Meredith M. Paker

Economic History

Notes & updates

J.M. Keynes's The General Theory of Employment, Interest, and Money

Notes on J.M. Keynes's
The General Theory of Employment, Interest and Money

The General Theory is a classic, and rightly so. That said, the book is dense, and Keynes's writing is occasionally unclear. After a close reading this summer, I wanted to share the notes I took on the work to offer a sort of "guide" to the text. The notes are straightforward summaries and extended quotes with little commentary. For good commentary on the work, I recommend Mark Blaug's guide in Economic Theory in Retrospect, as well as Paul Krugman's introduction to the General Theory here.

These notes are not intended to be comprehensive, instead simply reflecting the arguments as I interpreted them and quotes and comments that I found interesting.
Quotes are marked with quotation marks and have an exact page number in the text
Other page numbers are given by (###)
-> is a definition
=> is an implication
Typos are probably my own

The edition of the text cited here is The Collected Writings of John Maynard Keynes volume 7, from Cambridge University Press for the Royal Economic Society. This edition preserves the pagination of the original 1936 edition.


PREFACES & INTRODUCTIONS

Editorial introduction

Keynes to Harrod about General Theory, 30 Aug 1936 (xi)
    ▪ "To me the most extraordinary thing, regarded historically, is the complete disappearance of the theory of demand and supply for output as a whole, i.e. the theory of employment, after it had been for a quarter of a century the most discussed thing in economics."
    ▪ Four main contributions of his theory, according to Keynes
        - Effective demand implicit in multiplier
        - Increase in income => (Consumption - income) increases
        - Interest measures liquidity preference
        - Marginal efficiency of capital

Development of General Theory (xi)
    ▪ Timeline
        - 1932: Renamed Cambridge lectures "The Monetary Theory of Production"
        - 1933: Liquidity preference
        - 1933: Essay "The Monetary Theory of Production"
        - 1933: Pamphlet "The Means to Prosperity"
        - 1933: Article "The Multiplier"
        - 1933: Biographical sketch of Malthus
        - 1934: Marginal efficiency of capital
        - 1936: Published in February for 5 shillings
    ▪ General Theory proofread by RF Kahn, J Robinson, RF Harrod, DH Robertson
Keynes intended to revise the work as "Footnotes to the General Theory" but had a heart attack, and then WWII

Preface

"This book is chiefly addressed to my fellow economists…its main purpose is to deal with difficult questions of theory, and only in the second place with the applications of theory to practice."  (p. xv)

Divergences of opinion between economists "…have for the time being almost destroyed the practical influence of economic theory" (p. xv)

Treatise on Money takes money separate from general supply and demand (xvi)
    ▪ In attempting to reconnect them in Books III and IV of the Treatise, Keynes fails to deal with changes in output
    ▪ Fundamental equations in the Treatise are for a given level of output and show how profit disequilibrium => change in level of output

General Theory is "a study of the forces which determine changes in the scale of output and employment as a whole; and, whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary details fall into the background." (p. xvi)

"A monetary economy, we shall find, is essentially one in which changing views about the future are capable of influencing the quantity of unemployment 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. We are thus led to a more general theory, which includes the classical theory with which we are familiar, as a special case." (p. xvi)

The book is a "struggle of escape" from old ideas
    ▪ "The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds." (p. xvii)

Preface to the German edition

Marshall "grafts" marginal principle and substitution onto Ricardian tradition (xviii)

Germans have never been so committed to an orthodoxy as the English were—Wicksell led their theoretical unorthodoxy

"Can I persuade German economists that methods of formal analysis have something important to contribute to the interpretation of contemporary events and to the moulding of contemporary policy?" (p. xix)

Preface to the French edition

"…[Y]our economists are eclectic…without deep roots in systematic thought" (p. xxi)

General theory => "I am chiefly concerned with the behaviour of the economic system as a whole"

Equity of savings and investment
    ▪ Holds for system as a whole, not for each individual

Summarizes the theory of employment (xxii-xxiii)
    ▪ Level of output/employment depends on current decision to produce which depends on current decision to invest which depends on current expectations of current and future consumption
        - i.e. Expectations of present/future consumption => Current decision to invest => Current decision to production => Level of output/employment
    ▪ If we know expectations of present/future consumption for everyone, we can find the level of income in society and then back out the output/employment that is in equilibrium with some level of investment (multiplier)
    ▪ Propensity to save increases => Income decreases and output decreases
    ▪ Propensity to invest increases => Income increases and output increases

Theory of interest (xxiii)
    ▪ Interest rates "preserve equilibrium, not between the demand and supply of new capital goods, but between the demand and supply of money, that is to say between the demand for liquidity and the means of satisfying this demand" (p. xxiii)
        - From Montesquieu

Theory of money (xxiii)
    ▪ "…my final escape from the confusions of the Quantity Theory"
    ▪ Price level determined by supply and demand
        - Supply: Technical conditions, level of wages, extent of unused capacity of plant and labor, state of markets
        - Demand: Decisions of entrepreneurs which provide income to producers, decisions of those individuals about what to do with income
    ▪ "Money, and the quantity of money, are not direct influences at this stage in the proceedings. They have done their work at an earlier stage of the analysis." (p. xxiii-xxiv)
        - Quantity of money => supply of liquid resources => interest rates => inducement to invest (determined along with other factors like confidence) => equilibrium level of income, output, and employment, along with other factors, and price level via supply and demand

Economics dominated by Say's doctrines
    ▪ Economists of have dropped his law of markets but not "his fallacy that demand is created by supply" (p. xxiv)
"Say was implicitly assuming that the economic system was always operating up to its full capacity, so that a new activity was always in substitution for, and never in addition to, some other activity. Nearly all subsequent economic theory has dependedon, in the sense that it has required, this same assumption. Yet a theory so based is clearly incompetent to tackle the problems of unemployment and the trade cycle." (p. xxiv)


BOOK 1: INTRODUCTION

1: The general theory

General vs. classical (3)
    ▪ Classical includes followers of Ricardo, e.g. JS Mill, Marshall, Pigou

"I shall argue that the postulates of classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium" (p. 3)
"Misleading and disastrous" when special case of classical economics is applied to "facts of experience"

2: The postulates of classical economics

Concerned with distribution of resources not volume of resources (4)
    ▪ Discussions concerning fluctuations in employment do care about "actual employment of available resources" but its often overlooked
    ▪ Keynes quotes Pigou's Economics of Welfare in a footnote (5)
        - Pigou: "Throughout this discussion, except when the contrary is expressly stated, the fact that some resources are generally unemployed against the will of the owners is ignored. This does not affect the substance of the argument, while it simplifies its exposition"
        - According to Keynes, Pigou is basically writing here that for the national dividend, the same theory works under full employment and with involuntary unemployment

Classical theory of employment based on two postulates
    1. Wage = Marginal productivity of labor
        - Where marginal productivity of labor is the value lost if employment is reduced by 1 unit
        - Can be disturbed if competition or markets are imperfect
    2. "The utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment"
        - i.e. "…the real wage of an employed person is that which is just sufficient…to induce the volume of labour actually employed to be forthcoming"

Types of unemployment in classical economics
    ▪ Frictional unemployment ->  inexactness of adjustment (6)
        - Miscalculation, intermittent demand causing unbalanced resources
        - Time-lags due to unforseen changes
        - "Between jobs"
    ▪ Voluntary unemployment-> Refusal to accept a job for various reasons
    ▪ In classical economics, these two categories are comprehensive
        - "The classical postulates do not admit of the possibility of a third category, which I shall define below as 'involuntary' unemployment."

So the two postulates determine volume of employed resources, first demand and then supply
    ▪ "…and the amount of employment is fixed at the point where the utility of the marginal product balances the disutility of the marginal unemployment"

This leaves only four ways to increase employment (7)
    1. Decrease frictional unemployment
    2. Decrease marginal disutility for labor as expressed by the real wage for which additional labor is available => decrease voluntary unemployment
    3. Increase "marginal physical productivity of labour in the wage-goods industries"
    4. Increase price of non-wage goods relative to wage-goods so non-wage earners shift from expenditure on wage-goods to non-wage goods

Keynes cites Pigou's Theory of Unemployment as "the only detailed account of the classical theory of employment which exists"

"…the population is seldom doing as much work as it would like to do on the basis of the current wage" (p. 7)
    ▪ Classical explanation: Due to tacit agreement among workers not to work for less, so money-wages should be reduced to fix unemployment (8)
    ▪ Thus "involuntary" unemployment is actually voluntary due to collective bargaining

Keynes describes two objections to the second postulate of the classical theory (8-12)
    1. Actual behavior of labor
        - Workers don't withdraw labor when prices rise (so real wages fall)
            § "…whether logical or illogical, experience shows that this is how labour in fact behaves" (p. 9)
            § "Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labour or its productivity"
        - "These facts are prima facie ground for questioning the adequacy of the classical analysis" (p. 9)
            § Which Keynes argues from observed experience
        - "A fall in real wages due to a rise in prices, with money-wages unaltered, does not, as a rule, cause the supply of available labour on offer at the current wage to fall below the amount actually employed prior to the rise of prices. To suppose that it does is to suppose that all of those who are now unemployed though willing to work at the current wage will withdraw the offer of their labour in the event of even a small rise in the cost of living." (p. 13)
    2. Wage bargaining doesn't determine real wage
        - "For there may be no method available to labour as a whole whereby it can bring the wage-goods equivalent of the general level of money-wages into conformity with the marginal disutility of the current volume of unemployment. There may exist no expedient by which labour as a whole can reduce its real wage to a given figure by making revised money bargains with the entrepreneurs" (p. 13)
        - Level of real wages determined by other things (14)
            § Imperfect mobility of labor or the net advantage not perfectly equal in wages => reduction of money-wages relative to others => relative reduction in real wages
        - But its impractical to resist all reductions in real wages
            § So those that affect all workers are not resisted unless they are very extreme, while relative reductions in real wages would be resisted
            § And this resistance doesn't bar increases in aggregate employment like resisting every change in real wages would
        - "In other words, the struggle about money-wages primarily affects the distribution of the aggregate real wage between different labour groups, and not its average amount per unit employment, which depends, as we shall see, on a different set of forces. The effect of combination on the part of a group of workers is to protect their relative real wage. The general level of real wages depends on the other forces of the economic system." (p. 14)
            § So workers resist reductions of real wages when they are not all-around reductions but don't resist all-around reductions that ultimately increase aggregate unemployment and leave relative money-wages the same

Involuntary unemployment: "Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment." (p. 15)
    ▪ So if real wage = marginal disutility of unemployment then there is no involuntary unemployment => full employment
    ▪ Thus classical economists attributed unemployment to a refusal of the unemployed to accept a wage corresponding to their marginal productivity

"The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight—as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry." (p. 16)

Similarity of Keynes's system with classical system (17)
    ▪ Given firm, equipment, technique: If volume of output/employment increases then wages decrease (and profits increase)
        - If n men are employed and nth man adds 1 bushel of corn a day, wages have (real) buying power of 1 bushel a day. The n+1th man only adds 0.9 bushel, so n+1th man not hired until prices of corn rise relative to wages, so wages only by 0.9 bushel. So wages then are 0.9(n+1) instead of n, transferring income from workers to entrepreneurs
    ▪ So long as marginal product diminishes, any increase in employment leads to diminishing marginal product and diminishing rate of wages in terms of the product
    ▪ "But when we have thrown over the second postulate, a decline in employment, although necessarily associated with labour's receiving a wage equal in value to a larger quantity of wage-goods, is not necessarily due to labour's demanding a larger quantity of wage-goods; and a willingness on the part of labour to accept lower money-wages is not necessarily a remedy for unemployment." (p. 18)

