2013년 1월 12일 토요일

[발췌] Keynes and the classics: the simplest approach (2011)

지은이: Rogério Arthmar, Michael Emmett Brady, March 2011.

출처: International Journal of Applied Economics and Econometrics, Vol. 19, No. 1, pp. 1-33, January-March 2011 

※ Abstract:
  • A recap of the pivotal role to overall demand in the dynamics of the business cycle by many economists prior to the "General Theory" is conducted. Some considerations are presented with respect to Keynes's original understanding in The Treatise on Money of price variations engendered by the differences between saving and investment, followed by an examination of his evolving ideas over the links between saving, income, expenditure and sub-optimal equilibrium output. (...) Finally, a diagrammatic presentation of Keynes's view on the quantitative relationship between investment and consumption within the context of the transformation curve is introduced, in what Keynes called his simplest approach. 
  • Keynes's view is that economics must deal with economic relationships which are non linear and non additive at both the micro and macro levels. Classical (neoclassical) economics assumes linearity and additivity in economic relationships at both the micro and macro level. Keynes's strategy was to maintain linearity and additivity in this multiplier model but introduce non linearity and non additivity, in order to account for the impact of uncertainty as opposed to risk, in his elasticity analysis in chapter 21. This analysis was based on the integration of expectations into a microeconomic foundation of purely competitive firms operating with one fixed input and one variable input that Keynes accomplished in chapter 20.

※ 발췌(excerpts): 

* * *


In an address delivered at the very first meeting of the Cambridge Economic Club, in 1896, Alfred Marshall, then at the height of his professional career, urged the new generation of economists to avoid the temptation of dealing with an idealized society and rather study things as they really presented themselves to the philosopher: “We must not picture to ourselves an unreal world as it might be, or ought to be, and make schemes for it”, voiced Marshall with persuasiveness, adding in the sequence: “Our first duty as economists is to make a reasoned catalogue of the world as it is [...] A chief part of the work that lies before the economist of the 20th century is to make that estimateㅡnot well, for that is impossible, butㅡsomewhat less badly than it has been made hitherto”([1896] 1925, p. 302-3). Those were wise and almost prophetic words. One of his future pupils, even though a youth at the time, judged his mission to fulfil Marshall's mandate 40 years later. Indeed, as the broad conception of the General Theory of Employment, Interest and Money(GT) assumed definite contours in Keynes's mind, his conviction became stronger that most of the economic science that he got acquainted with, inclusive the teachings he had learned from his esteemed teacher, Marshall, were not applicable to the existing state of economic reality. In a short note on a historical retrospect of economic ideas, written around 1933, Keynes portrayed the orthodox equilibrium theory as an outdated abstract construction obsessed with the metaphysical power of saving to create wealth and with no regard to the heavy cot of ignoring the practical man's advice on the importance of spending. (...)

(...) Despite his manifold attacks on the tenets of classical theory, as against the traditional approach to the interest rate or in the way the labor market reached equilibrium, the present papaer tries to reassess Keynes position on the subject by focusing primarily on his interpretation of the principle of effective demand and its influence on the level of aggregate output. (...)

1. Effective demand and the theory of business cycles

Keynes's well known charge against what he designated as classical economics in the GT rested in his perception that the orthodox doctrine, as professed by Pigou, Marshall, Edgeworth and previously by Ricardo and Stuart Mill, denied any significant role to effective demand, its being limited only by the productive power of the economy.
“The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century”([1936] 1964, p. 32). [※ 아마도 일반이론, 2장 고전파 경제학의 공준, 혹은 3장 유효수요의 원리] 
Keynes considered this regrettable stance because it ended up preventing incomplete economic theory from solving the presing economic problems of the more affluent nations during the interwar year. The consequent distrust of the common citizen in the prescriptions of economists, characteristic of the day, was a strong indication of a major flaw within the science, namely, that in stead of serving as an element of promoting the wealth and well being of society, it had become an impediment to achieving a position of higher prosperity. [Keynes says in the GT:]
“It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assuming that it actually does so is to assume our difficulties away”([1936] 1964, p. 34). [※ 아마도 일반이론 2장 혹은 3장].
  The gist of Keynes's novel approach to economics, in short, sprang from the idea that when output and income expand, consumption expenditure grows also, but in a lesser proportion, leaving a gap in demand that might not be automatically filled by private consumption. This proposition, of course, led Keynes to directly oppose the ancient stream of economic thought, generally associated with the classical authors like Mill, Ricardo and Say, that envisaged each decision to invest as being necessarily preceded by an equivalent act of saving. Given this connection, no lasting deficiency of demand would ever appear, except in the shape of a temporary mismatch between the supply and the want of certain commodities which, anyway, would before long be corrected by competition. But,[:]

