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MR. KEYNES AND THE NEOCLASSICS: A REINTERPRETATION
George H. Blackford, Ph.D.
(Last updated: 9/25/2020)
Keywords: Keynes, Keynesian, Causality, Methodology, Macroeconomics, Neoclassical
Economics
JEL Codes: B22, B40, E12, E13
Abstract
A model of Keynes’ integration of monetary and value
theory that incorporates the price of non-debt assets
as well as the prices of consumption and investment
goods is specified below. This model is used to ex-
plain how Keynes’ short- and long-run equilibriums
are obtained. It is demonstrated that the Keynesian
IS/LM model is a special (static) case of this model,
and that the Marshallian roots of Keynes’ model
makes a causal analysis of dynamic behavior possible
while the Walrasian roots of the neoclassical Keynes-
ian model only allow for a description of dynamic be-
havior without explanation other than through the in-
vocation of a mythical auctioneer.
Chapter 6:
Mr. Keynes and the NeoClassics:
A Reinterpretation
Keynes summarized the independent and de-
pendent variables in the analytical framework he de-
veloped throughout The General Theory at the begin-
ning of Chapter 18. He then outlined the aggregate
model embodied in this framework as follows:
[W]e can sometimes regard our ultimate independent
variables as consisting of (1) the three fundamental psy-
chological factors, namely, the psychological propensity
to consume, the psychological attitude to liquidity and
the psychological expectation of future yield from capi-
tal-assets, (2) the wage-unit as determined by the bar-
gains reached between employers and employed, and (3)
the quantity of money as determined by the action of the
central bank; so that, if we take as given the factors
specified above, these variables determine the national
income (or dividend) and the quantity of employment.
But these again would be capable of being subjected to
further analysis, and are not, so to speak, our ultimate
atomic independent elements. (p. 246-7) 1
In order to derive the behavioral equations of the
model described by Keynes in this paragraph it is nec-
essary to express its variables in terms of Keynes’ cho-
sen units of measurement. It is also necessary to in-
corporate the crucial role played by expectations in
Keynes’ general theory in determining causality as the
system changes through time.
1 See also Keynes (1936, p. 247):
178 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
B-a. Keynes’ Aggregate Model The analytical framework developed by Keynes
throughout The General Theory makes use of but two
units of measurement: money and the labor-unit
where Keynes defined the labor-unit as “an hour’s
employment of ordinary labour” (1936, p. 41).
Behavioral Equations In specifying the behavioral equations of Keynes’
model in terms of money and labor units we begin by
a) dividing the money values of the rates at which
consumption ( ) and investment goods (
) are
produced by what Keynes defined as the wage-unit
( )—that is, “the money-wage of a labour-unit”
(1936, p.41)—in order to express the rates at which
consumption ( ) and investment ( ) goods are pro-
duced in ‘wage-units’ and b) summing to obtain the
aggregate level of output/income measured in wage-
units ( ):2
,
where and
are the aggregate rates of con-
sumption and investment goods production
measured in hours of ordinary labor per unit of
time,3 and and
are the (complexes of the
2 This specification does not presume homogeneous consumption or
investment goods. Any number of consumption and investment goods
can be aggregated in this way. 3 It is rather misleading to refer to Keynes’ wage-unit measure as
“constant-wage-unit dollars” as Hansen did in 1953 (p. 44). When the
value of a flow variable such as consumption, investment, income, or
labor which are measured in money-units/time-unit (e.g., dollar/year)
is divided by Keynes’ wage-unit which is measured in money-
units/labor-unit (e.g., dollars/hour-of-ordinary-labor) the money-units
cancel and we are left with labor-units/time-unit or hours of ordinary
labor per unit of time (e.g., (dollar/year)/(dollars/hour-of-ordinary-
App..B Mr.-Keynes-and-the-NeoClassics 179
various) prices of and , respectively.4
Similarly, the “psychological attitude to liquidity”
is embodied in Keynes’ liquidity-preference/money-
demand function and is assumed to be an inverse
function of the (complex of the various) rate(s) of in-
terest ( ) and a direct function of income measured
in wage-units :
,
,
where is the nominal value of the stock of
money demanded divided by the wage-unit
which measures the value of the stock of
money demanded in terms of hours of ordi-
nary labor.5
labor) = hour(s)-of-ordinary-labor/year). Similarly, when a stock
variable such as debt, non-debt assets, or money which are measured in
money-units (e.g., dollars) is divided by Keynes’ wage-unit (e.g.,
dollars/hour-of-ordinary-labor) the money-units again cancel and we
are left with labor-units or hours of ordinary labor (e.g.,
dollars/(dollars/hour-of-ordinary-labor) = hour(s)-of-ordinary-labor).
As a result, money-units (e.g., dollars), constant or otherwise, cancel
and are not part of the unit of measurement when a quantity is
measured in wage-units. It must be noted, however, that since Keynes’
measure presumes that “different grades and kinds of labour … enjoy a
more or less fixed relative remuneration” it is not clear that Keynes’
measure is superior to the constant-dollar measure of neoclassical
economics in light of the changes in relative remunerations for various
kinds of labor that have occurred over the past fifty-odd years. See
Piketty (Chap. 9) and Blackford (2018, pp. 1-9, 279). 4 The complex of prices are treated in what fallows in the same way
Keynes dealt with the complex of interest rates (1936, pp. 28, 137n,
143, 167n, 168-9, 205-6). 5 Keynes argued in The General Theory (p. 304) that the demand for
money is a function of effective demand (22), and in his 1938
attempt to clarify the nature of the demand for money and its
relationship to ‘finance’ Keynes argued that the demand for money is
also “a function of income and of business habits” (1938, p. 321-2).
Since effective demand is only related to producers’ demands for
money and is not related to the demands of purchasers, I believe that
180 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
Since Keynes simply assumed the stock of money
in existence is exogenously “determined by the action
of the central bank” in his summary above, it is as-
sumed here that the quantity of money supplied
measured in wage-units ( ) is given by the exoge-
nously determined nominal value of the stock of mon-
ey in existence ( ) divided by the money wage :
,
where is the exogenously determined stock
of money in existence measured in terms of
hours of ordinary labor.
It is also assumed that the existing stock of non-
debt assets ( ) is exogenously determined. This stock
measured in wage-units ( ) is given by:
,
where is the (complex of the various) price(s)
of non-debt assets. The demand for non-debt
assets measured in wage-units ( ) is assumed
to be inversely related to the price of non-debt
assets and the rate of interest :
.
It is also instructive for expository purposes to
specify the non-debt asset equilibrium function in this
model even though Keynes did not discuss this rela-
the best way to incorporate these two aspects of Keynes understanding
of the demand for money is to assume that the demand for money is a
direct function of value of output/income (1), which is related to
the demands of both produces and purchasers, and to assume that
changes in effective demand (22) have the effect of shifting the
demand for money function (2) by way of changes in the
demand for ‘finance’. Cf., Davidson, Bibow (1995), and Keynes
(1937b).
App..B Mr.-Keynes-and-the-NeoClassics 181
tionship. This function can be obtained by setting the
supply of non-debt assets (4) equal to the demand for
non-debt assets (5),
,
and solving for the price of non-debt assets as
a function of the rate of interest and stock of
non-debt assets :
.
The “psychological expectation of future yield
from capital assets” is embodied in Keynes’ Marginal
Efficiency of Capital (MEC) schedule which is, in ef-
fect, the investment goods equilibrium function.
