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The General Theory of Employment, Interest and Money

The General Theory of Employment, Interest and Money of 1936 is the last and most important book by the English economist John Maynard Keynes. It created a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology[1] – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.

The General Theory of Employment, Interest and Money
GT Palgrave.jpg
AuthorJohn Maynard Keynes
CountryUnited Kingdom
PublisherPalgrave Macmillan
Publication date
Media typePrint paperback
Pages472 (2007 edition)

Keynes denied that an economy would automatically adapt to provide full employment even in equilibrium, and believed that the volatile and ungovernable psychology of markets would lead to periodic booms and crises. The General Theory is a sustained attack on the 'classical' orthodoxy of its time. It introduced the concepts of the consumption function, the principle of effective demand and liquidity preference, and gave new prominence to the multiplier and the marginal efficiency of capital.


Keynes's aims in the General TheoryEdit

The central argument of The General Theory  is that the level of employment is determined not by the price of labour, as in classical economics, but by the level of aggregate demand. If the total demand for goods at full employment is less than the total output, then the economy has to contract until equality is achieved. Keynes thus denied that full employment was the natural result of competitive markets in equilibrium.

In this he challenged the conventional ('classical') economic wisdom of his day. In a letter to his friend George Bernard Shaw on New Year's Day, 1935, he wrote:

I believe myself to be writing a book on economic theory which will largely revolutionize — not I suppose, at once but in the course of the next ten years — the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say,— in my own mind, I'm quite sure.[2]

The first chapter of the General theory (only half a page long) has a similarly radical tone:

I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

Summary of the General TheoryEdit

Keynes's main theory (including its dynamic elements) is presented in Chapters 2-15, 18, and 22, which are summarised here. A shorter account will be found in the article on Keynesian economics. The remaining chapters of Keynes's book contain amplifications of various sorts and are described later in this article.

Book I: IntroductionEdit

The first Book of the General Theory is a repudiation of Say's Law. The classical view for which Keynes made Say a mouthpiece held that the value of wages was equal to the value of the goods produced, and that the wages were inevitably put back into the economy sustaining demand at the level of current production. Hence, starting from full employment, there cannot be a glut of industrial output leading to a loss of jobs. As Keynes put it on p18, "supply creates its own demand".

Stickiness of wages in money termsEdit

Say's Law depends on the operation of a market economy. If there is unemployment (and if there are no distortions preventing the employment market from adjusting to it) then there will be workers willing to offer their labour at less than the current wage levels, leading to downward pressure on wages and increased offers of jobs.

The classics held that full employment was the equilibrium condition of an undistorted labour market, but they and Keynes agreed in the existence of distortions impeding transition to equilibrium. The classical position had generally been to view the distortions as the culprit[3] and to argue that their removal was the main tool for eliminating unemployment. Keynes on the other hand viewed the market distortions as part of the economic fabric and advocated different policy measures which (as a separate consideration) had social consequences which he personally found congenial and which he expected his readers to see in the same light.

The distortions which have prevented wage levels from adapting downwards have lain in employment contracts being expressed in monetary terms; in various forms of legislation such as the minimum wage and in state-supplied benefits; in the unwillingness of workers to accept reductions in their income; and in their ability through unionisation to resist the market forces exerting downward pressure on them.

Keynes accepted the classical relation between wages and the marginal productivity of labour, referring to it on p5[4] as the 'first postulate of classical economics' and summarising it as saying that 'The wage is equal to the marginal product of labour'.

The first postulate can be expressed in the equation y' (N ) = W / p, where y (N ) is the real output when employment is N, and W  and p  are the wage rate and price rate in money terms (and hence W / p  is the wage rate in real terms). A system can be analysed on the assumption that W  is fixed (i.e. that wages are fixed in money terms) or that W / p is fixed (i.e. that they are fixed in real terms) or that N  is fixed (e.g. if wages adapt to ensure full employment). All three assumptions had at times been made by classical economists, but under the assumption of wages fixed in money terms the 'first postulate' becomes an equation in two variables (N  and p ), and the consequences of this had not been taken into account by the classical school.

Keynes proposed a 'second postulate of classical economics' asserting that the wage is equal to the marginal disutility of labour. This is an instance of wages being fixed in real terms. He attributes the second postulate to the classics subject to the qualification that unemployment may result from wages being fixed by legislation, collective bargaining, or 'mere human obstinacy'  (p6), none of which can be identified with the marginal disutility of labour and all of which are likely to fix wages in money terms.

Outline of Keynes's theoryEdit

Keynes's economic theory is based on the interaction between demands for saving, investment, and liquidity (i.e. money). Saving and investment are necessarily equal, but different factors influence decisions concerning them. The desire to save, in Keynes's analysis, is mostly a function of income: the richer people are, the more wealth they will seek to put aside. The profitability of investment, on the other hand, is determined by the relation between the return available to capital and the interest rate. The economy needs to find its way to an equilibrium in which no more money is being saved than will be invested, and this can be accomplished by contraction of income and a consequent reduction in the level of employment.

In the classical scheme it is the interest rate rather than income which adjusts to maintain equilibrium between saving and investment; but Keynes asserts that the rate of interest already performs another function in the economy, that of equating demand and supply of money, and that it cannot adjust to maintain two separate equilibria. In his view it is the monetary role which wins out. This is why Keynes's theory is a theory of money as much as of employment: the monetary economy of interest and liquidity interacts with the real economy of production, investment and consumption.

Book II: Definitions and ideasEdit

The choice of unitsEdit

Keynes sought to allow for the lack of downwards flexibility of wages by constructing an economic model in which the money supply and wage rates were externally determined (the latter in money terms), and in which the main variables were fixed by the equilibrium conditions of various markets in the presence of these facts.

Many of the quantities of interest, such as income and consumption, are monetary. Keynes often expresses such quantities in wage units (Chapter 4): to be precise, a value in wage units is equal to its price in money terms divided by W, the wage (in money units) per man-hour of labour. Keynes generally writes a subscript w  on quantities expressed in wage units, but in this account we omit the w. When, occasionally, we use real terms for a value which Keynes expresses in wage units we write it in lower case (e.g. y  rather than Y ).

As a result of Keynes's choice of units, the assumption of sticky wages, though important to the argument, is largely invisible in the reasoning. If we want to know how a change in the wage rate would influence the economy, Keynes tells us on p266 that the effect is the same as that of an opposite change in the money supply.

The identity of saving and investmentEdit

The relationship between saving and investment, and the factors influencing their demands, play an important role in Keynes's model. Saving and investment are considered to be necessarily equal for reasons set out in Chapter 6 which looks at economic aggregates from the viewpoint of manufacturers. The discussion is intricate, considering matters such as the depreciation of machinery, but is summarised on p63:

Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumption... the equality of saving and investment necessarily follows.

This statement incorporates Keynes's definition of saving, which is the normal one.

Book III: The propensity to consumeEdit

Keynes's propensities to consume and to save as functions of income Y.

Book III of the General Theory is given over to the propensity to consume, which is introduced in Chapter 8 as the desired level of expenditure on consumption (for an individual or aggregated over an economy). The demand for consumer goods depends chiefly on the income Y and may be written functionally as C (Y ). Saving is that part of income which is not consumed, so the propensity to save S (Y ) is equal to Y – C (Y ). Keynes discusses the possible influence of the interest rate r  on the relative attractiveness of saving and consumption, but regards it as 'complex and uncertain' and leaves it out as a parameter.

His seemingly innocent definitions embody an assumption whose consequences will be considered later. Since Y  is measured in wage units, the proportion of income saved is considered to be unaffected by the change in real income resulting from a change in the price level while wages stay fixed. Keynes acknowledges that this is undesirable in Point (1) of Section II. It would be possible to correct it by giving the propensity to consume a form like C (Y, p /W ) where p  is the price level, but Keynes does not do so.

In Chapter 9 he provides a homiletic enumeration of the motives to consume or not to do so, finding them to lie in social and psychological considerations which can be expected to be relatively stable, but which may be influenced by objective factors such as 'changes in expectations of the relation between the present and the future level of income' (p95).

The marginal propensity to consume and the multiplierEdit

The marginal propensity to consume, C '(Y ), is the gradient of the purple curve, and the marginal propensity to save S '(Y ) is equal to 1 – C '(Y ). Keynes states as a 'fundamental psychological law' (p96) that the marginal propensity to consume will be positive and less than unity.

Chapter 10 introduces the famous 'multiplier' through an example: if the marginal propensity to consume is 90%, then 'the multiplier k is 10; and the total employment caused by (e.g.) increased public works will be ten times the employment caused by the public works themselves' (pp116f). Formally Keynes writes the multiplier as k = 1/S '(Y ). It follows from his 'fundamental psychological law' that k  will be greater than 1.

