John Maynard Keynes And His Influence on Modern Economic Theory

In 1911 he became editor of the Economic Journal. During the First World War he held a post in the Treasury, but resigned because he believed that the figure for German war reparations was set too high (The Economic Consequences of the Peace (1919). He was also a severe critic of the decision of the government to return to the gold standard and at the pre-war exchange rate (The Economic Consequences of William Churchill). In 1930 he published A Treatise on Money, and in the same year was appointed a member of the Macmillan Committee on Finance and Industry. His major work, The General Theory of Employment. Interest and Money, appeared in 1936. He served a second spell in the Treasury during the Second World War, and was responsible for negotiating with the USA on Lend-Lease. He took a leading part in the discussions at Bretton Woods in 1944 which established the International Monetary Fund.

Unemployment during the inter-war period persisted in the UK at high levels, never falling below 5 per cent, and at its worst reaching 20 per cent of the total labor force. The failure of the economy to recover from such a long depression was unprecedented in the economic history of industrial society. Fluctuations in activity were well known, and had received much attention from theorists on the business cycle in the past. The classical economists held that in the downturn of the business cycle both wage rates and the rate of interest fell. Eventually, they reached levels low enough for businessmen to see a significant improvement in the profitability of new investments. The investment so induced generated employment and new incomes and the economy expanded again until rising prices in the boom brought the next phase in the cycle.

The classical economists therefore concluded that the failure of the economy to expand was because wages were inflexible. Their policy recommendations were that the unions should be persuaded to accept a wage cut. Keynes argued that, although this policy might make sense for a particular industry, a general cut would lower »consumption, income and aggregate demand, and this would offset the encouragement to employment by the lowering of the 'price' of labor relative to the price of capital, e.g. plant and machinery.

Pigou countered Keynes's argument by pointing out that, by lowering wages, the general price level would be lowered; therefore, liquid balances which people owned would have a higher spending value.

The upturn, it was agreed, was stimulated by businessmen responding to lower wages with increased investment expenditure.

Why, said Keynes, should not the government take over the businessman's function and spend money on public works?

Current opinion upheld the belief that government budget-deficit financing would bring more hardship than already existed. The balanced budget was regarded as equally correct accounting practice for the government as it was for a private household. Most economists of the period accepted that public-works expenditure would reduce unemployment, even given the need to keep the budget in balance. Pigou showed the mechanism by which this could be brought about. However, the Treasury view was that public works would merely divert savings and labor from the private sector and, as the former was less productive, the net effect would be a worsening of the situation.

It was not until after Keynes had written his General Theory and crystallized his arguments into a coherent theoretical framework that his views were accepted.

Keynes did not deny the classical theory. He agreed that a reduction in wage rates could be beneficial, but it would operate only through the liquidity preference schedule. A fall in prices would increase the value of the stock of money in people's hands in real terms. This would make available an increase in the amount that people were willing to lend, with a consequent drop in the rate of interest to the benefit of investment.

However, if this is so, why not operate directly on the rate of interest or the quantity of money in the economy? Moreover, Keynes argued that there exists a level of interest rate below which further increases in money supply are simply added to idle balances rather than being used to finance investment. Wage cuts or not, the economy would stick at this point with chronic unemployment. In the classical system, the national product was determined by the level of employment and the latter by the level of »real wages. The quantity of money determined the level of prices.

Savings and investment were brought into balance by means of the rate of interest.

In Keynes's system, the equality of savings and investment was achieved by adjustments in the level of national income or output working through the multiplier. The rate of interest was determined by the quantity of money people desired to hold in relation to the money supply. The level of output at which savings equals investment does not necessarily correspond to full employment.

The innovation in the Keynesian system was that the rate of interest was determined by the quantity of money and not the level of output, as in the classical system.

In the Keynesian model, if you increased the propensity to invest or consume, you did not simply raise the rate of interest, you raised output and employment. Keynes's study of monetary aggregates of investment, savings, etc., led to the development of national accounts. Keynes's general theory of employment is now criticized for its reliance on special cases (wage rigidity, the insensitivity of investment to the rate of interest, and the idea of a minimum rate of interest at which the demand for money became infinitely elastic), its preoccupation with equilibrium and the fact that, despite its presentation as a radical new departure, it nevertheless embodies many of the analytical limitations of the classical school of economics.

However, the transformation which Keynes brought about, in both theory and policy, was considerable. In effect, he laid the foundations for what is now macroeconomics; Keynesian economics; Keynesian unemployment; new Keynesian economics.

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