Say's law: "Supply creates its own demand"
    ▪ In aggregates, costs of production spent in buying product
    ▪ Corollary: Savings => investment (19)
    ▪ "Contemporary economists who might hesitate to agree with Mill['s form of Say's Law] do not hesitate to accept conclusions which require Mill's doctrine as their premiss" (p. 19)
    ▪ Marshall has been less explicit about this in his later work

Keynes writes that Robbins is the only economist whose theory and predictions are consistent (20)
    ▪ Pigou treats money only frictionally; employment and production determined by "real" exchanges, ignoring money
    ▪ Costs of output covered by sales-proceeds of demand would only work in a Robinson Crusoe economy
        - But this is similar to the "indubitable" fact that aggregate income = value of output

Keynes argues that decision to abstain from present consumption =/= decision to provide for future consumption (21)
    ▪ So classical theory's "axiom of parallels"  is that demand price of aggregate output = supply price of aggregate output

Thus classical theory relies on 3 logically interrelated assumptions
    1. Real wage = marginal disutility of existing employment
    2. No involuntary unemployment in the strictest sense
Supply creates its own demand, i.e. aggregate demand price = aggregate supply price for all employment and output levels

3: The principle of effective demand

Basic definitions
    ▪ Given technique, resources, costs: employment of some volume of labor involves two costs (23)
        - Factor cost: amount paid to factors
        - User cost: amount paid to other products and opportunity cost of employing equipment instead of leaving it idle
    ▪ Income/profit to entrepreneur = output - (factor cost + user cost)
        - Entrepreneur tries to maximize his profit when deciding level of employment
    ▪ Total income/aggregate income = income + factor cost (24)
        - Total income/aggregate income: proceeds from employment at some level
    ▪ Aggregate supply price of output at some level of employment = expected proceeds that make that level of employment worthwhile
        - Net of user costs, which are hard to determine

So the choice of what volume of employment (for firms and for the entire industry) depends on the expected proceeds from corresponding level of output

Z aggregate supply price of output from N employment (25)
Z = phi(N) aggregate supply function
D proceeds expected from employment of N workers
D = f(N) aggregate demand function
If D>Z, then N increases until D = Z'

Effective demand: value of D at intersection of aggregate supply and aggregate demand

Say's Law would mean the f(N) = phi(N) for all N and that an increase in Z (due to change in N) moves D by same amount (26)
    ▪ "That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limits" (p. 26)
        - Then competitive between employers => employment increases until an increase in D does not increase phi(N) [i.e. until full employment]
        - Thus full employment -> "a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output"
    ▪ So Say's Law implies no obstavles to full employment

Outline of the theory of employment (27)
    ▪ Employment increases => aggregate real income increases => aggregate consumption increases (by psychology) but by less than increase in income
        - So increased employment cannot be to just satisfy immediate increased consumption demands
    ▪ Gap between output and what is consumed needs to be filled with investment to justify employment
        - So given propensity to consume: Equilibrium level of employment depends on amount of current investment
        - And "relation between the schedule of marginal efficiency of capital and the complex of rates on loans of various maturities and risks" => inducement to invest => amount of current investment
    ▪ So there is only one equilibrium level of employment which is bounded above by full employment but is not necessarily equal to full employment (28)
        - Full employment is a special case

Keynes offers a list of propositions
    1. Given technique, resources, cost: Money-income and real income depend on N
    2. Propensity to consume, a psychologic characteristic of the community, determines relationship between income and consumptions for community, D1
        - Level of employment N => level of aggregate income => consumption
    3. N depends on D, the effective demand (29)
        - D = D1 + D2
        - D1 -> Amount community expects to spend on consumption
        - D2 -> Amount expected to devote to new investment
    4. D1 + D2 = phi(N)
        - phi(N) -> aggregate supply function
        - D1 = chi(N) and so depends on propensity to consume
        - => phi(N) - chi(N) = D2
    5. So volume of employment in equilibrium depends on
        - Phi -> aggregate supply function
        - Chi -> propensity to consume
        - D2 -> volume of investment
        - "This is the essence of the General Theory of Employment" (p. 29)
    6. For all N, there is a marginal productivity of labor in wage-good industries that determines real wages
        - So N cannot exceed the value that reduces the real wage to equality with the marginal disutility of labor
        - Basically this means we can't assume constant money-wage forever, but Keynes assures us we will dispense with this assumption soon
    7. In Classical Theory, D = phi(N) for all N
        - Then all values of N less than maximum give neutral equilibriums of employment volume
        - Competition pushes toward this maximum value of N, which is the only stable equilibrium
    8. When employment increases, D1 increases but not by as much as D
        - Greater volume of employment => (Z - D1) increases (30)
            § Z aggregate supply price for output
            § D1 expenditure on consumption
        - So holding propensity to consume constant, employment cannot increase unless D2 increases to fill the gap between Z and D1

"…the economic system may find itself in stable equilibrium with N at a level below full employment, namely at the level given by the intersection of the aggregate demand function with aggregate supply function" (p. 30)
    ▪ "Thus the volume of employment is not determined by the marginal disutility of labour measured in terms of real wages, except in so far as the supply of labour available at a given real wage sets a maximum level to employment. The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages—not the other way around. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the level of employment." (p. 30)
    ▪ Insufficient effective demand stops employment before full employment is reached, inhibiting production

"This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty" (p. 30)
    ▪ Richer communities have a wider gap between actual and potential production (31)
        - Because poorer communities consume more of output (higher marginal propensity to consume)
        - Less investment opportunities due to prior accumulation of capital in rich countries
            § Interest rate falls rapidly

Ricardian economics neglects aggregate demand function (32)
    ▪ Malthus tried and failed to explain deficient effective demand
    ▪ Effective demand "could only live furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell, or Major Douglas"(p. 32)

Why was the Ricardian model so successful? (33)
    ▪ Unexpected conclusions => intellectual prestige
    ▪ Austere, unpalatable recommendations => virtue
    ▪ Vast, logically consistent superstructure => beauty
    ▪ Social injustice, cruelty, as incidents on the road to progress => authority
    ▪ Changing things could do more harm than good => authority
    ▪ Justification for free activities of capitalists => support of dominant social forces

But failure of Ricardian economics in practice has damaged prestige of economists
    ▪ "For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observations;—a discrepancy which the ordinary man has not failed to observed." (p. 33)
    ▪ "Celebrated optimism" of economics due to the failure of classical economists "to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand"
"It may well be that the classical theory represents the way in which we should like our economy to behave. But to assume that it actually does so is to assume our difficulties away." (p. 34)


BOOK II: DEFINITIONS AND IDEAS

4: The choice of units

National dividend, stock of real capital, and general price-level are poorly defined by Marshall and Pigou (37)
    ▪ They define national dividend as volume of current output or real income, not the value of output in money-income (38)
    ▪ There are issues here calculating the net output since the new items and equipment are not directly comparable to the old items and equipment especially when we must compare in terms of physical quantity, not money
    ▪ These are purely theoretical problems that only need to be addressed for the sake of quantitative analysis (39)
        - They can be approximated but really only belong in historical/social analyses (40)

Two units of quantity: money-value and employment (41)
    ▪ Employment can be weighted to be homogenous, e.g. an hour of special labor at double the rate counts as 2 hours of ordinary labor
    ▪ So employment measured in labour-unit
    ▪ And money-wage measured in wage-unit
    ▪ E wages and salaries bill = N * W wage-unit
        - Different efficiencies of workers should be reflected in their remuneration (p. 42)

Diminishing returns => Non-homogeneity of equally remunerated labor units is in the equipment being less capable of employing additional labor units, not in the laborers being less capable of using homogenous capital equipment

So Keynes measures changes in current output by number of hours of labor paid for an existing capital equipment, weighing the hours of skilled work based on its remuneration (44)
    ▪ And we don't need to know how output would change from a different pairing of workers and equipment

Supply curve and its elasticity can be written in these units of employment and money

Aggregate supply function for given firm, industry, or all industries
    ▪ Zr = phi_r(Nr)
    ▪ Zr -> Proceeds net user cost
        - Expectation of proceeds induces level of employment Nr

Output is a function of employment Nr
    ▪ Or = tau_r(Nr)

P = (Zr + Ur(Nr)) / Or = (phi_r(Nr) + Ur(Nr)) / tau_r(Nr)
    ▪ Ur(Nr) -> Expected user cost corresponding to Nr

Zr = phi_r(Nr) can be evaluated in the usual way if Or has definite meaning for each homogenous good (45)
    ▪ But Nr's can be aggregated while Or's cannot be since the sum of Or is non-numerical

5: Expectation as determining output and employment

Short-term expectation: Expectation of the price a manufacturer can get for finished output by the time he finishes it, measured when he starts the process to produce it (46)
Long-term expectation: Expectation of what the manufacturer will earn in future returns if he adds to his capital equipment with purchases of finished output (47)
    ▪ Actually realized results are relevant to employment only in their modification of subsequent expectations
    ▪ Original expectations irrelevant once choices have been ade
    ▪ "Thus on each and every occasion of such a decision, the decision will be made, with reference indeed to this equipment and stock, but in the light of the current expectations of prospective costs and sale-proceeds" (p. 47)

Changes in expectation are slow to affect employment (48)
    ▪ "It follows that, although expectation may change so frequently that the actual level of employment has never had time to reach the long-period employment corresponding to the existing state of expectation, nevertheless every state of expectation has its definite corresponding level of long-period unemployment." (p. 48)
    ▪ "…a mere change in expectation is capable of producing an oscillation of the same kind of shape as a cyclical movement, in the course of working itself out." (p. 49)

At any point, multiple overlapping activities reflecting various past states of expectation are going on. The level of employment at any time depends on present expectations and the expectations of past periods—but these past expectations are embodied in the present capital equipment. (50)
    ▪ "It follows, therefore, that, in spite of the above, to-day's employment can be correctly described as being governed by to-day's expectations taken in conjunction with to-day's capital equipment." (p. 50)

Short-term expectations are gradual and continuous, and are modified more "in light of results than in anticipation of prospective changes" (p. 51)
    ▪ For durable goods, short-term expectations are based on long-term expectations of investors and cannot be approximated by realized results

6.1: The definition of income

A sum of return from selling output (52)
A1 sum spent on purchasing finished output from others
G value of capital equipment one ends up with at end of period, including stocks of unfinished goods/working capital and stock of finished goods

A + G - A1 needs to be adjusted to remove the value that was contributed by equipment from a past period to get present income. Two ways to do this:
    1. G is net of improvements to capital via purchases and maintenance anddepreciation
    - B' spent on maintenance and improvement
    - G' value of capital equipment at end of period if B' spent
    - (G' - B') maximum net value conserved from previous period if capital hadn't been used to produce A
    - User cost of A = U = (G' - B') - (G - A1) = sacrifice of value in product of A
    - Factor cost of A = F = amount paid by entrepreneur to factors of production for their services
    - Prime cost of A = F + U

Income = value of finished product sold in period - prime cost
    ▪ Rest of community has income = F
    ▪ So aggregate income = A -U
        - And entrepreneur maximizes expectation of income = F in decisions about employment (54)
    ▪ (G - A1) > (G '- B') => user cost negative
        - If inputs increase but outputs have not been sold
        - Or if entrepreneurs make their own capital equipment
        - But usually in an economy where capital equipment manufactured by others, user cost and marginal user cost associated with an increase in A (i.e. dU/DA) are positive
    ▪ Aggregate consumption C of period = sum(A - A1)
    ▪ Aggregate investment I of period = sum(A1 - U)
    ▪ U is individual entrepreneur's disinvestment regarding his equipment and purchases