  • it must be noticed here, if Keynes' principle of effective demand placed him closer to that long list of heretical writers, who depreciated Say's Law since the early 19th century, at the same time it raised him well above them. [because, unlike Keynes, :]
  • Names such as Malthus, Blake, Sismondi, and later on, Hobson, by calling attention to the injurious effects of excessive savings, leading to the glut (engorgement) of markets, could only conceive, as the appropriate therapy to the permanent threat of economic stagnation, the unproductive expenditures of the landowners, government, or even the laborers, in general.[1]
[1] For a minute examination of the theories formulated by the critics of Say's Law either of the oversaving or of the underconsumption type, check Sowell(1972) and Bleaney(1976).
  Keynes was fully aware of his proximity to, as well as his distance from, the dissenters of the economic orthodoxy. While there recommendation of strengthening consumption could result in more production and employment in a period of economic distress, this diagnostic, in Keynes' opinion, reflected a distorted recognition of the true problem. To him, bad times were never due to a prior inordinate surge in overall investment, as commonly alleged, but quite the contrary.
  • According to his new perspective on this crucial question, economic crises were born out of a growing uncertainty with respect to the future yields of existing investment projects resulting in a drop of capital goods expenditures to a level sometimes far below the one justified by the real rate of return which could be obtained in normal conditions ([1936] 1964, p. 320-4). [※아마도 일반이론 18~21장]
  • So, instead of hampering the expansion of private investment, as many dissenters before him had insisted on, the most suitable course of action, in Keynes' perception, would be exactly the opposite one, i.e., to spur capital accumulation to its utmost in order to make its reward as low as possible[??] while, at the same time, increasing the income of the needy. As he stated in a lecture on the paradox of poverty among plenty deliverd to the BBC radio in 1934:
Now I range myself with the heretics. I believe their flair and their instinct move them towards the right conclusion [...] But I disagree with them [on the necessity of intensifying consumption] when they go further and argue that it is the only remedy. For there is an alternative, namely, to increase the output of capital goods by reducing the rate of interest and in other ways (JMK, v. XIII, 1987, p. 489-90).[2]
  Having briefly covered Keynes standing among the various dissenter groups, it seems in order now to look more carefully into his claim that classical economics simply dismissed effective demand in their analysis of industrial societies. Although it is well established that Ricardo and even Say adhered to a lighter version of the postulate of an automatic conversion of savings into investment, recognizing indeed some possibilities of demand falling short of supply (see Becker, Baumol, 1960 and Sowell, 1972), Keynes's indictment of the old classical position could be taken as accurate without much quarrel.[3] They, after all, just wanted to show that a progressive capitalistic economy could create its own outlets for savings, dispensing thus with any kind of unproductive spending. When the discussion involved neoclassical authors like Marshall and Pigou, however, fierce reactions would come up inevitably, even before the General Theory reached the public domain. Thus, Dennis Robertson, for instance, was in no mood to accept Keynes' attempt to lay the classical mantle over the shoulders of well-regarded contemporary economists. And he made this point quite vigorously in his comment on the GT galley proofs:
I am very much out of sympathy with your treatment of what you call the classical and I call modern economists! [...] What are Marshall's descriptions of the credit cycle in Principles pp. 709-11 and M(oney). C(redit). and C(ommerce). pp. 249-51 but studies of the fluctuations in 'effective demand'? [...] What is the whole monetary part of Pigou's Industrial Fluctuations, and of his Theory of Unemployment, but a study of the movements of 'effective demand'? (Robertson, February 3rd 1935, in JMK, v. XIII, 1987, p. 504-5, italics in the original; see also Robertson's letter, March 11th 1935, note (1), JMK, v. XIII, 1987, p. 520).[4]
Robertson's complaint, about Keynes' refusal to take into account the previous work done on the subject of business cycle by classical and neoclassical economists, had some support. If the neoclassical effort to rebuild the whole body of pure economic theory, related to value and exchange, was done through the marginalist analysis, with money being added to the structure as something that preserved the basic quantitative relations of the economic system defined by endowments, technology and tastes (Samuelson, 1970)[5], this unity of method was totally missing as soon as one shifts the focus to the subject of money and the cycle prior to the General Theory.
cf. SAMUELSON, Paul. Classical and neo-classical monetary theory. In: CLOWER, R. W. (ed.) Monetary theory. Baltimore, Penguin Books, 1970.
In his observations, Robertson could have included easily many other economists, such as Wicksell, Fisher, Hawtrey, Hayek, Tugan-Baranowsky, Aftalion and even himself, to mention a few, who had well formulated, complex, dynamic theories of how banking and credit acted upon effective demand, mainly through the reciprocal interaction of saving and investment. So much so that, in describing the congestion of warring theories on the field during the interwar years, Schumpeter assessed the situation as being marked by nothing less than "disagreement and antagonistic effort" (1963, p. 1125)[6]

