1st Introduction to the problem
2nd The main representatives and opponents
3rd Starting point: Say's law
4th Keynes' criticism on the Say's law
5th A simple C-I model
6th Criticism on the purchasing power parity theory
7th The alternative S-I model
8th Supply and demand for money
9th The Hick's IS-LM model
10th Integration of the employment function
11th Criticism on Keynes' assumptions
1st Introduction to the problem
In this chapter we will turn to the theory that was developed by John Maynard Keynes. In the same way that we have been able to establish for the historical school that at the turn of the century almost all chairs of economics in Germany were firmly in the hands of representatives of the historical school, we can also establish that in the first decades after the Second World War most of the chairs of economics in the Federal Republic of Germany, but also almost all over the world, were in turn in the hands of Keynesians. There is hardly any other direction in economics which has had such a strong influence on economic policy in the post-war period as Keynesianism.
While the analyses of both the older and the more recent classicism focused on value theory and with it the question of the long-term equilibrium of free markets, John Maynard Keynes was primarily concerned with demonstrating that the market mechanism fails primarily in the question of preventing mass unemployment, whereby it was not even the deficiencies of the labour market itself, but rather of the capital market, that underemployment was occurring on a larger scale and could no longer be reduced by market forces alone.
The free market, uninfluenced by the state, would indeed tend to be balanced in the goods markets, but at the same time the labour market was unbalanced, and unemployment occurred on a larger scale. Here it was not only the adjustment mechanisms to reduce unemployment in the labour market that would fail themselves. Rather, the capital market was incapable to react to interest rate reductions by expanding investment demand. Nor can it therefore provide the conditions for an increase in the demand for employment by itself.
The starting point of the Keynesian teachings is the Say's law, according to which no overall economic unemployment could arise in a free market economy since every supply would create its own demand. Keynes believes to have proved that Say's law was based on false assumptions and that a reduction of unemployment can only be achieved by the state. The demand that is emerging from private households and enterprises is too low to employ all those willing to work. For this reason, the state had to use a deficit budget to replace demand that was not sufficiently met by the private sector.
While both the older and the more recent classics, except for Leon Walras, have mainly dealt with the problem of individual markets, Keynes has almost exclusively dealt with macroeconomic relations that are in a cyclical connection. While the classics dealt with questions of allocation and thus with price relations, Keynes' interest focuses on macroeconomic variables such as domestic product, employment, investment volume and macroeconomic savings. Keynes neither dealt intensively with questions of allocation nor distribution.
2nd The main representatives and opponents
Apart from John Maynard Keynes himself, Keynesian teachings were spread and expanded above all by Roy F. Harrod, Lawrence R. Klein, Abba P. Lerner, Nicholas Kaldor and Alvin Hansen. More than almost any other school of science, there were disputes between adherents and opponents of Keynes' message.
The opponents of Keynesianism were referred to as the Neoclassics, although this group clearly differed from the Neoclassics of the early Cambridge school in its subject matter. Among the most important opponents of Keynesian teaching were John Richard Hicks, Arthur Cecil Pigou, Gottfried von Haberler, Sidney Weintraub, and Milton Friedman.
In addition to the Anglo-Saxon influenced Keynesian school, the group of German-Keynesians developed similar trains of thought at about the same time, independently of the Keynesian movement. This group included most notably Carl Föhl.
John Maynard Keynes lived from 1884 to 1946 and was a British economist and founder of the Keynesian school. Among his major works are: 'The Economic Consequences of the Peace' (1919), further: A Treatise on Money 2 vol. (1930), as well as his most famous work: 'The general theory of employment, interest and money' (1930).
Keynes criticised the Say's law because savings were hoarded, and investment demand was not increased even when interest rates were lowered. He also criticised the quantity theory because the liquidity preference, the reciprocal value of the velocity of circulation, depended on the interest rate. By way of increasing the money supply it was quite possible to increase the domestic product in case of underemployment. Keynes became known beyond the economic sphere for his criticism on the reparations policy of the Allies against Germany after the First World War.