Keynes defined this schedule as: “The relation be-
tween the prospective yield of a capital-asset and its
supply price or replacement cost” and argued that
“the rate of investment will be pushed to the point on
the investment demand-schedule where the MEC in
general is equal to the market rate of interest.” (1936,
pp. 135-6)
If it is assumed that the supply price of invest-
ment goods ( ) is a direct function of the rate of in-
vestment goods production measured in wage-units
the supply price of investment goods
can be
written as:
.
If it is also assumed that the demand price of in-
vestment goods ( ) is an inverse function of
the rate of investment goods production and
the rate of interest and a direct function of the
price of non-debt assets (Keynes, 1936, p.
151) the demand price of investment goods
can be written as:
.
182 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
Keynes’ MEC schedule can then be obtained by equat-
ing the supply price of investment goods (8) and
demand price of investment goods (9) to obtain:
,
and solving for Keynes’ MEC schedule, that is,
the relationship between the rate of investment
goods demanded and the rate of interest
such that “the MEC in general is equal to the
market rate of interest:”
,
where denotes Keynes’ MEC function, and
is the rate at which investment goods are de-
manded at each rate of interest given the ex-
ogenously determined stock of non-debt assets
and the prices of investment goods
and
non-debt assets as determined by the sup-
plies and demands in the markets for investment
goods and non-debt assets, (8), (4), (9), and (5),
respectively.
The “psychological propensity to consume” is em-
bodied in Keynes’ consumption function (i.e., the con-
sumption goods equilibrium function) which can be
derived in a manner parallel to the derivation of
Keynes’ MEC schedule. If it is assumed that the sup-
ply price of consumption goods ( ) is a direct func-
tion of the rate of consumption goods production
the supply price of consumption goods can be
written as:
.
If it is also assumed that the demand price of
consumption goods ( ) is an inverse function
of the rate of consumption goods production
and a direct function of the level of income
App..B Mr.-Keynes-and-the-NeoClassics 183
the demand price of consumption goods can
be written as:
.
Keynes’ consumption function can then be ob-
tained by equating the supply price of consump-
tion goods (12) and the demand price of con-
sumption goods (13),
,
and solving for the demand for consumption
goods as a function of output/income
:
,
where denotes Keynes’ aggregate consumption
function, is the rate of consumption goods
demanded at each level of output/income
given the price of consumption goods as de-
termined in the market(s) for consumption
goods, and it is assumed that the Marginal Pro-
pensity to Consume (MPC) lies between zero
and one. Thus, Keynes’ aggregate savings func-
tion (s) is given by:
,
and (15) and (11) imply that Keynes’ aggregate
demand function can be written as:
,
where is the aggregate demand for con-
sumption plus investment goods measured in
wage-units. 6
6 It should be noted that any number of individual consumption or
investment goods can be aggregated in this way and that to simplify the
exposition it is assumed that net income is a unique function of gross
income in what follows. See Keynes (1936, chs. 4, 8).
184 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
To complete Keynes’ aggregate model it is neces-
sary to explain the relationship between the level of
employment and effective demand where Keynes de-
fined effective demand as the point at which the “en-
trepreneurs’ expectation of profits will be maximized”
(1936, p. 25). Keynes explained this relationship in
Chapter 20 in terms of his employment function:
In Chapter 3 we have defined the aggregate supply func-
tion Z = φ(N), which relates the employment N with the
aggregate supply price of the corresponding output. The
employment function only differs from the aggregate
supply function in that it is, in effect, its inverse function
and is defined in terms of the wage-unit; the object of
the employment function being to relate the amount of
the effective demand, measured in terms of the wage-
unit, directed to a given firm or industry or to industry as
a whole with the amount of employment, the supply
price of the output of which will compare to that amount
of effective demand. Thus, if an amount of effective
demand Dwr, measured in wage-units, directed to a firm
or industry calls forth an amount of employment Nr in
that firm or industry, the employment function is given
by Nr= Fr(Dwr). Or, more generally, if we are entitled to
assume that Dwr is a unique function of the total effec-
tive demand Dw, the employment function is given by
Nr= Fr(Dw). (1936, p. 280)
Thus, if we assume the rates at which labor is de-
manded measured in wage-units in the investment
and consumption-goods industries are direct func-
tions of the effective demands for investment ( )
and consumption ( ) goods measured in wage-units
in each of these industries we can write the demand
for labor measured in wage-units in the investment-
goods industries ( ) as:
,
App..B Mr.-Keynes-and-the-NeoClassics 185
where the value of is expressed in terms of
hours of ordinary labor per unit of time. Simi-
larly, the demand for labor measured in wage-
units in the consumption-goods industries
( ) is given by:
.
And “if we are entitled to assume that [employ-
ment in each firm or industry] is a unique func-
tion of the total effective demand” (18) and (19)
imply that Keynes’ aggregate employment func-
tion can be written as: 7
,
where is the aggregate effective demand as
given by the sum of and
:
.
And since the “employment function only differs
from the aggregate supply function in that it is,
in effect, its inverse and is defined in terms of
the wage-unit,” the inverse of (20) yields
Keynes’ aggregate supply function defined in
terms of wage-units:
,
“which relates the employment [ ] with the
aggregate supply price [ ] of the correspond-
ing output [ ]”
) measured in
wage-units (Cf., Brady.). And since output is
determined by effective demand (=
) the
7 Since the aggregate employment function is defined in terms of
wage-units net of user cost, both and
define the number of
hours-of-ordinary-labor/time-unit needed to satisfy . Thus,
=
and
= which implies that . See footnote
3 above and Keynes (1936, p. 55n).
186 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
inverse of Keynes’ aggregate employment func-
tion (20) allows us to write Keynes’ aggregate
demand function as:
,
where denotes the aggregate demand at
each level of employment (both measured in
wage-units) given the rate of interest R and price
of non-debt assets , and, by definition,
is
equal to .8
Dynamic Adjustment Functions In specifying the dynamic adjustment functions
that determine the behavior of the individual varia-
bles in Keynes’ aggregate model it is assumed that
demanders and suppliers of money adjust the rate of
interest to equate the demand for money (2)
to the existing stock (supply) of money (3) (both
measured in wage-units) in accordance with what
Leijonhufvud (pp. 61-77) referred to as Marshall’s
“laws of motion”:
,
where is the time derivative operator d (=d/dt) applied to , and the time derivative
function (as well as the time derivative func-
tions specified below) is (are) assumed to in-
crease monotonically through the origin.9
It is also assumed that demanders and suppliers
8 See footnote 3 and 7 above. 9 It should be noted that the time derivative functions in this model are
not assumed to be continuous, well-behaved mathematical functions
though for ease of exposition they will be treated as such. See Hayes,
Brady, Leijonhufvud (pp. 61-77), Marshall, and Keynes (1936).
App..B Mr.-Keynes-and-the-NeoClassics 187
of non-debt assets adjust the price of non-debt assets
to equate the demand for non-debt assets
(5)
to the existing stock of non-debt assets (4):
.
Next it is assumed that producers in the invest-
ment- and consumption-goods industries adjust their
expectations to equate the effective demands for con-
sumption and investment
goods to the actual
demands for these goods as defined by the inverses of
(13) and (9):
,
as they adjust the rates of consumption and
investment goods production to their respec-
tive effective demands:
,
and that suppliers and demanders in the mar-
kets for investment and consumption goods ad-
just the prices of investment and consump-
tion goods to equate the supply prices
,
(8), (12) and demand prices ,
(9), (13) of
these goods:
,
.