For a completely integrated system (A1 = 0), C = A and I = -U = G - (G' - B')

Effective demand = aggregate income/proceeds entrepreneurs expect to receive, including incomes they give to other factors of production, from some level of employment (55)
    ▪ Aggregate demand function "relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield"
    ▪ Effective demand is the point on the aggregate demand function that "taken in conjunction with the conditions of supply…corresponds to the level of employment which maximizes the entrepreneur's expectation of profit"

Marginal proceeds/income = marginal factor cost
    ▪ Similar to supply price = marginal factor cost
        - Used by economists who've ignored user cost or have assumed user cost is 0

    2. Involuntary loss of value of capital equipment due to change in market, wastage due to progression of time, catastrophes, etc (56)
        ▪ Supplementary cost = V = depreciation of equipment (involuntary but not unexpected) = expected depreciation - user cost

    ▪ Net income and net profit deduct supplementary cost from income and profit (57)
        ▪ In entrepreneur's capacity as a consumer this supplementary cost comes off his profit as he determines what to spend and save
        ▪ In entrepreneur's capacity as a producer, the prime cost and gross profit determine whether to use equipment
        ▪ Net income = A - U - V

    ▪ Windfall loss = change in value of equipment due to involuntary and unforeseen events, e.g. change in market, obsolescence or destruction by catastrophe
        ▪ Does not affect consumption decisions of producers as causally as supplementary costs, which come directly from a producer's profit (58)
        ▪ But the distinction between supplementary costs and windfall losses is conventional/psychological and changes of the supplementary cost due to changing expectations gets complicated

Basic supplementary cost -> initial expectation of supplementary cost when equipment first acquired

Current supplementary cost -> basic supplementary cost recalculated with up-to-date current values and expectations

"Net income" similar here to Marshall's "income" and Pigou's "money value of national dividend" (59)
    ▪ It's a mistake for these authors to emphasize "net income" when current production relies on the unambiguous "income" concept (60)

This definition of income/net income is difference from Keynes's definitions in the Treatise (61)

6.2 Saving and investment

Saving is by the normal definition: income - expenditure on consumption (61)

Expenditure on consumption is thus sum(A-A1) where sum(A) is total sales in period and sum(A1) is total sales from one entrepreneur to another (62)
    ▪ A = aggregate sales of all kinds
    ▪ A1 =  aggregate sales from one entrepreneur to another
    ▪ U = aggregate user costs of the entrepreneurs
    ▪ Implicit in the definition of A1 is the line drawn between consumer and entrepreneur

Income = A - U
Consumption = A - A1
Saving = A1 - U

Net saving = net income - consumption = A1 - U - V

Current investment equals savings in period
    ▪ Finished output has a value of A
    ▪ Capital equipment has deteriorated by U or has improved by -U with negative U producing A
        - After allowing for A1 purchases from other entrepreneurs
    ▪ So output A-A1 goes to consumption
    ▪ A - U - (A - A1) = A1 - U addition to capital equipment, i.e. investment in period
    ▪ A1 - U - V is net addition to capital equipment/net investment

So the amount of saving is due to consumers while the amount of investment is due to entrepreneurs, but both equal income - consumption so are equal (63)
    ▪ "Income = value of output = consumption + investment.
    Saving = income - consumption.
    Therefore saving = investment" (p. 63)
    ▪ This is due to bilateral nature of transactions between producers and consumers or purchasers of equipment

"Saving, in fact, is a mere residual" (p. 64)
    ▪ Think of decision to consume, not to save, and let aggregate income and aggregate saving be the results of choices of individuals
        - Propensity to consume, not to save

Appendix on User Cost situates the term in historical context (66-73)
    ▪ Pigou in Theory of Unemployment assumes marginal disinvestment in equipment due to production of marginal output is negligible
    ▪ "the notion that the disinvestment in equipment is zero at the margin of production runs through a good deal of recent economic theory" (p. 72)

7: The meaning of saving and investment

Everyone agrees on the definition of saving, but both investment and income have been defined in a variety of ways (74)

By investment, Keynes includes any increment of capital equipment—fixed, working, or liquid (75)
    ▪ Hawtrey focuses on changes in liquid capital like in the stock of unsold goods and excludes these from investment
    ▪ Capital formation and capital consumption from the Austrians are not well defined enough for Keynes to rebut (76)
    ▪ Keynes uses income differently than in the Treatise and explains that difference here (77)
        - It seems like he's saying the main difference is that in the Treatise he looks at change in (investment - saving) to handle profits and to govern volume of output, but he doesn't differentiate expected and realized profits
    ▪ DH Robertson in "Saving and Hoarding" (1933) makes the same argument as Keynes, contrasting effective demand and income, but using a "yesterday"/"today" structure (78)
    ▪ Keynes dismisses "forced saving" as having to do with quantity of money or credit—not savings and investment directly (79-81)
        - Mainly from Hayek
        - Hard to extend to conditions of not full employment

Saving is a two-sided transaction (81)
    ▪ Even the creation of bank credit is two-sided (82)
        - Makes output increase, marginal product in wage-unit increase, and wage-unit in money increase
    ▪ "Thus the old-fashioned view that saving always involves investment, though incomplete and misleading, is formally sounder than the new-fangled view that there can be saving without investment or investment without 'genuine' saving." (p. 83)
Everything is two-sided in aggregate but not for individuals. Increasing savings reduces incomes in aggregate, but changes in an individual's demand doesn't affect individual's income, e.g. (p. 85)


BOOK III: THE PROPENSITY TO CONSUME

8: The propensity to consume - the objective factors

Aggregate demand function relates level of employment to the proceeds of that level of employment
    ▪ Proceeds consist of: (89)
        - Sum spent on consumption at that employment level
        - Sum devoted to investment
    ▪ These each have distinct factors governing them

What sum will be spent on consumption at a given employment level, i.e. relating C to N? (90)
    ▪ Instead consider in terms of wage-units: consumption Cw and income Yw
    ▪ Yw is not a unique function of N but is approximately unique enough
    ▪ Propensity to consume then: chi between Yw (given level of income in terms of wage-units) and Cw (expenditure consumption from that level of income)
        - Cw = chi(Yw)
        - Or C = W * chi(Y)
    ▪ Chi then depends on (91)
        1. Amount of community's income
        2. Other objective factors
        3. Subjective/psychological factors of individuals composing community, and how income is divided between these individuals in a community

Objective factors influencing propensity to consume (92)
    1. Change in wage-unit
        - If wage-unit changes, expenditure on consumption for some level of employment will change proportionally
        - We've allowed for these changes by writing function in terms of wage-units
    2. Change in (income - net income)
        - Consumption depends on net income, not income
        - If leftover amount of income not reflected in net income changes, this could change consumption (not practically important)
    3. Windfall changes in capital values not allowed for when calculating net income
        - Very important, unstable relationship with income
    4. Changes in the rate of time-discounting [in ratio of exchange of present and future goods]
        - Not the same as interest rate since allows for changes in purchasing power
        - Classical approach assumes increasing interest rate => decreased consumption
        - "…the main conclusion suggested by experience is, I think, that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant…" (p. 94)
    5. Changes in fiscal policy
        - Income taxes, especially on unearned income, are as relevant as the interest rates in consumption decisions
        - Government sinking funds to pay off debt vs borrowing is like saving, so also affects consumption
    6. Changes in expected relationship between present and future income (95)
        - Likely averages out in aggregate
        - Too uncertain to measure

So propensity to consume is stable if wage changes are accounted for. Windfall changes will change propensity to consume as well as changes in interest rates and fiscal policy, but other factors might matter less (96)

The biggest influence on aggregate consumption is income, not the propensity to consume itself shifting
    ▪ People increase consumption as income increases, but not by as much as the increase in their income
        - Cw amount of consumption in wage-units, Yw income in wage-units
        - Change in Cw and change in Yw same size, but change in Cw < change in Yw
        - So dCw/dYw is positive and less than 1
        - Especially in the short-term
    ▪ As real income increases, proportion of income saved increases (97)
    ▪ In aggregate, when real income increases, consumption doesn’t increase as much absolutely
    ▪ But if income falls due to decline in employment, consumption can exceed income if individuals or the government uses up reserves, and consumption will fall by less than aggregate income has fallen (98)
        - So employment can only increase with an increase in investment unless there is a change in the propensity to consume, because consumers will spend less than the increase in aggregate supply price, making increased employment unprofitable

Long digression on "sinking funds" set up by corporations. While they seem prudential, its like extra supplementary cost, above and beyond what is required for the upkeep of capital. This needs to be balanced by new investment, which is now unlinked from wastage of old equipment. So the new investment available is diminished, and lower levels of employment become stable (98-104)
    ▪ "Take a house which continues to be habitable until it is demolished or abandoned. If a certain sum is written off its value out of the annual rent paid by the tenants, which the landlord neither spends on upkeep nor regards as net income available for consumption, this provision, whether it is a part of U or of V; constitutes a drag on employment all through the life of the house, suddenly made good in a lump when the house has to be rebuilt. (p. 99)
        - So large deductions made from income before we get net income that provides consumption
    ▪ Provision for financial needs of future consumption diminishes aggregate demand and makes it harder to find something to provide for in the future, since it limits current physical investment

"Consumption—to repeat the obvious—is the sole end and object of all economic activity…The consumption for which we can profitably provide in advance cannot be pushed indefinitely into the future. We cannot, as a community, provide for future consumption by financial expedients but only by current physical output. In so far as our social and business organisation separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being, as there are many examples to testify. The greater, moreover, the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance, and the greater our dependence on present consumption as a source of demand. Yet the larger our incomes, the greater, unfortunately, is the margin between our incomes and our consumption. So, failing some novel expedient, there is, as we shall see, no answer to the riddle, except that there must be sufficient unemployment to keep us so poor that our consumption falls short of our income by no more than the equivalent of the physical provision for future consumption which it pays to produce to-day." (p. 104)

Disinvestment to satisfy consumption contracts current demand (105)
    ▪ "New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase." (p. 105)
    ▪ Every equilibrium we secure through increase investment makes the next more difficult

9: The propensity to consume - the subjective factors

Aggregate demand function relates level of employment to the proceeds of that level of employment
    ▪ Proceeds consist of: (89)
        - Sum spent on consumption at that employment level
        - Sum devoted to investment
    ▪ These each have distinct factors governing them

What sum will be spent on consumption at a given employment level, i.e. relating C to N? (90)
    ▪ Instead consider in terms of wage-units: consumption Cw and income Yw
    ▪ Yw is not a unique function of N but is approximately unique enough
    ▪ Propensity to consume then: chi between Yw (given level of income in terms of wage-units) and Cw (expenditure consumption from that level of income)
        - Cw = chi(Yw)
        - Or C = W * chi(Y)
    ▪ Chi then depends on (91)
        1. Amount of community's income
        2. Other objective factors
        3. Subjective/psychological factors of individuals composing community, and how income is divided between these individuals in a community

Objective factors influencing propensity to consume (92)
    1. Change in wage-unit
        - If wage-unit changes, expenditure on consumption for some level of employment will change proportionally
        - We've allowed for these changes by writing function in terms of wage-units
    2. Change in (income - net income)
        - Consumption depends on net income, not income
        - If leftover amount of income not reflected in net income changes, this could change consumption (not practically important)
    3. Windfall changes in capital values not allowed for when calculating net income
        - Very important, unstable relationship with income
    4. Changes in the rate of time-discounting [in ratio of exchange of present and future goods]
        - Not the same as interest rate since allows for changes in purchasing power
        - Classical approach assumes increasing interest rate => decreased consumption
        - "…the main conclusion suggested by experience is, I think, that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant…" (p. 94)
    5. Changes in fiscal policy
        - Income taxes, especially on unearned income, are as relevant as the interest rates in consumption decisions
        - Government sinking funds to pay off debt vs borrowing is like saving, so also affects consumption
    6. Changes in expected relationship between present and future income (95)
        - Likely averages out in aggregate
        - Too uncertain to measure

