[The passages quoted here are reorganized and sometimes quite out of the order they appear in the book, but seem to be clearer in this order, given the brevity of the excerpt. I have changed a few mathematical symbols to make them more predictable on the web. When in doubt, consult the original.]
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 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.
From the time of Say and Ricardo the classical economists have taught that supply
creates its own demand; meaning by this in some significant, but not clearly defined,
sense that the whole of the costs of production must necessarily be spent in the
aggregate, directly or indirectly, on purchasing the product.
Those who think in this way are deceived, nevertheless, by an optical illusion, which
makes two essentially different activities appear to be the same. They are fallaciously
supposing that there is a nexus which unites decisions to abstain from present consumption
with decisions to provide for future consumption; whereas the motives which determine
the latter are not linked in any simple way with the motives which determine the
former.
We must now define the ... category of unemployment, namely ‘involuntary’ unemployment in the strict sense, the possibility of which the classical theory does not admit.
Clearly we do not mean by ‘involuntary’ unemployment the mere existence of an unexhausted
capacity to work. An eight-hour day does not constitute unemployment because it is
not beyond human capacity to work ten hours. Nor should we regard as ‘involuntary’
unemployment the withdrawal of their labour by a body of workers because they do
not choose to work for less than a certain real reward. Furthermore, it will be convenient
to exclude ‘frictional’ unemployment from our definition of ‘involuntary’ unemployment.
... the equality of the real wage to the marginal disutility of employment ... realistically
interpreted, corresponds to the absence of ‘involuntary’ unemployment. This state
of affairs we shall describe as ‘full’ employment, both ‘frictional’ and ‘voluntary’
unemployment being consistent with ‘full” employment thus defined.
In dealing with the theory of employment I propose ... to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment. The first of these is strictly homogeneous, and the second can be made so. For, in so far as different grades and kinds of labour and salaried assistance enjoy a more or less fixed relative remuneration, the quantity of employment can be sufficiently defined for our purpose by taking an hour’s employment of ordinary labour as our unit and weighting an hour’s employment of special labour in proportion to its remuneration; i.e. an hour of special labour remunerated at double ordinary rates will count as two units. We shall call the unit in which the quantity of employment is measured the labour-unit; and the money-wage of a labour-unit we shall call the wage-unit. Thus, if E is the wages (and salaries) bill, W the wage-unit, and N the quantity of employment, E = N.W.
... in a given situation of technique, resources and factor cost per unit of employment, the amount of employment, both in each individual firm and industry and in the aggregate, depends on the amount of the proceeds which the entrepreneurs expect to receive from the corresponding output. For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of the proceeds over the factor cost.
Let Z be the aggregate supply price of the output from employing N men, the relationship
between Z and N being written Z = g(N), which can be called the Aggregate
Supply Function. Similarly, let D be the proceeds which entrepreneurs expect
to receive from the relationship between D and N being written D = f(N), which
can be called the Aggregate Demand Function.
[Just what Keynes means by Z, here, has been a bit mysterious. I take it from some of what follows that Z is an amount of total expenditure, that is, GDP. ]
This theory can be summed up in the following propositions:
[From these, it is pretty clear that D=f(N) describes total expenditure as it varies with the level of employment.]
IN Chapter 3 (p 25) we have defined the aggregate supply function Z = g(N), which relates the employment N with the aggregate supply price of the corresponding output. The employment function only differs from the aggregate supply function in that it is, in effect, its inverse function and is defined in terms of the wage-unit; the object of the employment function being to relate the amount of the effective demand, measured in terms of the wage-unit, directed to a given firm or industry or to industry as a whole with the amount of employment, the supply price of the output of which will compare to that amount of effective demand. Thus if an amount of effective demand Dwr, measured in wage-units, directed to a firm or industry calls forth an amount of employment Nr in that firm or industry, the employment function is given by Nr = Fr(Dwr). Or, more Generally, if we are entitled to assume that Dwr is a unique function of the total effective demand Dw, the employment function is given by Nr = Fr(Dw). That is to say, Nr men will be employed in industry r when effective demand is Dw.
