Keynesian economics comprises a body of theory and ways of thinking about the functioning of the aggregate (macro) economy that derives its inspiration from J.M.Keynes’s General Theory of Employment, Interest and Money (1936), and from the work of Keynes’s younger contemporaries such as Sir Roy Harrod, Lord Kaldor, Lord Kahn, Joan Robinson and Michal Kalecki, who extended Keynes’s analysis to the growing economy and to the question of the functional distribution of income between wages and profits which Keynes himself had neglected.
There was no formal macroeconomics before Keynes. The prevailing orthodoxy was that economic systems tend to a full employment equilibrium through the operation of the price mechanism, with the distribution of income determined by the payment to factors of production according to their marginal productivity. Growth was assumed to be a smooth continuous process: The twin pillars of classical employment theory were that savings and investment were brought into equilibrium at full employment by the rate of interest, and that labour supply and demand were brought into equilibrium by variations in the real wage. Anyone wanting to work at the prevailing real wage could do so. Keynes’s General Theory was written as a reaction to the classical orthodoxy. The debate is still very much alive. Keynesians take issue with pre-Keynesian modes of thought relating to such issues as: the tendency of economies to long-run full employment equilibrium; the functioning of aggregate labour markets; the distribution of income, and to other matters such as the relation between money and prices.
There are at least four major differences between Keynesian and pre-Keynesian economics.
First, in pre-Keynesian economics, investment is governed by decisions to save. Variations in the rate of interest always ensure that whatever saving takes place can be profitably invested. There is no independent investment function. By contrast, Keynesian economics emphasizes the primacy of the investment decision for understanding the level of employment and growth performance. Investment determines output which determines saving, through a multiple expansion of income (called the ‘multiplier process’) at less than full employment, and through changes in the distribution of income between wages and profits at full employment. It is capitalists, not savers, that take the investment decision, and they live in historical time with their present actions determined by past decisions and an uncertain future. By the changing ‘animal spirits’ of decision makers, capitalist economies are inherently unstable. Keynes brought to the fore the role of expectations in economic analysis, and emphasized their key role in understanding capitalist development.
Second, in pre-Keynesian theory there is a divorce between money and value theory. Money is a ‘veil’ affecting only the absolute price level, not the relative prices of goods and services in the economic system. There is no asset demand for money. Money is demanded for transactions only, and increases in the money supply affect only the price level. In Keynesian economics, money is demanded as an asset, and in the General Theory itself, the rate of interest is determined solely by the supply of and demand for money for speculative purposes, with the effect of money on prices depending on how interest rates affect spending relative to output. Keynesian economics attempts to integrate money and value theory. Keynesian inflation theory stresses the strong institutional forces raising the price level to which the supply of money adapts in a credit economy.
Third, in pre-Keynesian economics, the aggregate labour market is assumed to function like any micro-market, with labour supply and demand brought into equality by variations in the price of labour, the ‘real wage’. Unemployment is voluntary due to a refusal of workers to accept a lower real wage. Keynes turned classical voluntary unemployment into involuntary unemployment by questioning whether it was ever possible for workers to determine their own real wage since they have no control over the price level. Unemployment is not necessarily voluntary, due to a refusal to accept real wage cuts, if by an expansion of demand both labour supply and demand at the current money wage would be higher than the existing level of employment. There are still many economists of a pre-Keynesian persuasion who believe that the major cause of unemployment is that the aggregate real wage is too high and that workers could price themselves into jobs by accepting cuts in money wages to reduce real wages without any increase in the demand for output as a whole.
Fourth, Keynesian economics rejects the idea that the functional distribution of income is determined by factors of production being rewarded according to the value of their marginal product derived from an aggregate production function. This assumes a constant return to scale production function, otherwise factor income would not equal total output. More serious, since capital goods are heterogeneous they can be aggregated only once the price, the rate of interest or profit, is known. Therefore the marginal product cannot be derived independently. Keynesian distribution theory (as pioneered by Kalecki and Kaldor) shows the dependence of profits on the investment decision of firms and the savings propensities attached to wages and profits. This insight can be found in Keynes’s earlier work, The Treatise on Money (1930), the story of the widow’s cruse.
One unfortunate aspect of Keynes’s economics was that, for the most part, it assumed a closed economy. A Keynesian approach to the functioning of capitalist economies cannot ignore the balance of payments, or more precisely the export decision relative to the propensity to import. This is the notion of the Harrod trade multiplier revived by Kaldor and Thirlwall. Keynesian economics now embraces analysis of the functioning of the world economy, recognizing the mutual interaction between countries. What unites Keynesian economists, however, is the rejection of the facile belief that we live in a world in which the functioning of markets guarantees the Long-run full employment of resources, and, even if we did, that it would have any relevance. As Keynes said in his Tract on Monetary Reform (1923), ‘Economists set themselves too easy a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.’
A.P.Thirlwall
University of Kent
Further reading
Clarke, P. (1988) The Keynesian Revolution in the Making 1924–1936, Oxford.
Coddington, A. (1983) Keynesian Economics: The Search for First Principles, London.
Fletcher, G.A. (1989) The Keynesian Revolution and its Critics, London.
Leijonhufvud, A. (1968) On Keynesian Economics and the Economics of Keynes, Oxford.
Patinkin, D. and Clarke Leith, J. (1977) Keynes, Cambridge and the General Theory, London.
