Toward the Integration of Economic Science:
Further Notes on Keynesian Economics

Further Notes on
Keynesian Economics

Completing the Keynesian and monetarist revolutions
by integration of concepts and national accounts
in a dynamic money-flow perspective
John Atlee, 4/10/90

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  1. Classical equilibrium analysis
  2. Interest rates, liquidity preference, and economic growth
  3. Assumption of diminishing returns

Classical equilibrium analysis
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Because of the financial gap and credit-money confusions, the Keynesian theory of income determination must deal with its money and credit aspects indirectly in terms of the abstract (and abstruse!) market-based supply/demand-schedule IS/LM (investment/saving, liquidity/money) equilibrium analysis discussed below, rather than in terms of national-accounts-based empirical data.

This approach implicitly assumes an autonomous equilibrium-seeking economy managed by Adam Smith's unseen hand of effective competition carried out by rational "economic men." Its simplistic supply and demand curves always require the ceteris paribus ('other things being equal") provision. But in the real world of a dynamically changing economy "other things" are seldom equal. And when the schedules themselves shift, the feedback effects, as Keynes himself recognized, make this kind of analysis too complex for effective macroeconomic analysis. The failure of the neoclassical version of Keynesian theory to anticipate the effects of the OPEC oil tax illustrates the weakness of hypothetical approaches to general equilibrium analysis. [ 1 ]

Interest rates, liquidity preference and economic growth
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In Keynesian theory interest is not compensation for saving, but rather the saver's "reward for parting with liquidity." Thus, the supply of credit from saving is determined by the public's liquidity preference (LP) schedule -- i.e., the way "the public" (mainly individual and institutional financial speculators) want to divide their financial assets between "money" and "bonds." In this conceptual framework, since "money" is defined in terms of relative liquidity, it also includes "near moneys" (savings accounts, money-market funds, etc.). "Bonds" refers mainly to longer-term credit securities.

This means that the interest rate is determined by the complex interaction of three factors in the IS/LM equilibrium analysis:

In this analysis, lower interest rates tend to increase the speculative allocation of funds to "money," partly because of the resulting lower opportunity costs of holding money (although the theory here seems to imply that "money" refers mainly to non-interest-bearing demand deposits), and partly because of the reduced incentive to buy "bonds" (because of both the reduced interest earnings and the reduced likelihood of further bond price increases).

Even the banking system's supply of new money is channelled through this conceptual apparatus. The theory says that an increase in money supply affects interest rates mainly indirectly, by supplying "the public" with more money than they currently want to hold for transaction balances, thus releasing more "idle" funds (speculative balances) to buy bonds in the credit market, which in turn tends to reduce interest rates and stimulate investment.

Actually, in our present credit-money system an increase in bank-created new money tends to reduce interest rates directly by supplying the credit market with additional credit -- on average, about 10% of the total "primary" supply of credit. Most of the new money goes initially to borrowers who want to spend it, not to financial speculators who want to hold it. And when the borrowers spend it, the recipients undoubtedly tend to increase their cash balances more -because of the increased transaction-balance effect than because of any change in their speculative liquidity preference.

Because of the high degree of fluidity in our present-day credit markets, and the availability of high interest rates on even overnight repos, it is likely that speculators will want to hold very little actual money (checkable demand deposits) for Keynes' M2 (speculative) purpose. To the extent that the LP schedule relates primarily to allocation of speculative j funds between short-term and long-term credit investments, rather than between money and credit, it 0 is likely that such allocations will have little effect on either the general level of interest rates or real economic growth.

Assumption of diminishing returns
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Keynes postulate of the MEC rests on the explicit assumption of the classical 'law of diminishing returns." But empirical evidence casts serious doubt on the general validity of this assumption in a modern industrial economy. It appears that in actual practice the overall MEC tends to be quite elastic most of the time, with the secular rise in total real demand and the secular rise in wages (which continually increases the profitability of labor-saving equipment) tending to raise the whole MEC schedule just about as fast as there is downward movement along the schedule for any particular type of equipment (not to mention the effects of obsolescence of equipment as a result of new products).

As a result, the observed periodic decline in investment seems generally to occur not as a result of a gradual movement downward along a given MEC schedule until it falls below the rate of interest or because of a rise in the rate of interest, but rather because of an abrupt decline in the whole schedule as a result of an actual or expected decline in GNP and business sales (and/or a rise in interest rates due to a related restrictive monetary policy)-as Keynes implicitly admitted (General Theory, pp. 313-317).

If the initial decline in the MEC and investment is a result rather than a cause of the decline in GNP, then the whole analysis breaks down. In classical economics the assumption of declining marginal productivity and U-shaped marginal cost curves served the convenient function of making possible the necessary hypothetical equilibrium with a declining demand curve-regardless of how common or uncommon this is in empirical experience.


  1. Of course, the supply and demand curves used in textbooks and drawn on blackboards are intended only to show tendencies. But they also tend to convey a false sense of reality and precision. In many cases even the basic tendencies they are designed to illustrate, on both the supply and demand sides, are more than offset by non-price factors which are implicitly brushed aside in the ceteris paribus assumption-factors such as volatile expectations, advertising, fads, customs, relative market power, government policies, the pervasive lack of adequate information, and irrational behavior, not to mention the short-run/long-run problem. Such factors can make realistic supply and demand curves "lumpy" and even reverse-sloping.

    Will more or less labor be "supplied" as real wages go up? Will more or less saving be "supplied" as interest rates go up? Just how much does business "confidence" affect investment decisions, and in what ways? "lt all depends," of course, on the "other things" that can only be explained in other ways. How often do teachers who use supply and demand curves to demonstrate economic principles attempt to base them on actual empirical data? The really important economic tendencies ("laws") can usually be explained much more appropriately by simple realistic empirical examples, with appropriate qualifications -- as the econ. 101 text does in some aspects of its micro analysis. The IDMF model facilitates this for macro analysis.
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Written: April 10, 1990
Last revised: May 1998
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