Roy F. Harrod lived from 1900 to 1978 and was a British economist and one of the most influential Keynesians. He became known particularly through his works: 'International Economics' (1945), furthermore: 'Towards a Dynamic Economics' (1948) and: 'Factor-Price Relations Under Free Trade' (1958).
In his growth theory he introduced the concept of neutral technical progress, which differed from Hicks' concept in the way that Harrod spoke of neutral technical progress when the capital coefficient remains constant at a constant interest rate. Hicks, on the other hand, speaks of neutral technical progress if the input ratio of capital to labour remains constant at a constant wage-interest rate. The subject of Harrod's dynamic theory is the question of the balanced growth rate. At the centre of his growth theory is the thesis of growth on a knife-edge. He has also proved that the Leontief paradox could be explained by changing factor intensities.
Lawrence R. Klein, born in 1920, was an American economist who promoted the spread of Keynesianism in the USA. He received the Nobel Prize in 1980. His major works include: 'Macroeconomics and the Theory of Rational Behavior' (1946), 'The Keynesian Revolution' (1947), and 'A Textbook of Econometrics' (1953).
Klein sees the difference between Keynes and Marx in the fact that John Maynard Keynes wanted to save and preserve, while Karl Marx wanted to criticise and destroy. He was convinced that Keynes brought about a revolution both in his theoretical analysis and in the application of economic policy. He developed a series of dynamic economic models.
Abba P. Lerner lived from 1903 to 1982, was a Russian-British economist and a Keynesian. His major works include: 'The Concept of Monopoly and the Measurement of Monopoly Power' (1934), furthermore: 'The Relation of Wage Policies and Price Policies' (1939), as well as: 'The Economics of Control: Principles of Welfare Economics' (1944) and finally 'Factor Prices and International Trade' (1952).
He criticised Pareto's thesis that the utility could not be measured interpersonally. He was convinced that utility could indeed be compared on an interpersonal basis and that at income equality the overall welfare was maximised. Wage rate increases could then increase employment if the consumption rate increased due to redistribution. He developed the idea of an optimal currency area. He became known mainly through the formulation of the Marshall-Lerner condition in foreign trade. Very early on he recognised the danger of stagflation.
Nicholas Kaldor lived from 1908 to 1986 and was a British economist, Keynesian and became known mainly for his welfare-theoretical works. His main works deal with: 'Welfare Propositions in Economics' (1939), furthermore with: 'Alternative Theories of Distribution' (1956) and: 'A Model of Economic Growth' (1957).
According to the Kaldor-Hicks criterion, one can also speak of an increase in welfare even though there are losers if the winners of a measure can compensate the losers. In the context of his macroeconomic distribution theory the profit rate is significantly determined by the savings- and investment function, while the wage rate has no influence on distribution. Within the framework of his growth theory, Kaldor attempts to prove that economic growth had an inherent tendency towards neutral technical progress.
Alvin Hansen lived from 1887 to 1975 and was the main representative of Keynesianism in the USA. His major works are: 'Full Recovery or Stagnation?' (1938), 'Economic Progress and Declining Population Growth' (1939), 'A Guide to Keynes' (1953), and 'The Dollar and the International Monetary System' (1965).
The main difference between Alvin Hansen and Keynes is that he sees the danger of unemployment not only in the context of economic crises but assumes also in the framework of his stagnation thesis that if population growth declines, private investment will not be sufficient to guarantee full employment because of lower housing demand and a decline in industrial plants.
John Richard Hicks lived from 1904 to 1989, was a British economist and mediator between Neoclassicism and Keynes. His major works deal with the following themes: The Theory of Wages' (1932), 'Mr Keynes and the “Classics”: A Suggested Simplification' (1932), 'The Foundations of Welfare Economics' (1939) and finally: 'Value and Capital' (1939).
Hicks became known primarily for the Kaldor-Hicks criterion, according to which an increase in welfare can still be expected if there are losers of a measure, but if the winners of a measure can compensate the losers. From Hicks originates mainly today's presentation of Keynesian theory in textbooks, the IS-LM scheme, which shows that the combination of money and capital markets (saving and investing) leads to a macroeconomic equilibrium, possibly at underemployment.