So propensity to consume is stable if wage changes are accounted for. Windfall changes will change propensity to consume as well as changes in interest rates and fiscal policy, but other factors might matter less (96)

The biggest influence on aggregate consumption is income, not the propensity to consume itself shifting
    ▪ People increase consumption as income increases, but not by as much as the increase in their income
        - Cw amount of consumption in wage-units, Yw income in wage-units
        - Change in Cw and change in Yw same size, but change in Cw < change in Yw
        - So dCw/dYw is positive and less than 1
        - Especially in the short-term
    ▪ As real income increases, proportion of income saved increases (97)
    ▪ In aggregate, when real income increases, consumption doesn’t increase as much absolutely
    ▪ But if income falls due to decline in employment, consumption can exceed income if individuals or the government uses up reserves, and consumption will fall by less than aggregate income has fallen (98)
        - So employment can only increase with an increase in investment unless there is a change in the propensity to consume, because consumers will spend less than the increase in aggregate supply price, making increased employment unprofitable

Long digression on "sinking funds" set up by corporations. While they seem prudential, its like extra supplementary cost, above and beyond what is required for the upkeep of capital. This needs to be balanced by new investment, which is now unlinked from wastage of old equipment. So the new investment available is diminished, and lower levels of employment become stable (98-104)
    ▪ "Take a house which continues to be habitable until it is demolished or abandoned. If a certain sum is written off its value out of the annual rent paid by the tenants, which the landlord neither spends on upkeep nor regards as net income available for consumption, this provision, whether it is a part of U or of V; constitutes a drag on employment all through the life of the house, suddenly made good in a lump when the house has to be rebuilt. (p. 99)
        - So large deductions made from income before we get net income that provides consumption
    ▪ Provision for financial needs of future consumption diminishes aggregate demand and makes it harder to find something to provide for in the future, since it limits current physical investment

"Consumption—to repeat the obvious—is the sole end and object of all economic activity…The consumption for which we can profitably provide in advance cannot be pushed indefinitely into the future. We cannot, as a community, provide for future consumption by financial expedients but only by current physical output. In so far as our social and business organisation separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being, as there are many examples to testify. The greater, moreover, the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance, and the greater our dependence on present consumption as a source of demand. Yet the larger our incomes, the greater, unfortunately, is the margin between our incomes and our consumption. So, failing some novel expedient, there is, as we shall see, no answer to the riddle, except that there must be sufficient unemployment to keep us so poor that our consumption falls short of our income by no more than the equivalent of the physical provision for future consumption which it pays to produce to-day." (p. 104)

Disinvestment to satisfy consumption contracts current demand (105)
    ▪ "New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase." (p. 105)
    ▪ Every equilibrium we secure through increase investment makes the next more difficult

10: The marginal propensity to consume and the multiplier

Employment only increases with investment if there is a change in the propensity to consume (113)

Multiplier -> Ratio between income and investment and then between total employment and primary employment
    ▪ Primary employment -> Employment directly for investment

RF Kahn in "The Relation of Home Investment to Employment" in Economic Journal 1931
    ▪ Given propensity to consume, if monetary/fiscal policy stimulates or slows investment, employment is a function of this change in investment

Fluctuations in real income from applying different employment in labor-units to given capital equipment (114)
    ▪ Assume diminishing marginal returns
    ▪ Then income in wage-units rises more than proportionally to amount of employment
    ▪ And amount of employment rises more than proportionally to amount of real income in terms of product
        - This is hard to measure, so use Yw income in wage-units to index changes in real income
        - So sometimes Yw and real income in product change in different proportions, but always together

Real income of community increases/decreases => Consumption increases/decreases but by less (115)
    ▪ Change in Cw and change in Yw have same sign by change in Yw > change in Cw
    ▪ Marginal propensity to consume dCw/dYw
        - Gives how next increment of output is divided between consumption and investment
            § Change in Yw = change in Cw + change in Iw
            § Change in Yw = K*change in Iw, where marginal propensity to consume = 1 - (1/K)
    ▪ K investment multiplier -> Given increase in aggregate investment, income increases by K times that increase

Kahn's multiplier K' is employment multiplier -> Given increase in aggregate primary employment in investment industries, total employment increases by K' * that increase
    ▪ Change in Iw => change in N2 primary employment in investment industries
    ▪ Change in N => K' * (change in N2)

K does not equal K' in all cases but we assume K = K' (116)
    ▪ This assumption is that the shapes of the aggregate supply functions for the different groups of industries are the same
    ▪ It simplifies things

So assuming K=K', then if, for example, a community consumes 9/10 of increment of investment in terms of wage-units, then K=10 and total employment caused by investment is 10 times primary employment of investment (116)
    ▪ At the corners (117)
        - If community holds consumption equal despite increase in employment and increase in income, then total employment doesn't increase with primary employment
        - If community consumes all increase income "there will be no point of stability and prices will rise without limit"
    ▪ Normally with an increase in primary employment and thus income, total employment will only decrease if propensity to consume falls (like due to war), which is the only way consumption industries could be hurt by an increase in income

Multiplier gives how much employment must increase to give increase in real income sufficient so that savings in wage-units are increased enough to permit the increment of investment in terms of wages, which is a function of psychological properties

Marginal propensity to consume (118)
    ▪ Near 1
        - Small change in I => big change in N
        - Involuntary unemployment easily fixed
    ▪ Near 0
        - Small change in I => small change in N
        - "In the latter case, employment may be less variable but liable to settle down at a low level and to prove recalcitrant to any but the most drastic remedies." (p. 118)
    ▪ But actually we have "the worst of both worlds" in the middle
        - Lots of fluctuations in employment
        - Large investment required to produce full employment
        - "Unfortunately the fluctuations have been sufficient to prevent the nature of the malady from being obvious, whilst its severity is such that it cannot be remedied unless its nature is understood." (p. 118)

At full employment, increasing investment raises money-prices (119)
    ▪ But before full employment, rising prices also show increasing aggregate real income
    ▪ Net changes in investment then need to take into account decreased investment in other sectors due to the increase in investment being considered, and also need to hold propensity to consume constant
    ▪ Kahn considers these possible decreased factors
        1. Financing policy/working cash might raise interest rates, decreasing other kinds of investment (can be corrected for through monetary policy), but increased costs of investment/decreased marginal efficient can only be corrected for in lowering interest rates
        2. If government program affects confidence, liquidity preferences or marginal efficiency of capital could change (120)
        3. Increased consumption domestically weakens foreign trade balance. So some of the employment benefit from the multiplier could be accrued abroad. But a country can then also take into account leakage that benefits them from other countries.
        4. Marginal propensity to consume isn't actually constant and varies with employment. Keynes bets that it diminishes employment
            - Increase in N => increased proportion of income to entrepreneurs (due to diminishing returns, and entrepreneurs might have lower marginal propensity to consume)
            - Unemployment => Negative savings publically or privately, so increase in N => rapid reduction in negative savings => faster marginal propensity to consume
    ▪ "In any case, the multiplier is likely to be greater for a small net increment of investment than for a large increment; so that, where substantial changes are in view, we must be guided by the average value of the multiplier based on the average marginal propensity to consume over the range in question." (p. 121)
        - Impossible to generalize what the multiplier will be
        - Fluctuations in I are less important to employment with large foreign trade and borrowing to finance unemployment relief
            ▪ Like in the UK in 1920s-1930s and unlike US in that period


We assume change in investment in consumption-goods industries is foreseen well enough that capital-goods can adjust without affecting prices of consumption goods more than changes due to increased quantity produced (122)
    ▪ Multiplier works continuously without time-lag

Changes in investment in capital-goods is gradual and subject to a time-lag (123)
    ▪ Aggregate investment increments slowly
    ▪ Marginal propensity to consume changes each period
    ▪ But changes in aggregate demand = multiplier * (change in aggregate I)
    ▪ So unforeseen changes in capital-goods investments only affect employment over a period of some time (124)
        - Important in Treatise analysis of trade cycles
        - But this doesn't affect Keynes's theory of the multiplier here
    ▪ There's no reason to believe that any time lag is necessary for the increase of employment in consumption-goods to match increase of employment in capital-goods usually, because we assume that increasing employment just uses existing plant more intensively rather than expanding the plant due to it having reached capacity

"We have seen above that the greater the marginal propensity to consume, the greater the multiplier, and hence the greater the disturbance to employment corresponding to a given change in investment." (p. 125)
    ▪ This doesn't mean that a poor community with low saving experiences more fluctuations in employment than a rich community with high savings—because a high marginal propensity to consume can have a large proportionate effect on employment but small absolute effect if average propensity to consume is high
    ▪ Regardless of whether a community is poor due to underemployment or inferior skills/production techniques, if current investment isn't a large proportion of current output, the large multiplier will not make fluctuations in investment have a great effect on employment (126)
        - Richer communities could see much larger absolute effects

The numerical example Keynes gives (125-127)
    ▪ Propensity to consume = 100 if <5,000,000 employed, =99 if 5,000,000 to 5,100,00 employed, =98 if 5,100,000 to 5,200,000 employed, etc
    ▪ 10,000,000 is full employment
    ▪ When 5,000,000 + n*100,000 employed, the multiplier (at margin) is 100/n
        - (n*(n+1))/(2*(50+n)) percent of national income is invested
    ▪ So multiplier at 5,200,000 employment = 100/2 = 50 (very big), but investment at 5,200,000 = (2*3)/(2*52) = 0.06 (very small proportion of current income)
        - If investment falls by large proportion (about 2/3), then employment only falls to 5,100,000 (about 2%)
    ▪ But multiplier at 9,000,000 employed = 2.5, while investment = 9% of income
        - If investment falls by 2/3 now, employment falls to 6,900,000 (about 19%)

Employment on investment project has larger impact on aggregate employment when there is severe unemployment than when employment is close to full employment (127)
    ▪ E.g. employing 100,000 on public works with employment at 5,200,000 => employment rises to 6,900,000
    ▪ But employing 100,000 on public works with employment at 9,000,000 => employment rises only to 9,200,000
    ▪ "Thus public works even of doubtful utility may pay for themselves over and over again at a time of severe unemployment, if only from the diminished cost of relief expenditure, provided that we can assume that a smaller proportion of income is saved when unemployment is greater; but they may become a more doubtful proposition as a state of full employment is approached" (p. 127)
    ▪ Keynes refers again to Kuznets data for the US
        - Implies lower and more stable investment multiplier (around 2.5) => marginal propensity to consume <60-70%
        - Keynes views this propensity to consume as "improbably low for the slump" but it may be accounted for by extremely conservative corporate finance (128)

Involuntary unemployment => marginal disutility of labor < utility of marginal product
    ▪ But even if long-term unemployment offers some utility, the multiplier means that "wasteful loan expenditure" might still help the community

Keynes draws an absurd analogy involving gold mines—and concludes that gold mines are essential to civilization because "…gold-mining is the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance " like wars are the only loan expenditures seen as justifiable (129)
    ▪ Failing something better, these policies aid progress
    ▪ But really we should be increasing employment in ways that increase the stock of useful wealth
    ▪ In this tongue-in-cheek argument, Keynes is basically saying that we are so prudent we don't have (or permit, politically) "pyramid-building" activities that could address unemployment
        - Instead, individuals pile up riches they don't intend to employ (131)