Finally, it is assumed that the producers adjust
aggregate employment to equate the aggregate
188 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
supply of output (22) and the aggregate effective
demand for output (21): 10
,
as the effective demand for output (21) ad-
justs to the actual demand for output ( )
by way of the identity:
,
and that aggregate output/income adjusts by
way of the identity:
.
Structure of Keynes’ Aggregate Model The adjustment functions (24) - (34) define the
way in which changes in eleven endogenous variables
are determined in Keynes’ aggregate model: , ,
,
, ,
, ,
, ,
, and . Since these
functions are assumed to pass through the origin the
system is in equilibrium in the sense that there is no
reason for any variable to change when all of the ad-
justment functions (24) - (34) are equal to zero. This
gives us eleven equilibrium conditions which contain
eleven behavioral variables and eleven endogenous
variables as summarized in Table 1.
This table outlines the mathematical structure of
the short-run aggregate model described by Keynes in
the passage quoted above. The equilibrium values of
10 Cf., Keynes: “the effects on employment of the realised sale-
proceeds of recent output and those of the sale-proceeds expected from
current input; and producers' forecasts are more often gradually
modified in the light of results than in anticipation of prospective
changes” (1936, p. 51).
App..B Mr.-Keynes-and-the-NeoClassics 189
the endogenous variables in this table are assumed to
be determined by the behavioral relationships defined
by the aggregate behavioral equations (1) - (23), given
the assumption that employment, output, and prices
are determined in accordance with the adjustment
functions (24) - (34) as the expectations of producers
adjust to the actual demands that exist in markets.
Table 1: Structure of Keynes’ Aggregate Model
Market Equilibrium Conditions
Behavioral Variables
Endogenous Variables
Assets =
=
,
,
Investment =
=
,
,
, ,
Consumption =
=
,
,
, ,
Labor =
Identities
The fundamental difference between the structure
of this model and that of the Walrasian paradigm of
neoclassical economics is that Keynes’ behavioral
equations are assumed to be consistent with Marshal-
lian supply and demand functions rather than the
Walrasian supply and demand functions assumed by
neoclassical economists. (Cf., Marshall; Brady; Hayes;
Clower; Leijonhufvud.) They are presumed to be de-
termined by the optimizing behavior of decision-
making units as they interact in markets, just as
Walrasian supply and demand functions are pre-
sumed to be determined by optimizing behavior. The
difference is that in Keynes’ understanding of these
functions they are specified by isolating those factors
that are perceived to have a direct effect on the will-
ingness of buyers and sellers to buy and sell in indi-
190 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
vidual markets whether the system as a whole is in
equilibrium or not without assuming that these choic-
es are constrained by an arbitrary Walrasian budget
constraint. Instead, they are derived by observing the
actual behavior of decision-making units in markets,
hypothesizing with regard to the motivations of these
units given their expectations with regard to those
magnitudes that affect their choices directly in each
individual market, and then reasoning through the
logical implications of what the actual choices availa-
ble to decision-making units and their motivations
and expectations imply with regard to their willing-
ness to buy and sell in individual markets. (Cf., Black-
ford, 1975; 1976; Clower.) As a result, even though the
set of equilibrium conditions specified above when
taken together define a general equilibrium of the sys-
tem as a whole they are the product of a partial equi-
librium analysis of individual markets rather than the
product of a general equilibrium analysis as such
(Marshall, 1961, Books III-IV; cf., Keynes, 1936, Books
III-IV; Hayes; Brady)
It should also be noted that the supply and de-
mand for loanable funds are not independent behav-
ioral functions in this model. In a world in which de-
cision-making units do not go into debt simply for the
sake being in debt—a world in which debt, in itself,
offers no satisfaction or utility—there must be a de-
mand for money for some reason other than the satis-
faction of being in debt before there can be a willing-
ness to borrow money. Thus, it is assumed that deci-
sion-making units borrow money only to meet their
financial needs for money. Similarly, it is assumed
that decision-making units lend money only to dis-
pose of excess money balances they have no use for
App..B Mr.-Keynes-and-the-NeoClassics 191
otherwise or in the case of trade credit to provide the
money needed to facilitate current transactions. This
makes the supply and demand for loanable funds ex
post functions, determined within the system by the
supply and demand for money as dictated by the de-
sired transactions of decision-making units as deter-
mined by the behavioral equations of the model. As a
result, there are no redundant equations in the model
outlined in Table 1, and Walras’ Law—a law that can
only be enforced by a mythical auctioneer—has no
relevance in this model, just as it has no relevance in
Keynes’ general theory or in the real world. (Cf.,
Clower; Blackford, 1975; 1976.)11
Short-Run Equilibrium The way in which the short-run equilibrium val-
ues of the variables in the model are determined by
supply and demand in individual markets and the
ways in which the markets are interconnected as
summarized by Keynes’ MEC (11), consumption (15),
and the asset market equilibrium (7) functions are il-
lustrated in Figure 1 in that: 12
1. Given the rate of interest R and price of non-debt
assets the equilibrium price and rate of in-
11 This does not mean that the system-wide consistency requirements
that Lavoie and Godley (p. 14) examined are violated. It only means
that there is no reason to believe that at any given point in time the
excess demands in the model sum to zero. 12 For a detailed discussion of the way in which equilibrium is defined
and achieved in the works of Marshall, Keynes, and neoclassical
economists see Hayes (2006), Kregel, and Lavoie and Godley. The
focus of this paper is on the relationship between partial-equilibrium
and what Hayes refers to as “system” equilibrium and “the dynamic
process of convergence in which a series of positions of short-period
equilibrium trace a path towards a position of long-period equilibrium
in Keynes’s sense” (2006, pp. 3-9). See Kregel, and Lavoie and
Godley.
192 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
vestment goods production are determined in
panels (A) and (B) by demanders and suppliers of
investment goods as given by the inverses of the
demand price (9) and supply price
(8) of investment goods functions in pan-
el (B) from which Keynes’ MEC schedule
in panel (A) is derived.
Figure 1: Short-Run Equilibrium.
2. Given the equilibrium rate of investment the
value of output/income is determined by savers
and investors in accordance with Keynes’ savings
function (16) in panel (C) which is implied
by Keynes’ consumption function (15) in
panel (F).
3. Given output/income the equilibrium rate of
interest R is determine by the demanders and
suppliers of money as dictated by the demand
(2) and supply (3) of money func-
App..B Mr.-Keynes-and-the-NeoClassics 193
tions in panel (D), and the equilibrium price
and rate of consumption goods production are
determined in panels (E) and (F) by the demand-
ers and suppliers of consumption goods as given
by the inverses of the demand price
(13) and supply price (11) of consumption
goods functions in panel (E) from which Keynes’
consumption function (15) in panel (F) is
derived.
4. Given the rate of interest the equilibrium price
of non-debt assets is determine in panels (G)
and (H) by the demanders and suppliers of non-
debt assets as given by the supply of non-debt as-
sets (4) and the inverse of the demand for
non-debt assets (5) functions in panel
(H) from which the non-debt asset equilibrium
function (7) in panel (G) is derived.
5. Given the rate of interest R and the price of non-
debt assets the point of effective demand
and equilibrium rate of employment are deter-
mined by producers at the intersection of Keynes’
aggregate supply (22) and demand
(23) schedules in panel (I).
But what is most significant about the model em-
bodied in equations (1) through (34) above is that it
formalizes the analytical framework develop by Keynes
throughout The General Theory—a framework with-
in which a causal analysis of the dynamic behavior of
the economic system is possible.