  A quick glance at some of the major books dealing with the economic cycle in the pre-Keynesian era would suffice to show the essential role played by demand in the theories of the time (an extensive review of the pertinent literature is found in Harberler, 1946, Hansen, 1964, Bridel, 1987 and Laidler, 1999). One of the outstanding illustrations is given by Alfred Marshall in his Economics of Industry when he delineates the mechanics of the commercial cycle, most often initiated by good harvests that depressed the price of food and released a fraction of revenues to be spent on other commodities, whose respective demand increased. Taking advantage of the easy credit provided by the banks, speculators exacerbated the wave of rampant trading, fueling the prosperity phase of the business cycle by their acquisition of speculative stocks of goods to be sold at higher prices in the near future. Marshall even provided a hint of some kind of propagation effect in demand with his vivid description of the upswing phase of the cycle:
Producers find that the demand for their goods is increasing; they expect to sell at a profit, and are willing to pay good prices for the prompt delivery of what they want. Employers compete with one another for labour; wages raise[? rise]; and the employed in spending their wages increase the demand for all kinds of commodities (Marshall, A., Marshall, M.P., [1879] 1994, p. 152).
( ... 마셜의 경기순환 묘사에 대한 추가 설명... )

Some years later, in Sweden, Wicksell's Interest and prices (1898), first presented his influential description of the Cumulative Process, a hypothetical situation taking place in a stationary economy with universal competition and an elastic supply of credit. Under these circumstances which assumed an initial position of balance between saving and investment, any escalation in the demand for capital goods is promptly accommodated by new bank loans at a constant interest rate. The entrepreneurs, that is, the borrowers of liquid capital from the banks, start to compete for additional labor and other resources, causing a hike in factor earnings soon followed by an increase in spending:
If the workers and landlords raise their demand for goods for the consumption of the current year to the extent that money wages and money rents have gone up, this increased demand is met by the same amount of commodity capital as before. It necessarily results in a rise in all pricesㅡa rise which it is simplest to regard as proportional to the increase in demand (Wicksell, [1898] 1965, p. 144, italics in the original).
Prices and incomes are readjusted to a commensurate extent. Profits are then kept stable so that, in the next production period, the demand for loans increases in order to match the increased level of prices and costs. This ignites a new round of inflation. This cumulative process, in Wicksell's conception, could go on indefinitely, at least until investments came to fruition, expanding therefore the supply of consumption goods or, else, until interest rates were raised, to curtail the demand for loans, launching then the reverse phase of the process.

  The number of examples of effective demand, treated as a central element in the theories of business cycles during the interwar years, could be easily multiplied. It is enough for our purposes here to add just one further illustration. Pigou, rightly remembered by Robertson, had, in truth, published a whole book titled Industrial Fluctiations (1927) that covered most of the past contributions to the subject along with an emphasis on expectations much in line with Marshall's previous insights on this topic. The forward looking nature of investment decisions, in Pigou's theory, allied with the credit opportunities provided by the banking system, could make effective, in the form of a larger demand for labor, an excess of optimism, soon amplified by the public access to the capital markets. Due to the long gestation period of construction projects, errors of forecast would be discovered just when the newly produced equipment was already in operation. When that finally happened, the former bright, optimistic outlook of the prosperity phase would then turn into a pessimistic outlook about the future yield of capital, affecting business confidence in general and giving way to a violent liquidation of assets and stocks, leading to a substantial fall in prices:

( ... 피구 인용문 ... )

  So, considering the antecedents above indicated, some scholars have argued, following Robertson early contention, that the fundamental elements of the General Theory were in fact already there before the book came into being. In other words, they were just scattered throughout the works of the period until Keynes skillfully collected and put them together. This is, for example, Laidler's opinion, who leaves no room for doubt: “Rather, it [the Keynesian economics] synthesized and permitted orderly debate about questions which, far from being revolutionary in the sense of superseding what had gone before, had themselves permeated the complex discussions of money, the cycle and employment that had taken place in the years after WWI” (1999, p. 4).

