Reflections

We have come to the end of a rather long trail. Following the trail blazed by John Maynard Keynes' General Theory of Employment, Interest, and Money, we have gradually built up a complete theory of unemployment equilibrium at a given price level, or, in other words, of aggregate demand. (Actually we are not yet at the end of the trail, since we have yet to bring aggregate supply into the picture, but we have followed it as far as Keynes can lead us).

It may help if we put it in the framework of the reasonable dialog. Keynes' ideas were very much a departure from the mainstream ideas of economists in his time, and he could anticipate that they would be strongly criticized (as they were). Keynes wanted to base his diagnosis of, and prescription for, the unemployment of the 1930's on the Simple Keynesian Model, that is, on income-expenditure equilibrium and the multiplier. While he thought the diagnosis and the prescription were right, he recognized they were based on very abstract and simplified ideas about a market economy. As such, they would be subject to criticisms that he had neglected such things as money and the influence of interest rates, and that his conclusions could be unreliable for that reason. Keynes wanted to anticipate those arguments, and show that they were not really important or sound. In the jargon of the Reasonable Dialog, the arguments that Keynes had left out money and interest would undercut his basic diagnosis and prescription, and he wanted to undercut those undercutters in advance -- to make his own argument more conclusive against them.

In order to anticipate, and minimize, the counterarguments based on money and interest, Keynes had to state the counterarguments himself. (He was moving so fast that his critics didn't have a chance to come up with their own points). This is one of the things that made the book so hard to understand -- Keynes sometimes seemed to be arguing against his own ideas, only then to return to them. But confusing as that may be, it's one way to try to deal in advance with very committed critics.

That's why Keynes developed the Complete Keynesian Theory, with its allowances for monetary policy and the impact of interest on money. But having worked all that out, Keynes went on to argue that monetary policy and interest rate impacts would be very weak and ineffective in the conditions of the 1930's. He concluded that the Simple Keynesian Model explained most of the changes in employment and production, and that the only policy that would really work to bring the depression economies back would be government deficit spending.

Was Keynes right? Does the Simple Keynesian Model, with its multiplier effects, explain most of the changes in production and unemployment? To this day, economists do not agree on that. My own opinion, for what it is worth, is that Keynes was pretty close to right -- that multipliers and income-expenditure interactions are among the most important factors in explaining fluctuations in employment and production. That explains (to me) why government deficits kept rising in the 1970's and 1980's, even when the country was governed by conservatives who quite sincerely hated government deficits. In the short run, deficit spending works -- and the short run is long enough to get them re-elected.

What about the long run? We'll have to come back to that after looking into aggregate supply.

But, regardless, monetary policy is still important, indeed more important than ever. The conditions we have now are not those of the 1930's, or even of the 1980's. In almost all, perhaps all, of the developed countries, large government debts have become a fact of life, and these debts make the market for government bonds a key factor in the market for loans. Many people believe that increases in government debt will lead to still higher real interest rates and frustrate the hope of increased production. This has brought about an increasing consensus that fiscal policy is no longer possible. Right or wrong, that means monetary policy is the "only game in town."

And, indeed, it is monetary policy that makes the headlines. The central banks, including the American Federal Reserve in particular, behave as though they believed in the Complete Keynesian Model -- and it seems pretty certain that they really do believe in it. They manage the interest rates from day to day.

Have you ever wondered why, in economics, bad news is good news? Why every report of increased production leads to a drop in the stock market, for example? It wasn't always that way .... The answer is that good news may cause the Federal Reserve governors to worry that inflation will increase, and to react to the worry by increasing interest rates.

This, too, will pass. But monetary policy is the main tool of macroeconomic management today and for that reason the Complete Keynesian Theory is a key to understanding developments in our economy.

Chapter Summary