Keynes's account is not intelligible until his economic system has been fully set out (see below). In Chapter 10 he describes his multiplier as being related to the one introduced by R. F. Kahn in 1931,[5] but the two have little in common. The mechanism of Kahn's multiplier lies in an infinite series of transactions, each conceived of as creating employment: if you spend a certain amount of money, then the recipient will spend a proportion of what he or she receives, the second recipient will spend a further proportion again, and so forth. Enough meaning can be extracted from Keynes's account of his own mechanism (in the second para of p117) to see that it makes no reference to infinite series. It also differs from Kahn's multiplier in being attached to investment rather than to spending in general, and in having a value determined by the marginal propensity to consume rather than by the marginal propensity to spend.

Book IV: The inducement to investEdit

The rate of investmentEdit

Keynes's schedule of the marginal efficiency of capital

Book IV discusses the inducement to invest, with the key ideas being presented in Chapter 11. The 'marginal efficiency of capital' is defined as the annual revenue which will be yielded by an extra increment of capital as a proportion of its cost. The 'schedule of the marginal efficiency of capital' is the function which, for any rate of interest r, gives us the level of investment which will take place if all opportunities are accepted whose return is at least r. By construction this depends on r  alone and is a decreasing function of its argument; it is illustrated in the diagram, and we shall write it as Is (r ).

This schedule is a characteristic of the current industrial process which Irving Fisher described as representing the 'investment opportunity side of interest theory';[6] and in fact the condition that it should equal S (Y,r ) is the equation which determines the interest rate from income in classical theory. Keynes is seeking to reverse the direction of causality (and omitting r  as an argument to S () ).

He interprets the schedule as expressing the demand for investment at any given value of r , giving it an alternative name: "We shall call this the investment demand-schedule..." (p136). He also refers to it as the 'demand curve for capital' (p178). However it has many of the properties of a supply curve (for instance not being constrained by income). It is analogous to the curve giving the amount of gold which can be extracted from the soil at a price less than p. Nonetheless the schedule of the marginal efficiency of capital was a demand function in Keynes's eyes.

For fixed industrial conditions, we conclude that 'the amount of investment... depends on the rate of interest' as John Hicks put it in 'Mr Keynes and the "Classics" '.

Interest and liquidity preferenceEdit

Keynes proposes two theories of liquidity preference (i.e. the demand for money): the first as a theory of interest in Chapter 13 and the second as a correction in Chapter 15. His arguments offer ample scope for criticism, but his final conclusion is that liquidity preference is a function mainly of income and the interest rate. The influence of income (which really represents a composite of income and wealth) is common ground with the classical tradition and is embodied in the Quantity Theory; the influence of interest had also been noted earlier, in particular by Frederick Lavington (see Hicks's Mr Keynes and the "Classics"). Thus Keynes's final conclusion may be acceptable to readers who question the arguments along the way. However he shows a persistent tendency to think in terms of the Chapter 13 theory while nominally accepting the Chapter 15 correction.

Chapter 13 presents the first theory in rather metaphysical terms. Keynes argues that:

It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.[7]

To which Jacob Viner retorted that:

By analogous reasoning he could deny that wages are the reward for labor, or that profit is the reward for risk-taking, because labor is sometimes done without anticipation or realization of a return, and men who assume financial risks have been known to incur losses as a result instead of profits.[8]

Keynes goes on to claim that the demand for money is a function of the interest rate alone on the grounds that:

The rate of interest is... the "price" which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash... [9]

which, as Frank Knight commented,[10] seems to assume that demand is simply an inverse function of price. The upshot from these reasonings is that:

Liquidity-preference is a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r  is the rate of interest, M  the quantity of money and L  the function of liquidity-preference, we have M  = L(r ). This is where, and how, the quantity of money enters into the economic scheme.[11]

And specifically it determines the rate of interest, which therefore cannot be determined by the traditional factors of 'productivity and thrift'.

Chapter 15 looks in more detail at the three motives Keynes ascribes for the holding of money: the 'transactions motive', the 'precautionary motive', and the 'speculative motive'. He considers that demand arising from the first two motives 'mainly depends on the level of income' (p199), while the interest rate is 'likely to be a minor factor' (p196).

Keynes treats the speculative demand for money as a function of r  alone without justifying its independence of income. He says that...

what matters is not the absolute  level of r  but the degree of its divergence from what is considered a fairly safe  level... [12]

but gives reasons to suppose that demand will nonetheless tend to decrease as r  increases. He thus writes liquidity preference in the form L1(Y ) + L2(r ) where L1 is the sum of transaction and precautionary demands and L2 measures speculative demand. The structure of Keynes's expression plays no part in his subsequent theory, so it does no harm to follow Hicks by writing liquidity preference simply as L (Y,r ).

'The quantity of money as determined by the action of the central bank' is taken as given (i.e. exogenous - p247) and constant (because hoarding is ruled out on p174 by the fact that the necessary expansion of the money supply cannot be 'determined by the public').

Keynes does not put a subscript 'w ' on L or M, implying that we should think of them in money terms. This suggestion is reinforced by his wording on p172 where he says "Unless we measure liquidity-preference in terms of wage-units (which is convenient in some contexts)... ". But seventy pages later there is a fairly clear statement that liquidity preference and the quantity of money are indeed "measured in terms of wage-units" (p246).

The Keynesian economic systemEdit

Keynes's economic modelEdit

In Chapter 14 Keynes contrasts the classical theory of interest with his own, and in making the comparison he shows how his system can be applied to explain all the principal economic unknowns from the facts he takes as given. The two topics can be treated together because they are different ways of analysing the same equation.

Keynes's presentation is informal. To make it more precise we will identify a set of 4 variables – saving, investment, the rate of interest, and the national income – and a parallel set of 4 equations which jointly determine them. The graph illustrates the reasoning. The red S  lines are shown as increasing functions of r  in obedience to classical theory; for Keynes they should be horizontal.

Graphical representation of Keynes's economic model, based on his own diagram at p180 of the General Theory.

The first equation asserts that the reigning rate of interest   is determined from the amount of money in circulation   through the liquidity preference function and the assumption that L ( ) = .

The second equation fixes the level of investment   given the rate of interest through the schedule of the marginal efficiency of capital as Is ( ).

The third equation tells us that saving is equal to investment: S (Y ) = . The final equation tells us that the income   is the value of Y  corresponding to the implied level of saving.

All this makes a satisfying theoretical system.

Three comments can be made concerning the argument. Firstly, no use is made of the 'first postulate of classical economics', which can be called on later to set the price level. Secondly, Hicks (in 'Mr Keynes and the "Classics" ') presents his version of Keynes's system with a single variable representing both saving and investment; so his exposition has three equations in three unknowns.

And finally, since Keynes's discussion takes place in Chapter 14, it precedes the modification which makes liquidity preference depend on income as well as on the rate of interest. Once this modification has been made the unknowns can no longer be recovered sequentially.

Keynesian economic interventionEdit

The state of the economy, according to Keynes, is determined by four parameters: the money supply, the demand functions for consumption (or equivalently for saving) and for liquidity, and the schedule of the marginal efficiency of capital determined by 'the existing quantity of equipment' and 'the state of long-term expectation' (p246).

Adjusting the money supply is the domain of monetary policy. The effect of a change in the quantity of money is considered at p298. The change is effected in the first place in money units. According to Keynes's account on p295, wages will not change if there is any unemployment, with the result that the money supply will change to the same extent in wage units.

We can then analyse its effect from the diagram, in which we see that an increase in   shifts   to the left, pushing   upwards and leading to an increase in total income (and employment) whose size depends on the gradients of all 3 demand functions. If we look at the change in income as a function of the upwards shift of the schedule of the marginal efficiency of capital (blue curve), we see that as the level of investment is increased by one unit, the income must adjust so that the level of saving (red curve) is one unit greater, and hence the increase in income must be 1 / S' (Y ) units, i.e. k units. This is the explanation of Keynes's multiplier.

It does not necessarily follow that individual decisions to invest will have a similar effect, since decisions to invest above the level suggested by the schedule of the marginal efficiency of capital are not the same thing as an increase in the schedule.

The equations of Keynesian and classical economicsEdit

Keynes's initial statement of his economic model (in Chapter 14) is based on his Chapter 13 theory of liquidity preference. His restatement in Chapter 18 doesn't take full account of his Chapter 15 revision, treating it as a source of 'repercussions' rather than as an integral component. It was left to John Hicks to give a satisfactory presentation.[13] Equilibrium between supply and demand of money depends on two variables – interest rate and income – and these are the same two variables as are related by the equation between the propensity to save and the schedule of the marginal efficiency of capital. It follows that neither equation can be solved in isolation and that they need to be considered simultaneously.