Within the framework of welfare theory, Hicks has shown that in an indifference curve system the price increases of a good can be divided into an income effect and a substitution effect. Here, the substitution effect is always negative, but the income effect is positive for inferior goods.
Arthur Cecil Pigou lived from 1877 to 1959 and was a British economist of the Cambridge School as well as a critic of Keynes. His main works are: 'Producers' and Consumers' Surplus' (1910), further: 'Wealth and Welfare' (1912), 'Mr. J.M. Keynes's General Theory' (1936) and finally: 'Real and Money Wage Rates in Relation to Unemployment' (1937).
Pigou has shown that the elasticity of labour demand is generally greater than one. He also pointed out that exploitation of labour was given when the wage rate is below the marginal product of labour. This statement, however, is only valid in the case of complete competition, since in monopolistic market forms the wage rate is always below the marginal product.
The so-called Pigou effect is also named after him: according to this effect, wage increases lead to a decrease in wealth via price increases, thus to an increase in savings and finally to a reduction in the domestic product and employment. Pigou had also been concerned with environmental issues already since the beginning of the 20th century and proposed a tax on products to compensate for external costs (Pigovian tax).
Gottfried von Haberler lived from 1900 to 1995, was an Austrian economist, later taught in Havard and was one of the main critics of Keynes. His main works were: 'Der internationale Handel' (1939), 'Prosperität und Depression' (1948), 'Mr Keynes' Theory of the Multiplier' (1936), and finally: 'Integration and Growth of the World Economy in Historical Perspective' (1964).
Gottfried von Haberler has pointed out that the theory of comparative costs can be purified from the remnants of the labour value theory by introducing opportunity costs. He has also criticised empirical studies by J. Prebish, by showing that wrong conclusions have been drawn from the empirical material on the terms of trades in the relation between highly developed and developing countries, because transport costs have been allocated incorrectly. In his opinion, economic crises are predominantly caused by overinvestment.
Sidney Weintraub lived from 1914 to 1983, was an American economist, and dealt with the issues: money and the economy and belongs to the group of supply theorists who, in contrast to Keynes, attribute unemployment not to insufficient demand but to deficiencies in the supply factors. His main works are: 'An Approach to the Theory of Income Distribution' (1958), 'A General Theory of the Price Level, Output and Income Distribution' (1959), and finally: 'Classical Keynesianism: A plea for its Abandonment' (1961).
According to Weintraub, inflation is mainly caused by the increase in unit costs. The entrepreneurs provide for a mark-up on unit costs that is customary in the industry and thus influence the price level.
Milton Friedman lived from 1912 to 2006, was an American economist and founder of the neo-quantity theory. His major works include: 'Studies in the Quantity Theory of Money' (1956), further: 'A Theory of the Consumption Function' (1957), and finally: 'Capitalism and Freedom' (1962).
In the context of his neo-quantity theory, he points out that each inflation has monetary causes ultimately. His plea against a 'stop-go' monetary policy is well known. He is also one of the few leading economists who argued against deflation. In his criticism of Keynes, he assumes that in the long run, the demand for cash will increase with welfare.
Carl Föhl lived from 1901 to 1973 and is one of the most important German-Keynesians who developed similar ideas at about the same time, independently of Keynes. His two main works are: 'Geldschöpfung und Wirtschaftskreislauf' (1937), and 'Kritik der progressiven Einkommensbesteuerung' (1953/54).
Carl Föhl is regarded as one of the German-Keynesians who anticipated important findings of Keynesian theory. According to Föhl, the progressive income tax has led to an increase in profits in the first place and thus to inflation. The increased tax revenues from the taxation of profits would be fully used by the state to purchase goods and services, so that gross profits and revenues would increase, but the net profit total would remain unchanged. In contrast to Keynes, his macroeconomic models are capable to explain not only income and employment but also income distribution.
3rd Starting point: Say's law
The Keynesian revolution begins with with the Keynes' criticism of Say's law. Therefore, it is necessary to start our analysis of Keynes's doctrine with Say's law.
Jean Baptiste Say lived from 1767 to 1832 and was one of the main representatives of French classicism. He became famous mainly due to the Say's law, which was named after him.