[Thus the inverse, N=g-1(D), describes the amount of labor necessary to produce expenditure D. In other words, g-1 is the inverse of the production function as it is shown in most principles of economics textbooks and g is the production function itself.]
Now if for a given value of N the expected proceeds are greater than the aggregate
supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs
to increase employment beyond N and, if necessary, to raise costs by competing with
one another for the factors of production, up to the value of N for which Z has become
equal to D. Thus the volume of employment is given by the point of intersection between
the aggregate demand function and the aggregate supply function; for it is at this
point that the entrepreneurs’ expectation of profits will be maximised. The value
of D at the point of the aggregate demand function, where it is intersected by the
aggregate supply function, will be called the effective demand. ... this is
the substance of the General Theory of Employment ... .
The classical doctrine, on the other hand, which used to be expressed categorically
in the statement that “Supply creates its own Demand” and continues to underlie all
orthodox economic theory, involves a special assumption as to the relationship between
these two functions. For “Supply creates its own Demand” must mean that f(N)
and g(N) are equal for all values of N, i.e. for all levels of output and
employment; and that when there is an increase in Z( = f(N)) corresponding
to an increase in N, D( =f(N)) necessarily increases by the same amount as
Z. The classical theory assumes, in other words, that the aggregate demand price
(or proceeds) always accommodates itself to the aggregate supply price; so that,
whatever the value of N may be, the proceeds D assume a value equal to the aggregate
supply price Z which corresponds to N. That is to say, effective demand, instead
of having a unique equilibrium value, is an infinite range of values all equally
admissible; and the amount of employment is indeterminate except in so far as the
marginal disutility of labour sets an upper limit.
This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.
The aggregate demand function relates any given level of employment to the “proceeds” which that level of employment is expected to realise. The “proceeds” are made up of the sum of two quantities – the sum which will be spent on consumption when employment is at the given level, and the sum which will be devoted to investment.
Since we are here concerned in determining what sum will be spent on consumption
when employment is at a given level, we should, strictly speaking, consider the function
which relates the former quantity (C) to the latter (N). It is more convenient, however,
to work in terms of a slightly different function, namely, the function which relates
the consumption in terms of wage-units (Cw) to the income in terms of wage-units
(Yw) corresponding to a level of employment N. We will therefore define what we shall
call the propensity to consume as the functional relationship c between Yw
a given level of income in terms of wage-units, and Cw the expenditure on consumption
out of that level of income, so that
Cw = c(Yw) or C = W.c(Yw).
The principal objective factors which influence the propensity to consume appear to be the following:
ALL production is for the purpose of ultimately satisfying a consumer. Time usually elapses, however – and sometimes much time – between the incurring of costs by the producer (with the consumer in view) and the purchase of the output by the ultimate consumer. Meanwhile the entrepreneur (including both the producer and the investor in this description) has to form the best expectations he can as to what the consumers will be prepared to pay when he is ready to supply them (directly or indirectly) after the elapse of what may be a lengthy period; and he has no choice but to be guided by these expectations, if he is to produce at all by processes which occupy time.
These expectations, upon which business decisions depend, fall into two groups, certain
individuals or firms being specialised in the business of framing the first type
of expectation and others in the business of framing the second. The first type is
concerned with the price which a manufacturer can expect to get for his “finished”
output at the time when he commits himself to starting the process which will produce
it; output being “finished” (from the point of view of the manufacturer) when it
is ready to be used or to be sold to a second party. The second type is concerned
with what the entrepreneur can hope to earn in the shape of future returns if he
purchases (or, perhaps, manufactures) “finished” output as an addition to his capital
equipment. We may call the former short-term expectation and the latter long-term
expectation.
I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.