The 'first postulate' of classical economics was also accepted as valid by Keynes, though not used in the first four books of the General Theory. The Keynesian system can thus be represented by three equations in three variables as shown below, roughly following Hicks. Three analogous equations can be given for classical economics. As presented below they are in forms given by Keynes himself (the practice of writing r  as an argument to V  derives from his Treatise on money[14]).

Classical Keynesian
y' (N ) = W / p The 'first postulate' d (W · Y / p ) / dN  = W / p
is (r ) = s (y (N ),r ) Determination of the interest rate Is (r ) = S (Y ) Determination of income
= p ·y (N ) / V (r ) Quantity theory of money = L (Y ,r ) Liquidity preference
y, is , s  in real terms; in money terms Y, Is , S , , L in wage units

Here y  is written as a function of N, the number of workers employed; p  is the price (in money terms) of a unit of real output; V (r ) is the velocity of money; and W is the wage rate in money terms. N, p  and r  are the 3 variables we need to recover. In the Keynesian system income is measured in wage units and is therefore not a function of the level of employment alone since it will also vary with prices. The first postulate assumes that prices can be represented by a single variable. Strictly it should be modified to take account of the distinction between marginal wage cost and marginal prime cost.[15]

The classics took the second equation as determining the rate of interest, the third as determining the price level, and the first as determining employment. Keynes believed (perhaps incorrectly: see wage unit) that the last two equations could be solved together for Y  and r , which is not possible in the classical system. He accordingly concentrated on these two equations, treating income as 'almost the same thing' as employment on p247 but looking more closely at the relation between them in Chapter 20. Here we see the benefit he has gained by simplifying the form of the consumption function. If he had written it (slightly more accurately) as C (Y, p /W ), then he would have needed to bring in the first equation to get a solution.

The classical theory of employment for wages fixed in money terms. (The three curves have different vertical scales.)

If we wish to examine the classical system our task is made easier if we assume that the effect of the interest rate on the velocity of circulation is small enough to be ignored. This allows us to treat V  as constant and solve the first and third equations (the 'first postulate' and the quantity theory) together, leaving the second equation to determine the interest rate from the result.[16] We then find that the level of employment is given by the formula


The graph shows the numerator and denominator of the left-hand side as blue and green curves; their ratio – the pink curve – will be a decreasing function of N  even if we don't assume diminishing marginal returns. The level of employment   is given by the horizontal position at which the pink curve has a value of  , and this is evidently a decreasing function of W. This diagram cannot have been in Keynes's mind when he wrote (Chapter 2, p12) that "one would have expected the classical school to argue" that if money-wages change then the effect on prices would leave "the level of unemployment practically the same as before".

Chapter 3: The principle of effective demandEdit

The theoretical system we have described is developed over chapters 4–18, and is anticipated by a chapter which – amidst a proliferation of symbols – interprets Keynesian unemployment in terms of 'aggregate demand'.

The aggregate supply Z  is the total value of output when N  workers are employed, written functionally as φ(N ). The aggregate demand D  is manufacturers' expected proceeds, written as f (N ). In equilibrium Z  = D. D  can be decomposed as D1 + D2  where D1  is the propensity to consume, which may be written C (Y ) or χ(N ). D2  is explained as 'the volume of investment', and the equilibrium condition determining the level of employment is that D1 + D2  should equal Z  as functions of N. D2  can be identified with Is (r ).

The meaning of this is that in equilibrium the total demand for goods must equal total income. Total demand for goods is the sum of demand for consumption goods and demand for investment goods. Hence Y = C (Y ) + S (Y ) = C (Y ) + Is (r ); and this equation determines a unique value of Y  given r.

Samuelson's Keynesian cross is a graphical representation of the Chapter 3 argument.[17]

Dynamic aspects of Keynes's theoryEdit

Chapter 5: Expectation as determining output and employmentEdit

Chapter 5 makes some common-sense observations on the role of expectation in economics. Short-term expectations govern the level of production chosen by an entrepreneur while long-term expectations govern decisions to adjust the level of capitalisation. Keynes describes the process by which the level of employment adapts to a change in long-term expectations and remarks that:

the level of employment at any time depends... not merely on the existing state of expectation but on the states of expectation which have existed over a certain past period. Nevertheless past expectations, which have not yet worked themselves out, are embodied in to-day's capital equipment... and only influence [the entrepreneur's] decisions in so far as they are so embodied...[18]

Chapter 11: Expectation as influencing the schedule of the marginal efficiency of capitalEdit

The main role of expectation in Keynes's theory lies in the schedule of the marginal efficiency of capital which, as we have seen, is defined in Chapter 11 in terms of expected  returns. Keynes differs here from Fisher[19] whom he largely follows, but who defined the 'rate of return over cost' in terms of an actual revenue stream rather than its expectation. Keynes was certainly correct in this, and the point has a particular significance in his theory.

Chapters 14, 18: The schedule of the marginal efficiency of capital as influencing employmentEdit

Keynes differed from his classical predecessors in assigning a role to the schedule of the marginal efficiency of capital in determining the level of employment. The classics regarded this, as they regarded other supply curves, as simply influencing the allocation of resources. But here too, even from a classical point of view, Keynes can be seen to be correct, at least assuming fixed wage rates. The classics (who had written little about unemployment) had not taken account of Lavington's observation[20] that interest is the opportunity cost of holding money. They should have reasoned that an increase in the marginal efficiency of capital leads to an increase in the interest rate which increases the cost of holding money and therefore leads to faster circulation; that this has the same effect on prices as an increase in the money supply; and that higher prices at a given wage level lead to higher employment. They might have thought this to be a weak effect, but they could not with consistency have denied its existence.

On the other hand, Keynes may have considered the effect to be larger than it really is. He defines his multiplier k  as 1 / S '(Y ), and this gives the response of income to a change in the schedule of the marginal efficiency of capital for a given interest rate. However the interest rate is not given, and Keynes should have looked at the income component of the joint response of income and interest rate to a change in the schedule using his Chapter 15 model of liquidity preference.

In his 'restatement' of Chapter 18 (pp248f) he again treats the interest rate as given and discusses the effect of 'an increase in the rate of investment', concluding that 'the ratio... between an increment of investment and the corresponding increment of aggregate income... is given by the multiplier'. He then mentions the 'repercussions' arising from changes in liquidity preference due to an increase in employment, thereby treating the role of interest in determining liquidity preference as primary and the role of income as a secondary correction separate from the main analysis. Hansen comments:

But this is wrong. His mistake follows from the fact that he often, perhaps generally, made the rate of interest depend exclusively on liquidity preference and the quantity of money.[21]

Keynes compounds this error when he writes in his reply to Viner that...

...there is always a formula, more or less of this kind, relating the output of consumption-goods which it pays to produce to the output of investment-goods; and I have given attention to it in my book under the name of the multiplier.[22]

This relates the multiplier to the 'output of consumption-goods' rather than the output of all  goods and ignores the 'repercussions'. In fact a different multiplier κ can be defined to relate changes in income to changes in the schedule of the marginal efficiency of capital under the Chapter 15 model of liquidity preference. If the schedule of the marginal efficiency of capital increases by a small unit in the region of the equilibrium position, then income increases by κ units where:


Here 0 ≤ κ ≤ k. The lower bound is attained under a pre-Lavington classical model in which interest  has no effect on liquidity preference, and the upper bound under the Chapter 13 theory in which income  has no effect; in general the position of κ between the extremes will depend on the relative magnitudes of the two influences.

Chapter 12: Animal spiritsEdit

Chapter 12 discusses the psychology of speculation and enterprise.

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantified benefits... Thus if the animal spirits are dimmed and spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.[23]

Keynes's picture of the psychology of speculators is less indulgent.

In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield... The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.[24]

(Henry Hazlitt examined some railway share prices and found that they did not bear out Keynes's assertion.[25])

Keynes considers speculators to be concerned...

...not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of mass psychology, three months or a year hence...

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional;– it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs – a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

Chapter 21: Wage behaviourEdit

Keynes's theory of the trade cycle is a theory of the slow oscillation of money income which requires it to be possible for income to move upwards or downwards. If he had assumed that wages were constant, upward motion of income would have been impossible at full employment, and he would have needed some mechanism to frustrate upward pressure if it arose in such circumstances.

His task is made easier by a less restrictive (but nonetheless crude) assumption concerning wage behaviour:

let us simplify our assumptions still further, and assume... that the factors of production... are content with the same money-wage so long as there is a surplus of them unemployed... ; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand.[26]

Chapter 22: The trade cycleEdit

Keynes's theory of the trade cycle is based on 'a cyclical change in the marginal efficiency of capital' induced by 'the uncontrollable and disobedient psychology of the business world' (pp313, 317).

