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MR. KEYNES AND THE NEOCLASSICS: A REINTERPRETATION

George H. Blackford, Ph.D.

[email protected]

(Last updated: 9/25/2020)

Keywords: Keynes, Keynesian, Causality, Methodology, Macroeconomics, Neoclassical

Economics

JEL Codes: B22, B40, E12, E13

Abstract

A model of Keynes’ integration of monetary and value

theory that incorporates the price of non-debt assets

as well as the prices of consumption and investment

goods is specified below. This model is used to ex-

plain how Keynes’ short- and long-run equilibriums

are obtained. It is demonstrated that the Keynesian

IS/LM model is a special (static) case of this model,

and that the Marshallian roots of Keynes’ model

makes a causal analysis of dynamic behavior possible

while the Walrasian roots of the neoclassical Keynes-

ian model only allow for a description of dynamic be-

havior without explanation other than through the in-

vocation of a mythical auctioneer.

mailto:[email protected]

Chapter 6:

Mr. Keynes and the NeoClassics:

A Reinterpretation

Keynes summarized the independent and de-

pendent variables in the analytical framework he de-

veloped throughout The General Theory at the begin-

ning of Chapter 18. He then outlined the aggregate

model embodied in this framework as follows:

[W]e can sometimes regard our ultimate independent

variables as consisting of (1) the three fundamental psy-

chological factors, namely, the psychological propensity

to consume, the psychological attitude to liquidity and

the psychological expectation of future yield from capi-

tal-assets, (2) the wage-unit as determined by the bar-

gains reached between employers and employed, and (3)

the quantity of money as determined by the action of the

central bank; so that, if we take as given the factors

specified above, these variables determine the national

income (or dividend) and the quantity of employment.

But these again would be capable of being subjected to

further analysis, and are not, so to speak, our ultimate

atomic independent elements. (p. 246-7) 1

In order to derive the behavioral equations of the

model described by Keynes in this paragraph it is nec-

essary to express its variables in terms of Keynes’ cho-

sen units of measurement. It is also necessary to in-

corporate the crucial role played by expectations in

Keynes’ general theory in determining causality as the

system changes through time.

1 See also Keynes (1936, p. 247):

178 ESSAYS-ON-POLITICAL-ECONOMY-III CH..5

B-a. Keynes’ Aggregate Model The analytical framework developed by Keynes

throughout The General Theory makes use of but two

units of measurement: money and the labor-unit

where Keynes defined the labor-unit as “an hour’s

employment of ordinary labour” (1936, p. 41).

Behavioral Equations In specifying the behavioral equations of Keynes’

model in terms of money and labor units we begin by

a) dividing the money values of the rates at which

consumption ( ) and investment goods (

) are

produced by what Keynes defined as the wage-unit

( )—that is, “the money-wage of a labour-unit”

(1936, p.41)—in order to express the rates at which

consumption ( ) and investment ( ) goods are pro-

duced in ‘wage-units’ and b) summing to obtain the

aggregate level of output/income measured in wage-

units ( ):2

,

where and

are the aggregate rates of con-

sumption and investment goods production

measured in hours of ordinary labor per unit of

time,3 and and

are the (complexes of the

2 This specification does not presume homogeneous consumption or

investment goods. Any number of consumption and investment goods

can be aggregated in this way. 3 It is rather misleading to refer to Keynes’ wage-unit measure as

“constant-wage-unit dollars” as Hansen did in 1953 (p. 44). When the

value of a flow variable such as consumption, investment, income, or

labor which are measured in money-units/time-unit (e.g., dollar/year)

is divided by Keynes’ wage-unit which is measured in money-

units/labor-unit (e.g., dollars/hour-of-ordinary-labor) the money-units

cancel and we are left with labor-units/time-unit or hours of ordinary

labor per unit of time (e.g., (dollar/year)/(dollars/hour-of-ordinary-

App..B Mr.-Keynes-and-the-NeoClassics 179

various) prices of and , respectively.4

Similarly, the “psychological attitude to liquidity”

is embodied in Keynes’ liquidity-preference/money-

demand function and is assumed to be an inverse

function of the (complex of the various) rate(s) of in-

terest ( ) and a direct function of income measured

in wage-units :

,

,

where is the nominal value of the stock of

money demanded divided by the wage-unit

which measures the value of the stock of

money demanded in terms of hours of ordi-

nary labor.5

labor) = hour(s)-of-ordinary-labor/year). Similarly, when a stock

variable such as debt, non-debt assets, or money which are measured in

money-units (e.g., dollars) is divided by Keynes’ wage-unit (e.g.,

dollars/hour-of-ordinary-labor) the money-units again cancel and we

are left with labor-units or hours of ordinary labor (e.g.,

dollars/(dollars/hour-of-ordinary-labor) = hour(s)-of-ordinary-labor).

As a result, money-units (e.g., dollars), constant or otherwise, cancel

and are not part of the unit of measurement when a quantity is

measured in wage-units. It must be noted, however, that since Keynes’

measure presumes that “different grades and kinds of labour … enjoy a

more or less fixed relative remuneration” it is not clear that Keynes’

measure is superior to the constant-dollar measure of neoclassical

economics in light of the changes in relative remunerations for various

kinds of labor that have occurred over the past fifty-odd years. See

Piketty (Chap. 9) and Blackford (2018, pp. 1-9, 279). 4 The complex of prices are treated in what fallows in the same way

Keynes dealt with the complex of interest rates (1936, pp. 28, 137n,

143, 167n, 168-9, 205-6). 5 Keynes argued in The General Theory (p. 304) that the demand for

money is a function of effective demand (22), and in his 1938

attempt to clarify the nature of the demand for money and its

relationship to ‘finance’ Keynes argued that the demand for money is

also “a function of income and of business habits” (1938, p. 321-2).

Since effective demand is only related to producers’ demands for

money and is not related to the demands of purchasers, I believe that


Since Keynes simply assumed the stock of money

in existence is exogenously “determined by the action

of the central bank” in his summary above, it is as-

sumed here that the quantity of money supplied

measured in wage-units ( ) is given by the exoge-

nously determined nominal value of the stock of mon-

ey in existence ( ) divided by the money wage :

,

where is the exogenously determined stock

of money in existence measured in terms of

hours of ordinary labor.

It is also assumed that the existing stock of non-

debt assets ( ) is exogenously determined. This stock

measured in wage-units ( ) is given by:

,

where is the (complex of the various) price(s)

of non-debt assets. The demand for non-debt

assets measured in wage-units ( ) is assumed

to be inversely related to the price of non-debt

assets and the rate of interest :

.

It is also instructive for expository purposes to

specify the non-debt asset equilibrium function in this

model even though Keynes did not discuss this rela-

the best way to incorporate these two aspects of Keynes understanding

of the demand for money is to assume that the demand for money is a

direct function of value of output/income (1), which is related to

the demands of both produces and purchasers, and to assume that

changes in effective demand (22) have the effect of shifting the

demand for money function (2) by way of changes in the

demand for ‘finance’. Cf., Davidson, Bibow (1995), and Keynes

(1937b).


tionship. This function can be obtained by setting the

supply of non-debt assets (4) equal to the demand for

non-debt assets (5),

,

and solving for the price of non-debt assets as

a function of the rate of interest and stock of

non-debt assets :

.

