Keynes theory was aimed at integrating real and monetary sectors but only succeeded after the publishing of his own work Money, Interest, and Prices. However, I think it is wrong to say that there were no theories that integrated real and monetary sectors before Keynes. Wicksell, Walras, Fisher and others had developed quite sophisticated theories that did this. These theories mainly lacked micro foundations, but that is true of Keynes work also. Keynes point was that classical theories failed because they were built on highly specialized assumptions--assumptions which did not fit the facts.

At Wednesday, January 25, 2006 1:39:00 AM, Anonymous Anonymous said...

What makes the GT GENERAL is Keynes's generalization of the neoclassical,necessary,first order condition for a maximum in the theory of purely competitive firms.The neoclassical condition is w/p=mpl,where w=the money wage,p=the price leval,and mpl is the marginal product of labor.This becomes w/p=mpl/(mpc+mpi),where mpc is the marginal propensity to consume and mpi is the marginal propensity to invest.Only in the case where mpc+mpi=1 does the special neoclassical thoery hold.

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