The Say's law opposes the underconsumption theories, according to which a too low demand for consumer goods would cause unemployment. According to Say’s law, too little demand for goods cannot explain general unemployment since every supply would create its own demand. However, Say by no means denies the emergence of mass unemployment, but he does not attribute it to insufficient demand for goods, but to incorrect price relations in his theory of blocked distribution channels
The value of supply is converted fully into income, which in turn is converted fully into demand, since savings are invested always. General unemployment could therefore be explained only by structural causes.
Let us take a closer look at the individual steps of this theorem. The first step is to establish that all sales revenues are turned into income. We are not considering a single enterprise here, but a consolidated balance sheet of all enterprises. On the right-hand side of the balance sheet, in the upper part of the graphic, we enter the sales revenues, that is the value of the supply, which the sellers of the final products achieve. Here we must consider that a part of these sales revenues is needed to purchase semi-finished products and raw materials from other enterprises. Here, the expenditures of the final product enterprises coincide with the sales revenues of the semi-finished product enterprises and raw material enterprises, thus we can neglect these amounts in a consolidated total balance sheet.
The sales revenues of the final product enterprises continue to be used to remunerate the purchased factors of production, wages are paid to the employed workers, land rents to the landowners and interest to the capital providers. The remaining sum from the sales proceeds accrues to the entrepreneur as profit income. We can thus conclude that the entire sales revenue sum turns into income.
Next, we turn to the usage of these incomes. Income can be used for the purchase of consumer goods or can also be saved. Both together always correspond to the total purchase sum. For the sake of simplicity, we will assume a closed economy without economic activity by the state.
The savings serve the enterprises to finance their investments, that is to purchase capital goods. Thus, not only the part of the income that is used for the purchase of consumer goods becomes demand, but also the savings sum is fully used for the purchase of investment goods.
However, this proves that the total supply (sales revenues) becomes demand, either as consumer demand or investment demand. Which had to be proven.
How are the assumptions made here to be evaluated now? The first step, the proof that the sum of sales revenues becomes completely income for the producer of the final product, results from logical considerations. The profit of the enterprise (G) is defined in such a way that it corresponds to the difference between sales revenues (P * X) and the remuneration of the used production factors (EF). The equations therefore apply:
Let us therefore turn to the second step in the analysis of Say's law. The fact that a part of the income (EF + G) is consumed and therefore leads to the demand for consumption goods results again from logical connections, whoever consumes goods must have bought them previously.
The second thesis, that savings are always invested completely, is to be assessed more critically. This assumption, however, results from the fact that during Jean Baptiste Say's lifetime the predominant form of enterprise was the joint partnership and that its entrepreneurs had to raise the necessary capital from their own income in the form of savings, since the income of non-entrepreneurs was still too low to save larger parts of their income. The only reason to save was therefore that entrepreneurs needed capital for their investments. Entrepreneurs thus only saved when they had a need for investment. Their capital needs could only be satisfied through their own savings, but not by borrowing on the capital market. In the time in which Say lived, it was quite true that almost all savings were used for the purchase of capital goods.
In the meantime, two major changes occurred in this question. On the one hand, corporations emerged which had such high capital requirements that the entrepreneurs' own savings were not sufficient and therefore additional capital had to be demanded on the capital market. On the other hand, the income of large parts of the population had risen so much in the meantime that non-entrepreneurial households were also able to save a part of their income and offered these savings on the capital market.
Although savers and investors were no longer the same persons and although it was therefore to be expected that the aggregate savings sum would be larger or smaller than the aggregate investment sum, neoclassical theory still assumed that Say's law applied as before, since the capital market now ensured that savings and investment correspond.
The free-market mechanism ensured that if savings exceeded investment demand, the interest rate would fall and that therefore less savings would be created and at the same time more investments would be made. Similarly, if there is an investment surplus, the interest rate will rise and for these reasons savings will increase and investment projects will be reduced. In other words, the neoclassics assumed that the market mechanism would automatically balance savings and investment.