The marginal efficiency of capital depends... on current expectations... But, as we have seen, the basis for such expectations is very precarious. Being based on shifting and unreliable evidence, they are subject to sudden and violent changes.[27]

Optimism leads to a rise in the marginal efficiency of capital and increased investment, reflected – through the multiplier – in an even greater increase in income until 'disillusion falls upon an over-optimistic and over-bought market' which consequently falls with 'sudden and even catastrophic force' (p316).

There are reasons, given firstly by the length of life of durable assets... and secondly by the carrying-costs of surplus stocks, why the duration of the downward movement should have an order of magnitude... between, let us say, three and five years.[28]

And a half cycle of 5 years tallies with Jevons's sunspot cycle length of 11 years.

Income fluctuates cyclically in Keynes's theory, with the effect being borne by prices if income increases during a period of full employment, and by employment in other circumstances.

Wage behaviour and the Phillips curveEdit

Keynes's assumption about wage behaviour has been the subject of much criticism. It is likely that wage rates adapt partially to depression conditions, with the consequence that effects on employment are weaker than his model implies, but not that they disappear.

Lerner pointed out in the 40s that it was optimistic to hope that the workforce would be content with fixed wages in the presence of rising prices, and proposed a modification to Keynes's model. After this a succession of more elaborate models were constructed, many associated with the Phillips curve.

Keynes's optimistic prediction that an increase in money supply would be taken up by an increase in employment led to Jacob Viner's pessimistic prediction that "in a world organized in accordance with Keynes' specifications there would be a constant race between the printing press and the business agents of the trade unions".[29]

Models of wage pressure on the economy needed frequent correction and the standing of Keynesian theory suffered. Geoff Tily wrote ruefully:

Finally, the most destructive step of all was Samuelson's and [Robert] Solow's incorporation of the Phillips curve into 'Keynesian' theory in a manner which traduced not only Phillips but also Keynes's careful work in the General Theory, Chapter 21, substituting for its subtlety an immutable relationship between inflation and employment. The 1970s combination of inflation and stagnating economic activity was at odds with this relationship, and therefore 'Keynesianism', and by association Keynes were rejected. Monetarism was merely waiting in the wings for this to happen.[30]

Keynes's assumption of wage behaviour was not an integral part of his theory – very little in his book depends on it – and was avowedly a simplification: in fact it was the simplest assumption he could make without imposing an unnatural cap on money income.

The writing of the General TheoryEdit

Keynes drew a lot of help from his students in his progress from the Treatise on Money  (1930) to the General Theory  (1936). The Cambridge Circus, a discussion group founded immediately after the publication of the earlier work, reported to Keynes through Richard Kahn, and drew his attention to a supposed fallacy in the Treatise  where Keynes had written:

Thus profits, as a source of capital increment for entrepreneurs, are a widow's cruse which remains undepleted however much of them may be devoted to riotous living.[31]

The Circus  disbanded in May 1931, but three of its members – Kahn and Austin and Joan Robinson – continued to meet in the Robinsons' house in Trumpington St. (Cambridge), forwarding comments to Keynes. This led to a 'Manifesto' of 1932 whose ideas were taken up by Keynes in his lectures.[32] Kahn and Joan Robinson were well versed in marginalist theory which Keynes did not fully understand at the time (or possibly ever),[33] pushing him towards adopting elements of it in the General Theory. During 1934 and 1935 Keynes submitted drafts to Kahn, Robinson and Roy Harrod for comment.

There has been uncertainty ever since over the extent of the collaboration, Schumpeter describing Kahn's "share in the historic achievement" as not having "fallen very far short of co-authorship"[34] while Kahn denied the attribution.

Keynes's method of writing was unusual:

Keynes drafted rapidly in pencil, reclining in an armchair. The pencil draft he sent straight to the printers. They supplied him with a considerable number of galley proofs, which he would then distribute to his advisers and critics for comment and amendment. As he published on his own account, Macmillan & Co., the 'publishers' (in reality they were distributors), could not object to the expense of Keynes' method of operating. They came out of Keynes' profit (Macmillan & Co. merely received a commission). Keynes' object was to simplify the process of circulating drafts; and eventually to secure good sales by fixing the retail price lower than would Macmillan & Co.[35]

The advantages of self-publication can be seen from Étienne Mantoux's review:

When he published The General Theory of Employment, Interest and Money  last year at the sensational price of 5 shillings, J. M. Keynes perhaps meant to express a wish for the broadest and earliest possible dissemination of his new ideas.[36]


Keynes's work on the General Theory  began as soon as his Treatise on Money  had been published in 1930. He was already dissatisfied with what he had written[37] and wanted to extend the scope of his theory to output and employment.[38] By September 1932 he was able to write to his mother: 'I have written nearly a third of my new book on monetary theory'.[39]

In autumn 1932 he delivered lectures at Cambridge under the title 'the monetary theory of production' whose content was close to the Treatise except in giving prominence to a liquidity preference theory of interest. There was no consumption function and no theory of effective demand. Wage rates were discussed in a criticism of Pigou.[40]

In autumn 1933 Keynes's lectures were much closer to the General Theory, including the consumption function, effective demand, and a statement of 'the inability of workers to bargain for a market-clearing real wage in a monetary economy'.[41] All that was missing was a theory of investment.

By spring 1934 Chapter 12 was in its final form.[42]

His lectures in autumn of that year bore the title 'the general theory of employment'.[43] In these lectures Keynes presented the marginal efficiency of capital in much the same form as it took in Chapter 11, his 'basic chapter' as Kahn called it.[44] He gave a talk on the same subject to economists at Oxford in February 1935.

This was the final building block of the General Theory. The book was finished in December 1935[45] and published in February 1936.

Observations on its readabilityEdit

Keynes was an associate of Lytton Strachey and shared much of his outlook. According to Hazlitt his "reputation as a great economist rested from the beginning on his purely literary brilliance",[46] but this quality was belied by the General Theory, which in the words of Étienne Mantoux attained "a degree of obscurity without precedent in his past work".[47] Frank Knight, another hostile critic, commented on "the exasperating difficulty of following his exposition".[48]

More significant is the view of writers sympathetic to Keynes. Michel DeVroey comments that "many passages of his book were almost indecipherable".[49]

Paul Davidson wrote that...

...even after reading the General Theory in 1936, [Paul] Samuelson, perhaps reflecting [Robert] Bryce's view of the difficulty of understanding Keynes's book, found the General Theory analysis "unpalatable" and not comprehensible.[50]

Hazlitt quotes Samuelson as saying:

It bears repeating that the General Theory is an obscure book so that would-be anti-Keynesians must assume their position largely on credit unless they are willing to put in a great deal of work and run the risk of seduction in the process.[51]

He declares himself surprised by "Samuelson's implication that the very obscurity of the book is an embarrassment, not to the disciples of Keynes, but chiefly to his critics".[52]

Raúl Rojas dissents, saying that "obscure neo-classical reinterpretations" are "completely pointless since Keynes' book is so readable".[53]

Differences of interpretationEdit

Keynes had been an outspoken and iconoclastic commentator on economic policy during the early 1930s, often dissenting from the views of more classically minded figures such as Ralph Hawtrey and A. C. Pigou. In the General theory  he was able to provide a more theoretical justification for the views he had been expressing. In the course of writing it his views matured, and inconsistencies can be seen which may be attributed to their changing in the course of his writing it, or his wishing to maintain continuity with his earlier position, or a desire to be provocative, or (possibly) simple confusion.

Generally the later statements in the book (mostly in Book IV) are less radical than the reader expects from earlier chapters. The main axis of disagreement between Keynesian interpreters lies in the relative weights they give to Books I and IV, Keynesians of the Neoclassical synthesis placing weight on the IS–LM model derived from Chapters 14 and 18 of Book IV while their Post-Keynesian opponents rely more on the Principle of Effective Demand of Book 1 together with Keynes’s emphasis on uncertainty dispersed through the book.

Italian Wikipedia contains a Book I interpretation of the Teoria generale.

The demand for investmentEdit

Keynes's principle of effective demand asserts that only for a particular income will demands for saving and investment be equal, and that this equality determines the equilibrium income for the economy. The classics had considered that 'an act of individual saving inevitably leads to a parallel act of investment' (p21) and that the associated demands were therefore essentially the same thing. Keynes declared the classical view to be 'crude' (p19) and 'absurd' (p210) without explanation and Hazlitt flatly contradicted him saying that 'normally an act of saving is  an act of investment' with an equal lack of argument.[54]

The little that Keynes said to clarify his view is summarised below. At least seven different accounts (not always mutually exclusive) have been proposed of the gap between the demands for saving and investment. It may be useful to consider them in the light of five representative forms of saving:

  1. An individual spends some of his or her income on the construction of a summerhouse (considered as a capital good).
  2. An individual lends to a relative who wishes to build a summerhouse.
  3. An individual lends to a bank which lends to householders wanting to make home improvements.
  4. An individual lends to a bank which lends to entrepreneurs who make capital investments.
  5. An individual puts money under the mattress, leading to increased inventories of unsold goods which constitute investment under Keynes's definition (p75).