Causality in Keynes’ Aggregate Model As is indicated in Figure 1, rather than view the
economic system from the perspective of a set of
194 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
Walrasian simultaneous equations Keynes viewed the
system from the perspective of a set of Marshallian
partial equilibrium models in which the values of in-
dividual variables are determined by the choices of
those decision-making units that actually have the
power to determine the value of each variable at each
point in time as the system evolves through time.
(Cf., Bibow, 2000a; 2001; Brady; Hayes.) According-
ly, given the wage unit and those factors that are sub-
sumed in the functional form of the MEC, consump-
tion, liquidity preference, money supply, and em-
ployment functions (Keynes, 1936, pp. 245-7):13
1. The prices and rates of production and sale of
goods and resources along with the price of non-
debt assets (i.e., the complex of prices of goods, re-
sources, and real and financial non-debt assets) is
(are) determined through the interactions of sup-
pliers and demanders in the markets for goods, re-
sources, and non-debt assets.
2. The rate of interest (i.e., the complex of rates of
interest on new loans and debt assets) is (are) de-
termined by the suppliers and demanders for
money (i.e., liquidity) in the money market.
13 The fact that the wage-unit, money supply, and other exogenous
variables and parameters are assumed to be given does not mean that
these factors do not change. It only means that the effects of changes in
these factors can either be ignored in considering the problem at hand
or that they are not determined in a systematic way within the system
such that their effects must be examined separately. See Keynes (1936,
p. 245-7) and sections III and VI below.
It should also be noted that Keynes defined the “daily” decisions of
produces in terms of “the shortest interval after which the firm is free to
revise its decision as to how much employment to offer. It is, so to
speak, the minimum effective unit of economic time” (1936, p. 47n).
App..B Mr.-Keynes-and-the-NeoClassics 195
3. Employment is determined by producers in ac-
cordance with their effective demands—that is, the
rate at which producers expect to maximize their
profits.
4. The income (i.e., the value of output produced) is
determined by savers and investors as they inter-
act in the markets for consumption and invest-
ment goods.
5. And the entire process by which these variables are
determined at each point in time is governed by
the expectations of decision-making units as their
expectations adjust to the realized results that are
achieved within the system as the system evolves
through time.
These assumptions made it possible for Keynes to
isolate those factors that directly and in themselves
determine each variable at each point in time whether
the system is in equilibrium or not. This makes it
possible to establish the temporal order in which
events must occur as the system responds to changes
in the exogenous determinants of the variables in
each sector of the economy. This, in turn, makes it
possible to separate cause and effect within the ana-
lytical framework developed by Keynes throughout
The General Theory which makes a causal analysis of
dynamic behavior possible in Keynes’ general theory.
(Cf., Lavoie and Godley.)
Consider, for example, a ceteris paribus increase
in the MEC brought about by an optimistic shift in
long-term expectations in a situation in which there
are unemployed resources in the system. How will
this affect the short-run equilibrium position of the
economic system shown in Figure 1, and how will
196 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
the new short-run equilibrium come about?
The direct effects of a ceteris paribus increase in
the MEC will be to increase the MEC curve
(11) in panel (A) of Figure 1 and the demand for in-
vestment goods curve (9) in panel (B)
while leaving the other curves in this figure un-
changed. The resulting excess demand for investment
goods will cause an increase in the demand for money
(2) in panel (D) as the demand for invest-
ment finance increases in response to the increase in
the demand for investment goods . The resulting
excess demands for money will, in turn, cause the rate
of interest R to increase in accordance with (24), and
as the increase in the demand for investment goods is
financed the resulting excess demand for investment
goods will cause the price of investment goods to
increase in accordance with (30).14 As Producers’ ef-
fective demands for investment goods adjust to
the actual demand for investment goods in ac-
cordance with (27) the level of investment goods pro-
duced in panel (B) will increase in accordance with
(29).15 At the same time there will be a concomitant
14 Note that the initial excess demands for money and investment goods
are not associated with an excess supply in any other part of the system.
There is no reason to believe that Walras’ Law holds at any point in
time as the system moves from one point of equilibrium to another
through time in this model, but there is reason to believe that the
increase in the rate of interest R and price of investment goods will
subsequently cause changes in the rest of the system. Cf. Blackford
(1975; 1976) and Clower. 15 Cf., Keynes:
There will be an inducement to push the rate of new investment to
the point which forces the supply-price of each type of capital-
asset to a figure which, taken in conjunction with its prospective
yield, brings the marginal efficiency of capital in general to
approximate equality with the rate of interest. That is to say, the
App..B Mr.-Keynes-and-the-NeoClassics 197
increase in aggregate demand (23) in
panel (I) as the effective demand for output ad-
justs to the actual demand for output in accord-
ance with (33) and employment and out-
put/income increase in accordance with (32) and
(34).
These effects on , , , and caused by the
optimistic shift in long-term expectations will be in-
hibited to some extent by the concomitant increase in
the rate of interest R which will inhibit the increase in
the demand for investment goods (9)
in panel (B). In addition, this effect of the increase in
the rate of interest R will be enhanced by the continu-
ing rise in demand for money (2) in panel
(D) that results from the increase in the transactions
demand for money as output/income increases.
The increase in the rate of interest R will also cause a
fall in the demand for non-debt assets (5)
in panel (H). The resulting excess demand for non-
debt assets will cause the price of non-debt assets
to fall in accordance with (25) which will also inhibit
the effects of the optimistic shift in long-term expecta-
tions on , , , and by further inhibiting the
increase in investment demand (9) in
panel (B) and the increase in the MEC (11) in
panel (A).
At the same time the increase in the value of ag-
gregate output/income that results from the in-
physical conditions of supply in the capital-goods industries, the
state of confidence concerning the prospective yield, the
psychological attitude to liquidity and the quantity of money
(preferably calculated in terms of wage-units) determine, between
them, the rate of new investment. (1936, p. 248)
198 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
crease in the output of investment goods will have
the effect of increasing the demand for consumption
goods (13) in panel (E). This, in turn,
will set in motion a causal feedback loop within the
system (the multiplier) as the excess demand for con-
sumption goods that results causes an increase in the
price of consumption goods in panel (E) in accord-
ance with (28), and as the effective demand for con-
sumption goods adjusts to the actual demand for
consumption goods in accordance with (26) pro-
ducers will increase the output of consumptions goods
in accordance with (29) which will further in-
crease the aggregate demand (23) in
panel (I) which will cause a further increase aggregate
effective demand , aggregate employment , and
output/income in accordance with (33), (32) and
(34), respectively.
The increase in aggregate output/income
caused by the increase in consumption goods pro-
duced will cause a further increase in the price
and output of consumption goods which will cause
a further increase in employment , output/income
, and the demand for money which will
cause a further increase in the rate of interest R and
fall in the price of non-debt assets which will fur-
ther inhibit the increase in investment as effective
demand , employment , output/income , and
the price and rate of consumption goods produc-
tion increase. This causal loop will continue until
system has achieved the short-run system equilibrium
depicted in Figure 2 where the price of investment
goods, rate of interest, output/income, employment,
consumption, and the price of consumption goods
have increased from , , R, , , , , and
App..B Mr.-Keynes-and-the-NeoClassics 199
to *, *, *, *, *, *, *, and * in this
ceteris paribus situation while the price of non-debt
assets falls from to *.16 (Cf., Keynes, 1936, pp.
48-50, 247-9; Kregel, pp. 215-6; Hayes.)
Figure 2: Achieving Short-Run Equilibrium.