Thirdly, one can of course also doubt whether consuming and saving are the only usage types of income. After all, one must assume that considerable parts of the income must be paid in the form of taxes. It can therefore be criticised that Say's law assumes a closed economy without economic activity.
In response to this last criticism, it can be stated, however, that it can be particularly useful to refrain from certain real facts very deliberately for a better understanding of complex interrelations. Once the interrelations have been correctly recognised with the help of simple models, the unrealistic assumptions of the first model can be eliminated very quickly. It is easy to redefine Say's law in such a way that the most important results of Say's law can also be maintained for an open economy with economic activity by the state.
4th Keynes' criticism on the Say’s law
As already mentioned, John Maynard Keynes criticised Say's law because it was based on false assumptions. One could not expect the free market to harmonise savings and investment. In reality, the capital market would not function as assumed within the framework of neoclassical theory.
There were two main reasons for this: Firstly, it cannot be expected that all savings will be offered on the capital market; savings are partly hoarded, i.e. not invested to earn interest. But even if savings are offered on the capital market and the interest rate falls due to the increase in capital supply, this would by no means lead to an increase in investment demand. That is because industrial investment is largely inelastic to interest rates. However, according to Say's law, a high interest rate elasticity was a precondition for the total demand to correspond to the respective supply.
Now, how does Keynes give reasons for his assertion that a part of the savings is hoarded and not offered to the capital market? Here, one could think of the behaviour observed in earlier times among many pensioners, namely that they distrusted the banks and the capital market and for these reasons kept their savings in their stockings (in the own home), whereby their distrust was so strong that they even gave up other interest income in this way.
Such irrational behaviour may have been observed in the past, but it does not correspond to the assumptions that led Keynes to his theory of hoarding. Keynes' theory of hoarding (theory of liquidity preference) is indeed based on rational behaviour. It was highly rational considerations that prompted private households to temporarily invest their savings in a manner that did not yield interest.
In order to understand this thesis, we have to realise that a part of risk-averse households invests savings predominantly in fixed-income securities. We generally distinguish between shares and equity funds and fixed-income securities. While there are high risks associated with the purchase of shares - to a somewhat lesser extent with equity funds - the risks associated with the purchase of fixed-income securities are limited in general. After a few years, the fixed-income securities are repaid at full nominal value, but the interest remains constant, regardless of how the current market interest rate develops.
Now there are unequivocal links between the current interest rate and the price of fixed-income securities. If the current interest rate rises, then this means that the constant interest rate granted on fixed-interest securities falls behind the current interest rate. Therefore, many owners of fixed-interest securities are anxious to sell their securities in order to acquire investments with higher interest rates. However, this sale of these securities leads to a fall in prices.
The reverse applies in the case that the current interest rate falls. Here, the owners of fixed-interest securities receive interest rates that are higher than the market interest rate and it is precisely for these reasons that owners of savings will strive to buy the existing securities with a higher interest rate. However, this purchase causes the prices of these papers to rise.
Thus, we have shown that variations in current interest rates automatically lead to oppositely directed changes in the prices of fixed-income securities. Interest rate increases therefore lead to price decreases while interest rate decreases lead to price increases.
Furthermore, we must remember that the current interest rate - mainly also due to the active policy of the central bank - also falls during the economic downturns and thus reaches its low point in the economic trough. The lower the current interest rate has fallen, the more likely it is that it has already reached its low point and will therefore rise again within a short time.
This means that when interest rates are low, they are expected to rise soon, which - according to the explanations just given - is tantamount to expecting strong price losses for fixed-interest securities in the near future. Those who are now faced with the decision whether to invest their savings in an interest-bearing manner must assume that the already low interest yield will be lost again in times of an economic depression because price losses are to be expected. In such a situation, it is quite likely that the expected price losses will be higher than the expected interest income. In such a situation, it is extremely rational to wait with the capital investment, i.e. to hoard the savings initially and thus forego interest income.
Now let us turn to the thesis that investment demand would not react with an expansion in response to interest rate reductions. This thesis was first formulated by Keynes for periods of recession and depression. Keynes defends his thesis, that investment demand hardly reacts to interest rate reductions, with three arguments.