The “psychological expectation of future yield

from capital assets” is embodied in Keynes’ Marginal

Efficiency of Capital (MEC) schedule which is, in ef-

fect, the investment goods equilibrium function.

Keynes defined this schedule as: “The relation be-

tween the prospective yield of a capital-asset and its

supply price or replacement cost” and argued that

“the rate of investment will be pushed to the point on

the investment demand-schedule where the MEC in

general is equal to the market rate of interest.” (1936,

pp. 135-6)

If it is assumed that the supply price of invest-

ment goods ( ) is a direct function of the rate of in-

vestment goods production measured in wage-units

the supply price of investment goods

can be

written as:

.

If it is also assumed that the demand price of in-

vestment goods ( ) is an inverse function of

the rate of investment goods production and

the rate of interest and a direct function of the

price of non-debt assets (Keynes, 1936, p.

151) the demand price of investment goods

can be written as:

.


Keynes’ MEC schedule can then be obtained by equat-

ing the supply price of investment goods (8) and

demand price of investment goods (9) to obtain:

,

and solving for Keynes’ MEC schedule, that is,

the relationship between the rate of investment

goods demanded and the rate of interest

such that “the MEC in general is equal to the

market rate of interest:”

,

where denotes Keynes’ MEC function, and

is the rate at which investment goods are de-

manded at each rate of interest given the ex-

ogenously determined stock of non-debt assets

and the prices of investment goods

and

non-debt assets as determined by the sup-

plies and demands in the markets for investment

goods and non-debt assets, (8), (4), (9), and (5),

respectively.

The “psychological propensity to consume” is em-

bodied in Keynes’ consumption function (i.e., the con-

sumption goods equilibrium function) which can be

derived in a manner parallel to the derivation of

Keynes’ MEC schedule. If it is assumed that the sup-

ply price of consumption goods ( ) is a direct func-

tion of the rate of consumption goods production

the supply price of consumption goods can be

written as:

.

If it is also assumed that the demand price of

consumption goods ( ) is an inverse function

of the rate of consumption goods production

and a direct function of the level of income


the demand price of consumption goods can

be written as:

.

Keynes’ consumption function can then be ob-

tained by equating the supply price of consump-

tion goods (12) and the demand price of con-

sumption goods (13),

,

and solving for the demand for consumption

goods as a function of output/income

:

,

where denotes Keynes’ aggregate consumption

function, is the rate of consumption goods

demanded at each level of output/income

given the price of consumption goods as de-

termined in the market(s) for consumption

goods, and it is assumed that the Marginal Pro-

pensity to Consume (MPC) lies between zero

and one. Thus, Keynes’ aggregate savings func-

tion (s) is given by:

,

and (15) and (11) imply that Keynes’ aggregate

demand function can be written as:

,

where is the aggregate demand for con-

sumption plus investment goods measured in

wage-units. 6

6 It should be noted that any number of individual consumption or

investment goods can be aggregated in this way and that to simplify the

exposition it is assumed that net income is a unique function of gross

income in what follows. See Keynes (1936, chs. 4, 8).


To complete Keynes’ aggregate model it is neces-

sary to explain the relationship between the level of

employment and effective demand where Keynes de-

fined effective demand as the point at which the “en-

trepreneurs’ expectation of profits will be maximized”

(1936, p. 25). Keynes explained this relationship in

Chapter 20 in terms of his employment function:

In Chapter 3 we have defined the aggregate supply func-

tion Z = φ(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 effec-

tive demand Dw, the employment function is given by

Nr= Fr(Dw). (1936, p. 280)

Thus, if we assume the rates at which labor is de-

manded measured in wage-units in the investment

and consumption-goods industries are direct func-

tions of the effective demands for investment ( )

and consumption ( ) goods measured in wage-units

in each of these industries we can write the demand

for labor measured in wage-units in the investment-

goods industries ( ) as:

,


where the value of is expressed in terms of

hours of ordinary labor per unit of time. Simi-

larly, the demand for labor measured in wage-

units in the consumption-goods industries

( ) is given by:

.

And “if we are entitled to assume that [employ-

ment in each firm or industry] is a unique func-

tion of the total effective demand” (18) and (19)

imply that Keynes’ aggregate employment func-

tion can be written as: 7

,

where is the aggregate effective demand as

given by the sum of and

:

.

And since the “employment function only differs

from the aggregate supply function in that it is,

in effect, its inverse and is defined in terms of

the wage-unit,” the inverse of (20) yields

Keynes’ aggregate supply function defined in

terms of wage-units:

,

“which relates the employment [ ] with the

aggregate supply price [ ] of the correspond-

ing output [ ]”

) measured in

wage-units (Cf., Brady.). And since output is

determined by effective demand (=

) the

7 Since the aggregate employment function is defined in terms of

wage-units net of user cost, both and

define the number of

hours-of-ordinary-labor/time-unit needed to satisfy . Thus,

=

and

= which implies that . See footnote

3 above and Keynes (1936, p. 55n).


inverse of Keynes’ aggregate employment func-

tion (20) allows us to write Keynes’ aggregate

demand function as:

,

where denotes the aggregate demand at

each level of employment (both measured in

wage-units) given the rate of interest R and price

of non-debt assets , and, by definition,

is

equal to .8

Dynamic Adjustment Functions In specifying the dynamic adjustment functions

that determine the behavior of the individual varia-

bles in Keynes’ aggregate model it is assumed that

demanders and suppliers of money adjust the rate of

interest to equate the demand for money (2)

to the existing stock (supply) of money (3) (both

measured in wage-units) in accordance with what

Leijonhufvud (pp. 61-77) referred to as Marshall’s

“laws of motion”:

,

where is the time derivative operator d (=d/dt) applied to , and the time derivative

function (as well as the time derivative func-

tions specified below) is (are) assumed to in-

crease monotonically through the origin.9

It is also assumed that demanders and suppliers

8 See footnote 3 and 7 above. 9 It should be noted that the time derivative functions in this model are

not assumed to be continuous, well-behaved mathematical functions

though for ease of exposition they will be treated as such. See Hayes,

Brady, Leijonhufvud (pp. 61-77), Marshall, and Keynes (1936).


of non-debt assets adjust the price of non-debt assets

to equate the demand for non-debt assets

(5)

to the existing stock of non-debt assets (4):

.

Next it is assumed that producers in the invest-

ment- and consumption-goods industries adjust their

expectations to equate the effective demands for con-

sumption and investment

goods to the actual

demands for these goods as defined by the inverses of

(13) and (9):

,

as they adjust the rates of consumption and

investment goods production to their respec-

tive effective demands:

,

and that suppliers and demanders in the mar-

kets for investment and consumption goods ad-

just the prices of investment and consump-

tion goods to equate the supply prices

,

(8), (12) and demand prices ,

(9), (13) of

these goods:

,

.

Finally, it is assumed that the producers adjust

aggregate employment to equate the aggregate


supply of output (22) and the aggregate effective

demand for output (21): 10

,

as the effective demand for output (21) ad-

justs to the actual demand for output ( )

by way of the identity:

,

and that aggregate output/income adjusts by

way of the identity:

.