It is worth reemphasizing at this point that what
makes this kind of causal analysis of the dynamic be-
havior possible as the system movers from one point
of short-run equilibrium to another is Keynes’ use of
16 The only reason the price of non-debt assets can be seen to fall in
this situation is that it is assumed that the optimistic shift in long-term
expectations does not have a positive effect on the demand for non-debt
assets (5) in panel (H). If it were to have a positive effect
on the demand for non-debt assets the resulting increase in
the price of non-debt assets in panel (H) would simply enhance the
positive effect of the increase in optimism on the MEC (11) in
panel (A) and the demand for investment goods (9) in
panel (B), and the ultimate direction of change in the price of non-debt
assets would be indeterminate depending on the relative effects of the
increases in optimism and the rate of interest R on the demand for non-
debt assets in panel (H).
200 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
the Marshallian ceteris paribus, partial-equilibrium
methodology of supply and demand to establish those
factors that determine the value of each variable in the
system at each point in time whether the system as a
whole is in equilibrium or not. As was noted above, it
is this that makes it possible to establish the temporal
order in which events must occur which is the sine
qua non of establishing causality.17 (Hume, Blackford
2020c, ch. 2)
Long-Run Equilibrium In specifying Keynes’ short-run equilibrium mod-
el above the stock of non-debt assets is assumed to
be exogenously determined, but positive net invest-
ment must, by definition, increase over time.
17 Cf., Keynes:
A monetary economy, we shall find, is essentially one in which
changing views about the future are capable of influencing the
quantity of employment and not merely its direction. But our
method of analysing the economic behaviour of the present under
the influence of changing ideas about the future is one which
depends on the interaction of supply and demand, and is in this
way linked up with our fundamental theory of value. (1935, p. vii)
And:
We can consider what distribution of resources between different
uses will be consistent with equilibrium under the influence of
normal economic motives in a world in which our views
concerning the future are fixed and reliable in all respects;—with a
further division, perhaps, between an economy which is
unchanging and one subject to change, but where all things are
foreseen from the beginning. Or we can pass from this simplified
propaedeutic to the problems of the real world in which our
previous expectations are liable to disappointment and
expectations concerning the future affect what we do to-day. It is
when we have made this transition that the peculiar properties of
money as a link between the present and the future must enter into
our calculations. But, although the theory of shifting equilibrium
must necessarily be pursued in terms of a monetary economy, it
remains a theory of value and distribution and not a separate
'theory of money'. (1936, pp. 293-4)
App..B Mr.-Keynes-and-the-NeoClassics 201
While the effects of this increase can be assumed to be
insignificant in the short run, Keynes argued that the-
se effects can be dramatic in the long run. (1936, p.
217-8) Specifically, he argued that the “position of
[long-run] equilibrium, under conditions of laissez-
faire, will be one in which employment is low enough
and the standard of life sufficiently miserable to bring
savings to zero.” (1936, p. 217-18)
The nature of this long-run equilibrium can be
demonstrated in the model specified above by explic-
itly including the stock of non-debt assets among
the independent variables of the supply-price func-
tions for investment (8) and consumption (12) goods.
In addition, noting that “an increased investment in
any given type of capital during any period of time the
marginal efficiency of that type of capital will diminish
as the investment in it is increased” (Keynes, 1936, p.
136) it is also necessary to explicitly include the stock
of non-debt assets in the demand-price of invest-
ment goods function (9) as well. Accordingly, (8), (9),
(11), (12), (15), and (16) are respecified as:
where the respecified MEC function (11a) and
consumption function (15a) are derived by sub-
stituting (8a), (9a), (12a) into (10) and (14) and
solving for and
. Given (11a) and (15a)
the aggregate demand function (23) becomes:
202 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
.18
Given these extensions of the model the mecha-
nisms by which an increase in the capital stock leads
to Keynes’ long-run equilibrium can be demonstrated
by examining the effects of a ceteris paribus increase
in the stock of non-debt assets from to * in pan-
el (H) of Figure 3.
Figure 3: Toward Long-Run Equilibrium.
As the stock of non-debt assets increases the
direct effect is an excess supply of non-debt assets in
panel (H) that leads to a fall in the price of non-debt
assets in accordance with (25) which combined
with the increase in will cause a fall in the MEC
schedule (11a) in panel (A) and in the
demand for investment goods curve (9a) in panel (B). The resulting excess supply of in-
vestment goods in the market for investment goods
18 .The way in which changes in the money wage affect the system are
examined in section B-b below.
App..B Mr.-Keynes-and-the-NeoClassics 203
will lead to a fall in the price investment goods pro-
duced . As the effective demand for investment
goods adjusts to the actual demand for investment
goods in accordance with (27) the output of
investment goods will fall in accordance with (29) as
the aggregate effective demand for output adjusts
to the actual demand for output in accordance
with (33) causing the aggregate demand curve
(23a) in panel (I) to fall as aggregate
employment and output/income fall in accord-
ance with (32) and (33).
The fall in employment and output/income
will decrease the transactions demand for money
which will cause a fall in the demand for money
(1) in panel (D). The resulting excess
supply of money will cause a fall in the rate of interest
R in accordance with (24) which will mitigate the ef-
fects of the increased supply and price of non-debt as-
sets by increasing the demand for non-debt assets
(5) in panel (H) thereby preventing the
price of non-debt assets from falling by as much as
it otherwise would. The fall in output/income will
also cause a fall in the demand for consumption goods
curve (13) in panel (E). As the effective
demand for consumption goods adjusts to the ac-
tual demand for consumption goods in accord-
ance with (26) the output of consumption goods pro-
duced will fall in accordance with (28). This, in
turn, will cause a further fall in output/income and
consumption as the multiplier process works its
way through the system until system has achieved the
short-run system equilibrium depicted in Figure 3
where the price of non-debt assets, investment goods,
204 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
rate of interest, output/income, employment, con-
sumption, and the price of consumption goods have
fallen from , , , R, , , , and to *,
*, *, *, *, *, *, and * as the stock of
non-debt assets increases from to *.
The stock of non-debt assets must continue to
increase and the price of non-debt assets , the out-
puts of investment and consumption goods ,
and the level of employment , output/income ,
and the rate of interest R must continue to fall in this
ceteris paribus situation until the investment goods
demand function (11a) in panel (B)
has fallen to the point at which the level of investment
is just sufficient to replace the capital that is con-
sumed in the process of producing . At that point
the long-run equilibrium will have been achieved as
net investment will be zero and the stock of non-debt
assets will no longer increase.19
19 See Keynes (1936, pp. 27-32, 136, 211-15, 217-8, 228-31). These
results illustrate Keynes’ paradox of thrift and are contrary to those
obtained in Lavoie and Godley (LG) (pp. 117, 122, 229–32, 240, 422-
3). The fundamental difference between the model specified above and
that of LG is the model specified above assumes an increase in non-
debt assets lowers the MEC and ignores the effects of a change in
wealth on the propensity to consume while the LG model ignores the
effects of a change in non-debt assets on the MEC and assumes an
increase in wealth increases the propensity to consume. This issue is
empirical rather than theoretical, and is beyond the scope of this
appendix which is to explain Keynes’ model.
It is worth noting that Keynes (1936, pp. 218) argued that it would
be “an unlikely coincidence that the propensity to save in conditionsof
full employment should become satisfied just at the point where the
stock of capital reaches the level where its marginal efficiency is zero.”