Argument 1: In times of recession and depression, sales in the consumer industry decline because employees are laid off and therefore have lower incomes or because fewer hours are worked, and incomes decline for these reasons. However, a decline in demand for consumer goods can also be expected among workers whose employment situation has not yet worsened, but who hold back their consumption demands for fear that their income situation might worsen in the near future due to the economic situation.
This decline in consumer demand in times of economic downturn now has the direct consequence that the producers of consumer goods reduce their production and thus have surplus capacities.
At such a time, it could not be expected that enterprises would increase their underutilised capacities by means of new investments. Even if the interest rate for loans fell and a reduction in interest rates in normal times led to the fact that new investment projects became profitable now, it could not be expected that enterprises would carry out such investment projects in times of economic crisis.
Argument 2: When interest rates decline, it generally means that costs are reduced and therefore the profits increase. In times of recession and depression, however, these profit increases could not be realised. Precisely because demand has declined, enterprises will try to expand demand again by lowering prices or at least to prevent a further reduction in demand. This meant, however, that because of the supply surplus, enterprises would be under pressure to pass on all cost reductions and thus also any reductions in interest payments immediately in the price - i.e. in the form of price reductions. So even if interest costs were to decline and enterprises were to have room for further investment under normal conditions, these effects would not come into play, since all cost reductions would be passed on to consumers due to the economic cycle. Therefore, even if interest rates were lowered, enterprises would lack the means to make new investments.
Argument 3: Incidentally, very specific depreciation methods in industry have led to the fact that the extent of interest costs is already so small that it can be neglected and that therefore, even in the case of actually considerable interest rate reductions on the part of the central bank, it cannot be assumed that the total costs can be decisively decreased in this way and that in this manner impulses for an expansion of demand are created.
Keynes refers to the so-called pay-off methods, which are mainly used in industry. According to this method, enterprises strive to depreciate their production facilities within a very short period of 3 to 5 years. Keynes sees the reason for such behaviour in the fact that, due to rapid technological progress, machinery becomes obsolete relatively quickly. However, since an enterprise is usually only willing to purchase new equipment when the old equipment has been fully depreciated, enterprises are forced to use such short-term depreciation methods.
While arguments 1 and 2 are only valid for a specific economic situation - namely recession and depression - the third argument refers to specific depreciation practices that are applied regardless of the respective economic situation.
As already mentioned, Keynes developed his theses for specific cyclical phases (the recession and depression) and in this respect Keynes' theory was not originally a general theory valid for all cyclical phases. Alvin Hansen differed considerably from Keynes on this issue when he saw the danger of mass unemployment not only as a cyclical phenomenon but was of the conviction that there was such a thing as a secular depression and thus persistent unemployment.
If we follow Hansen's considerations, there is another fourth argument to be mentioned, namely that industrial investment does not react positively to interest rate reductions.
Alvin Hansen fears a secular depression primarily because in the advanced national economies a decline in population growth to the point of population stagnation was to be expected. Several factors have contributed to this development: As the industrial society has developed into an educational society, more and more costs are associated with raising and educating children. At the same time, due to the emergence of social security systems, children contribute less and less to financing older employees after their retirement.
Children had gone from being a yield factor at the beginning of industrialisation to a cost factor, which directly reduced the willingness to have children. The discovery and spread of contraceptive measures then also contributed to satisfying the desire for sexual relations, even without having to accept that sexual relations must automatically lead to the birth of children. Finally, one could add to this catalogue of reasons for a decline in the birth rate that women's emancipation contributed at least temporarily to the fact that among young working women the desire to have children was postponed initially.
The population growth at the beginning of industrialisation now entailed for a long time that the need for investment was high and therefore sufficient to satisfy the supply of savings. On the one hand, with an increase in population and thus also in the number of employees, the need for investment is high since new jobs would have to be established again and again. On the other hand, population growth makes it necessary to build new homes in order to provide sufficient housing capacity for all households.
This need for investment would drop away in the event of population stagnation or even a at reduction in the population, and in such a situation, interest rate reductions would not be able to compensate for this deficit in investment demand.
To be continued!