Only the first act of saving is strictly an act of investment, but the classics considered the first four together, viewing (2)-(4) as investment by proxy and as having the same economic consequences as direct investment. The fifth item is hoarding which was absent from classical considerations. A Keynesian may deny that some or all of these forms of saving contribute to the demand for investment.

Explanation based on hoardingEdit

A natural interpretation of Keynes's view is that he draws a demarcation line after the first four items in the list. It is certainly true that saving can find an outlet in hoarding whose demand is not a demand for investment. This was the line pursued by Jacob Viner, who wrote of Keynes that:

He finds fault with the "classical" economists for their alleged neglect of the gulf between the desire to save and the desire to invest, i.e., for their neglect of "liquidity preferences"... It was a shortcoming of the Ricardian wing of the classical school that... they steadfastly adhered to their position that hoarding was so abnormal a phenomenon as not to constitute a significant contributing factor to unemployment...[55]

Hoarding constitutes a fairly small proportion of saving, and Viner accordingly doubted that it could play the role he thought Keynes assigned to it. Keynes, in his reply, did not seem to understand why Viner had imagined hoarding to be an important part of his theory.[56] In fact his model of liquidity allows no scope for either the supply or the demand for hoarding: the quantity of money is fixed and each individual person desires to hold a static amount.

Supporters as well as critics of Keynes have adopted hoarding explanations. Paul Davidson, after rejecting Samuelson's reading of the General Theory, reported that a 1977 paper by 'the perennial renegade' F. H. Hahn had generalised monetary hoarding to 'non-reproducible assets':

Some forty years after Keynes, Hahn rediscovered Keynes's point that a stable involuntary unemployment equilibrium could exist even in a Walrasian system with flexible wages and prices  whenever there are "resting places for savings in other than reproducible assets"... [since] any non-reproducible asset allows for a choice between employment inducing and non-employment inducing demand.[57]

Joan Robinson, on the other hand, rejected hoarding explanations with characteristic vigour as...

...simply an error... [which] arises, no doubt, from the desire to find where the vanished savings have got to... It is of no use to search for the non-existent savings either in "hoards" or anywhere else.[58]

Of course the mystery is not that savings themselves have gone missing, but that there is a demand to save which is neither the demand for capital goods nor the demand to accumulate money in lieu of spending it.

Explanation based on lendingEdit

Lending and borrowing are two sides of the same transaction which necessarily cancel out, and which the classics therefore ignored for most purposes. It may be that Keynes saw the demand for lending as a demand for saving which was not the same thing as a demand for investment, thus drawing his demarcation under the first item in the list. He says that:

So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive... [59]

and that:

...there is always an alternative to the ownership of real capital-assets, namely the ownership of money and debts... [60]

The identification of lending as a cause of unemployment has received little support in the later literature.

Explanation based on the endogeneity of money supplyEdit

Hansen suggested that adjustments to the money supply might absorb the gap between demands for saving and investment:

If expectations are favorable for investment, though funds are currently lacking, means of purchase can readily be made available in a society with an elastic money and credit system.[61]

This draws a line after the second item in the list.

Explanation based on the separation of rolesEdit

Alternatively it might be said that when money is lent, the decision to lend is made by the saver and the decision to invest by the borrower, and that these may not conform with each other. This draws a line somewhere around the middle of the list and seems to be the assumption made by Frank Knight, who commented that:

It almost seems as if the money which is saved is completely distinct from the money which is lent and borrowed, and that the former, if it ever reaches a bank, or any lending agency, is still kept entirely separate.[62]

The significance of the separation of roles is rejected every bit as forcefully by Keynes himself in §V of Chapter 7.

This explanation too had acceptance among some of Keynes's 'Book I' supporters. Joan Robinson wrote:

Decisions to save and decisions to invest are taken quite independently of each other... Under a completely socialist system the government would decide how much investment was desirable... But in the system under which we live the decision to save and the decision to invest are not bound together, and the motives governing them are quite different... The individual saver has no direct influence upon the rate of investment. If entrepreneurs see a profit to be made by investment, investment will take place, and if they do not it will not. The initiative lies with the entrepreneurs, not with the savers. The savers, as a group, are helpless in the hands of the entrepreneurs...[63]

She doesn't tell us whether decisions to save are independent of decisions to lend, or whether savers' decisions to lend are independent of entrepreneurs' decisions to borrow, or whether entrepreneurs' decisions to borrow are independent of their decisions to invest.

Hansen mostly follows this explanation. He writes that:

Under modern conditions savers and real investors are to a high degree different groups.[64]

Denial of a causal link from saving to investmentEdit

The previous explanations have sought to identify particular forms of saving which do not contribute to the demand for investment. A more extreme viewpoint is that all  forms of saving have this property. Gordon Fletcher deemed it a 'myth' that 'saving finances investment':

Keynes attacked the widespread belief that investment is somehow financed by saving.[65]

The position has several advantages. The whole of Keynes's theory is based on saving qua  saving, not on the special properties of particular forms. The propensity to save embraces all forms of saving, and it is total saving which equals total investment. Sometimes Keynes is open in saying that all forms of saving partake of the harmful effects he ascribes to it:

If... an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment...[66]

an observation which can be applied to summerhouses as easily as to industrial plant.[67] On the other hand, capital expenditure constitutes saving under Keynes's definition, and it seems counter-intuitive to deny that investment is financed (or stimulated) by capital expenditure.

Explanation based on the gap between plans and realityEdit

Schumpeter provided the following summary of Keynes's theory:

Current saving and current investment, being identically equal, cannot determine anything. Planned (ex ante) saving and planned (ex ante) investment determine income (total net output)...[34]

G. L. S. Shackle later wrote that:

Myrdalian ex ante language would have saved the General Theory from describing the flow of investment and the flow of saving as identically, tautologically equal, and within the same discourse, treating their equality as a condition which may, or not, be fulfilled.[68]

All forms of saving may depart slightly from their planned levels.

Explanation based on Chapters 11 and 14Edit

The IS  equation emerges in Keynes's theory in Chapter 14 as common ground with the classics: he says that he would not dispute the classical proposition that "the current rate of interest must lie at the point where the demand curve for capital... cuts the curve of the amounts saved" (p178). It can also be argued from the identity of saving and investment. Harrod's and Hicks's readings of Keynes did not go far beyond this: see 'Mr Keynes and the "Classics" '.

But if one starts from the IS  equation, taking the schedule of marginal efficiency as the demand curve for capital, then it is a natural step to add it to the demand curve for consumption to get the Keynesian cross argument of Chapter 3, and thus to obtain the ‘Principle of Effective Demand’ without detailed consideration of what wage-earners seek to do with their income.

The multiplierEdit

The respending multiplier as explained by SamuelsonEdit

The multiplier was introduced to economic theory by Richard Kahn in a 1931 paper[69] cited by Keynes in his own discussion. Kahn's mechanism is based on looking at an initial expenditure and noting that it will end up in the pockets of various employees and suppliers who in turn will spend a proportion of what they receive, thereby creating more employment; and so forth. Robinson, Samuelson and Hansen include it in their accounts. Mantoux wrote that "The entire demonstration, it would seem... rests on this function".

Samuelson explained the multiplier in these terms:

Let's suppose that I hire unemployed resources to build a $1000 woodshed. My carpenters and lumber producers will get an extra $1000 of income... If they all have a marginal propensity to consume of 2/3, they will now spend $666.67 on new consumption goods. The producers of these goods will now have extra incomes... they in turn will spend $444.44... Thus an endless chain of secondary consumption respending  is set in motion by my primary  investment of $1000.[70]

In common with other exponents of the multiplier,[71] Samuelson makes no attempt to justify the claim that secondary employment arises from carpenters' consumption spending but not from their investment spending, while seeing the chain as being set in motion by a primary investment rather than by primary consumption. If the carpenters spend their remaining $333.33 on housing and infrastructure, the builders of these goods too will have extra incomes; and if Samuelson had instead spent $1000 on Napa Valley wine, it is reasonable to assume that the growers would likewise have spent their revenue on consumption and investment goods giving rise to similar 'secondary respending'.

Keynes's multipliersEdit

There are two slightly incompatible accounts of the multplier in the General Theory : an opaque definition followed by a satirical illustration in Chapter 10 and a perfectly lucid account of its theoretical role in Chapter 18 – the Book IV "restatement". Since it is the theoretical functioning of the multiplier which matters, and since Chapter 18 makes its meaning clear, one is free to dispense with the description in Chapter 10. As we might expect, the earlier account is the more radical, the later the more classical; but in neither is there any sign of an argument based on the repeated spending of the same money as we saw with Kahn and Samuelson.