It is also worth noting that the limiting factor is ultimately the point at
which the rate of interest is forced to zero after adjusting for risk and
the cost of bringing borrower and lender together, and this limit cannot
be overcome by Robertson’s “progressive increase in the supply of
App..B Mr.-Keynes-and-the-NeoClassics 205
B-b. Mr. Keynes and the ‘NeoClassics’ In one way or another, the equilibrium conditions
and behavioral equations of the aggregate model out-
lined in Table 1 have been at the center of neoclassi-
cal macroeconomics since Keynes published The Gen-
eral Theory of Employment, Interest, and Money or
at least since 1937 when John R. Hicks published his
iconic paper, Mr. Keynes and the ‘Classics’: A Sug-
gested Interpretation. (Patinkin, 1976, p. 1092) Dis-
putes have arisen with regard to the choice of units,
the choice of endogenous and exogenous variables
and parameters, the way in which the endogenous
variables are determined, the role played by expecta-
tions, the nature of the dynamic adjustment functions,
the appropriate specification of the behavioral equa-
tions, and the nature of the micro-foundations of this
model, but the general framework of the model is
more or less as outlined above. There is, however, a
fundamental difference between the way in which
Keynes viewed this model and the neoclassical under-
standing of it as exemplified by the analytical frame-
work within which Hicks chose to explain his inter-
pretation of Keynes and the classics.
Hicks’ Two-Good Model Hicks began his interpretation by assuming the
existence of two short-run production functions:
,
where C and I denote the output of consumption
and investment goods, and and denote the
input of labor devoted to the production of each
of these goods. He also assumed that the prices
money” (1936, p. 188). See Keynes ( 1936, pp. 216-9).
206 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
of consumption goods ( ) and of investment
goods ( ) are equal to their marginal costs:
0
0.
Hicks then argued that income earned in the
consumption goods sector ( ), income earned
in the investment goods sector ( ), and total in-
come ( ) can be written as:
= 0
,
and argued that if the stock of capital and the
money wage ( ) are exogenously determined
“once [ ] and [ ] are determined, [ ] and [ ]
can be determined.”20 (p. 148)
Having structured the problem of explaining the
level of employment (i.e., the sum of and ) in
this way Hicks offered his interpretation of the classi-
cal solution to this problem by adding the “Cambridge
Quantity equation” which assumes a proportional re-
lationship (k) between the exogenously determined
stock of money (M) and total income Y:
,
and concluded: “As soon as k is given, total In-
come is therefore determined.”21 (p. 149) He
20 I find Hicks' 1937 notation exceedingly difficult to work with and
have adopted a notation that I find more manageable. 21 This is decidedly not the way in which variables are ‘determined’ in
Keynes’ general theory. Variables are determined by the actions of
those decision-making units that actually have the power to determine
App..B Mr.-Keynes-and-the-NeoClassics 207
then argued that income earned in the produc-
tion of investment goods (= ) is a function
of the rate of interest:
,
and stated: “This is what becomes the marginal-
efficiency-of-capital schedule in Mr. Keynes’
work.” Next, Hicks added the saving/investment
equilibrium condition:
,
where savings is assumed to be a function s of
both total income Y and the rate of interest R.
After noting that: “Since Income is already de-
termined, we do not need to bother about insert-
ing Income here unless we choose,” he argued
that taking (42) - (44) “as a system … we have
three fundamental equations … to determine
three unknowns [ , , ] …. [ ] and [ ] can
be determined from [ ] and [ ]. Total em-
ployment, [ ] + [ ], is therefore determined.”
(p. 149)
Having outlined his interpretation of the classical
solution to the problem of explaining the level of em-
ployment in this way Hicks then offered his interpre-
tation of Keynes’ solution to this problem by replacing
the Cambridge equation (42) in the classical model
with Keynes’ liquidity preference equilibrium condi-
tion:
.
He then argued that income earned in the pro-
variables as they interact in markets in Keynes’ general theory not by
mathematical equations. Keynes viewed the determination of variables
as an economic problem, not a mathematical problem. See Keynes
(1936, pp. 23-35, 46-7, 245-55, 257-71, 280-91, 297-8).
208 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
duction of investment goods should be a func-
tion of both the rate of interest R and total in-
come Y and replaced his classical version of
Keynes’ MEC schedule (43) with:
.
Equations (44) - (46) are central to Hicks' analyt-
ical framework in that (45) defines Hicks’ LM sched-
ule (those combinations of Y and R for which the
supply and demand for money are equal) and (44)
and (46) can be combined to obtain Hicks’ IS sched-
ule (those combinations of Y and R for which desired
saving and investment are equal):
.
Hicks used these two schedules to solve for the
rate of interest R and income Y the values of
which presumably make it possible to solve (35)
– (41) for , C, I, , , and in terms of
the exogenously determined money wage W and
stock of money M.
Keynesian One-Good Model Hicks’ model became the backbone of Keynesian
economics in the 1950s in the name of what Samuel-
son called the Neoclassical Synthesis. (Weintraub;
Zouache) In the process, Hicks’ two-good model was
converted to a one-good model by a) replacing the in-
dividual prices and with a single price (P), b)
replacing the individual levels of employment and
by a single level of employment (N), and c) replac-
ing equations (35) - (44) with their aggregate one-
good counterparts:
,
App..B Mr.-Keynes-and-the-NeoClassics 209
where is the aggregate output produced
, and is an aggregate production func-
tion.
These modifications greatly simplified the way in
which the short-run, static-equilibrium level of em-
ployment N could be explained in terms of the exoge-
nously determined money wage W and stock of mon-
ey M by reducing the number of variables to be solved
for from nine (Y, R, , C, I, , , , ) to six ( ,
Y, R, , P, N) which reduced the number of equa-
tions to six (45) – (50) as well. Once the IS (45) and
LM (47) equations are solved for Y and R in the
Keynesian one-good version of Hicks’ two-good model
it is only necessary to solve one equation (50) to ob-
tain N. Given N, P is implied by (49), (i.e., the
nominal value of investment, PI) by (46), and, by
(48), all in terms of the exogenously determined
money wage W and stock of money M. (Cf., Klein,
1966, pp. 59, 63, 73-5, 193-4; Patinkin, 1965; Ackley.)
Deriving Hicks’ Model from Keynes’ Model Setting aside units of measurement (one can mul-
tiply through by the wage-unit where appropriate
if one wishes), it is easily demonstrated that Hicks’
two-good model as outlined above (hence, the
Keynesian one-good model as well) can be derived
from Keynes’ model outline in Table 1 above by set-
ting Keynes savings function (16) equal to Keynes’
MEC function (11) to obtain Hicks’ IS savings/in-
vestment equilibrium condition:
.
Hicks’ LM monetary equilibrium condition is
implied by the assumption that when the system
is in equilibrium the quantity of money demand-
ed (2) in Keynes’ model must be equal to
210 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
the exogenously determined stock of money in
existence (3):
.
Given an exogenously determined money wage
and stock of money (51) and (52) can be
solved for the equilibrium values of and
which can be substituted into (15) and (11) to
obtain the equilibrium output of consumption
and investment
goods which, in turn, can
be substituted into (18) and (19) to obtain em-
ployment in the investment and consump-
tion goods industries. Given
, ,
, and
the equilibrium prices of investment and
consumption goods are implied by Keynes’
market equilibrium functions (10) and (14)
where all of these equilibrium values are solved
for in terms of the exogenously determined
money wage and the stock of money , giv-
en the price and stock
of non-debt assets
(which are implicitly held constant in Hicks’
model) and the assumption that the effective
demands and
are equal to their actual
demands and
.