  It should be noticed here, however in favor of Keynes, that it was impossible for anyone dealing with the theory of business cycles after the end of 19th century not to talk about it in terms of saving and investment, as done by Wicksell, and without stressing the key role played by the volatility in the acquisition of capital goods in industrial societies. As Hansen rightly stressed once with regard to the pioneering work of Tugan-Baranowsky on this subject: “[He] boldly set forth the view that the industrial cycle, as he called it, related in particular to the periodic creation of fixed capital. His analysis came like a fresh ocean breeze. He placed his finger upon the essential characteristic of the cycleㅡthe fluctuation in the rate of investment”(1964, p. 226).

  Keynes, for his part, never denied his affiliation with the economic theory that preceded him. In one of his letters to Hawtrey, shortly before the GT was published, he acknowledges his debt to his forebears when he explains the determining factors of investment decisions, in opposition to Hawtrey's habit of thinking uniquely through the traditional scheme of supply and demand (adjustments of inventories) in matters of capital accumulation: “But that is not what Marshall or Pigou or most modern economists do. The demand which determines the decision as to how much plant to employ must necessarily concern itself with expectations. And I am in this respect simply trying to put more precisely what is implicit of most contemporary economics”(Keynes, letter from November 8th 1935, JMK,v. XIII, 1987, p. 602). A few months earlier, he also remarked to Harrod, in the same vein, that his true intent in GT was not just to attack the economic orthodoxy but also give the due credit to past heretics who were always disdained for having pointed out the incongruence of classical economics with the reality of the capitalistic system it was supposed to depict:
What I want is to do justice to schools of thought which the classical have treated imbecile for the last hundred years and, above all, to show that I am not really so great an innovator, except as against the classical school, but have important predecessors and am returning to an age-long tradition of common-sense (JMK,v. XIII, 1987, p. 552).

2. The end of the saving-investment duality

If, as shown above, the economists, who concentrated on the study of the business cycle before the GT appeared, regarded the phenomenon as having originated from some kind of disturbance in effective demand especially coming from the saving-investment quarter of the economy, one is entitled to ask: where, after all, can Keynes's claim to originality from his classical fellows be established? The answer requires a step back in time, when he had just finished his Treatise on Money (1930 [? 1931]). In that book, [:]
the oscillations in prices of both consumption and capital goods were assumed as dependent on the effects on windfall profits, due to the discrepancies between saving and investment. In this setting, an increase in saving, for instance, might produce a fall in the price of consumption goods without affecting capital goods prices, for this extra saving could assume a financial form in the event of consumption goods producers selling securities to make up for their losses or if the banks attended to this additional demand for financial investments by selling assets in their possession. Anyway, once saving surpassed investment, profits would fall below their normal level and deflation in consumption goods would take place without any change in the supply of money.
  In spite of the enthusiastic reception by some in the academy,[7] Keynes' criticism's [? criticisms] of the quantity theory of money dogma in the pages of the Treatise turned it immediately into an easy target to many of his contemporaries.
  • Robertson, who until then worked in close association with Keynes, criticized the book's lack of harmony and the conceptual confusion surrounding the determination of the overall price level, since he could not understand how a reduction in consumption expenditure should not be accompanied by a simultaneous increase in capital goods outlay (Robertson, 1931). 
  • From an Austrian perspective, Hayek qualified Keynes' ideas as merely experimental, lacking not only the solid foundation in capital theory provided by Böhm-Bawerk but also a true knowledge of Wicksell's monetary analysis. Furthermore, he added, most of the bizarre theoretical results obtained by Keynes resulted from his assuming that the output of consumption goods remained constant in the face of a contraction in demand. Hayek countered that, in normal conditions, money subtracted from consumption would be spent in more profitable venues, allowing thus for the optimal use of economic resources, the only manner in which prices could be increased would be through the creation of credit by the banking system to finance a demand for fixed capital beyond the amount deliberately saved by the community (Hayek, 1931, 1932).
(...) [Keynes] characterized their[Robertson & Hayek] criticisms as being expressions of the old doctrine, commonly associated with Say's Law, that if purchasing power were taken away from consumption spending it ought to be directed to the acquisition of capital goods (non-liquid assets), like the opposite movements of "buckets in a well" (JMK, v. XIII, 1987, p. 230). Be that as it may, what Keynes seemed to be trying to convey in the Treatise was that the mere intent to save more might not be automatically translated into additional investment, a point of view which would mature in full in his first draft of the GT:
In so far as our social and business organization separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the later[? latter] with them, financial prudence will be liable to destroy effective demand and thus impair well-being, as there are many examples to testify (Keynes, JMK, 1934 draft, v. XIII, 1987, p. 429).
  Of real importance to Keynes's theoretical progress was Hawtrey's extensive comments on the Treatise. Here one finds perhaps the most valuable hints about the road Keynes was to follow toward the GT. First of all, Hawtrey did not agree with the Treatise proposition that prices were highly sensitive to demand conditions, since for him[,] production, through the swift action of dealers, would be the first variable impacted by changes in spending: “Mr. Keynes' formula only takes account of the reduction of prices in relation to costs, and does not recognize the possibility of a reduction of output being caused directly by a contraction of demand without an intervening fall in prices.”[8] If this is so, he goes on, some interesting results might follow, mainly if the volume of savings is tied to the level of incomes. “In my opinion”, wrote Hawtrey, “the principal factor determining the amount of savings out of the consumers' outlay is the magnitude of certain classes of incomes out of which savings are chiefly made”. From these two assumptions, a kind of cumulative effect was to take place whenever saving happened to go beyond investment. “Thereupon there begins a shrinkage in the consumers' income in proportion to the decline of production”. This process, however, was not without end, at least as Hawtrey saw it. In a hypothetical case conceived by him, if income and expenditure equaled £100 million monthly, £90 million being spent in consumption and £10 million in capital goods, an increase of £5 million in savings would not fail to affect aggregate earnings, contrariwise to Keynes' assumption. “Thus there may be a stage at which consumers' income and outlay have been reduced to £95 million a month, and output has been reduced in the same proportion, without any reduction in the price level. There would then be no windfall loss, and savings and investment would balance”(Hawtrey, JMK, v. XIII, 1987, p 152, 157, 158).