BOOK IV: THE INDUCEMENT TO INVEST

11: The marginal efficiency of capital

Prospective yield of investment: Q1, Q2,…,Qn series of annuities (135)
Supply price/replacement cost: Price that would induce a manufacturer to produce a unit of the good
Marginal efficiency of capital: Discount rate such that present value of expected returns of investment = current supply price
    ▪ Greatest marginal efficiency of investment of the types of capital assets gives the overall marginal efficiency of capital
    ▪ Expectation of yield = current supply price

Diminishing marginal efficiency of type of capital with investment in that capital due to fall in prospective yield as supply of that capital increases and to the decreased ability of current facilities to produce that capital (less important in long run) (136)
    ▪ Can construct investment demand-schedule or schedule of marginal efficiency in aggregate to reflect this relationship

Qr prospective yield from asset at time r (137)
Dr present value of£I deferred r at current rate of interest
Sum(QrDr) demand price of investment
Investment changes so that sum(QrDr) = supply price of investment

So inducement to invest depends on investment demand-schedule and interest rate
    ▪ Neither of which come from knowledge of an asset's prospective yield or of the marginal efficiency of the asset

Comments on schedule of marginal efficiency of capital
    ▪ Here the increment of physical product is per unit value (not per unit of physical capital)(138)
    ▪ Marginal efficiency of capital is a ratio, not absolute quantity
    ▪ Need to distinguish "the increment of value obtainable by using an additional quantity of capital in the existing situation, and the series of increments which it is expected to obtain over the whole life of the additional capital asset; — i.e. the distinction between Q1 and the complete series Q1 , Q2 , . . . Qr , . . . .This involves the whole question of the place of expectation in economic theory" (p. 138)

If we assume capital now gets its marginal productivity, we are only in a stationary state (139)
    ▪ Aggregate current return to capital has no relation to marginal efficiency
    ▪ Current return at the margin (which enters supply price of capital) = marginal user cost, and also has no relation to marginal efficiency

Keynes views his definition of the marginal efficiency of capital as similar to Marshall's "marginal net efficiency" or "marginal utility of capital" (140)
    ▪ Marshall "appears to accept the view set forth above, that the rate of interest determines the point to which new investment will be pushed, given the schedule of the marginal efficiency of capital" (p. 140)
    ▪ But other times he is less cautious

Keynes's definition is also identical to Irving Fisher's "rate of return over cost" in Theory of Interest, 1930

So marginal efficiency of capital depends on prospective yield of capital, not just current yield (141)
    ▪ If expected prospective costs of production fall, marginal efficiency of capital produced today is diminished to compete with these future goods produced at lower cost
    ▪ This is how expected changes in the value of money affect volume of current output

"The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital." (p. 141-142)
    ▪ So changes in the value of money affect output by changing the marginal efficiency of capital, not through interest rate changes as Fisher has suggested (142)
    ▪ And interest rate changes can affect output in the same way
    ▪ "It is important to understand the dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the trade cycle." (p. 143-144)

Two types of risk that affect investment (144)
    1. Borrower's risk that she won't actually earn the prospective yield
    2. Lender's risk or moral hazard/voluntary default, involuntary default, or changes in the monetary standard
For risky transactions, these act in the same direction, making minimum prospective yield for transactions very high

User cost and marginal efficiency of capital restore theoretical connection between present and future through durable equipment—making it realistic (146)
    ▪ "The expectation of the future should affect the present through demand price for durable equipment"

12: The state of long-term expectation

Scale of investment depends on relation between rate of interest and marginal efficiency of capital. Marginal efficiency of capital depends on the relation between the supply price of a capital-asset and its prospective yield (147)

What determines the prospective yield of an asset? (148)
    ▪ Existing facts that are true
    ▪ Future events that can be forecasting with some amount of confidence
        - State of long-term expectation depends on most probable forecast and our confidence in this forecast
        - So confidence affects marginal efficiency of capital, which in turn affects the rate of investment (149)
        - But we don't usually have much knowledge about what will happen in the future

In the past, "Business men play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand." But now, with securities markets, investments are constantly revalued and influence investment (150)
    ▪ In practice, these stocks are revalued based on the convention that the present will continue into the future unless we have a specific (i.e. certain) reason to expect a change (152)
    ▪ This is self-enforcing, giving continuity and stability if we can maintain belief in the convention
    ▪ Investments are safe in the short-run and thus in successive short-runs
    ▪ But certain factors can make this arrangement more precarious (153)
        1. Real knowledge in valuation of investments falls
        2. Effects of day-to-day profits (which shouldn't have influence)
        3. Sudden, ungrounded fluctuations in public opinion (154)
        4. Investors focusing on winning gains based on prospective changes in mass psychology, not in actual value—"beating the market"(155)
            - Keynes described this as markets organized with respect to liquidity
            - "Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is 'to beat the gun', as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow. " (p. 155)
            - "…we devote our intelligences to anticipating what average opinion expects the average opinion to be." (p. 156)
            - Not many advantages to be won by the serious long-term investor since that takes so much time and knowledge, especially relatively, it's boring, and it can't be done on a large scale
        5. State of credit
            - Sufficient to bring about collapse if it weakens
            - Strengthening is necessary but not sufficient to recover (also needs confidence)

Speculation doesn't necessarily dominate enterprise (158)
    ▪ But it is more likely to in organized markets, like the US
    ▪ Keynes considers that if investments were permanent, speculation could be stopped (160)
        - But then that would hurt investment if there were other ways to store value, like hoarding money
        - "The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-asset which, even though it be on precarious evidence, impresses him as the most promising investment available to him." (p. 161)

Decisions are often based on "spontaneous optimism rather than on mathematical expectation, whether moral or hedonistic or economic"
    ▪ "…individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits" (p. 162)
    ▪ So slumps and booms depend on political and social climate
    ▪ "We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance." (p. 162-163)

Some factors can mitigate future uncertainty—investments whose lifetime returns are dominated by near future, residential investments where risk can be transferred from owner to occupier, public utilities that enjoy monopolies, and public social goods that never intend to yield enough to break even (163)

Keynes states that the rate of interest, after considering long-term expectation, still affects rate of investment. However, he is not convinced (anymore) that pure monetary policy will be successful. Instead the state should take "an even greater responsibility" for calculating the marginal efficiency of capital-goods and organizing investment (164)
    ▪ "…since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest." (p. 164)

13: The general theory of the rate of interest

There are forces keeping the marginal efficiency of capital equal to the rate of interest through adjusting the rate of investment (165)
    ▪ Schedule of marginal efficiency of capital governs terms on which loanable funds are demanded for new investment
    ▪ Rate of investment governs the terms on which funds are currently supplied

Rate of interest depends on interaction of marginal efficiency of capital with psychological propensity to save
    ▪ So does not equalize supply and demand for investment
    ▪ Propensity to save is a question of what form a person wants to reserve income for future consumption (166)
        - What is the individual's liquidity preference?
        - Liquidity preference -> "a schedule of the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circumstances" (p. 166)
    ▪ Rate of interest measures unwillingness to part with liquid control over money (167)
        - Not the price that equilibrates supply and demand of investment
        - Instead is "the 'price' which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash"
    ▪ So rate of interest determined by liquidity preference and the quantity of money (168)
        - r rate of interest
        - M quantity of money
        - L function of liquidity-preference
        - M = L( r )

Whyliquidity-preference?
    ▪ Consider money as a means of transaction and store of wealth
    ▪ Sometimes we sacrifice an amount of interest to get more liquidity
        - "But, given that the rate of interest is never negative, why should anyone prefer to hold his wealth in a form which yields little or no interest to holding it in a form which yields interest (assuming, of course, at this stage, that the risk of default is the same in respect of a bank balance as of a bond)?" (p. 168)
    ▪ Uncertainty as to future interest rates permits a liquidity preference for money as a store of wealth too
        - 1dr is value in present year 1 of £I deferred for r years
        - ndr is value in year n of £I deferred r years from that date
        - ndr = 1d_(n+r) / 1d_n = rate at which debt can be turned into cash n years from now (169)
            ▪ "If the current rate of interest is positive for debts of every maturity, it must always be more advantageous to purchase a debt than to hold cash as a store of wealth." (p. 169)
        - But with uncertainty, its not clear that ndr = 1d_(n+r) / 1d_n
            ▪ If there's a need for cash before n, one could face a loss when trying to convert debt into cash

Mass psychology also affects liquidity-preference through expectations of the interest rate (170)
    ▪ Market price equilibrates sales of "bears" and purchases of "bulls"

So in sum, 3 dimensions of liquidity preference
    1. Transaction-motive: Need for cash for transactions
    2. Precautionary-motive: Security of future liquidity
    3. Speculative motive: Beating the market

Rate of interest falls as quantity of money increases (171)
    ▪ Fall in rate of interest => More money for transactions motive since r falling => national income rises => increase in transactions, and since r falling => decreased cost of lost interest
    ▪ Fall in rate of interest => increase in cash held by individuals in speculation

But large increase in quantity of money could cause so much uncertainty that precautionary cash holding occurs (172)
    ▪ Differing opinions lends stability to changes in quantity of money usually, which is why this method is "more precarious in the United States, where everyone tends to hold the same opinion at the same time, than in England where differences of opinion are more usual" (p. 172)

Increase in quantity of money => interest rate falls ceteris paribus (153)
    ▪ But not if liquidity-preferences increase more than the quantity of money
Decrease in rate of investment => increase in volume of investment
    ▪ But not if propensity to consume falls too much
Increase in employment => increase in prices
    ▪ And then increases quantity of money needed to maintain a certain rate of investment

Keynes prefers this method to the Treatise's "state of bearishness" (which was confused) and to propensity to hoard, which is incomplete

14: The classical theory of the rate of interest

In the classical theory, market forces bring rate of interest to the point that amount of investment/demand for investible resources equals amount of saving/supply of investible resources (175-177)
    ▪ But not explicitly stated by Marshall in Principles
        - Or in Cassel's Nature and the Necessity of Wealth
        - Or in Carver's Distribution of Wealth
        - Or in Flux's Economic Principles
        - Or in Taussing's Principles
        - Or in Walras's Elements d'economie pure
        - Keynes also talks about Knight's "Capital, Time, and the Interest Rate"
    ▪ Neoclassical schools believes savings and investment can actually be unequal, while classical school believes they are equal
        - "Indeed, most members of the classical school carried this belief much too far; since they held that every act of increased saving by an individual necessarily brings into existence a corresponding act of increased investment." (p. 178)
    ▪ Keynes argues here that classical theory considers a given income and says the interest rate is at the intersection of demand for investment at interest rates and supply of savings out of given income for different interest rates. They err in believing that the curves can shift independent of income just because income is held constant—if either curve shifts, income shifts and the model based on given income breaks down
    ▪ "Thus the functions used by the classical theory, namely, the response of investment and the response of the amount saved out of a given income to change in the rate of interest, do not furnish material for a theory of the rate of interest; but they could be used to tell us what the level of income will be, given (from some other source) the rate of interest; and, alternatively, what the rate of interest will have to be, if the level of income is to be maintained at a given figure (e.g. the level corresponding to full employment)." (p. 181)