Structure of Keynes’ Aggregate Model The adjustment functions (24) - (34) define the

way in which changes in eleven endogenous variables

are determined in Keynes’ aggregate model: , ,

,

, ,

, ,

, ,

, and . Since these

functions are assumed to pass through the origin the

system is in equilibrium in the sense that there is no

reason for any variable to change when all of the ad-

justment functions (24) - (34) are equal to zero. This

gives us eleven equilibrium conditions which contain

eleven behavioral variables and eleven endogenous

variables as summarized in Table 1.

This table outlines the mathematical structure of

the short-run aggregate model described by Keynes in

the passage quoted above. The equilibrium values of

10 Cf., Keynes: “the effects on employment of the realised sale-

proceeds of recent output and those of the sale-proceeds expected from

current input; and producers' forecasts are more often gradually

modified in the light of results than in anticipation of prospective

changes” (1936, p. 51).


the endogenous variables in this table are assumed to

be determined by the behavioral relationships defined

by the aggregate behavioral equations (1) - (23), given

the assumption that employment, output, and prices

are determined in accordance with the adjustment

functions (24) - (34) as the expectations of producers

adjust to the actual demands that exist in markets.

Table 1: Structure of Keynes’ Aggregate Model

Market Equilibrium Conditions

Behavioral Variables

Endogenous Variables

Assets =

=

,

,

Investment =

=

,

,

, ,

Consumption =

=

,

,

, ,

Labor =

Identities

The fundamental difference between the structure

of this model and that of the Walrasian paradigm of

neoclassical economics is that Keynes’ behavioral

equations are assumed to be consistent with Marshal-

lian supply and demand functions rather than the

Walrasian supply and demand functions assumed by

neoclassical economists. (Cf., Marshall; Brady; Hayes;

Clower; Leijonhufvud.) They are presumed to be de-

termined by the optimizing behavior of decision-

making units as they interact in markets, just as

Walrasian supply and demand functions are pre-

sumed to be determined by optimizing behavior. The

difference is that in Keynes’ understanding of these

functions they are specified by isolating those factors

that are perceived to have a direct effect on the will-

ingness of buyers and sellers to buy and sell in indi-


vidual markets whether the system as a whole is in

equilibrium or not without assuming that these choic-

es are constrained by an arbitrary Walrasian budget

constraint. Instead, they are derived by observing the

actual behavior of decision-making units in markets,

hypothesizing with regard to the motivations of these

units given their expectations with regard to those

magnitudes that affect their choices directly in each

individual market, and then reasoning through the

logical implications of what the actual choices availa-

ble to decision-making units and their motivations

and expectations imply with regard to their willing-

ness to buy and sell in individual markets. (Cf., Black-

ford, 1975; 1976; Clower.) As a result, even though the

set of equilibrium conditions specified above when

taken together define a general equilibrium of the sys-

tem as a whole they are the product of a partial equi-

librium analysis of individual markets rather than the

product of a general equilibrium analysis as such

(Marshall, 1961, Books III-IV; cf., Keynes, 1936, Books

III-IV; Hayes; Brady)

It should also be noted that the supply and de-

mand for loanable funds are not independent behav-

ioral functions in this model. In a world in which de-

cision-making units do not go into debt simply for the

sake being in debt—a world in which debt, in itself,

offers no satisfaction or utility—there must be a de-

mand for money for some reason other than the satis-

faction of being in debt before there can be a willing-

ness to borrow money. Thus, it is assumed that deci-

sion-making units borrow money only to meet their

financial needs for money. Similarly, it is assumed

that decision-making units lend money only to dis-

pose of excess money balances they have no use for


otherwise or in the case of trade credit to provide the

money needed to facilitate current transactions. This

makes the supply and demand for loanable funds ex

post functions, determined within the system by the

supply and demand for money as dictated by the de-

sired transactions of decision-making units as deter-

mined by the behavioral equations of the model. As a

result, there are no redundant equations in the model

outlined in Table 1, and Walras’ Law—a law that can

only be enforced by a mythical auctioneer—has no

relevance in this model, just as it has no relevance in

Keynes’ general theory or in the real world. (Cf.,

Clower; Blackford, 1975; 1976.)11

Short-Run Equilibrium The way in which the short-run equilibrium val-

ues of the variables in the model are determined by

supply and demand in individual markets and the

ways in which the markets are interconnected as

summarized by Keynes’ MEC (11), consumption (15),

and the asset market equilibrium (7) functions are il-

lustrated in Figure 1 in that: 12

1. Given the rate of interest R and price of non-debt

assets the equilibrium price and rate of in-

11 This does not mean that the system-wide consistency requirements

that Lavoie and Godley (p. 14) examined are violated. It only means

that there is no reason to believe that at any given point in time the

excess demands in the model sum to zero. 12 For a detailed discussion of the way in which equilibrium is defined

and achieved in the works of Marshall, Keynes, and neoclassical

economists see Hayes (2006), Kregel, and Lavoie and Godley. The

focus of this paper is on the relationship between partial-equilibrium

and what Hayes refers to as “system” equilibrium and “the dynamic

process of convergence in which a series of positions of short-period

equilibrium trace a path towards a position of long-period equilibrium

in Keynes’s sense” (2006, pp. 3-9). See Kregel, and Lavoie and

Godley.


vestment goods production are determined in

panels (A) and (B) by demanders and suppliers of

investment goods as given by the inverses of the

demand price (9) and supply price

(8) of investment goods functions in pan-

el (B) from which Keynes’ MEC schedule

in panel (A) is derived.

Figure 1: Short-Run Equilibrium.

2. Given the equilibrium rate of investment the

value of output/income is determined by savers

and investors in accordance with Keynes’ savings

function (16) in panel (C) which is implied

by Keynes’ consumption function (15) in

panel (F).

3. Given output/income the equilibrium rate of

interest R is determine by the demanders and

suppliers of money as dictated by the demand

(2) and supply (3) of money func-


tions in panel (D), and the equilibrium price

and rate of consumption goods production are

determined in panels (E) and (F) by the demand-

ers and suppliers of consumption goods as given

by the inverses of the demand price

(13) and supply price (11) of consumption

goods functions in panel (E) from which Keynes’

consumption function (15) in panel (F) is

derived.

4. Given the rate of interest the equilibrium price

of non-debt assets is determine in panels (G)

and (H) by the demanders and suppliers of non-

debt assets as given by the supply of non-debt as-

sets (4) and the inverse of the demand for

non-debt assets (5) functions in panel

(H) from which the non-debt asset equilibrium

function (7) in panel (G) is derived.

5. Given the rate of interest R and the price of non-

debt assets the point of effective demand

and equilibrium rate of employment are deter-

mined by producers at the intersection of Keynes’

aggregate supply (22) and demand

(23) schedules in panel (I).

But what is most significant about the model em-

bodied in equations (1) through (34) above is that it

formalizes the analytical framework develop by Keynes

throughout The General Theory—a framework with-

in which a causal analysis of the dynamic behavior of

the economic system is possible.

Causality in Keynes’ Aggregate Model As is indicated in Figure 1, rather than view the

economic system from the perspective of a set of


Walrasian simultaneous equations Keynes viewed the

system from the perspective of a set of Marshallian

partial equilibrium models in which the values of in-

dividual variables are determined by the choices of

those decision-making units that actually have the

power to determine the value of each variable at each

point in time as the system evolves through time.