As with Hicks’ model, the one-good Keynesian
models of neoclassical economics are, in general, also
implicit in Keynes aggregate model outlined above.
They are, in effect, special static cases of Keynes’ gen-
eral model, but this is where the similarity between
Keynesian neoclassical economics and the economics
of Keynes ends. The difference can be seen by com-
paring the way in which a flexible money wage W is
assumed to affect the level of employment N in the
Keynesian version of Hicks’ model as modified by
(48) - (50) above and the way in which a flexible
App..B Mr.-Keynes-and-the-NeoClassics 211
money wage is assumed to affect the level of em-
ployment in Keynes’ general theory.
Keynesian NeoClassics and the Money Wage As was noted above, in the Keynesian version of
Hicks’ model the IS (51) and LM (52) curves can be
solved for Y and R, and once these values are ob-
tained it is only necessary to solve (50) to obtain the
level of employment N given the exogenously deter-
mined money wage W. Since changes in the money
wage W cannot affect either the IS (51) or the LM
(52) curves in this model, by virtue of a) the assump-
tion that the price of output P is equal to marginal
cost (49), b) the law of diminishing returns (48), and
c) the fact that a change in the money wage W cannot
change income Y, (49) implies that there is an inverse
relationship between the money wage W and em-
ployment N. Thus, a fall in the money wage W must
lead to an increase in employment N, and, “by simple
arithmetic” it is possible to show that an unemploy-
ment problem can be solved by a fall in the money
wage. This is taken to indicate (even to prove for
some economists) that the cause of unemployment is
a lack of flexibility in wages.
The problem is, there is no way to explain how or
why the increase in employment that is supposed to
result from a fall in the money wage can come into be-
ing within the Keynesian neoclassical paradigm since
there is no way to explain how the system gets from
one point of equilibrium to another other than
through the invocation of a mythical Walrasian auc-
tioneer.
Keynes explained the fallacy involved in the clas-
sical explanation of the effects of a change in the mon-
ey wage on employment as follows:
212 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
In any given industry we have a demand schedule for
the product relating the quantities which can be sold to
the prices asked; we have a series of supply schedules
relating the prices which will be asked for the sale of
different quantities on various bases of cost; and these
schedules between them lead up to … the demand
schedule for labour in the industry relating the quantity
of employment to different levels of wages… This con-
ception is then transferred without substantial modifica-
tion to industry as a whole....
If this is the groundwork of the argument (and, if it is
not, I do not know what the groundwork is), surely it is
fallacious. For the demand schedules for particular in-
dustries can only be constructed on some fixed assump-
tion … as to the amount of the aggregate effective de-
mand…. [But] the precise question at issue is whether
the reduction in money-wages will or will not be accom-
panied by the same aggregate effective demand as be-
fore [emphasis added]…. [I]f the classical theory is not
allowed to extend by analogy its conclusions in respect
of a particular industry to industry as a whole, it is whol-
ly unable to answer the question what effect on em-
ployment a reduction in money-wages will have. For it
has no method of analysis wherewith to tackle the prob-
lem [emphasis added]…. (1936, pp. 258-60)
Keynes’ point here is that the classical theory
simply assumes that a decrease in the money wage
will lead to an increase in the effective demand for
output in all industries that will be accompanied by
an increase in the actual demand for output in all in-
dustries without any analysis as to how the decrease
in the money wage will affect incomes, prospective
yields on investment, the solvency of debtors, or
countless other ways in which a decrease in the money
wage can affect the actual demands for goods. There
is no way to explain how or why the actual demands
App..B Mr.-Keynes-and-the-NeoClassics 213
for goods will increase in response to a fall in the
money wage within the classical theory even if there is
an increase in the effective demands in this situation.
Keynes’ arguments in this passage apply with
equal force to the Keynesian neoclassical analysis of
this problem. There is no way to explain how a fall in
the money wage will lead to an increase in employ-
ment in Keynesian neoclassical economics except by
ignoring the effects of a fall in the money wage on de-
mand and just assuming that wages and prices will
adjust automatically in such a way that employment
increases along a falling marginal product of labor
function (49)—that is, without assuming a mythical
auctioneer is adjusting prices and quantities in such a
way as to allow the system to move instantaneously to
its short-run equilibrium values at each point in time
as the money wage and prices fall through time. In
other words, it is impossible to give a logically con-
sistent, causal explanation as to how the new equilib-
rium is achieved within the context of Keynesian neo-
classical economics. The problem is simply assumed
away through the invocation of a mythical auctioneer.
Keynes and the Money Wage Rather than view the economic system from the
perspective of a set of simultaneous equations (“a ma-
chine, or method of blind manipulation, which will
furnish an infallible answer” [Keynes, 1936, p. 297]),
as we have seen Keynes viewed the system as being
determined by a set of partial equilibrium models in
which the values of individual variables are deter-
mined by the choices of those decision-making units
that actually have the power to determine the value
of each variable at each point in time as the system
evolves through time. Given Keynes’ assumption that
214 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
employment is determined by producers at the point
of effective demand the only way in which a fall in the
money wage can affect the level of employment is
through an effect on the expectations of producers as
these expectations adjust to the effects of a fall in the
money wage on a) the MEC, b) the propensity to con-
sume, and c) the rate of interest (Keynes, 1936, pp.
183-4). These three factors determine the equilibrium
level of employment, and output/income in Keynes’
general theory in that the equilibrium level of em-
ployment and output/income cannot change un-
less at least one of these factors change.22 This follows
directly from Keynes’ Marshallian aggregate supply
(22) and demand (23) functions. Since:
1. levels of employment in the consumption and
investment goods industries are determined
by the effective demands and
in these in-
dustries in accordance with (19) and (18), and
2. effective demands for consumption and in-
vestment goods adjust to the actual demands
for consumption and investment
goods in
accordance with (26) and (27)
the equilibrium aggregate demand curve (23)—
that is, the aggregate demand curve for which
expectations can be realized—can change only by
way of a change in a) the MEC, b) the propensity
22 It should also be noted that while Keynes clearly accepted the first
fundamental postulate of classical economics (i.e., the classical labor
demand functions) embodied in Hicks’ (37) and (38) specifications and
in the Keynesians’ (49) he did not assume this function determines
employment. Keynes assumed that given the money wage prices
are adjusted by producers to satisfy (25), (30), and (31) “in accordance
with certain principles, if competition and markets are imperfect.”
(Keynes, 1936, pp. 4-18; 1939a) See also Keynes (1939b), Brady,
Brothwell, Hayes, Leijonhufvud, and Kregel.
App..B Mr.-Keynes-and-the-NeoClassics 215
to consume, or c) the rate of interest. (Keynes,
1936, chs. 3 and 20)
This means that if a fall in the money wage were
to increase expectations directly so as to induce pro-
ducers to increase employment in the absence of a
change in at least one of these three factors, all of the
increased output that results can be sold “[o]nly if the
community's marginal propensity to consume is equal
to unity.” (Keynes, 1936, p. 261)23 Barring this possi-
bility, the expectations of producers must eventually
become reconciled to this reality, and any increase in
employment that results solely from a ceteris paribus
increase in expectations can only be temporary as in-
ventories and debt accumulate and liquid assets are
depleted. (Keynes, 1936, pp. 261-2; Blackford, 2020c,
ch. 2)
This situation is illustrated in Figure 4 where it
is assumed that a fall in money wages increased ex-
pectations such that aggregate demand in panel (I)
increases from to * (17)
which increases effective demand from to * with
no change in the propensity to consume (15) in
panel (F), or the schedule of marginal efficiencies of
23 Strictly speaking, (11), (15), (22) and (23) imply that the price of
non-debt assets must be given as well as the rate of interest to
require the MPC equal unity in this situation:
d
216 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
capital (11) in panel (A), or on the rate of in-
terest in panel (D) where it is assumed in panel (D)
that the supply of money has increased to * to
keep the rate of interest R from increasing. (Cf.,
Wray.)