Classical and neoclassical approaches are inconsistent and have adjusted or forced constant the quantity of money to make their systems work (182)
    ▪ But they don't isolate the correct independent variables
        - Savings and investment are determinates
        - Propensity to consume, schedule of the marginal efficiency of capital, and rate of interest are determinants
            ▪ They are complex and intertwined, but their values cannot be inferred form one another
    ▪ "The traditional analysis has been aware that saving depends on income but it has overlooked the fact that income depends on investment, in such fashion that, when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment." (p. 184)
    ▪ Economists have assumed:
        - Decreased spending => decreased rate of interest, ceteris paribus
        - Increased investment => increase rate of interest, ceteris paribus
    ▪ But if spending and investment cause employment, our policy looks different
        - Decreased spending => decreased rate of interest and decreased employment, ceteris paribus
    ▪ So traditional ideas and policies about the value of saving might be off


Appendix to Chapter 14 describes what Marshall, Edgeworth, Pigou, Ricardo, and von Mises/Hayek/Robbins say about interest rates

15: The psychological and business incentives to liquidity

Unlike in the Treatise, Keynes looks at an individual's aggregate demand for money, which is composed of different motives (194)
    ▪ "Transactions-motives" (195)
        - Income-motive: Holding cash to cover interval between receipt of income and its spending (also can be described with income-velocity)
        - Business-motive: Holding cash to cover interval between business costs and receipt of sale proceeds
    ▪ "Precautionary-motive" (196)
        - To provide for contingencies and unexpected opportunities
    ▪ "Speculative-motive"
        - "In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income. But it is by playing on the speculative-motive that monetary management (or, in the absence of management, chance changes in the quantity of money) is brought to bear on the economic system" (p. 196)
    ▪ Transactions-motive and precautionary-motive are a response to actual changes in economic activity/income (197)
    ▪ Speculative-motive actions occur continuously and depend on interest rate
        - Evidence for this in the workable open market operations monetary system

Change in interest rates can be due to
    1. Changes in supply of money for speculation, without changes in liquidity function
    2. Changes in expectation affecting liquidity function

M1 amount of cash held to satisfy transactions- and precautionary-motives (199)
M2 amount of cash held to satisfy speculative-motive
L1 and L2 liquidity functions correspond to M1 and M2, respectively
    ▪ L1 liquidity function depends mainly on level of income
    ▪ L2 liquidity function depends mainly on the relation between current rate of interest and state of expectation
M = M1 + M2 = L1(Y) + L2( r )

Relation of changes in M to Y and r (200)
    ▪ Change in M changes r
    ▪ Change in r leads to new equilibrium by changing M2 and by changing Y and therefore M1
    ▪ The split of cash between M1 and M2 in new equilibrium depends on how investment responses to decrease of interest rate r and how income responds to increase in investment

What determines the shape of L1? (201)
    ▪ L1(Y) = Y/V = M1, where V is the income-velocity of money, which we treat as a constant in the short-run

What is the relation between M2 and r?
    ▪ "…what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level of r" (p. 201)
    ▪ But in any state of expectation, a decrease in r => M2 increases (202)
        - Reduces market rate r relative to (given) "safe" rate
        - Reduces earnings from illiquidity

"…[T]he rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal." (p. 203)
    ▪ "The difficulties in the way of maintaining effective demand at a level high enough to provide full employment, which ensue from the association of a conventional and fairly stable long-term rate of interest with a fickle and highly unstable marginal efficiency of capital, should be, by now, obvious to the reader." (p. 204)
    ▪ But public opinion on interest rates can be managed fairly well—see UK after departure from the gold standard with falling long-term interest rates

    1. Monetary authority limits willingness to deal debt of particular types (like long-term debts)
    2. If interest rate falls to a certain level where everyone prefers cash to holding a low-interest yielding debt then control over the interest rate by monetary authorities is lost
        ▪ Keynes says this hasn't occurred before but recommends if it did occur that public authorities could borrow through the banking system "on an unlimited scale at a nominal rate of interest"
    3. Liquidity function flattens so nobody can be induced to hold or give up money
        - Interest rates can't keep pace with marginal efficiency of capital
    4. Intermediate costs of connecting borrower and lender, and allowances for risk (208)


16: Sundry observations on the nature of capital

Saving doesn’t imply future consumption at the same level as would have been if presently consumed (211)
    ▪ Instead it reflects a desire for "wealth"
    ▪ "The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished." (p. 211)
    ▪ Owners don't possess capital-assets but just potential yields from such assets (212)
    ▪ If saving doesn't improve the prospective yield of some asset, it isn't promoting investment

Keynes states he sympathizes with labor as the sole/underlying factor of production
    ▪ Since capital isn't "productive", instead just offering some yield over cost driven by scarcity
    ▪ "We have seen that capital has to be kept scarce enough in the long-period to have a marginal efficiency which is at least equal to the rate of interest for a period equal to the life of the capital, as determined by psychological and institutional conditions." (p. 217)
        - So if a society has so much capital that its marginal efficiency is 0 and investments lose money, stock of capital and level of employment must decrease until aggregate savings is 0
    ▪ There is risk that the aggregate desire to accumulate wealth is not satiated before interest rate hits its minimum—which puts us in a similar awkward position
    ▪ "The post-war experiences of Great Britain and the United States are, indeed, actual examples of how an accumulation of wealth, so large that its marginal efficiency has fallen more rapidly than the rate of interest can fall in the face of the prevailing institutional and psychological factors, can interfere, in conditions mainly of laissez-faire, with a reasonable level of employment and with the standard of life which the technical conditions of production are capable of furnishing." (p. 219)

Digging holes in the ground, paid for from savings, increases employment and income, "the real national dividend of useful goods and services" (220)
    ▪ But a sensible community can understand effective demand better to avoid these "wasteful mitigations"

Keynes suggests we could make capital goods so abundant that the marginal efficiency of capital is zero for "getting rid of the most objectionable features of capitalism" (221)
    ▪ Rate of return on wealth would disappear
    ▪ Rentiers would disappear
    ▪ Assets could still have different prospective yields based on different evaluations of risk

17: The essential properties of interest and money

Rate of interest sets level that marginal efficiency of capital must reach for it to be newly produced, and thus limits the level of employment (222)

How is money different from other assets?

Own-rate of interest -> Future price of some good / Current price equal to some quantity
    ▪ Every commodity will have a different own rate of interest (223)

If money-rate of interest is 5% then
    ▪ Price for future: (Current price)*1.05
    ▪ Price for future * (Quantity / price for future) = Future quantity

Total return expected from ownership of asset over a period = Yield - carrying cost + liquidity-premium = q - c + l (226)
    ▪ "…it is an essential difference between money and all (or most) other assets that in the case of money its liquidity-premium much exceeds its carrying cost, whereas in the case of other assets their carrying cost much exceeds their liquidity- premium" (p. 227)

Keynes then associates q1 with house-rate of interest in terms of houses, -c2 with wheat-rate of interest in terms of what, l3 money-rate of interest in terms of money, since those are the characteristics that determine the commodity
    ▪ Then a1 + q1 = a2 - c2 = l3 in terms of money-interest
    ▪ Wealth is thus directed to houses, wheat, or money depending on which quantity is greatest
    ▪ Suppose rate of interest for money is fixed or falling slower than q1 or -c2 (228)
        - Then a1 and a2 must be rising
        - "In other words, the present money-price of every commodity other than money tends to fall relatively to its expected future price. Hence, if q1 and − c2 continue to fall, a point comes at which it is not profitable to produce any of the commodities, unless the cost of production at some future date is expected to rise above the present cost by an amount which will cover the cost of carrying a stock produced now to the date of the prospective higher price." (p. 228)
    ▪ This relationship occurs if any asset's own-interest rate doesn't decline as output increases (229)

Why can we believe that the money-rate of interest is more reluctant to fall as stock of asset increases than the own-rate of interest for other assets? (230)
    1. Money has small elasticity of production—cannot be readily produced by the private sector, so supply is relatively fixed
    2. But all pure rent-factors meet (1). Money has an additional characteristic they don't have, which is an elasticity of substitution near 0 (231)
        - As exchange value for money rises, no other factor is substituted for it
    3. Could money-rates of interest fall by releasing cash into the liquidity-motive by reducing wages, etc? (232)
        - If fall in wages reduces marginal efficiency of capital, decline in rate of interest could be offset
        - Wages tend to be sticky, and money-wage is more stable than the real wage
        - Money is extremely liquid with no carrying costs, so carrying costs can't offset expectations for the future value of money
"The significance of the money-rate of interest arises, therefore, out of the combination of the characteristics that, through the working of the liquidity-motive, this rate of interest may be somewhat unresponsive to a change in the proportion which the quantity of money bears to other forms of wealth measured in money, and that money has (or may have) zero (or negligible) elasticities both of production and of substitution." (p. 234)

"Unemployment develops, that is to say, because people want the moon;—men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. " (p. 235)
    ▪ The inelastic supply of money is at the root of the problem; but the inelastic supply of gold had always been celebrated as making gold suitable as use for money

"Our conclusion can be stated in the most general form (taking the propensity to consume as given) as follows. No further increase in the rate of investment is possible when the greatest amongst the own-rates of own-interest of all available assets is equal to the greatest amongst the marginal efficiencies of all assets, measured in terms of the asset whose own-rate of own-interest is greatest.
In a position of full employment this condition is necessarily satisfied. But it may also be satisfied before full employment is reached, if there exists some asset, having zero (or relatively small) elasticities of production and substitution, whose rate of interest declines more closely, as output increases, than the marginal efficiencies of capital-assets measured in terms of it." (p. 236)

Low elasticity of production and substitution and low carrying costs => expectation that money will be stable => money's liquidity-premium increases (238)

Keynes writes that Pigou assumes the real wage is more stable than money-wages
    ▪ This assumes stability of employment
    ▪ And then small changes in propensity to consume and inducement to invest would cause wild fluctuations of money-prices (239)
    ▪ So this is a mistake in logic, not just in facts and experience

The peculiarity of money is due to high liquidity relative to low carrying-costs
    ▪ Keynes briefly considers a "non-monetary" economy where no asset meets this condition
    ▪ He argues that historic mortgages with high rates of interest might have played a similar role to money in checking investment in the past (241)
        - "That the world after several millennia of steady individual saving, is so poor as it is in accumulated capital-assets, is to be explained, in my opinion, neither by the improvident propensities of mankind, nor even by the destruction of war, but by the high liquidity-premiums formerly attaching to the ownership of land and now attaching to money." (p. 242)
        - Marshall, in contrast, attributes this to human resistance to deferring gratification "with an unusual dogmatic force"

In the Treatise, Keynes uses "natural" rate of interest but fails to consider how there is a different natural rate for interest for each level of unemployment
    ▪ "I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment" (p. 242-243)
    ▪ Natural rate is just status quo rate, and non-interesting
    ▪ Neutral/optimum rate is consistent with full employment
        - Neutral rate of interest -> Rate of interest in equilibrium of employment and output when elasticity of employment is 0
        - Classical economics assumes the actual rate of interest is always equal to this neutral rate of interest (or to some other rate maintaining unemployment at a constant level) and that the condition is satisfied through the actions of the market or some banking authority
            ▪ "With this limitation in force, the volume of output depends solely on the assumed constant level of employment in conjunction with the current equipment and technique; and we are safely ensconced in a Ricardian world." (p. 244)


18: The general theory of employment re-stated

Given variables (245)
    ▪ Skill and quantity of labor
    ▪ Quality and quantity of equipment
    ▪ Technique
    ▪ Degree of competition
    ▪ Tastes and habits of consumers
    ▪ Disutility of different intensities of labor, supervision, organization
    ▪ Social structures determining distribution of national income

Independent variables
    ▪ Propensity to consume
    ▪ Schedule of marginal efficiency of capital
    ▪ Rate of interest