(Cf., Bibow, 2000a; 2001; Brady; Hayes.) According-

ly, given the wage unit and those factors that are sub-

sumed in the functional form of the MEC, consump-

tion, liquidity preference, money supply, and em-

ployment functions (Keynes, 1936, pp. 245-7):13

1. The prices and rates of production and sale of

goods and resources along with the price of non-

debt assets (i.e., the complex of prices of goods, re-

sources, and real and financial non-debt assets) is

(are) determined through the interactions of sup-

pliers and demanders in the markets for goods, re-

sources, and non-debt assets.

2. The rate of interest (i.e., the complex of rates of

interest on new loans and debt assets) is (are) de-

termined by the suppliers and demanders for

money (i.e., liquidity) in the money market.

13 The fact that the wage-unit, money supply, and other exogenous

variables and parameters are assumed to be given does not mean that

these factors do not change. It only means that the effects of changes in

these factors can either be ignored in considering the problem at hand

or that they are not determined in a systematic way within the system

such that their effects must be examined separately. See Keynes (1936,

p. 245-7) and sections III and VI below.

It should also be noted that Keynes defined the “daily” decisions of

produces in terms of “the shortest interval after which the firm is free to

revise its decision as to how much employment to offer. It is, so to

speak, the minimum effective unit of economic time” (1936, p. 47n).


3. Employment is determined by producers in ac-

cordance with their effective demands—that is, the

rate at which producers expect to maximize their

profits.

4. The income (i.e., the value of output produced) is

determined by savers and investors as they inter-

act in the markets for consumption and invest-

ment goods.

5. And the entire process by which these variables are

determined at each point in time is governed by

the expectations of decision-making units as their

expectations adjust to the realized results that are

achieved within the system as the system evolves

through time.

These assumptions made it possible for Keynes to

isolate those factors that directly and in themselves

determine each variable at each point in time whether

the system is in equilibrium or not. This makes it

possible to establish the temporal order in which

events must occur as the system responds to changes

in the exogenous determinants of the variables in

each sector of the economy. This, in turn, makes it

possible to separate cause and effect within the ana-

lytical framework developed by Keynes throughout

The General Theory which makes a causal analysis of

dynamic behavior possible in Keynes’ general theory.

(Cf., Lavoie and Godley.)

Consider, for example, a ceteris paribus increase

in the MEC brought about by an optimistic shift in

long-term expectations in a situation in which there

are unemployed resources in the system. How will

this affect the short-run equilibrium position of the

economic system shown in Figure 1, and how will


the new short-run equilibrium come about?

The direct effects of a ceteris paribus increase in

the MEC will be to increase the MEC curve

(11) in panel (A) of Figure 1 and the demand for in-

vestment goods curve (9) in panel (B)

while leaving the other curves in this figure un-

changed. The resulting excess demand for investment

goods will cause an increase in the demand for money

(2) in panel (D) as the demand for invest-

ment finance increases in response to the increase in

the demand for investment goods . The resulting

excess demands for money will, in turn, cause the rate

of interest R to increase in accordance with (24), and

as the increase in the demand for investment goods is

financed the resulting excess demand for investment

goods will cause the price of investment goods to

increase in accordance with (30).14 As Producers’ ef-

fective demands for investment goods adjust to

the actual demand for investment goods in ac-

cordance with (27) the level of investment goods pro-

duced in panel (B) will increase in accordance with

(29).15 At the same time there will be a concomitant

14 Note that the initial excess demands for money and investment goods

are not associated with an excess supply in any other part of the system.

There is no reason to believe that Walras’ Law holds at any point in

time as the system moves from one point of equilibrium to another

through time in this model, but there is reason to believe that the

increase in the rate of interest R and price of investment goods will

subsequently cause changes in the rest of the system. Cf. Blackford

(1975; 1976) and Clower. 15 Cf., Keynes:

There will be an inducement to push the rate of new investment to

the point which forces the supply-price of each type of capital-

asset to a figure which, taken in conjunction with its prospective

yield, brings the marginal efficiency of capital in general to

approximate equality with the rate of interest. That is to say, the


increase in aggregate demand (23) in

panel (I) as the effective demand for output ad-

justs to the actual demand for output in accord-

ance with (33) and employment and out-

put/income increase in accordance with (32) and

(34).

These effects on , , , and caused by the

optimistic shift in long-term expectations will be in-

hibited to some extent by the concomitant increase in

the rate of interest R which will inhibit the increase in

the demand for investment goods (9)

in panel (B). In addition, this effect of the increase in

the rate of interest R will be enhanced by the continu-

ing rise in demand for money (2) in panel

(D) that results from the increase in the transactions

demand for money as output/income increases.

The increase in the rate of interest R will also cause a

fall in the demand for non-debt assets (5)

in panel (H). The resulting excess demand for non-

debt assets will cause the price of non-debt assets

to fall in accordance with (25) which will also inhibit

the effects of the optimistic shift in long-term expecta-

tions on , , , and by further inhibiting the

increase in investment demand (9) in

panel (B) and the increase in the MEC (11) in

panel (A).

At the same time the increase in the value of ag-

gregate output/income that results from the in-

physical conditions of supply in the capital-goods industries, the

state of confidence concerning the prospective yield, the

psychological attitude to liquidity and the quantity of money

(preferably calculated in terms of wage-units) determine, between

them, the rate of new investment. (1936, p. 248)


crease in the output of investment goods will have

the effect of increasing the demand for consumption

goods (13) in panel (E). This, in turn,

will set in motion a causal feedback loop within the

system (the multiplier) as the excess demand for con-

sumption goods that results causes an increase in the

price of consumption goods in panel (E) in accord-

ance with (28), and as the effective demand for con-

sumption goods adjusts to the actual demand for

consumption goods in accordance with (26) pro-

ducers will increase the output of consumptions goods

in accordance with (29) which will further in-

crease the aggregate demand (23) in

panel (I) which will cause a further increase aggregate

effective demand , aggregate employment , and

output/income in accordance with (33), (32) and

(34), respectively.

The increase in aggregate output/income

caused by the increase in consumption goods pro-

duced will cause a further increase in the price

and output of consumption goods which will cause

a further increase in employment , output/income

, and the demand for money which will

cause a further increase in the rate of interest R and

fall in the price of non-debt assets which will fur-

ther inhibit the increase in investment as effective

demand , employment , output/income , and

the price and rate of consumption goods produc-

tion increase. This causal loop will continue until

system has achieved the short-run system equilibrium

depicted in Figure 2 where the price of investment

goods, rate of interest, output/income, employment,

consumption, and the price of consumption goods

have increased from , , R, , , , , and


to *, *, *, *, *, *, *, and * in this

ceteris paribus situation while the price of non-debt

assets falls from to *.16 (Cf., Keynes, 1936, pp.

48-50, 247-9; Kregel, pp. 215-6; Hayes.)

Figure 2: Achieving Short-Run Equilibrium.