Now it is obvious that the actual rate of current investment will be pushed to the point where there is no longer any class of capital-asset of which the marginal efficiency exceeds the current rate of interest. In other words, the rate of investment will be pushed to the point on the investment demand-schedule where the marginal efficiency of capital in general is equal to the market rate of interest.
The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to-day and to-morrow. Even the rate of interest is, virtually, a current phenomenon; and if we reduce the marginal efficiency of capital to the same status, we cut ourselves off from taking any direct account of the influence of the future in our analysis of the existing equilibrium.
The considerations upon which expectations of prospective yields are based are partly
existing facts which we can assume to be known more or less for certain, and partly
future events which can only be forecasted with more or less confidence. Amongst
the first may be mentioned the existing stock of various types of capital-assets
and of capital-assets in general and the strength of the existing consumers’ demand
for goods which require for their efficient production a relatively larger assistance
from capital. Amongst the latter are future changes in the type and quantity of the
stock of capital-assets and in the tastes of the consumer, the strength of effective
demand from time to time during the life of the investment under consideration, and
the changes in the wage-unit in terms of money which may occur during its life. We
may sum up the state of psychological expectation which covers the latter as being
the state of long-term expectation; – as distinguished from the short-term
expectation upon the basis of which a producer estimates what he will get for a product
when it is finished if he decides to begin producing it to-day with the existing
plant, which we examined [previously].
The outstanding fact is the extreme precariousness of the basis of knowledge on which
our estimates of prospective yield have to be made. Our knowledge of the factors
which will govern the yield of an investment some years hence is usually very slight
and often negligible. If we speak frankly, we have to admit that our basis of knowledge
for estimating the yield ten years hence of a railway, a copper mine, a textile factory,
the goodwill of a patent medicine, an Atlantic liner, a building in the City of London
amounts to little and sometimes to nothing; or even five years hence. In fact, those
who seriously attempt to make any such estimate are often so much in the minority
that their behaviour does not govern the market.
Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many 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 quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; – though fears of loss may have a basis no more reasonable than hopes of profit had before.
The psychological time-preferences of an individual require two distinct sets of
decisions to carry them out completely. The first is concerned with that aspect of
time-preference which I have called the propensity to consume, which ... determines
for each individual how much of his income he will consume and how much he will reserve
in some form of command over future consumption.
But this decision having been made, there is a further decision which awaits him,
namely, in what form he will hold the command over future consumption which
he has reserved, whether out of his current income or from previous savings. Does
he want to hold it in the form of immediate, liquid command (i.e. in money
or its equivalent)? Or is he prepared to part with immediate command for a specified
or indefinite period, leaving it to future market conditions to determine on what
terms he can, if necessary, convert deferred command over specific goods into immediate
command over goods in general? In other words, what is the degree of his liquidity-preference
– where an individual’s liquidity-preference is given by a schedule of the amounts
of his resources, valued in terms of money or of wage-units, which he will wish to
retain in the form of money in different sets of circumstances.
The rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. The rate of interest is not the “price” which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash; – which implies that if the rate of interest were lower, i.e. if the reward for parting with cash were diminished, the aggregate amount of cash which the public would wish to hold would exceed the available supply, and that if the rate of interest were raised, there would be a surplus of cash which no one would be willing to hold. If this explanation is correct, the quantity of money is the other factor, which, in conjunction with liquidity-preference, determines the actual rate of interest in given circumstances. 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.
At this point, however, let us turn back and consider why such a thing as liquidity-preference
exists. In this connection we can usefully employ the ancient distinction between
the use of money for the transaction of current business and its use as a store of
wealth. As regards the first of these two uses, it is obvious that up to a point
it is worth while to sacrifice a certain amount of interest for the convenience of
liquidity. But, given that the rate of interest is never negative, why should anyone
prefer to hold his wealth in a form which yields little or no interest to holding
it in a form which yields interest (assuming, of course, at this stage, that the
risk of default is the same in respect of a bank balance as of a bond)? .... There
is ... a necessary condition failing which the existence of a liquidity-preference
for money as a means of holding wealth could not exist. This necessary condition
is the existence of uncertainty as to the future of the rate of interest,
i.e. as to the complex of rates of interest for varying maturities which will
rule at future dates.
