How Flaws in the General Theory Render It Irrelevant to the Real World

I realized yesterday that my spending increases the velocity of money in the locality I travel to. That should be sufficient to explain the small boost I provide. “And that excess supply of money causes P and/or Y to increase until the quantity of money demanded adjusts to equal the quantity supplied. Say’s Law, paradoxically, only applies to money itself. The supply of money creates its own demand.” The “endogenous money” crowd like to focus on one bit of the story – the bit where banks create new loans and thereby increase the supply of broad money. Technically banks really do increase broad money when they issue loans but to focus on this above everything else in the story is to fail to see the woods for the trees.

  • The incomes used for paying back the debts do not get spent on consumer goods and services and therefore leak away from the income stream.
  • Kahn’s multiplier gives the title (“The multiplier model”) to the account of Keynesian theory in Samuelson’s Economicsand is almost as prominent in Alvin Hansen’s Guide to Keynesand in Joan Robinson’s Introduction to the Theory of Employment.
  • The rate of interest determines the level of investment Îthrough the schedule of the marginal efficiency of capital, shown as a blue curve in the lower graph.
  • Since the GDP is equal to Income, we can model the Spending in the economy in terms of GDP instead of in terms of Income.
  • Therefore, if private consumption expenditure increases by 10 units, the total GDP will increase by more than 10 units.
  • The marginal propensity to consume tells us the intercept of the consumption function.

If drastic enough, such changes may thus cause a severe recession as investors contemplate trillions of dollars of losses on their bets in the stock market. But at this level, total demand is Y1E1 which exceeds total supply by AE1. This will further tend to raise income to OY in period t+2 and to increase in consumption to E1E2. This leads to a rise in demand to Y2E2, leading to an excess of total demand over total supply by BE2. The important thing, however, is the timing of public investment in such a manner that the multiplier is able to work with full force and there is little scope for the income stream to peter out. Moreover, public investment should not supplant but supplement private investment so that it could be increased during depression and reduced during inflation.

In our above explanation of multiplier, we have made many simplifying assumptions. First, we have assumed that the marginal propensity to consume remains constant throughout as the income increases in various rounds of consumption expenditure. However, the marginal propensity to consume may differ in various rounds of consumption expenditure. Moreover, Keynes’s definition of full employment includes “frictional” and “voluntary” unemployment [25, pp. 15-16]. If “voluntary” unemployment is only considered according to Walras’s definition then such definition of full employment might have certain reasoning, because in this case each individual is either employed or unemployed by his own wishes.

Thus increased taxation reduces the income stream and lowers the size of the multiplier. If people prefer to hoard the increased income in the form of idle cash balances to satisfy a strong liquidity preference for the transaction, precautionary and speculative motives, that will act as a leakage out of the income stream. As income increases people will hoard money in inactive bank deposits and the multiplier process is checked. Saving is the most important leakage of the multiplier process.


Keynes took the idea from Kahn and formulated the Investment Multiplier. The interest rate is monetary, and represents the combined effect of the real interest rate and inflation. “International difficulties arising out of the financing of public works during depressions,” Economic Journal, 1932.

Making their money redeemable against the bundle of goods that defines the currency unit would be a good way of doing this. The money “multiplier” simply tells us the limit of money creation by the commercial banks, given their reserves. In itself it is not sufficient to tell us how much money will actually be created.

the keynesian multiplier is simply the reciprocal of the

Additionally, the essence of the problems is sometimes varied depending on the chapter of the book it is discussed in. This means that Keynes’s theory is characterized by a twofold approach, so that, sometimes there are two opposite essences about the same issues2. In this paper it will be shown that this dual approach is one of crucial reasons for the above-mentioned controversial interpretation and understanding of Keynes’s theory. In order to unravel these conflicting views surrounding Keynes’s General Theory it is necessary, at first, to elucidate whether Keynes’s theory is an equilibrium theory and, if it is, then what kind of an equilibrium theory it is? One group of economists claims that Keynes’s theory essentially is a theory of disequilibrium . Another group states that Keynes’s theory does deal with the issue of equilibrium .

The Tax Multiplier

The wider the range to industries over which initial investment is undertaken, the greater will be the multiplier effect. This is because monetary demand or expenditure generated by investment in any one industry would be easily met by the increase in production capacity in a variety of industries. In this way increase in demand resulting from investment would not lead to rise in prices but will cause real output to rise.

The textbook cuts directly to the chase scene, which the cultist never gets to. Keynes’s followers have been trying to vindicate the “multiplier” and therefore, have been considered successsive-period multiplier according to Kahn, in parallel with his instantaneous version . First, Keynes discussed closed economy where the source of the investment is the national income, while Kahn considered open economy where the borrowing is the source of the investment increment.