It is worth reemphasizing at this point that what

makes this kind of causal analysis of the dynamic be-

havior possible as the system movers from one point

of short-run equilibrium to another is Keynes’ use of

16 The only reason the price of non-debt assets can be seen to fall in

this situation is that it is assumed that the optimistic shift in long-term

expectations does not have a positive effect on the demand for non-debt

assets (5) in panel (H). If it were to have a positive effect

on the demand for non-debt assets the resulting increase in

the price of non-debt assets in panel (H) would simply enhance the

positive effect of the increase in optimism on the MEC (11) in

panel (A) and the demand for investment goods (9) in

panel (B), and the ultimate direction of change in the price of non-debt

assets would be indeterminate depending on the relative effects of the

increases in optimism and the rate of interest R on the demand for non-

debt assets in panel (H).


the Marshallian ceteris paribus, partial-equilibrium

methodology of supply and demand to establish those

factors that determine the value of each variable in the

system at each point in time whether the system as a

whole is in equilibrium or not. As was noted above, it

is this that makes it possible to establish the temporal

order in which events must occur which is the sine

qua non of establishing causality.17 (Hume, Blackford

2020c, ch. 2)

Long-Run Equilibrium In specifying Keynes’ short-run equilibrium mod-

el above the stock of non-debt assets is assumed to

be exogenously determined, but positive net invest-

ment must, by definition, increase over time.

17 Cf., Keynes:

A monetary economy, we shall find, is essentially one in which

changing views about the future are capable of influencing the

quantity of employment and not merely its direction. But our

method of analysing the economic behaviour of the present under

the influence of changing ideas about the future is one which

depends on the interaction of supply and demand, and is in this

way linked up with our fundamental theory of value. (1935, p. vii)

And:

We can consider what distribution of resources between different

uses will be consistent with equilibrium under the influence of

normal economic motives in a world in which our views

concerning the future are fixed and reliable in all respects;—with a

further division, perhaps, between an economy which is

unchanging and one subject to change, but where all things are

foreseen from the beginning. Or we can pass from this simplified

propaedeutic to the problems of the real world in which our

previous expectations are liable to disappointment and

expectations concerning the future affect what we do to-day. It is

when we have made this transition that the peculiar properties of

money as a link between the present and the future must enter into

our calculations. But, although the theory of shifting equilibrium

must necessarily be pursued in terms of a monetary economy, it

remains a theory of value and distribution and not a separate

'theory of money'. (1936, pp. 293-4)


While the effects of this increase can be assumed to be

insignificant in the short run, Keynes argued that the-

se effects can be dramatic in the long run. (1936, p.

217-8) Specifically, he argued that the “position of

[long-run] 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.” (1936, p. 217-18)

The nature of this long-run equilibrium can be

demonstrated in the model specified above by explic-

itly including the stock of non-debt assets among

the independent variables of the supply-price func-

tions for investment (8) and consumption (12) goods.

In addition, noting that “an increased investment in

any given type of capital during any period of time the

marginal efficiency of that type of capital will diminish

as the investment in it is increased” (Keynes, 1936, p.

136) it is also necessary to explicitly include the stock

of non-debt assets in the demand-price of invest-

ment goods function (9) as well. Accordingly, (8), (9),

(11), (12), (15), and (16) are respecified as:

where the respecified MEC function (11a) and

consumption function (15a) are derived by sub-

stituting (8a), (9a), (12a) into (10) and (14) and

solving for and

. Given (11a) and (15a)

the aggregate demand function (23) becomes:


.18

Given these extensions of the model the mecha-

nisms by which an increase in the capital stock leads

to Keynes’ long-run equilibrium can be demonstrated

by examining the effects of a ceteris paribus increase

in the stock of non-debt assets from to * in pan-

el (H) of Figure 3.

Figure 3: Toward Long-Run Equilibrium.

As the stock of non-debt assets increases the

direct effect is an excess supply of non-debt assets in

panel (H) that leads to a fall in the price of non-debt

assets in accordance with (25) which combined

with the increase in will cause a fall in the MEC

schedule (11a) in panel (A) and in the

demand for investment goods curve (9a) in panel (B). The resulting excess supply of in-

vestment goods in the market for investment goods

18 .The way in which changes in the money wage affect the system are

examined in section B-b below.


will lead to a fall in the price investment goods pro-

duced . As the effective demand for investment

goods adjusts to the actual demand for investment

goods in accordance with (27) the output of

investment goods will fall in accordance with (29) as

the aggregate effective demand for output adjusts

to the actual demand for output in accordance

with (33) causing the aggregate demand curve

(23a) in panel (I) to fall as aggregate

employment and output/income fall in accord-

ance with (32) and (33).

The fall in employment and output/income

will decrease the transactions demand for money

which will cause a fall in the demand for money

(1) in panel (D). The resulting excess

supply of money will cause a fall in the rate of interest

R in accordance with (24) which will mitigate the ef-

fects of the increased supply and price of non-debt as-

sets by increasing the demand for non-debt assets

(5) in panel (H) thereby preventing the

price of non-debt assets from falling by as much as

it otherwise would. The fall in output/income will

also cause a fall in the demand for consumption goods

curve (13) in panel (E). As the effective

demand for consumption goods adjusts to the ac-

tual demand for consumption goods in accord-

ance with (26) the output of consumption goods pro-

duced will fall in accordance with (28). This, in

turn, will cause a further fall in output/income and

consumption as the multiplier process works its

way through the system until system has achieved the

short-run system equilibrium depicted in Figure 3

where the price of non-debt assets, investment goods,


rate of interest, output/income, employment, con-

sumption, and the price of consumption goods have

fallen from , , , R, , , , and to *,

*, *, *, *, *, *, and * as the stock of

non-debt assets increases from to *.

The stock of non-debt assets must continue to

increase and the price of non-debt assets , the out-

puts of investment and consumption goods ,

and the level of employment , output/income ,

and the rate of interest R must continue to fall in this

ceteris paribus situation until the investment goods

demand function (11a) in panel (B)

has fallen to the point at which the level of investment

is just sufficient to replace the capital that is con-

sumed in the process of producing . At that point

the long-run equilibrium will have been achieved as

net investment will be zero and the stock of non-debt

assets will no longer increase.19

19 See Keynes (1936, pp. 27-32, 136, 211-15, 217-8, 228-31). These

results illustrate Keynes’ paradox of thrift and are contrary to those

obtained in Lavoie and Godley (LG) (pp. 117, 122, 229–32, 240, 422-

3). The fundamental difference between the model specified above and

that of LG is the model specified above assumes an increase in non-

debt assets lowers the MEC and ignores the effects of a change in

wealth on the propensity to consume while the LG model ignores the

effects of a change in non-debt assets on the MEC and assumes an

increase in wealth increases the propensity to consume. This issue is

empirical rather than theoretical, and is beyond the scope of this

appendix which is to explain Keynes’ model.

It is worth noting that Keynes (1936, pp. 218) argued that it would

be “an unlikely coincidence that the propensity to save in conditionsof

full employment should become satisfied just at the point where the

stock of capital reaches the level where its marginal efficiency is zero.”