Dependent variables
    ▪ Volume of employment
    ▪ National income/dividend in wage-units

Given factors influence independent variables but do not determine them. They do determine (246)
    ▪ Level of national income in wage-units corresponding to any level of employment (i.e. the quantity of effort currently devoted to production)
    ▪ Shape of aggregate supply functions for different products (i.e. "the quantity of employment which will be devoted to production corresponding to any given level of effective demand in terms of wage-units"
    ▪ Supply function of labor and what point employment function ceases to be elastic

We could also have 3 different, but interrelated, independent variables
    ▪ Psychological factors: Psychological propensity to consume, psychological attitude to liquidity, psychological expectation of future yield from capital assets
    ▪ Wage-unit determined by bargaining between employers and employees
    ▪ Quantity of money determined by central bank

Keynes's division of independent/dependent variables is arbitrary and determined "entirely by experience" (247)

Keynes summarizes his system excellently (248-250)
    ▪ New investment until supply price of capital-asset and prospective yield make the marginal efficiencies of capital equal to the rate of interest
        - So the rate of new investment determined by
            ▪ Physical conditions of supply in capital goods industries
            ▪ State of confidence concerning prospective yield
            ▪ Psychological attitude to liquidity
            ▪ Quantity of money in wage-units
    ▪ Increase/decrease in rate of investment => Increase/decrease in rate of consumption because of the widening/narrowing gap between income and consumption, only if income is increased/decreased
        - Change in the rate of consumption is in the same direction but smaller than the change in the rate of income
    ▪ Marginal propensity to consume -> The increment of consumption which has to accompany an increment of saving
    ▪ Investment multiplier -> The ratio between increment in wage-units of investment and the corresponding increment of aggregate income in wage-units
    ▪ Take employment multiplier = investment multiplier
        - Then increment of investment => corresponding increment in employment
    ▪ Increase/decrease employment => raise/lower schedule of liquidity-preference
        - Increase in value of output (even if prices and wages constant) and/or increase in wage-unit and increase in price-unit all increase the demand for money

Experience shows the economic system is largely stable
    ▪ "[The economic system] seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. Moreover, the evidence indicates that full, or even approximately full, employment is of rare and short-lived occurrence. Fluctuations may start briskly but seem to wear themselves out before they have proceeded to great extremes, and an intermediate situation which is neither desperate nor satisfactory is our normal lot." (p. 249-250)
    ▪ What properties give rise to this stability? (250)
        - Output increases due to increase in employment but the multiplier is not very large
        - Moderate changes in prospective yield of capital-asset or to rate of interest don't cause big changes in investment rate
        - Investment falling affects marginal efficiency so that investment recovers
        - Consumption increases due to increased employment but by less than the full increment of income (which feeds into the first property)
    ▪ "Thus our four conditions together are adequate to explain the outstanding features of our actual experience;—namely, that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life." (p. 254)

BOOK V: MONEY-WAGES AND PRICES

19: Changes in money-wages

Classical theory: Reducing money wages stimulates demand since prices fall, so output increases and employment increases until a level of employment that just accepts money-wage reduction is offset by diminishing marginal efficiency of labor from increased output (257)
    ▪ The error of reasoning of the classical approach lies in extending the model of demand schedules for specific industries (relating employment and wages in the industry) to the whole economy
    ▪ But the demand schedules for industries are built on assumption about demand/supply schedules in other industries and about aggregate effective demand
    ▪ "It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed." (p. 259)
        - But the interesting question here is whether a reduction in money wages changes aggregate effective demand (to understand the effect on aggregate employment)
    ▪ "Professor Pigou's Theory of Unemployment seems to me to get out of the classical theory all that can be got out of it; with the result that the book becomes a striking demonstration that this theory has nothing to offer, when it is applied to the problem of what determines the volume of actual employment as a whole." (p. 260)

Reduction in money wages does not ceteris paribus increase employment
    ▪ "For we have shown that the volume of employment is uniquely correlated with the volume of effective demand measured in wage-units, and that the effective demand, being the sum of the expected consumption and the expected investment, cannot change, if the propensity to consume, the schedule of marginal efficiency of capital and the rate of interest are all unchanged. If, without any change in these factors, the entrepreneurs were to increase employment as a whole, their proceeds will necessarily fall short of their supply-price." (p. 260-261)

Reducing wages doesn't increase employment from lowered "cost of production" unless marginal propensity to consume = 1 (so no gap between increase in income and increase in consumption) or unless there is an increase in investment to cover gap between increment of income and consumption (which would require schedule of marginal efficiency of capital increased relative to interest rates)

How will a reduction in money wages affect community's propensity to consume, the schedule of the marginal efficiencies of capital, or rates of interest? (262)
    1. Money-wages decreased => prices decrease
        - Redistributes real income from wage-earners whose wages were reduced to those who wages weren't, and from entrepreneurs to rentiers on incomes fixed in terms of money
    2. In an open system, money wages decreased => reduction in money wages relative to abroad => increased balance of trade => increased investment
        - "The greater strength of the traditional belief in the efficacy of a reduction in money-wages as a means of increasing employment in Great Britain, as compared with the United States, is probably attributable to the latter being, comparatively with ourselves, a closed system." (p. 263)
    3. In an open system, money wages decreased => worse terms of trade => decreased real income => increased propensity to consume
    4. Money-wages decreased relative to future money-wages => increased marginal efficiency of capital => increased investment and increased consumption
        - Opposite if it leads to future expectations of wage reductions (decreased marginal efficiency of capital => decreased investment and decreased consumption)
    5. Money-wages decreased => decreased prices and decreased income => decreased schedule of liquidity preference
    6. General reduction of money-wages could make entrepreneurs optimistic and get the economy moving again—but this could be upset by labor troubles, since a general reduction in wages would be more strongly resisted than a gradual/automatic wage lowering as a result of rising prices
    7. But if wages and prices fall too far, entrepreneurs might face too great a burden of debt, adversely affecting investment

So any favorable effects on employment from reducing wages would come from increased marginal efficiency of capital in (4) or decreased interest rates in (5) (264)
    ▪ (4) would mean people believe wages have touched bottom and must rebound (265)
    ▪ Adjusting wages to this level in response to a slowing economy would be difficult administratively
    ▪ "Self-adjusting" economic systems rely on effect of falling wages and prices on demand for money (266)
        - But reducing wages works just like reducing quantity of money
        - "Just as a moderate increase in the quantity of money may exert an inadequate influence over the long-term rate of interest, whilst an immoderate increase may offset its other advantages by its disturbing effect on confidence; so a moderate reduction in money-wages may prove inadequate, whilst an immoderate reduction might shatter confidence even if it were practicable." (p. 266-267)

It's just as impossible for flexible wage policies to self-adjust to maintain full employment as flexible open-market monetary policy—and flexible money policy should be preferred to flexible wage policy (267)
    ▪ Wage policy cannot be enacted uniformly across all classes of labor, so those in the weakest bargaining position would be hurt the most with flexible wage policy. In contrast, we already have the means for flexible money policy
    ▪ Flexible wage policy disadvantages workers with flexible wages while advantaging those with fixed money wages (268)
    ▪ Increasing quantity of money in terms of wage-units by decreasing wages increases burden of debt, while just increasing quantity of money decreases burden of debt
    ▪ Sagging rate of interest due to sagging wage level is a double drag on marginal efficiencies of capital (269)

So gradual diminishing of money-wage doesn’t necessarily reduce real wages, since it can adversely affect output. Only a sudden, large, general wage policy could have the right effect—and as in Australia at the tine, this can cause a lot of instability
    ▪ "In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges." (p. 270)

Rigid wages = > short-run prices avoid fluctuations in employment, and in the long-run either prices fall slowly while wages are stable or wages rise with prices stable (271)
    ▪ Keynes prefers the latter

Appendix to Chapter 19 critiques Pigou's Theory of Unemployment directly (272-279)

20: The employment function

Z = phi(N) aggregate supply function relates employment N and aggregate supply price of corresponding output (280)
    ▪ Employment function is like the inverse of the aggregate supply function but defined in terms of wage-unit
    
Employment function relates effective demand in wage-unit for industry or whole economy with amount of employment whose supply price of output corresponds with effective demand

Dwr effective demand in wage-units in firm or industry
Nr amount of employment in firm or industry
Employment function Nr = Fr(Dwr)
If Dwr is a unique function of the total effective demand Dw, then employment function is Nr = Fr(Dw)
    ▪ Nr workers employed in industry r when effective demand is Dw

Why substitute employment function for supply curve? (281)
    ▪ Uses the units we are using, which are well-defined
    ▪ Lends itself to output as a whole, not just for a single firm or industry
        - Demand for a commodity makes assumptions about income so needs to be adjusted if incomes change; supply for a commodity makes assumptions about output so needs to be adjusted if aggregate output changes
        - So changes in aggregate employment require looking at changes in these two families of curves, and using employment function we can get a function for the industry as a whole

Given propensity to consume, etc., as employment changes in response to rate of investment, every level of effective demand in wage units corresponds to a level of aggregate employment (281)
    ▪ Effective demand proportioned between consumption and investment
    ▪ Corresponds to level of income
    ▪ Unique distribution of effective demand between different industries

What amount of employment in each industry corresponds to given level of aggregate employment? (282)
    ▪ Employment function for economy (that corresponds to level of effective demand) equals sum of employment functions for each industry

F(Dw) = N = sum(Nr) = sum(Fr(Dw))
Elasticity of employment for given industry : Eer = dNr/dDw * Dwr/Nr
    ▪ Response of number of labour units employed to changes in number of wage-units spend on purchasing output
Elasticity of employment for industry as a whole: Ee = dR/dDw * Dw/N
Elasticity of output/production: Eor = dOr/dDwr * Dwr/Or
    ▪ Rate of output in industry increased when more effective demand in wage-units is directed to it
Price = marginal prime cost => Change in Dwr = 1/(1-Eor)* change in Pr
    ▪ Pr -> expected profit
Eor = 0 => change in Dwr = change in Pr
    ▪ All increased effective demand accrues to entrepreneur as profit
Eor = 1 => phi''(Nr) = 0 (constant returns to increased employment)
    ▪ All increased effective demand accrues to factors entering marginal prime output
Phi(Nr) function for output of industry as function of labor employed
    ▪ (1 - Eor)/Eer = -(Nr * phi''(Nr))/(Pwr{phi'(Nr)}^2 ')
    ▪ Pwr expected price of unit output in terms of wage unit

When classical assumption that real wages = marginal disutility of labor (which increases with employment) does not hold, then increased expenditure in terms of money => increased employment until rage wages = marginal disutility of labor (full employment) (284)
    ▪ Amount real wages falls with money expenditure depends on elasticity of output

Elasticity of expected price pwr to changes in effective demand Dwr =E'pr = dPwr/dDwr * Dwr/Pwr
Or * Pwr = Dwr=> dOr/dDwr * Dwr/Or + dPwr/dDwr * Dwr/Pwr = E'pr + Eor = 1
    ▪ "That is to say, the sum of the elasticities of price and of output in response to changes in effective demand (measured in terms of wage-units) is equal to unity. Effective demand spends itsell, partly in affecting output and partly in affecting price, according to this law. " (p. 285)

For industry as a whole, E'p + Eo = 1
    ▪ Now in money and not wage-units
    ▪ W money-wages of labor
    ▪ P expected price for unit output as a whole in terms of money
    ▪ Elasticity of money-prices in response to changes in effective demand in money = Ep = dP/dD * D/P
    ▪ Elasticity of money-wages in response to changes in effective demand in money = Ew = dW/dD * D/W
    ▪ Ep = 1 = Eo(1- Ew)
        - Eo = 0 or Ew = 1 => Output unaltered and prices rise in proportion to effective demand in terms of money