Consumer Saving Is Not a Bad Thing

Keynesian economics, as part of the neoclassical synthesis, served as the standard macroeconomic model in the developed nations during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973). It was developed in part to attempt to explain the Great Depression and to help economists understand future crises. It lost some influence following the oil shock and resulting stagflation of the 1970s. Keynesian economics was later redeveloped as New Keynesian economics, becoming part of the contemporary new neoclassical synthesis, that forms current-day mainstream macroeconomics.

But even if they did not, it was a losing strategy because by making neighbors poorer, the policy limited their ability to import (i.e., decreased the first country’s exports) and thus led to no significant long-term change in NX. To change output in the economy from 1500 to 1400 you would have to reduce G by 40. In this case, the 40 in government spending is an inflationary gap. Demonstrate both graphically and algebraically the impact on GDP of increasing government spending and taxes by $5 billion dollars when the MPC is .9. Changes in government spending have a similar impact on equilibrium GDP as changes in investment. As a perhaps exaggerated example of his belief in the effect of the multiplier, Keynes suggested that governments could simply bury currency in the ground and lease out the right to dig it up.

Second, in the latter case, to calculate net multiplier it is necessary to reduce the amount of repayment for borrowing from yielding increasing income. Keynes definitions “f is the aggregate supply function, and … D1 is function of N,” are also problematic . In other words, there is a reciprocal connection between quantity and price for a particular commodity . It follows therefore that these functions might be invertible functions. Developed in 1937 by economist and Keynes disciple John Hicks, the IS-LM model is still used today to model aggregate output (gross domestic product , gross national product , etc.) and interest rates in the short run.

In this way, the chain of consumption expenditure would continue and the income of the people will go on increasing. But every additional increase in income will be progressively less since a part of the income received will be saved. Thus, we see that the income will not increase by only Rs. 100 crores, which was initially invested in the construction of roads, but by many times more. Then out of Rs. 100 crores they will spend Rs. 80 crores on consumer goods, which would increase incomes of those people who supply consumer goods equal to Rs. 80 crores. But those who receive these Rs. 80 crores will also in turn spend these incomes, depending upon their marginal propensity to consume. If their marginal propensity to consume is also 4/5, then they will spend Rs. 64 crores on consumer goods.

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On the other hand, Lange was one of the first economists to define involuntary unemployment graphically that is closely to its genuine meaning in economics literature13 [43, p. 6]. Lange correctly defined involuntary unemployment but, unfortunately, he identified it with total unemployment, which is only correct in one case . Namely, by Lange’s definition “involuntary unemployment” only exists if the labor supply curve includes the keynesian multiplier is simply the reciprocal of the the horizontal segment 14 and the equilibrium point is located on this line, except at the borders. In other words, involuntary unemployment occurs if the employment equilibrium point is located to the left of the right border point of the horizontal segment and is determined as a difference between the latter and former equilibrium points. This means that “involuntary unemployment,” if it exists, is an equilibrium phenomenon.

This proposition preempts the analysis of the determination of interest rates by the schedule of liquidity preference and the supply of money. Pasinetti (1974, pp. 37–38) demonstrates, equation still applies to investment projects. To make clear that I am using equation in the valid sense of applying to investment projects, I drop the concept of the marginal efficiency of capital in favor of the concept of net present value. According to the principle of non-sufficient reason, if investors do not have a reason to assign different probabilities to a set of possible outcomes, they must assign them equal probabilities. Orthodox economists thus interpret the expected profit in equation as the mathematical mean of the sum of the products of all possible outcomes of investment projects and their probability.

This was the contribution Keynes made to the economic thinking of the time and was fundamental then, and now, in the role of fiscal policy in getting the economy back to full employment. Economists attributed this unemployment and depression to the higher wage rates maintained by the trade unions and the Government. According to the Keynesian theory, the saying “penny saved is penny earned” is quite inappropriate for the economy as a whole when it is working at underemployment equilibrium, that is, when there prevails recession or depression. Keynes has showed that if all people in a society decide to save more, they may actually fail to do so but nevertheless reduce their consumption. Thrift (i.e., the desire to save more) is considered to be a virtue in most of the societies and it is regarded as an act of prudence on the part of individuals to save for a rainy day. According to a proverb, “a penny saved is a penny earned”.

By this definition of involuntary unemployment, Lange made a very important contribution. At the same time, he did not connect his definition to the size of the available labour. Namely, he did not clarify if the right border point can be identified with the size of available labour force, or the latter is greater than the former, as might be understood from Lange’s figure. Thus, Lange did not define “voluntary” unemployment or discuss “full” employment.

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