It is also worth noting that the limiting factor is ultimately the point at

which the rate of interest is forced to zero after adjusting for risk and

the cost of bringing borrower and lender together, and this limit cannot

be overcome by Robertson’s “progressive increase in the supply of


B-b. Mr. Keynes and the ‘NeoClassics’ In one way or another, the equilibrium conditions

and behavioral equations of the aggregate model out-

lined in Table 1 have been at the center of neoclassi-

cal macroeconomics since Keynes published The Gen-

eral Theory of Employment, Interest, and Money or

at least since 1937 when John R. Hicks published his

iconic paper, Mr. Keynes and the ‘Classics’: A Sug-

gested Interpretation. (Patinkin, 1976, p. 1092) Dis-

putes have arisen with regard to the choice of units,

the choice of endogenous and exogenous variables

and parameters, the way in which the endogenous

variables are determined, the role played by expecta-

tions, the nature of the dynamic adjustment functions,

the appropriate specification of the behavioral equa-

tions, and the nature of the micro-foundations of this

model, but the general framework of the model is

more or less as outlined above. There is, however, a

fundamental difference between the way in which

Keynes viewed this model and the neoclassical under-

standing of it as exemplified by the analytical frame-

work within which Hicks chose to explain his inter-

pretation of Keynes and the classics.

Hicks’ Two-Good Model Hicks began his interpretation by assuming the

existence of two short-run production functions:

,

where C and I denote the output of consumption

and investment goods, and and denote the

input of labor devoted to the production of each

of these goods. He also assumed that the prices

money” (1936, p. 188). See Keynes ( 1936, pp. 216-9).


of consumption goods ( ) and of investment

goods ( ) are equal to their marginal costs:

0

0.

Hicks then argued that income earned in the

consumption goods sector ( ), income earned

in the investment goods sector ( ), and total in-

come ( ) can be written as:

= 0

,

and argued that if the stock of capital and the

money wage ( ) are exogenously determined

“once [ ] and [ ] are determined, [ ] and [ ]

can be determined.”20 (p. 148)

Having structured the problem of explaining the

level of employment (i.e., the sum of and ) in

this way Hicks offered his interpretation of the classi-

cal solution to this problem by adding the “Cambridge

Quantity equation” which assumes a proportional re-

lationship (k) between the exogenously determined

stock of money (M) and total income Y:

,

and concluded: “As soon as k is given, total In-

come is therefore determined.”21 (p. 149) He

20 I find Hicks' 1937 notation exceedingly difficult to work with and

have adopted a notation that I find more manageable. 21 This is decidedly not the way in which variables are ‘determined’ in

Keynes’ general theory. Variables are determined by the actions of

those decision-making units that actually have the power to determine


then argued that income earned in the produc-

tion of investment goods (= ) is a function

of the rate of interest:

,

and stated: “This is what becomes the marginal-

efficiency-of-capital schedule in Mr. Keynes’

work.” Next, Hicks added the saving/investment

equilibrium condition:

,

where savings is assumed to be a function s of

both total income Y and the rate of interest R.

After noting that: “Since Income is already de-

termined, we do not need to bother about insert-

ing Income here unless we choose,” he argued

that taking (42) - (44) “as a system … we have

three fundamental equations … to determine

three unknowns [ , , ] …. [ ] and [ ] can

be determined from [ ] and [ ]. Total em-

ployment, [ ] + [ ], is therefore determined.”

(p. 149)

Having outlined his interpretation of the classical

solution to the problem of explaining the level of em-

ployment in this way Hicks then offered his interpre-

tation of Keynes’ solution to this problem by replacing

the Cambridge equation (42) in the classical model

with Keynes’ liquidity preference equilibrium condi-

tion:

.

He then argued that income earned in the pro-

variables as they interact in markets in Keynes’ general theory not by

mathematical equations. Keynes viewed the determination of variables

as an economic problem, not a mathematical problem. See Keynes

(1936, pp. 23-35, 46-7, 245-55, 257-71, 280-91, 297-8).


duction of investment goods should be a func-

tion of both the rate of interest R and total in-

come Y and replaced his classical version of

Keynes’ MEC schedule (43) with:

.

Equations (44) - (46) are central to Hicks' analyt-

ical framework in that (45) defines Hicks’ LM sched-

ule (those combinations of Y and R for which the

supply and demand for money are equal) and (44)

and (46) can be combined to obtain Hicks’ IS sched-

ule (those combinations of Y and R for which desired

saving and investment are equal):

.

Hicks used these two schedules to solve for the

rate of interest R and income Y the values of

which presumably make it possible to solve (35)

– (41) for , C, I, , , and in terms of

the exogenously determined money wage W and

stock of money M.

Keynesian One-Good Model Hicks’ model became the backbone of Keynesian

economics in the 1950s in the name of what Samuel-

son called the Neoclassical Synthesis. (Weintraub;

Zouache) In the process, Hicks’ two-good model was

converted to a one-good model by a) replacing the in-

dividual prices and with a single price (P), b)

replacing the individual levels of employment and

by a single level of employment (N), and c) replac-

ing equations (35) - (44) with their aggregate one-

good counterparts:

,


where is the aggregate output produced

, and is an aggregate production func-

tion.

These modifications greatly simplified the way in

which the short-run, static-equilibrium level of em-

ployment N could be explained in terms of the exoge-

nously determined money wage W and stock of mon-

ey M by reducing the number of variables to be solved

for from nine (Y, R, , C, I, , , , ) to six ( ,

Y, R, , P, N) which reduced the number of equa-

tions to six (45) – (50) as well. Once the IS (45) and

LM (47) equations are solved for Y and R in the

Keynesian one-good version of Hicks’ two-good model

it is only necessary to solve one equation (50) to ob-

tain N. Given N, P is implied by (49), (i.e., the

nominal value of investment, PI) by (46), and, by

(48), all in terms of the exogenously determined

money wage W and stock of money M. (Cf., Klein,

1966, pp. 59, 63, 73-5, 193-4; Patinkin, 1965; Ackley.)

Deriving Hicks’ Model from Keynes’ Model Setting aside units of measurement (one can mul-

tiply through by the wage-unit where appropriate

if one wishes), it is easily demonstrated that Hicks’

two-good model as outlined above (hence, the

Keynesian one-good model as well) can be derived

from Keynes’ model outline in Table 1 above by set-

ting Keynes savings function (16) equal to Keynes’

MEC function (11) to obtain Hicks’ IS savings/in-

vestment equilibrium condition:

.

Hicks’ LM monetary equilibrium condition is

implied by the assumption that when the system

is in equilibrium the quantity of money demand-

ed (2) in Keynes’ model must be equal to


the exogenously determined stock of money in

existence (3):

.

Given an exogenously determined money wage

and stock of money (51) and (52) can be

solved for the equilibrium values of and

which can be substituted into (15) and (11) to

obtain the equilibrium output of consumption

and investment

goods which, in turn, can

be substituted into (18) and (19) to obtain em-

ployment in the investment and consump-

tion goods industries. Given

, ,

, and

the equilibrium prices of investment and

consumption goods are implied by Keynes’

market equilibrium functions (10) and (14)

where all of these equilibrium values are solved

for in terms of the exogenously determined

money wage and the stock of money , giv-

en the price and stock

of non-debt assets

(which are implicitly held constant in Hicks’

model) and the assumption that the effective

demands and

are equal to their actual

demands and

.

