The General Theory of Employment, Interest and Money
The General Theory of Employment, Interest and Money is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision-making.
Keynes denied that an economy would automatically adapt to provide full employment even in equilibrium, and believed that the volatile and ungovernable psychology of markets would lead to periodic booms and crises. The General Theory is a sustained attack on the classical economics orthodoxy of its time. It introduced the concepts of the consumption function, the principle of effective demand and liquidity preference, and gave new prominence to the multiplier and the marginal efficiency of capital.
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 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 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 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".Stickiness of wages in money terms
Say's law depends on the operation of a market economy. If there is unemployment 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 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' = W/p, where y is the real output when employment is N, and W and p are the wage rate and price rate in money terms. A system can be analysed on the assumption that W is fixed or that W/p is fixed or that N is fixed. 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, and the consequences of this had not 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 instance of wages being fixed in real terms. He attributes the second postulate to the classics subject to the qualification that unemployment may result from wages being fixed by legislation, collective bargaining, or 'mere human obstinacy', all of which are likely to fix wages in money terms.
Outline of Keynes's theory
Keynes's economic theory is based on the interaction between demands for saving, investment, and liquidity. 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 relation 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 maintain 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 supply of money, and that it cannot adjust 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.
Book II: Definitions and ideas
The choice of units
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, 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 : to be precise, a value in wage units is equal to its price in money terms divided by W, the wage 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.
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.
Expectations as determining output and employment
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 "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 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.