The Chapter 18 "investment multiplier" simply measures the response of income to a change in a system parameter, namely the schedule of the marginal efficiency of capital. There will be an associated response for employment, and given Keynes's use of wage units this too can be expressed as a dimensionless constant. It might reasonably be termed the "employment multiplier" and one might well "assume (as a first approximation) that the employment multiplier is equal to the investment multiplier" (p248).

Keynes assigns a value 1 / (1–c ) to his investment multiplier, where c  is the marginal propensity to consume. This is correct under his Chapter 13 theory of liquidity preference but he does not notice that it needs to be modified in the light of his Chapter 15 theory. A respending multiplier would be expected to take he value of 1 / (1–x ) where x  is the marginal propensity to spend.

Multiplier triggered by value
Kahn's arbitrary spending 1 / (1–x )
Chapter 10 investment spending 1 / (1–c )
Chapter 18
change in the schedule of the
marginal efficiency of capital
1 / (1–c )
Chapter 18
change in the schedule of the
marginal efficiency of capital
no simple

Keynes describes the Chapter 10 multiplier as being set in motion by an "increment of investment" (p117) and gives the example of "increased public works" (p116). He explicitly differentiates it from Kahn's multiplier, which he terms the "employment multiplier" but which is still not the same as the employment multiplier which might be seen as implicit in Chapter 18.

Although the Chapter 10 multiplier appears to be associated with acts of investment, Keynes describes it in the same chapter as a "logical" multiplier which "holds good continuously, without time-lag" [72] suggesting that it is in fact a response to the schedule of the marginal efficiency of capital.

The four multipliers are summarised in the table.

Keynes makes an exception to the limitation to investment as a trigger for his multiplier in Chapter 10 by generalising this to "loan expenditure" which also includes public dis-saving. The passage explaining this exception occurs in a footnote justifying the inclusion of a satirical passage which may have been written much earlier:

It is often convenient to use the term "loan expenditures" to include the public investment financed by borrowing from individuals and also any other current public expenditure which is so financed. Strictly speaking, the latter should be reckoned as negative saving... [73]

Hansen's attempted reconciliationEdit

According to Hansen,[74] the main task of Kahn's paper was to show that the multiplier was finite. Kahn used the term cul-de-sac  for any use of money which removed it from the respending cycle (Hansen preferred 'leakage'). Kahn paid a lot of attention to the flow of money abroad to fund imports, but since Keynes worked with a closed economy this form of leakage can be ignored, and it appears that hoarding is the only one left. This is why a respending multiplier may be expected to take the value 1 / (1–x ), where x, the marginal propensity to spend, is not the same as Keynes's c.

Hansen sought to show that Keynes's multiplier had the same properties as a respending multiplier. The first difference to address lies in how the multiplier is put in motion. The initial expenditure for a respending multiplier is conventionally described as 'investment' but this term was dismissed by Hazlitt as a Pickwickianism[75] since, evidently, consumption outlay can also be respent; any expenditure will do. Hansen does not deny the Pickwickianism, nor does he doubt that Keynes associated his own multiplier with investment in a non-Pickwickian sense. He bridges the gap by defining 'investment expenditure' as including 'private-consumption outlays' on the grounds that:

Case c x k
IV 1 1
V 0 0 1

Whatever the initial increase in expenditure, whether private or public investment or simply an increase in private-consumption outlays resulting from tax reduction... the effect... is the same.[76]

Hansen then discusses the numerical value of a respending multiplier in a laborious case-by-case analysis (pp90–96). The third and sixth cases are based on repeated rather than one-off expenditure; the remaining four are summarised in the table on the right. Only the second makes a distinction between consumption and expenditure. Hansen draws the conclusion that a respending multiplier should take the value 1 / (1–c ) rather than 1 / (1–x ), thus putting it in harmony with Keynes's formula (p96).

The Book IV multiplierEdit

The Chapter 18 multiplier is simply an intermediate term in a calculation. Any presentation of Keynesian theory which ignores it, or simply embodies it in equations, is consistent with Keynes's Book IV since there is no need to focus attention on a single intermediate term. Hicks's account is a case in point: he says that 'the third equation becomes the multiplier equation, which performs such queer tricks' and leaves the matter there.

The role which the multiplier receives in Keynes's presentation slightly understates its significance. The response of income to changes in the schedule of the marginal efficiency of capital is discussed qualitatively  in Chapters 14 and 22: it is essential to the reasoning of the latter chapter (on the trade cycle) that the magnitude should be appreciable, but this assumption is not stated overtly. The relevance of the multiplier to Keynes's theory of the trade cycle is more clearly seen in his reply to Viner.[77]

Shackle regarded Keynes's departure from Kahn's multiplier as...

...a retrograde step... For when we look upon the Multiplier as an instantaneous functional relation... we are merely using the word Multiplier to stand for an alternative way of looking at the marginal propensity to consume.[78]

Liquidity preferenceEdit

The contradictions in Keynes's doctrine of liquidity occur within Book IV, between Chapters 13 and 15. Keynes never explains why he has two different accounts. It appears that the General Theory  was conceived on the basis of the Chapter 13 theory and that the second theory was added as an afterthought without its consequences being followed through. The 'restatement' of the theory in Chapter 18 is notable for its not applying the Chapter 15 correction accurately: one influence on liquidity preference (the rate of interest) is treated as an 'independent variable' and the other (income) as acting through a 'repercussion'.[79] There were no serious obstacles in Keynes's path, and Hicks showed how to handle the Chapter 15 liquidity preference correctly. What he couldn't change is the interpretation Keynes placed on his doctrines, which never shook off the picture of the interest rate being purely monetary, with a corresponding assumption that changes in the return on capital took their effect solely on income.

Viner, Knight and Étienne Mantoux understood Keynes as advancing the Chapter 13 view; Hicks and Franco Modigliani who followed him adopted the Chapter 15 generalisation.[80] Hansen recognised that Keynes often wrote as if liquidity preference was a function of interest rate alone, but saw this as a persistent error.

Samuelson accepted 'the classical theory of interest and capital' which determines the interest rate from the same equation as Keynes (and Samuelson himself) used to determine the level of employment.

The effect of wage rates on employmentEdit

Resistance to monetary reductions in wages is one of Keynes's key premises, introduced in Chapter 2. In his discussion of Pigou's Theory of unemployment  he criticises Pigou's view 'that unemployment is primarily due to a wage policy which fails to adjust itself sufficiently to changes in the real demand for labour'. When considering wage rates himself he argues against the desirability of reductions in the real wage firstly  by claiming that the theory he has developed so far shows that they would bring no benefit (Chapter 19 §II), and secondly  by remarks along the lines that 'there is no means of securing uniform wage reductions' (ibid.). He kept the second argument 'on reserve' (in words attributed to Schumpeter by W. H. Hutt [81]).

Once the wage rate had been absorbed into other quantities through use of the wage unit it disappeared from sight in the General Theory. Viner took him at his word that there was 'no place' for 'unemployment due to downward-rigidity of money-wages' in his system. Mantoux came to the opposite conclusion:

It would seem that Keynes acknowledges the necessity of reducing real wages to diminish unemployment.

Robinson denied that reductions in wages would be beneficial. Without providing an analysis (under the Keynesian or any other model) she asserted that when wages fell 'money incomes fall as much as costs, and money demand is reduced accordingly'. Hansen viewed Keynes as 'agnostic' and was so himself.[82]

Modigliani analysed the Keynesian model as developed by Hicks and concluded that 'except in a limiting case' it was 'rigid wages' which accounted for Keynesian unemployment. The limiting case was that of the liquidity trap.

Inessential chaptersEdit

Chapter 16: Sundry observations on the nature of capitalEdit

§I: Say's LawEdit

Keynes reiterates his denial that an act of saving constitutes an act of investment. A formulation of classical macroeconomics in three equations was given above as follows:

  • y' (N ) = W / p        is (r ) = s (y (N ),r )         = p ·y (N ) / V (r )

The role of Say's Law in Keynes's interpretation of them can be seen if we split the second equation into two components:

  • is (r ) = id (y (N ),r )        id (y (N ),r ) = s (y (N ),r )

the first of which asserts the equilibrium between the supply and demand for investment, and the second of which identifies the demand for investment with the desired level of saving. In rejecting the second component Keynes denies that the total demand for goods in an economy is identical with its total income – i.e. that supply creates its own demand – and is therefore able to make their equality an equilibrium condition.

Chapter 16 contains a few statements in support of the view that saving does not necessarily add to the demand for capital goods.

An act of individual saving means – so to speak – a decision not to have dinner to-day. But it does not  necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date.[83]

... an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order.[84]

He adds that:

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... 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.[85]

It is in this chapter that Keynes mentions "the ownership of money and debts" as "an alternative to the ownership of real capital-assets" (p212). On the same page he draws attention to what he considers to be the error of...

... believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield.

§ II–IV: The declining yield of capitalEdit

Keynes argues that the value of capital derives from its scarcity and sympathises with 'the pre-classical doctrine that everything is produced  by labour ' (p213). The preference for direct over roundabout processes will depend on the rate of interest.

He wonders what would happen to 'a society which finds itself so well equipped with capital that its marginal efficiency is zero' while money provides a safe outlet for savings. He does not consider this hypothesis far-fetched: on the contrary...

... a properly run community... ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation...[86]

He asserts that...

... the position of equilibrium, under conditions of laissez-faire, will be one in which employment is low enough and the standard of life sufficiently miserable to bring savings to zero'.[87]

The misery does not depend on any assumption of static wages. If the return to capital falls to zero then according to Keynes's theory there will be no investment, and income must collapse to the point at which the propensity to save disappears. However his conclusions are not pessimistic because he postulates that steps may be taken to adjust the interest rate to ensure full employment (p220), that 'enormous social changes would result' and that 'this may be the most sensible way of getting rid of many of the objectionable features of capitalism' (p221).

Chapter 17: The essential properties of interest and moneyEdit

Keynes begins by defining 'own rates of interest'. If the market price for purchasing the commitment to supply a bushel of wheat every year in perpetuity was the price of 50 bushels, then the 'wheat rate of interest' would be 2%. He then tries to find the property which justifies us in regarding the money rate as the true rate. His arguments didn't satisfy his supporters[88] who accepted Pigou's contention that it makes no difference which rate is used.[89]

Hazlitt went further, considering the very concept of an own rate of interest to be 'one of the most incredible' of the 'confusions in the General Theory '.[90]

Book V: Money-wages and pricesEdit

Chapter 23: Notes on mercantilismEdit

In §I–IV Keynes gives a sympathetic notice to the 17th century mercantilists who, like himself, believed interest to be a monetary phenomenon and saw high interest rates as harmful. He accepts their conclusion that in principle export restrictions may prevent the flow of money abroad and lead to economic advantages at home.

For similar reasons Keynes sees justice in scholastic prohibitions of usury. He remarks in §V that Adam Smith had supported a maximum legal rate of interest.[91] Smith's reasoning – certainly surprising from the proponent of the 'invisible hand' of markets – was based on a fear that a high rate of interest would lead to loans being cornered by spendthrifts and get-rich-quick 'projectors'.

§VI is devoted to the theories of 'the strange, unduly neglected prophet Silvio Gesell' who had proposed a system of 'stamped money' to artificially increase the carrying costs of money. 'The idea behind stamped money is sound', says Keynes, but subject to technical difficulties, one of which is the existence of other outlets for liquidity preference such as jewellery and formerly land. It is interesting that Keynes considered durable assets to be as much a problem as banknotes: even when they satisfy the same motives for ownership, they lack the property that wages are fixed in terms of them.

Keynes's final brief survey in §VII is of theories of underconsumption. Bernard Mandeville in the early 18th century and Hobson and Mummery in the late 19th were amongst those who believed that private thrift was the source of public poverty rather than riches.

Chapter 24: Concluding notes on social philosophyEdit

Saving does not, in Keynes's view, engender investment, but rather impedes it by reducing the likely return to capital: "One of the chief social justifications of great inequality of wealth is, therefore, removed" (p373).

It would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure... [This] would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital... it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce... And it would remain for separate decision on what scale and by what means it is right and reasonable to call on the living generation to restrict their consumption, so as to establish in course of time, a state of full investment for their successors.[92]

In some other respects the foregoing theory is moderately conservative in its implications... 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.[93]

... 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. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back... But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.[94]


Keynes did not set out a detailed policy program in The General Theory, but he went on in practice to place great emphasis on the reduction of long-term interest rates[95] and the reform of the international monetary system[96] as structural measures needed to encourage both investment and consumption by the private sector. Paul Samuelson said that the General Theory "caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea islanders."[97]


Many of the innovations introduced by The General Theory continue to be central to modern macroeconomics. For instance, the idea that recessions reflect inadequate aggregate demand and that Say's Law (in Keynes's formulation, that "supply creates its own demand") does not hold in a monetary economy. President Richard Nixon famously said in 1971 (ironically, shortly before Keynesian economics fell out of fashion) that "We are all Keynesians now", a phrase often repeated by Nobel laureate Paul Krugman (but originating with anti-Keynesian economist Milton Friedman, said in a way different from Krugman's interpretation).[98] Nevertheless, starting with Axel Leijonhufvud, this view of Keynesian economics came under increasing challenge and scrutiny[99] and has now divided into two main camps.

The majority new consensus view, found in most current text-books and taught in all universities, is New Keynesian economics, which accepts the neoclassical concept of long-run equilibrium but allows a role for aggregate demand in the short run. New Keynesian economists pride themselves on providing microeconomic foundations for the sticky prices and wages assumed by Old Keynesian economics. They do not regard The General Theory itself as helpful to further research. The minority view is represented by post-Keynesian economists, all of whom accept Keynes's fundamental critique of the neoclassical concept of long-run equilibrium, and some of whom think The General Theory has yet to be properly understood and repays further study.

In 2011, the book was placed on Time's top 100 non-fiction books written in English since 1923.[100]


From the outset there has been controversy over what Keynes really meant. Many early reviews were highly critical. The success of what came to be known as "neoclassical synthesis" Keynesian economics owed a great deal to the Harvard economist Alvin Hansen and MIT economist Paul Samuelson as well as to the Oxford economist John Hicks. Hansen and Samuelson offered a lucid explanation of Keynes's theory of aggregate demand with their elegant 45° Keynesian cross diagram while Hicks created the IS-LM diagram. Both of these diagrams can still be found in textbooks. Post-Keynesians argue that the neoclassical Keynesian model is completely distorting and misinterpreting Keynes' original meaning.

Just as the reception of The General Theory was encouraged by the 1930s experience of mass unemployment, its fall from favour was associated with the 'stagflation' of the 1970s. Although few modern economists would disagree with the need for at least some intervention, policies such as labour market flexibility are underpinned by the neoclassical notion of equilibrium in the long run. Although Keynes explicitly addresses inflation, The General Theory does not treat it as an essentially monetary phenomenon or suggest that control of the money supply or interest rates is the key remedy for inflation, unlike neoclassical theory.

Lastly, Keynes' economic theory was criticized by Marxian economists, who said that Keynes ideas, while good intentioned, cannot work in the long run due to the contradictions in capitalism. A couple of these, that Marxians point to are the idea of full employment, which is seen as impossible under private capitalism; and the idea that government can encourage capital investment through government spending, when in reality government spending could be a net loss on profits.