We had assumed each level of aggregate effective demand had a corresponding unique distribution of effective demand across industries (286)
    ▪ But aggregate expenditure changes won't change expenditure on products proportionally
    ▪ "…the way in which we suppose the increase in aggregate demand to be distributed between different commodities may considerably influence the volume of employment. " (p. 286)

n period of production ->  n time-units of notice of changes in demand for product needed for full elasticity of employment(287)

Price instability due to changes in demand for products doesn't affect actions of entrepreneurs but instead affects the way the windfall wealth is distributed (288)

What happens if expenditure is increased past the point of full employment? (289)
    ▪ Wages, prices, and profits rise in proportion to expenditure
    ▪ "Crude" quantity theory of money result that output does not change and that prices rise proportionally to MV (where V is income-velocity)
        - Rising prices could confuse entrepreneurs into increasing employment past profitable levels (290)
        - If fixed money-rents, could redistribute incomes to advantage entrepreneur and disadvantage rentiers
    ▪ "There is, perhaps, something a little perplexing in the apparent asymmetry between inflation and deflation. For whilst a deflation of effective demand below the level required for full employment will diminish employment as well as prices, an inflation of it above this level will merely affect prices." (p. 291)
        - But workers can always refuse to work while they can't demand real wages more than the marginal disutility of employment


21: The theory of prices

Division between theory of value and distribution (supply, demand, marginal cost, elasticity of supply) and the theory of money and prices (quantity of money, income velocity, velocity of circulation, hoarding, forced saving, inflation, deflation) is false (292)
    ▪ "The right dichotomy is, I suggest, between the theory of the individual industry or firm and of the rewards and the distribution between different uses of a given quantity of resources on the one hand, and the theory of output and employment as a whole on the other hand." (p. 293)
    ▪ Or the dichotomy of stationary vs shifting equilibrium
        - Since money links present and future
        - Considering money is unavoidable in a shifting equilibrium model, but it doesn't become a "theory of money" separate from the theory of value and distribution (294)

Just like for a single industry, the aggregate price level depends on the rate of remuneration of factors of production that enter marginal cost and on the scale of output (i.e. the volume of employment given equipment and technique)
    ▪ Unlike for a single industry, we need to consider changes in demand on the costs and volume

Assume for simplification that the different factors of production entering into marginal cost all change in the same proportion as the wage-unit. Then the general price level, given equipment and technique, depends on the wage unit and the volume of employment. The way quantity of money must affect price is then through these factors. (295)
    ▪ Assume also that all unemployed resources are homogenous and that factors of production take same money-wage if there is some unemployment (i.e. constant returns and a rigid wage unit, so long as there is unemployment)
    ▪ Then with unemployment, perfectly elastic supply
    ▪ At full employment, perfectly inelastic supply
        - And if effective demand changes proportionally to quantity of money, the quantity theory of money says: "So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money." (p. 296)

Next consider five interrelated complicating factors (297)
    ▪ "The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking." (p. 297)
        - Formal thinking is essential
        - But assuming strict independence between factors is difficult to maintain in real world
    ▪ "…in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep 'at the back of our heads' the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials 'at the back' of several pages of algebra which assume that they all vanish. Too large a proportion of recent 'mathematical' economics are merely concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. " (p. 297-298)
    ▪ The five factors
        1. "Effective demand will not change in exact proportion to the quantity of money" (p. 296)
            - Through the rate of interest, which depends on the schedule of liquidity preference, the schedule of marginal efficiencies of capital, and the investment multiplier (which all depend on the other complicating factors)
            - Ratio of quantity of effective demand and quantity of money similar to income-velocity, but Keynes thinks the use of the term causes confusion (299)
        2. "Since resources are not homogenous, there will be diminishing, and not constant, returns as employment gradually increases" (p. 296)
            - Supply price increases as output from given equipment increases, so increased output => increased prices, regardless of wage-unit (300)
        3. "Since resources are not interchangeable, some commodities will reach a condition of inelastic supply whilst there are still unemployed resources available for the production of other commodities." (p. 296)
            - Output can increase to a point where bottlenecks are reached (300)
            - Less important if sufficient time allowed for equipment change (increasing the elasticity of supply)
        4. "The wage-unit will tend to rise, before full employment has been reached." (p. 296)
            - Each group gains by a rise in their own wage, so they pressure in that direction and are more successful when business is doing well (301)
            - Wages rise discontinuously with effective demand
        5. "The remunerations of the factors entering into marginal cost will not all change in the same proportion." (p. 296)
            - Rates of remuneration have different rigidities and elasticities of supply (302)
            - Marginal user cost is especially likely to fluctuate differently from wage-unit

We can construct a cost-unit ->weighted average of remuneration for factors entering marginal prime-cost
    ▪ Cost-unit is essential standard of value

Price level (given technique and equipment) depends then on scale of output and cost-unit
    ▪ Output increases more than proportionally to cost-unit due to short-run diminishing returns
        - Increase in quantity of money increases output and cost-unit
        - Can't draw the line between which part of this increase is inflationary and which part isn't
    ▪ Full employment when marginal return for representative unit of factors of production decreases to equal minimum figure that make quantity of factors needed available (303)
        - Past this point, we have true inflation
        - Increase in effective demand only increases cost-unit

So there's an asymmetry
    ▪ Below critical level that determines true inflation
        - Contraction of effective demand => Reduction in amount of effective demand measured in cost-units
        - Factors of production resist reduction in money-rewards
    ▪ Above critical level
        - Expansion of effective demand => Does not increased effective demand measured in cost-units
        - Factors of production don't resist increase in money-rewards
    ▪ Without this asymmetry (i.e. if wages could fall uncontrollably) there is not a resting place below full employment until interest rates or wages are zero (204)
        - "In fact we must have some factor, the value of which in terms of money is, if not fixed, at least sticky, to give us any stability of values in a monetary system." (p. 304)
    ▪ Treating any increase in quantity of money as inflationary stems from classical assumption that reducing real wages lowers supply (full employment)

MV = D
    ▪ M quantity of money
    ▪ V income-velocity
    ▪ D effective demand

If V constant, then prices p change proportionally to quantity of money if Ep is unity (i.e. if Eo = 0 or if Ew = 1)
    ▪ Ew = 1 => Wage-unit in money rises proportionally to effective demand
    ▪ Ew = 0 => Output doesn’t respond to changes in effective demand

If V is not constant
    ▪ Elasticity of effective demand to changes in quantity of money = Ed = dD/dM * M/D

dP/dM * M/p = Ep * Ed
Ep = 1 - [Ee * Eo(1-Ew)]

E = Ed - (1-Ew)Ed * EeEo = Ed (1 - EeEo + EeEo * Ew)
    ▪ "apex of pyramid" (305)
    ▪ Response of money-prices to change in quantity of money
    ▪ Generalized statement of the quantity theory of money
        - Ed are liquidity factors determining the demand for money
        - Ew are labor factors determining the extent money-wages increase with employment
        - Ee and Eo are physical factors determining rate of decreasing returns with employment increasing on given equipment

Is there a simpler relationship between quantity of money and prices in the long run? (306)
    ▪ This is a historical, not theoretical, question
    ▪ Keynes cites the extended nineteenth century as 150 years where long-run interest rates stable around 5% and gilts at 3-3.5% (p. 308)
        - Modest enough to encourage investment consistent with unemployment "not intolerably low"
        - Stable prices—increasing wages and efficiency
            ▪ Employers prevented wage-units from rising much faster than efficiency
        - Conservative monetary systems kept quantity of money at a level corresponding to lowest acceptable interest rate by wealth-owners given their liquidity preferences
    ▪ "Now" in 1936
        - Lower marginal efficiency of capital than in nineteenth century
        - Average rate of interest tolerable by the wealthy not low enough to permit reasonable level of unemployment (309)
            ▪ So sufficient devaluation is not enough, as it was in the nineteenth century
        - Minimum acceptable rate of interest by wealthy not easily shifted, especially when adjustments for transactions costs, income taxes, and risk and uncertainty are taken into account
            ▪ Keynes cites Bagehot here
"To return to our immediate subject, the long-run relationship between the national income and the quantity of money will depend on liquidity-preferences. And the long-run stability or instability of prices will depend on the strength of the upward trend of the wage-unit (or, more precisely, of the cost-unit) compared with the rate of increase in the efficiency of the productive system." (p. 309)

BOOK VI: SHORT NOTES SUGGESTED BY THE GENERAL THEORY

This is an indulgent section of the General Theory, with observations and insights that have been less relevant in twenty-first century readings of the book.  It's incredibly fun and engaging to read, but only deserving of brief notes.

22: Notes on the trade cycle

In this chapter, Keynes connects the general theory to existing work on the trade cycle, giving particular attention to Jevons's theory of harvest cycles

23: Notes on mercantilism, the usury laws, stamped money, and theories of under-consumption

Keynes gives wide-ranging comments on economic history and thought.

He describes himself and his past views on mercantilism: "So lately as 1923, as a faithful pupil of the classical school who did not at that time doubt what he had been taught and entertained on this matter no reserves at all…" (p. 334) He is now more sympathetic to mercantilism and considers Hecksher's presentation of it very thoroughly.

With regards to interest rates, he writes, "Nevertheless, as a contribution to statecraft, which is concerned with the economic system as a whole and with securing the optimum employment of the system's entire resources, the methods of the early pioneers of economic thinking in the sixteenth and seventeenth centuries may have attained to fragments of practical wisdom which the unrealistic abstractions of Ricardo first forgot and then obliterated. There was wisdom in their intense preoccupation with keeping down the rate of interest by means of usury laws (to which we will return later in this chapter), by maintaining the domestic stock of money and by discouraging rises in the wage-unit; and in their readiness in the last resort to restore the stock of money by devaluation, if it had become plainly deficient through an unavoidable foreign drain, a rise in the wage-unit,or any other cause." (p. 340)

In this same line, he considers Smith and Bentham's critique of Smith. He also writes six pages on Silivio Gesell, considering his work that lead to Irving Fisher's stamped money proposal.

Keynes writes that "the two most delightful occupations open to those who do not have to earn their living" are authorship and experimental farming (p. 354)

He presents Hobson's theory of under-consumption as underappreciated and tells an interesting anecdote about Hobson's co-author and mountaineer friend, A.F. Mummery.

Keynes describes a brave army of heretics "who, following their intuitions, have preferred to see the truth obscurely and imperfectly rather than to maintain error, reached indeed with clearness and consistency and by easy logic but on hypotheses inappropriate to facts" (p. 371) which includes Mandeville, Malthus, Gesell, Hobson, and (to a lesser extent) Major Douglas

24: Concluding notes on the social philosophy towards which the general theory might lead

Keynes considers how his theory affects the distribution of wealth and income. He thinks some inequality is acceptable, but that today (1936) there is too much inequality.

He summarizes his line of criticism as: "Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world." (p. 378)

He defends his theory as not requiring more state socialism—"Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before." (p. 379)

Keynes argues that "curing" unemployment is essential to the maintenance of capitalism, which he sees as beneficial and efficient. "The authoritarian state systems of to-day seem to solve the problem of unemployment at the expense of efficiency and of freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated—and, in my opinion, inevitably associated—with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom." (p. 381)

And now is the time to present such a theory: "At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else…soon or late, it is ideas, not vested interests, which are dangerous for good or evil." (p. 383-384)


Thank you for reading, and please do not use these notes without permission and citation! Let me know in the comments below of any errors you find.