As with Hicks’ model, the one-good Keynesian

models of neoclassical economics are, in general, also

implicit in Keynes aggregate model outlined above.

They are, in effect, special static cases of Keynes’ gen-

eral model, but this is where the similarity between

Keynesian neoclassical economics and the economics

of Keynes ends. The difference can be seen by com-

paring the way in which a flexible money wage W is

assumed to affect the level of employment N in the

Keynesian version of Hicks’ model as modified by

(48) - (50) above and the way in which a flexible


money wage is assumed to affect the level of em-

ployment in Keynes’ general theory.

Keynesian NeoClassics and the Money Wage As was noted above, in the Keynesian version of

Hicks’ model the IS (51) and LM (52) curves can be

solved for Y and R, and once these values are ob-

tained it is only necessary to solve (50) to obtain the

level of employment N given the exogenously deter-

mined money wage W. Since changes in the money

wage W cannot affect either the IS (51) or the LM

(52) curves in this model, by virtue of a) the assump-

tion that the price of output P is equal to marginal

cost (49), b) the law of diminishing returns (48), and

c) the fact that a change in the money wage W cannot

change income Y, (49) implies that there is an inverse

relationship between the money wage W and em-

ployment N. Thus, a fall in the money wage W must

lead to an increase in employment N, and, “by simple

arithmetic” it is possible to show that an unemploy-

ment problem can be solved by a fall in the money

wage. This is taken to indicate (even to prove for

some economists) that the cause of unemployment is

a lack of flexibility in wages.

The problem is, there is no way to explain how or

why the increase in employment that is supposed to

result from a fall in the money wage can come into be-

ing within the Keynesian neoclassical paradigm since

there is no way to explain how the system gets from

one point of equilibrium to another other than

through the invocation of a mythical Walrasian auc-

tioneer.

Keynes explained the fallacy involved in the clas-

sical explanation of the effects of a change in the mon-

ey wage on employment as follows:


In any given industry we have a demand schedule for

the product relating the quantities which can be sold to

the prices asked; we have a series of supply schedules

relating the prices which will be asked for the sale of

different quantities on various bases of cost; and these

schedules between them lead up to … the demand

schedule for labour in the industry relating the quantity

of employment to different levels of wages… This con-

ception is then transferred without substantial modifica-

tion to industry as a whole....

If this is the groundwork of the argument (and, if it is

not, I do not know what the groundwork is), surely it is

fallacious. For the demand schedules for particular in-

dustries can only be constructed on some fixed assump-

tion … as to the amount of the aggregate effective de-

mand…. [But] the precise question at issue is whether

the reduction in money-wages will or will not be accom-

panied by the same aggregate effective demand as be-

fore [emphasis added]…. [I]f the classical theory is not

allowed to extend by analogy its conclusions in respect

of a particular industry to industry as a whole, it is whol-

ly unable to answer the question what effect on em-

ployment a reduction in money-wages will have. For it

has no method of analysis wherewith to tackle the prob-

lem [emphasis added]…. (1936, pp. 258-60)

Keynes’ point here is that the classical theory

simply assumes that a decrease in the money wage

will lead to an increase in the effective demand for

output in all industries that will be accompanied by

an increase in the actual demand for output in all in-

dustries without any analysis as to how the decrease

in the money wage will affect incomes, prospective

yields on investment, the solvency of debtors, or

countless other ways in which a decrease in the money

wage can affect the actual demands for goods. There

is no way to explain how or why the actual demands


for goods will increase in response to a fall in the

money wage within the classical theory even if there is

an increase in the effective demands in this situation.

Keynes’ arguments in this passage apply with

equal force to the Keynesian neoclassical analysis of

this problem. There is no way to explain how a fall in

the money wage will lead to an increase in employ-

ment in Keynesian neoclassical economics except by

ignoring the effects of a fall in the money wage on de-

mand and just assuming that wages and prices will

adjust automatically in such a way that employment

increases along a falling marginal product of labor

function (49)—that is, without assuming a mythical

auctioneer is adjusting prices and quantities in such a

way as to allow the system to move instantaneously to

its short-run equilibrium values at each point in time

as the money wage and prices fall through time. In

other words, it is impossible to give a logically con-

sistent, causal explanation as to how the new equilib-

rium is achieved within the context of Keynesian neo-

classical economics. The problem is simply assumed

away through the invocation of a mythical auctioneer.

Keynes and the Money Wage Rather than view the economic system from the

perspective of a set of simultaneous equations (“a ma-

chine, or method of blind manipulation, which will

furnish an infallible answer” [Keynes, 1936, p. 297]),

as we have seen Keynes viewed the system as being

determined by a set of partial equilibrium models in

which the values of individual variables are deter-

mined by the choices of those decision-making units

that actually have the power to determine the value

of each variable at each point in time as the system

evolves through time. Given Keynes’ assumption that


employment is determined by producers at the point

of effective demand the only way in which a fall in the

money wage can affect the level of employment is

through an effect on the expectations of producers as

these expectations adjust to the effects of a fall in the

money wage on a) the MEC, b) the propensity to con-

sume, and c) the rate of interest (Keynes, 1936, pp.

183-4). These three factors determine the equilibrium

level of employment, and output/income in Keynes’

general theory in that the equilibrium level of em-

ployment and output/income cannot change un-

less at least one of these factors change.22 This follows

directly from Keynes’ Marshallian aggregate supply

(22) and demand (23) functions. Since:

1. levels of employment in the consumption and

investment goods industries are determined

by the effective demands and

in these in-

dustries in accordance with (19) and (18), and

2. effective demands for consumption and in-

vestment goods adjust to the actual demands

for consumption and investment

goods in

accordance with (26) and (27)

the equilibrium aggregate demand curve (23)—

that is, the aggregate demand curve for which

expectations can be realized—can change only by

way of a change in a) the MEC, b) the propensity

22 It should also be noted that while Keynes clearly accepted the first

fundamental postulate of classical economics (i.e., the classical labor

demand functions) embodied in Hicks’ (37) and (38) specifications and

in the Keynesians’ (49) he did not assume this function determines

employment. Keynes assumed that given the money wage prices

are adjusted by producers to satisfy (25), (30), and (31) “in accordance

with certain principles, if competition and markets are imperfect.”

(Keynes, 1936, pp. 4-18; 1939a) See also Keynes (1939b), Brady,

Brothwell, Hayes, Leijonhufvud, and Kregel.


to consume, or c) the rate of interest. (Keynes,

1936, chs. 3 and 20)

This means that if a fall in the money wage were

to increase expectations directly so as to induce pro-

ducers to increase employment in the absence of a

change in at least one of these three factors, all of the

increased output that results can be sold “[o]nly if the

community's marginal propensity to consume is equal

to unity.” (Keynes, 1936, p. 261)23 Barring this possi-

bility, the expectations of producers must eventually

become reconciled to this reality, and any increase in

employment that results solely from a ceteris paribus

increase in expectations can only be temporary as in-

ventories and debt accumulate and liquid assets are

depleted. (Keynes, 1936, pp. 261-2; Blackford, 2020c,

ch. 2)

This situation is illustrated in Figure 4 where it

is assumed that a fall in money wages increased ex-

pectations such that aggregate demand in panel (I)

increases from to * (17)

which increases effective demand from to * with

no change in the propensity to consume (15) in

panel (F), or the schedule of marginal efficiencies of

23 Strictly speaking, (11), (15), (22) and (23) imply that the price of

non-debt assets must be given as well as the rate of interest to

require the MPC equal unity in this situation:

d


capital (11) in panel (A), or on the rate of in-

terest in panel (D) where it is assumed in panel (D)

that the supply of money has increased to * to

keep the rate of interest R from increasing. (Cf.,

Wray.)