  The following year Kahn published his famed paper "The relation home investment to unemployment" (1931) where he deduced the formula relating to the total volume of employment stemming from a primary expense in road construction by the government and assuming some positive elasticity of supply in the consumption goods industry. Keynes' theory in the Treatise, observed Kahn, contemplated solely the case of a fixed provision of consumption goods, allowing thus no possibility of secondary employment.[9] (...)

  Soon after, Joan Robinson, in her Parable on Savings (1933) also stressed that Keynes' widow's cruse allegory in the Treatise relied on the assumption of fixed output. If supply was assumed to be somewhat elastic to demand changes, an excess of saving would imply some layoffs. The unemployed then should have to spend on consumption out of their past savings or out of someone else's and, if they were on the dole financed by Treasury bills, these disbursements would be coming from the aggregate savings pool as well. All these events would work together to eliminate the surplus of savings over investment until equilibrium was finally restored. Keynes, in a letter from April 14th 1932, thanked Robinson for the paper (that he read in advance) and admitted his error in not fully pursuing the effects of a varying level of production in the Treatise, a fact that he ascribed to the exploratory nature of his book. Anyway, most of Robinson's arguments relied heavily on Keynes's June 1931 lectures at the Harris Foundation in Chicago under the title "An economic analysis of unemployment" (JMK, v. XIII, 1987, p 269-70, 356-8).

  The  consequence of Hawtrey's comments were to be felt already in 1931, when Keynes wrote to Kahn suggesting the possibility that, in the face of unemployed resources, changes in output could work as a corrective to an initial unbalance between saving and investment. Although the employment multiplier had just been set forth by Kahn, no one had visualized yet its application to income variations. Keynes, nevertheless, demonstrates his being already attentive to the fact that if saving S depended on income E+Q=OP (E=aggregate income, Q=windfall profits, O=output, P=price level), so that S/E=f1(E/P)+f2(Q/P), then an increase in investment could indeed generate some windfall profits, even though the ensuing expansion in output and incomes would progressively increase saving to the extent that it would end up leveling again with investment. This result would eliminate the origin of extraordinary profits, resulting in an equilibrium level of output lower than the full employment position. At this point in time it seems that the so-called Cambridge Circus was not fully prepared to figure out what their leader was aiming at, for Kahn declared himself “not quite [...] able to follow the steps” of Keynes' mathematical reasoning, while Joan Robinson was trying to convince him that output and investment could move in opposite directions through some kind of logic Keynes found rather “difficult and cumbersome”(JMK, v. XIII, 1987, p. 373-79); see also Dimand, 1988, p. 148-52). As he recorded in one of his first drafts of the GT:
An initial decline in disbursement having thus brought about a decline in output, we shall find that the position is one of great instability [...] Thus, apart from any stimulus to investment, we may reasonably rely upon a point of equilibrium being reached eventually at which -ΔQ averaged over the entrepreneurs who are still producing ceases to fall further, so that there is no reason for any further decline in output in the short period [...] The reader will notice that, apart from factors of which we have not yet taken account, there is no presumption whatever that the equilibrium output will be anywhere near the optimum output (JMK, 1932 GT draft, v. XIII, 1987, p. 383, 386, 387).