The three divisions of liquidity-preference ... may be defined as depending on (i) the transactions-motive, i.e. the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources; and (iii) the speculative-motive, i.e. the object of securing profit from knowing better than the market what the future will bring forth. As a rule, we can suppose that the schedule of liquidity-preference relating the quantity of money to the rate of interest is given by a smooth curve which shows the rate of interest falling as the quantity of money is increased.
We have now introduced money into our causal nexus for the first time, and we are
able to catch a first glimpse of the way in which changes in the quantity of money
work their way into the economic system. If, however, we are tempted to assert that
money is the drink which stimulates the system to activity, we must remind ourselves
that there may be several slips between the cup and the lip. For whilst an increase
in the quantity of money may be expected, cet. par., to reduce the rate of
interest, this will not happen if the liquidity-preferences of the public are increasing
more than the quantity of money; and whilst a decline in the rate of interest may
be expected, cet. par., to increase the volume of investment, this will not
happen if the schedule of the marginal efficiency of capital is falling more rapidly
than the rate of interest; and whilst an increase in the volume of investment may
be expected, cet. par., to increase employment, this may not happen if the
propensity to consume is falling off. Finally, if employment increases, prices will
rise in a degree partly governed by the shapes of the physical supply functions,
and partly by the liability of the wage-unit to rise in terms of money. And when
output has increased and prices have risen, the effect of this on liquidity-preference
will be to increase the quantity of money necessary to maintain a given rate of interest.
When involuntary unemployment exists, the marginal disutility of labour is necessarily less than the utility of the marginal product. Indeed it may be much less. For a man who has been long unemployed some measure of labour, instead of involving disutility, may have a positive utility. If this is accepted, the above reasoning shows how “wasteful” loan expenditure may nevertheless enrich the community on balance. Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths
in disused coalmines which are then filled up to the surface with town rubbish, and
leave it to private enterprise on well-tried principles of laissez-faire to
dig the notes up again (the right to do so being obtained, of course, by tendering
for leases of the note-bearing territory), there need be no more unemployment and,
with the help of the repercussions, the real income of the community, and its capital
wealth also, would probably become a good deal greater than it actually is. It would,
indeed, be more sensible to build houses and the like; but if there are political
and practical difficulties in the way of this, the above would be better than nothing.
The analogy between this expedient and the goldmines of the real world is complete.
At periods when gold is available at suitable depths experience shows that the real
wealth of the world increases rapidly; and when but little of it is so available,
our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value
and importance to civilisation. just as wars have been the only form of large-scale
loan expenditure which statesmen have thought justifiable, so gold-mining is the
only pretext for digging holes in the ground which has recommended itself to bankers
as sound finance; and each of these activities has played its part in progress-failing
something better. To mention a detail, the tendency in slumps for the price of gold
to rise in terms of labour and materials aids eventual recovery, because it increases
the depth at which gold-digging pays and lowers the minimum grade of ore which is
payable.
Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth,
in that it possessed two activities, namely, pyramid-building as well as the search
for the precious metals, the fruits of which, since they could not serve the needs
of man by being consumed, did not stale with abundance. The Middle Ages built cathedrals
and sang dirges. Two pyramids, two masses for the dead, are twice as good as one;
but not so two railways from London to York. Thus we are so sensible, have schooled
ourselves to so close a semblance of prudent financiers, taking careful thought before
we add to the “financial” burdens of posterity by building them houses to live in,
that we have no such easy, escape from the sufferings of unemployment. We have to
accept them as an inevitable result of applying to the conduct of the State the maxims
which are best calculated to “enrich” an individual by enabling him to pile up claims
to enjoyment which he does- not intend to exercise at any definite time.