  1. ^ Olivier Blanchard, Macroeconomics updated  (2011), p580.
  2. ^ Cassidy, Johnson (10 October 2011). "The Demand Doctor". The New Yorker.
  3. ^ "Thus we find that the power of bargaining given to the labourer does tend to raise wages; but that it may diminish the number of labourers employed, and often does so". Fleeming Jenkin, "The graphic representation of the laws of Supply and Demand..." in Sir A. Grant (ed.) "Recess Studies" (1870), p174. See also Pigou's evidence to the 1930 Macmillan Committee cited on p194 of Richard Kahn's, "The Making of Keynes' General Theory ".
  4. ^ References are to the edition published for the Royal Economic Society as Vol VII of the Collected Writings, whose pagination corresponds with the original edition.
  5. ^ See Kahn's "The Making of Keynes' General Theory", Fourth lecture, part 1.
  6. ^ "The theory of interest...", p155, quoted by Keynes, p141.
  7. ^ pp166ff.
  8. ^ "Mr Keynes on the causes of unemployment", Quarterly Journal of Economics, 1936.
  9. ^ p167.
  10. ^ "Unemployment: and Mr. Keynes's revolution in economic theory", Canadian Journal of Economics, 1937, p112.
  11. ^ p168.
  12. ^ p201.
  13. ^ 'Mr Keynes and the "Classics" '.
  14. ^ Robert Dimand, "The origins of the Keynesian revolution", p7.
  15. ^ See Appendix to Keynes's Chapter 19.
  16. ^ See Lawrence Klein, Ph. D. thesis ("The Keynesian Revolution", 1944), pp90ff.
  17. ^ P. A. Samuelson, "Economics: an introductory analysis", 1948 and many subsequent editions.
  18. ^ p50.
  19. ^ Theory of interest.
  20. ^ Frederick Lavington, "The English capital market" (1921), cited in 'Mr Keynes and the "Classics" '.
  21. ^ Alvin Hansen, "Guide to Keynes" (1953) pp165ff.
  22. ^ See below.
  23. ^ p161.
  24. ^ pp152, 154.
  25. ^ The Failure of the New Economics  (1959) p177.
  26. ^ p295.
  27. ^ p315.
  28. ^ p317.
  29. ^ "Mr Keynes on the causes of unemployment", Quarterly Journal of Economics, 1936.
  30. ^ 'Keynes's General Theory, the Rate of Interest and 'Keynesian' Economics' (2007).
  31. ^ Kahn, "The making of Keynes' General Theory " (1984), p106.
  32. ^ M. C. Marcuzzo, "The Collaboration between J. M. Keynes and R. F. Kahn from the Treatise  to the General Theory ", History of Political Economy, June 2002, p435.
  33. ^ M. C. Marcuzzo, op. cit. p441.
  34. ^ a b Joseph Schumpeter, History of economic analysis (1954).
  35. ^ Kahn, op. cit., p171.
  36. ^ Translated in Henry Hazlitt (ed.), "The critics of Keynesian economics", 1960.
  37. ^ Dimand, op. cit., p163.
  38. ^ Dimand, op. cit., p87.
  39. ^ Letter cited from Collected writings  by Kahn, op. cit., p112.
  40. ^ Dimand, op. cit., pp152f, 155.
  41. ^ Dimand, op. cit., pp162, 166.
  42. ^ Kahn, op. cit., p114.
  43. ^ Dimand, op. cit., p172.
  44. ^ Op. cit., chapter title.
  45. ^ Kahn, op. cit., p112.
  46. ^ "The critics of Keynesian economics", p9.
  47. ^ "Mr. Keynes' General Theory", trans. in H. Hazlitt, op. cit., p97.
  48. ^ Frank Knight, "Unemployment: And Mr. Keynes's Revolution in Economic Theory", p113, Canadian Journal of Economics, 1937.
  49. ^ "Dead or Alive? The Ebbs and Flows of Keynesianism Over the History of Macroeconomics" in Thomas Cate (ed). "Keynes's General Theory Seventy-five years later" (2012).
  50. ^ "Samuelson and the Keynes/Post-Keynesian revolution..." (2007), citing D. C. Colander and H. Landreth, "The Coming of Keynesianism To America", p159.
  51. ^ "The failure of the 'New Economics' " (1959), p89.
  52. ^ "The failure of the 'New Economics' ", pp2f, quoting "The development of economic thought", ed. by Henry William Spiegel, 1952.
  53. ^ "The Keynesian Model in the General Theory: A Tutorial", (2012).
  54. ^ Op. cit., p220.
  55. ^ "Mr. Keynes on the causes of unemployment" in Hazlitt, op. cit., p51.
  56. ^ Reply to Viner.
  57. ^ "Samuelson and the Keynes/Post-Keynesian revolution..." (2007), citing Hahn, "Keynesian Economics and General Equilibrium Theory" in "The Microfoundations of Macroeconomics", ed. by G. C. Harcourt. Davidson gives Hahn an erroneous middle initial. The term 'perennial renegade' is Gonçalo L. Fonseca's.
  58. ^ Introduction to the theory of employment, pp15ff.,
  59. ^ p160.
  60. ^ p212.
  61. ^ op. cit., p27.
  62. ^ "Unemployment: And Mr. Keynes's Revolution in Economic Theory", in Hazlitt, op. cit..
  63. ^ pp9, 10, 13.
  64. ^ op. cit., p154; see also p32.
  65. ^ 'The Keynesian revolution and its critics' (1987) p96.
  66. ^ p212.
  67. ^ 'Unemployment: is there a principal cause' by Bernard Schmitt, in M. Baranzini and A. Cencini, eds., 'Inflation and Unemployment: Contributions to a New Macroeconomic Approach' (1996), p79.
  68. ^ "What did the General Theory do?" (1989), in J. Pheby (ed), "New Directions in Post-keynesian Economics".
  69. ^ "The Relation of Home Investment to Unemployment", The Economic Journal.
  70. ^ 16th edition consulted.
  71. ^ E.g. Kahn, "The Relation of Home Investment to Unemployment" (1931); Robinson, "Introduction to the Theory of Employment" (1937) Chap III; Lawrence Klein, Ph. D. thesis ("The Keynesian Revolution", 1944) p49. Hansen (discussed below) is the only significant exception.
  72. ^ p122.
  73. ^ pp128ff.
  74. ^ op. cit., p89.
  75. ^ "The failure of the new economics", 1959, pp148ff.
  76. ^ p90, footnote.
  77. ^ See above.
  78. ^ "Time in economics" (1958), cited by G. M. Ambrosi, "Keynes, Pigou and Cambridge Keynesians" (2003).
  79. ^ Alvin Hansen, "Guide to Keynes" pp165ff.
  80. ^ Hazlitt, op. cit., for Mantoux and Modigliani.
  81. ^ Hazlitt, op. cit.
  82. ^ Guide , p175.
  83. ^ Opening sentence.
  84. ^ p211.
  85. ^ p211.
  86. ^ p220.
  87. ^ p218.
  88. ^ Lawrence Klein, Ph.D. thesis, 1944 (the basis of his 'Keynesian revolution', 1947), p120; Hansen, op. cit., p159; Abba Lerner, 'The essential properties of interest and money', Quarterly Journal of Economics, 1952, cited by Hansen.
  89. ^ Review of the General Theory, Economica, 1936, cited by Klein.
  90. ^ Op. cit., p237.
  91. ^ 'Wealth of nations', Book II, Chap 4.
  92. ^ pp375-378.
  93. ^ pp378ff.
  94. ^ pp383ff.
  95. ^ See Tily (2007)
  96. ^ See Davidson (2002)
  97. ^ Samuelson 1946, p. 187.
  98. ^ Krugman, Paul. "Introduction to the General Theory". Retrieved 25 December 2008.
  99. ^ See Leijonhufvud (1968), Davidson (1972), Minsky (1975), Patinkin (1976), Chick (1983), Amadeo (1989), Trevithick (1992), Harcourt and Riach (1997), Ambrosi (2003), Lawlor (2006), Hayes (2006), Tily (2007)
  100. ^ "All-Time 100 Nonfiction Books". Time. 30 August 2011.

Further readingEdit


The earliest attempt to write a student guide was Robinson (1937) and the most successful (by numbers sold) was Hansen (1953). These are both quite accessible but adhere to the Old Keynesian school of the time. An up-to-date post-Keynesian attempt, aimed mainly at graduate and advanced undergraduate students, is Hayes (2006), and an easier version is Sheehan (2009). Paul Krugman has written an introduction to the 2007 Palgrave Macmillan edition of The General Theory.

Journal articlesEdit


  • Amadeo, Edward (1989). The principle of effective demand. Aldershot UK and Brookfield US: Edward Elgar.
  • Ambrosi, Gerhard Michael (2003). Keynes. Pigou and Cambridge Keynesians, London: Palgrave Macmillan.
  • Chick, Victoria (1983). Macroeconomics after Keynes. Oxford: Philip Allan.
  • Davidson, Paul (1972). Money and the Real World. London: Macmillan.
  • Davidson, Paul (2002). Financial markets, money and the real world. Cheltenham UK and Northampton US: Edward Elgar.
  • Hansen, Alvin (1953). A Guide To Keynes. New York: McGraw Hill.
  • Harcourt, Geoff and Riach, Peter (eds.) (1997). A 'Second Edition' of The General Theory. London: Routledge.
  • Hayes, Mark (2006). The economics of Keynes: a New Guide to The General Theory. Cheltenham UK and Northampton US: Edward Elgar.
  • Hazlitt, Henry (1959). The Failure of the New Economics. Princeton, NJ: Van Nostrand.
  • Keynes, John Maynard (1936). The General Theory of Employment, Interest and Money. London: Macmillan (reprinted 2007).
  • Lawlor, Michael (2006). The economics of Keynes in historical context. London: Palgrave Macmillan.
  • Leijonhufvud, Axel (1968). Keynesian economics and the economics of Keynes. New York: Oxford University Press.
  • Markwell, Donald (2006). John Maynard Keynes and International Relations: Economic Paths to War and Peace. Oxford: Oxford University Press.
  • Markwell, Donald (2000). Keynes and Australia. Sydney: Reserve Bank of Australia.
  • Minsky, Hyman (1975). John Maynard Keynes. New York: Columbia University Press.
  • Patinkin, Don (1976). Keynes's monetary thought. Durham NC: Duke University Press.
  • Robinson, Joan (1937). Introduction to the theory of employment. London: Macmillan.
  • Sheehan, Brendan (2009). Understanding Keynes' General Theory. London: Palgrave Macmillan.
  • Tily, Geoff (2007). Keynes's General Theory, the Rate of Interest and 'Keynesian' Economics. London: Palgrave Macmillan.
  • Trevithick, James (1992). Involuntary unemployment. Hemel Hempstead: Simon & Schuster.

External linksEdit