By June 1934, Keynes had finally worked out his income-version of the multiplier, a major theoretical breakthrough which definitely cleared the path for the GT. And that was so for many reasons.[:]

  • First of all, he had finally disentangled himself from the old Treatise way of thinking; from now on, Keynes would not talk anymore about discrepancies between saving and investment. “In that book”, he wrote, “an important role was played by the difference between investment and saving. But with our new definition, saving and investment will always, and necessarily, be equal”(JMK, v. XIII, 1987, p. 436, italics in the original).
  • Second, once the dichotomy saving-investment was no longer functional as an analytical tool, the whole problem of the economy's short run stability could be treated from the exclusive viewpoint of expenditure or, in Keynes['] own definitions at the time, of the joint propensities to spend and to invest (JMK, 1934, GT draft, v. XIII, 1987, p. 442-56). 
  • In connection with this point, changes in aggregate demand could now be analyzed exclusively in terms of changing expectations, meaning that expectations about the future yield of current projects would determine the amount of investment in the present. In other words, the past, which had always conditioned the present through saving, lost his former crucial role in dictating the pace of capital accumulation, now taken over by the state of long term expectations of profits (quasi-rents) on capital-goods.
  • Third, since the interest rate was no longer the coordination device for saving and investment decisions for a large multitude of heterogeneous individuals, a new theory was needed in order to explain the true nature and determination of this key variable. This is the moment when the liquidity preference formulation formulation comes to forefront, while the old and venerable notion of saving is finally thrown overboard by Keynes: “My theory is that the rate of interest is the price which brings the demand for liquidity into equilibrium with the amount of liquidity available. It has nothing whatever to do with saving”(JMK, letter to Harrod from August 27th 1935, v. XIII, 1987, p. 550).

3. Classical and Keynesian equilibrium

The last point mentioned in the previous section was to become the focus of an intense debate between Keynes and Harrod, lasting from July to October 1935, that is truly helpful in understanding why Keynes departed from the classical orthodoxy. Harrod was quite uneasy with what he considered the controversial tone adopted in the drafts of the GT, especially Keynes' sweeping dismissal of the idea that the interest rate was established by the interaction between the schedule of supply of savings and demand for liquid capital. So, in a letter from August 21th 1935, Harrod complained:
The inequality between saving and investment was a newfangled idea propounded by you in the Treatise and since taken up by others and misapplied. So that when you argue that once we see that saving must be equal to investment, this argument falls, they would reply that they had always supposed that saving must be equal to investment and that that was the basis of their argument (JMK, c. XIII, 1987, p. 544).
Harrod was absolutely correct in his statement. But, as we are going to see later, it was of the utmost importance, as regards this point, to know the exact way through which equilibrium was supposed to take place. Keynes, in his August 27th 1935 reply to Harrod, denied not only the independence but, beyond that, even the existence of the demand and supply schedule of saving. How can an economist maintain such a notion, he asked, if a lowering of interest rate produces an increase in both investment and saving? Harrod, according to Keynes, was still slipping into the old habit of thinking about investment and saving as distinct and separate entities that for some reason could be unequal, at least temporarily. Whatever the way they were brought to equality in the classical explanation of the business cycle, it has always kept tacit, as Keynes pointed out, that there was always a constancy of output. A few days later, in September 10th 1935, he was to present this same argument in stronger words: “The fault in the classical theory lies not in its limiting its terrain by assuming constant income, but in its failing to see that, if either of its own variables (namely, propensity to save and schedule of marginal efficiency of capital) change, income must also, cet. par., change; so that its tools breaks in its hand and it doesn't know and can't tell us what will happen to rate of interest” (JMK, v. XIII, 1987, p. 559).

The problem with Keynes' assessment of the classical theory lies in the conclusion that his opinion appears to be both correct and false at the same time. Let's specify the reason for this inconsistency and/or contradiction more carefully. On the one hand, Wicksell, for instance, whose cumulative process inspired many theories of the cycle in the first decades of the 20th century, including Keynes' theory in the Treatise, assumed explicitly throughout his analysis the steadfastness of output at its full employment level. As one may read, in ^Interest and prices^:

It is impossible to endorse the widespread view that under suitable conditions a country's output can be expanded almost indefinitely by "arousing the spirit of enterprise" and the like. This fallacious view is derived by concentrating attention on one single branch of production, provided perhaps with an excess of fixed capital (builings, machines, etc.). In such a single branch of production it would be possible to increase output immediately, but only ^at the expense of the other branches of production^ from which labour and capital have to be drawn ([1898] 1965, p. 143, italics in the original).