Figure 4: Equilibrium Employment and Out-put.

As the increase in effective demand increases the

aggregated demand function (17)

in panel (I) producers will increase employment

in accordance with (32) as output/income

increases in accordance with (34). The in-

crease in output/income will increase the

demand for consumption goods (13) in panel (E) in accordance with the con-

sumption function (15) in panel (F) which

will increase the quantity and price of

consumption goods demanded in accordance

with (28) and (30). But so long as a) there is no

change in the rate of interest R in panel (D), b)


propensity to consume in panel (F), and c)

the MEC schedule (11) in panel (A) and

so long as the marginal propensity to consume

is less than one (i.e., the marginal propensity to

save is greater than zero) the only way the

demand for investment goods can increase to

* (9) in panel (B) is if producers

are willing to accumulate inventories and oth-

erwise maintain their scale of operations at the

level of employment *.

This is, of course, a situation in which desired sav-

ing exceeds desired investment by * *

in panel (C) of Figure 4, and, as a result, “entrepre-

neurs as a whole must be making losses exactly equal

to the difference [between by * and ]. These

losses … represent a failure to receive cash up to ex-

pectations from sales of current output” (Keynes,

1930, p. 131) and “the date of their disappointment

can only be delayed for the interval during which

their own investment in increased working capital is

filling the gap” (Keynes, 1936, p. 262). It is only after

the disappointment has set in, expectations change,

and the effective demand and level of employment re-

turn to their equilibrium levels and in panel

(I) that the losses can be eliminated in this ceteris pa-

ribus situation. (Blackford, 2020b, ch. 2)

Even though an increase in expectations that re-

sult from a fall in the money wage cannot in itself

cause a change in the equilibrium level of employment

and output in the absence of a change in one of the

three factors that determine the position of the equi-

librium aggregate demand function in Figure 4 there

are a number of ways in which a fall in the money

wage can be expected to affect these three factors,


and, thereby, change the equilibrium levels of em-

ployment and output/income in Keynes’ general theo-

ry. For example, to the extent a fall in the money

wage lowers domestic wages relative to foreign wages

it could lead to an increase net exports that leads to an

increase in employment through an increase in the

aggregate propensity to consume schedule (15)

in panel (F) by way of the decrease in foreign-sector

saving. The resulting increase in the aggregate de-

mand schedule (23) in panel (I) could

lead to a further increase in employment by increasing

the MEC schedule (11) in panel (A) provided,

of course, this entire process is not cut short by an off-

setting change in foreign exchange rates or relative

prices.

A fall in the money wage may also have an effect

on the aggregate propensity to consume through a re-

distribution of income from wage earners to the own-

ers of other factors of production to the extent there

are differences in the propensities to consume be-

tween wage earners and the owners of other factors of

production though this is apt to reduce the propensity

to consume schedule (15) in panel (F) rather

than increase it. And to the extent a fall in wages is

accompanied by a fall in prices the resulting fall in the

transactions demand for money must cause the de-

mand for money schedule in panel (D) to

fall which given the supply of money can be ex-

pected to reduce the rate of interest R causing an in-

crease in the demand for investment schedule

(9) in panel (B) and the MEC schedule

in panel (A) provided the fall in wages and

prices does not lead to an expectation of a further fall

in wages and prices that has a negative effect on the


MEC schedule (11) in panel (A).

Keynes undertook a detailed examination of these

and other aspects of the problem of explaining the ef-

fects of a fall in the money wage on employment in

Chapter 19 of The General Theory, and he did not

view this problem as a matter of “simple arithmetic.”

He saw it as a problem of keeping track of the “com-

plicated partial differentials ‘at the back’ of several

pages of algebra” (Keynes, 1936, pp. 297-8) and trying

to understand and explain how the non-vanishing dif-

ferentials affect the economic system through time in

terms of the behavior of those decision-making units

that actually have the power to affect the system at

each point in time. This way of looking at economic

problems made it possible for Keynes to establish the

temporal order in which events must occur and,

thereby, to undertake a causal analysis of the dynam-

ic behavior of the economic system by way of “an or-

ganized and orderly method of thinking out particular

problems, … isolating the complicating factors one by

one” and after reaching provisional conclusions going

back, as well as he could, to account “for the probable

interactions of the factors amongst themselves” in an

attempt to understand “the complexities and interde-

pendencies of the real world.” (Keynes, 1936, pp. 297-

8) This was Keynes’ method of analysis throughout

The General Theory of Employment, Interest, and

Money as he followed the example set by Marshall,

and it is the inability or unwillingness of neoclassical

economists to examine economic problems in this way

that makes neoclassical economics descriptive and

static. (Blackford, 2020a; 2020b, chs. 2-4)

This does not mean that the incredibly powerful

descriptive/static tools of neoclassical economics are


not useful. It does mean, however, that these models

cannot provide a meaningful guide to economic poli-

cy if they are not used in conjunction with the caus-

al/dynamic methodology of Keynes’ general theory

as the economic, political, and social problems we face

today bear witness, problems that are the inevitable

result of economic policies that ignored Keynes’ anal-

ysis in The General Theory and led directly to the

Crash of 2008 and the economic stagnation that fol-

lowed. (Keynes, 1936; Blackford, 2020a; 2020b, ch. 1)

List of Equations

B-a. Keynes’ Aggregate Model Behavioral Equations

,

,

,

.

,

.

,

.

.

.

,

,

.

.

,

,

,

,

,

,


,

.

,

,

Dynamic Adjustment Functions

,

.

,

,

.

,

,

Ch..6 Mr.-Keynes-and-the-NeoClassics 223

.

Structure of Keynes’ Aggregate Model

Table 1: Structure of Keynes’ Aggregate Model

Market Equilibrium Conditions

Behavioral Variables

Endogenous Variables

Assets =

=

,

,

Investment =

=

,

,

, ,

Consumption =

=

,

,

, ,

Labor =

Identities

B-b. Short-Run Equilibrium

Figure 1: Short-Run Equilibrium.


B-c. Causality and Dynamics in Keynes’ General Theory

Figure 2: Achieving Short-Run Equilibrium.

B-d. Long-Run Equilibrium

.1

1 .The way in which changes in the money wage affect the system are

examined in section B-b below.


Figure 3: Achieving Long-Run Equilibrium.

B-e. Mr. Keynes and the ‘NeoClassics’ Hicks’ Two-Good Model

,

.

=

,

,

,

,

.


.

.

Keynesian One-Good Model

,

Deriving Hicks’ Model from Keynes’ Model

.

.

B-f. NeoClassics on Changes in the Money

Wage B-g. Keynes on Changes in the Money Wage

Figure 4: Equilibrium Employment and Output.

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