Figure 4: Equilibrium Employment and Out-put.
As the increase in effective demand increases the
aggregated demand function (17)
in panel (I) producers will increase employment
in accordance with (32) as output/income
increases in accordance with (34). The in-
crease in output/income will increase the
demand for consumption goods (13) in panel (E) in accordance with the con-
sumption function (15) in panel (F) which
will increase the quantity and price of
consumption goods demanded in accordance
with (28) and (30). But so long as a) there is no
change in the rate of interest R in panel (D), b)
App..B Mr.-Keynes-and-the-NeoClassics 217
propensity to consume in panel (F), and c)
the MEC schedule (11) in panel (A) and
so long as the marginal propensity to consume
is less than one (i.e., the marginal propensity to
save is greater than zero) the only way the
demand for investment goods can increase to
* (9) in panel (B) is if producers
are willing to accumulate inventories and oth-
erwise maintain their scale of operations at the
level of employment *.
This is, of course, a situation in which desired sav-
ing exceeds desired investment by * *
in panel (C) of Figure 4, and, as a result, “entrepre-
neurs as a whole must be making losses exactly equal
to the difference [between by * and ]. These
losses … represent a failure to receive cash up to ex-
pectations from sales of current output” (Keynes,
1930, p. 131) and “the date of their disappointment
can only be delayed for the interval during which
their own investment in increased working capital is
filling the gap” (Keynes, 1936, p. 262). It is only after
the disappointment has set in, expectations change,
and the effective demand and level of employment re-
turn to their equilibrium levels and in panel
(I) that the losses can be eliminated in this ceteris pa-
ribus situation. (Blackford, 2020b, ch. 2)
Even though an increase in expectations that re-
sult from a fall in the money wage cannot in itself
cause a change in the equilibrium level of employment
and output in the absence of a change in one of the
three factors that determine the position of the equi-
librium aggregate demand function in Figure 4 there
are a number of ways in which a fall in the money
wage can be expected to affect these three factors,
218 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
and, thereby, change the equilibrium levels of em-
ployment and output/income in Keynes’ general theo-
ry. For example, to the extent a fall in the money
wage lowers domestic wages relative to foreign wages
it could lead to an increase net exports that leads to an
increase in employment through an increase in the
aggregate propensity to consume schedule (15)
in panel (F) by way of the decrease in foreign-sector
saving. The resulting increase in the aggregate de-
mand schedule (23) in panel (I) could
lead to a further increase in employment by increasing
the MEC schedule (11) in panel (A) provided,
of course, this entire process is not cut short by an off-
setting change in foreign exchange rates or relative
prices.
A fall in the money wage may also have an effect
on the aggregate propensity to consume through a re-
distribution of income from wage earners to the own-
ers of other factors of production to the extent there
are differences in the propensities to consume be-
tween wage earners and the owners of other factors of
production though this is apt to reduce the propensity
to consume schedule (15) in panel (F) rather
than increase it. And to the extent a fall in wages is
accompanied by a fall in prices the resulting fall in the
transactions demand for money must cause the de-
mand for money schedule in panel (D) to
fall which given the supply of money can be ex-
pected to reduce the rate of interest R causing an in-
crease in the demand for investment schedule
(9) in panel (B) and the MEC schedule
in panel (A) provided the fall in wages and
prices does not lead to an expectation of a further fall
in wages and prices that has a negative effect on the
App..B Mr.-Keynes-and-the-NeoClassics 219
MEC schedule (11) in panel (A).
Keynes undertook a detailed examination of these
and other aspects of the problem of explaining the ef-
fects of a fall in the money wage on employment in
Chapter 19 of The General Theory, and he did not
view this problem as a matter of “simple arithmetic.”
He saw it as a problem of keeping track of the “com-
plicated partial differentials ‘at the back’ of several
pages of algebra” (Keynes, 1936, pp. 297-8) and trying
to understand and explain how the non-vanishing dif-
ferentials affect the economic system through time in
terms of the behavior of those decision-making units
that actually have the power to affect the system at
each point in time. This way of looking at economic
problems made it possible for Keynes to establish the
temporal order in which events must occur and,
thereby, to undertake a causal analysis of the dynam-
ic behavior of the economic system by way of “an or-
ganized and orderly method of thinking out particular
problems, … isolating the complicating factors one by
one” and after reaching provisional conclusions going
back, as well as he could, to account “for the probable
interactions of the factors amongst themselves” in an
attempt to understand “the complexities and interde-
pendencies of the real world.” (Keynes, 1936, pp. 297-
8) This was Keynes’ method of analysis throughout
The General Theory of Employment, Interest, and
Money as he followed the example set by Marshall,
and it is the inability or unwillingness of neoclassical
economists to examine economic problems in this way
that makes neoclassical economics descriptive and
static. (Blackford, 2020a; 2020b, chs. 2-4)
This does not mean that the incredibly powerful
descriptive/static tools of neoclassical economics are
220 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5
not useful. It does mean, however, that these models
cannot provide a meaningful guide to economic poli-
cy if they are not used in conjunction with the caus-
al/dynamic methodology of Keynes’ general theory
as the economic, political, and social problems we face
today bear witness, problems that are the inevitable
result of economic policies that ignored Keynes’ anal-
ysis in The General Theory and led directly to the
Crash of 2008 and the economic stagnation that fol-
lowed. (Keynes, 1936; Blackford, 2020a; 2020b, ch. 1)
List of Equations
B-a. Keynes’ Aggregate Model Behavioral Equations
,
,
,
.
,
.
,
.
.
.
,
,
.
.
,
,
,
,
,
,
222 ESSAYS-ON-POLITICAL-ECONOMY-III CH..6
,
.
,
,
Dynamic Adjustment Functions
,
.
,
,
.
,
,
Ch..6 Mr.-Keynes-and-the-NeoClassics 223
.
Structure of Keynes’ Aggregate Model
Table 1: Structure of Keynes’ Aggregate Model
Market Equilibrium Conditions
Behavioral Variables
Endogenous Variables
Assets =
=
,
,
Investment =
=
,
,
, ,
Consumption =
=
,
,
, ,
Labor =
Identities
B-b. Short-Run Equilibrium
Figure 1: Short-Run Equilibrium.
224 ESSAYS-ON-POLITICAL-ECONOMY-III CH..6
B-c. Causality and Dynamics in Keynes’ General Theory
Figure 2: Achieving Short-Run Equilibrium.
B-d. Long-Run Equilibrium
.1
1 .The way in which changes in the money wage affect the system are
examined in section B-b below.
Ch..6 Mr.-Keynes-and-the-NeoClassics 225
Figure 3: Achieving Long-Run Equilibrium.
B-e. Mr. Keynes and the ‘NeoClassics’ Hicks’ Two-Good Model
,
.
=
,
,
,
,
.
226 ESSAYS-ON-POLITICAL-ECONOMY-III CH..6
.
.
Keynesian One-Good Model
,
Deriving Hicks’ Model from Keynes’ Model
.
.
B-f. NeoClassics on Changes in the Money
Wage B-g. Keynes on Changes in the Money Wage
Figure 4: Equilibrium Employment and Output.
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