Marshall, in his ^Economics of Industry^, assumed as well a similar state of affais when he condemned as futile any attempt to create an artificial demand for home commodities not anticipated by an increment in the supply of capital. In presenting his position on the matter he quoted Bastiat's example of the candlemakers who asked the authorities for a law shutting up all windows in order to inflate the demand for artificial light, bolstering thus their manufactures and all the other connected trades. [:]

“Doubtless government could thus give employment to many industries; the effects which ^were seen^ would be beneficial. But the candlemakers did not ^foresee^ that the capital which came into their industry, say, that of growing corn, in which it was giving good employment of labourl and that the corn growers would have purchased from other trades just as much as the candlemakers would”(Marshall..l, p. 18, italics in the original).

  Now, it is not difficult to realize that as long as one is dealing with the subject of economic fluctuations the hypothesis of constant output is no longer of utility. For the phenomenon of the cycles in industrial societies, especially during the interwar years, were marked not only by price and earnings oscillations, but also and mainly by violent upheavals in the trend of both output and employment. So, the single purpose of formulating a theory of the cycle, either of a classical or of a heterodox leaning, implied that the volatile behavior of supply must be included in the picture. And that actually was the case with most of the economists of neoclassical background in the first decades of the 20th century such as Cassel([1924] 1953), Robertson([1926] 1932) and Pigou ([1927] 1967), who occupied themselves with explaining the ups and downs of the business cycles. Although no common interpretation of output movements was ever achieved by the many authors dedicated to the subject,[10] it may be useful here to briefly outline Robertson's theory on this topic for it was one of the few advanced at the time.

( ... ...)

  After this concise reminder of Robertson's description of output movements much in tune with what was admitted by other neoclassical economists at the time, one is tempted to strongly disbelieve Keynes' dictum that classical economics assumed all the way fixed output at the full employment level. The conclusion, therefore, is inevitable: Keynes was wrong! But, nevertheless, it ought to be added in the same breath: he was right, too! The explanation for this contradiction is not difficult to grasp. For, in spite of their insightful inroads into the conditions of supply encompassing the analysis real costs, of innovations and of expectations, neither Robertson nor any of his contemporaries was able to make any of these elements truly operational at a higher theoretical level. To Pigou, Cassel, Hayek, and other economists of the interwar years, the business cycle was always seen as a symptom of some fundamental disequilibrium ingrained within the economy, generally a disproportion between saving and investment somehow sanctioned by a lenient credit policy adopted by the banking system. When it came time to analyze the ways these derangements impacted the economy overall, these insights were omitted or suppressed. It is here that Keynes hits the nail in the head. Keynes realized that all of these economist invariably reasoned as if the changes in output could be safely omitted.

  (...) [Let's bring up] a few instances of the classical mode of thought on how saving and investment were imagined to be made equal to each other, as Harrod kept hammering in his letter to Keynes.[:]

  Let's assume an increased desire to save by the community, without a fall in the interest rate and, consequently, with no correspondent advance in investment. More specifically, as explained by Pigou, for example, if a rentier decides to deposit £100 in the bank, such an act does not mean an automatic accumulation of consumable things ready to be used anywhere in the future, as a kind of progressive pile up of ammunition to be put forth later on in a single, great charge. On the contrary [By the way], if this increase in bank balances were not injected back into the system in the form of £100 in new credits, no effective sacrifice whatsoever would have occurred in the economy, since[in which case] the same amount of consumption goods would be purchased after the fall in prices, generating thus what some called ^abortive saving^. “His conduct [of the rentier] reacts to lower prices slightly all round, but does not lead, as he had intended, to any real saving.”(Pigou, [1927] 1967, p. 147).

  Under the contrary assumption of an abrupt escalation in the desire to invest, the interest rate should increase in order to reduce consumption and expand saving, freeing, in this way, the real resource needed to make effective the supplementary capital formation. If the banking system, however, does not immediately adjust its interest rates on loan; equilibrium would end up being restored in one of three alternative ways, namely: (i) by means of the ^forced saving^ imposed through the resulting inflation on everyone with sticky incomes, as supposed by Hayek and others. This effect coincides with what Robertson called ^automatic lacking^, defined by him in the following manner: “The key to the whole matter is that ‘command over capital’ conferred on the borrower by an additional bank-loan is in reality provided [...] by some other moneyholder who refrains, whether spontaneously or under pressure, from consuming the full value of his current output”([1926] 1932, p. 52, n. 1); (ii) by a tardy but firm increase in interest rates when the demand for credit is spiraling out of control due to speculation and the rise in capital goods price, fueling thus the rush to the banks in search for more accommodation. As Marshall puts it when explaining the ordinary course of commercial fluctuations: “The lenders of capital already wish to contract their loans; and the demand for more loans raises the rate of interest very high. Distrust increases, those who have lend become eager to secure themselves; and refuse to renew their loans on easy or even on any terms”([1923] 1929,p. 250), or finally, (iii) by the belated abandonment of the new investment plans that were based on the unwarranted optimism of entrepreneurs and speculators who now have turned highly pessimistic. The overturn of the prosperity phase and the eruption of a crisis, according to Cassel's theory, for example, would come up inexorably because investors, as a rule, tend to overestimate the forthcoming supply of savings:
The high conjuncture must them be pressed onward, but at last there will come a time when it is clear that the market cannot find savings for the purchase of real capital produced in sufficient amounts. There must then be a sudden fall in the value of real capital, and employers must find it extraordinarily difficult to get the capital they need, either by loan or selling([1924] 1953, p. 126).

4. Keynes's "simplest" approach to classical economics

At this stage, the prior theoretical discussion may now be summed up in the following way. To classical economists the problem of the cycle, and of the economic disequilibrium associated with it, was, invariably, caused by the fact that an increase (or decrease) in spending was supposed to happen at a certain point in the economic system without an equivalent and simultaneous decrease (or increase) in spending at some other point. This type of reasoning was unequivocally stated by Keynes, although in aggregate terms, in a correspondence to Hawtrey soon after the publication of the GT, in April 15th 1936:
I am not sure that the following is not the best definition of full employment in my sense: “There is less than full employment if the propensity to consume being assumed unchanged, an increase in investment will cause an increase in consumption”. As against this the normal assumption of the classical theory is that an increase in investment will [or must] involve a ^decrease^ in consumption (JMK, c. XIV, 1973, p. 26, italics in the original).

Graphic 1. Keynes's view on effective demand and classical economics

The way Keynes understood his theoretical disagreement with classical economics may be better visualized through a pictorial image. Hence, in diagram 1, all variables are presented in real values, i.e. expressed in terms of wage-units as done by Keynes.
  • The ordinate axis plots the values for real consumption Cw, while the abscissa axis plots the different values for real investment Iw
  • The Yw ray coming from the origin of the coordinate plane shows the aggregate demand function Dw not at its total value, but instead, as the set of all points formed by the conjunction of expected proceeds in both capital goods and consumption industries, where the latter are calculated as a fraction (the marginal propensity to consume b) of aggregate income given by total investment times the multiplier 1/(1-b)Iw . 
  • Then, any value assumed by investment will be accompanied by a proportionate demand for consumption goods along the ray Yw as is the case with Iw(1) and Cw(1), both of them adding up to effective demand Dw(1).
  • The outer concave line going from the abscissa to the ordinate axis is the well known full employment Possibilities. Production Frontier(PPF) Curve, also called Transformation Curve. (...) If diminishing returns prevail in the production of consumption and capital goods, then each successive increase in the supply of the latter (...) will required a greater sacrifice of the former (...). 
  • Once the scale of the marginal efficiency of capital, the interest rate and the marginal propensity to consume are given, Iw is determined and so is consumption Cw. If, as indicated in diagram 1, investment Iw(1) falls short of its full employment level Iw(2), the longitudinal distance between the two points along the abscissa is a deflationary gap, while any volume of investment beyond the full employment level, such as Iw(3), means that this supplementary demand or else, the inflationary gap, can no longer be matched by an increase in output but only by a rise in prices.[11]

( ... ... )

Getting back, then, to the above diagram, the generality of Keynes['] theory of effective demand, in comparison with the classical view, is easily grasped. His splitting of aggregate demand into consumption and investment allowed him to conceive the twin concepts of the "marginal propensity to consume"(MPC) and the "marginal propensity to invest"(MPI) ... so that MPC+MPI≤1. (...) When talking about the main economic problem faced by affluent societies, Keynes remarks that the declining propensity to consume, as income grows, means a narrowing of the prospective fields of investment that widens thus the gulf between potential output and effective demand. "Not only is the propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate" ([1936] 1964, p. 31). The inevitable result of this predicament, considering an economy organized under the principle of free competition, is a level of production below the full employment, i.e. at some spot in the interior space delimited by the PPF curve, irrespective of what is happening in the markets for productive factors: "This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand ^may, and often will^, bring the increase of employment to a standstill before a level of full employment has been reached"(p. 30-1, italics are ours).

  It is not hard to see now that both the classical and neoclassical economists always assumed, as Keynes insisted on, the prevalence of the condition MPC+MPI=1. (...)

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