Keynesian economics

Keynesian economicssThe propositions of Keynes’s General Theory are by now well known. I would, however, restate them in a slightly different order, placing emphasis on certain ingredients and bringing out one or two implicit assumptions which are relevant to the present enquiry.

Let me start with the definition of ‘full employment’, from which is derived the core of Keynesian economics—the concept of involuntary unemployment. Full employment signifies a state in which any person willing to work at a wage rate that corresponds to his economic contribution to the product of the industry, finds a job at that wage. To put it in more precise terms, in a state of full employment, the marginal unit of labour gets a wage in real terms, the utility derived from which is’ equal to the disutility that the work involves. From this it follows that in a state of involuntary unemployment the utility of wage exceeds the marginal disutility of labour.

‘Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.’1
Keynes does not offer an independent theory of wages. He accepts the ordinary theory that the ‘real’ wage rate is equated in equilibrium to the marginal productivity of labour. But—and this is important— he emphasizes that real wage is a derived concept and does not in itself represent the terms on which wage bargains are made. The wage bargain in the market runs in money terms, and the real wage rate is derived from the money wage rate relative to the prices of wage-goods.

The period of reference is a ‘short period’ over which, among other things, capital equipment and technique are given and constant, these being the result of past investment. Labour is employed upon a given capital equipment, and is pushed up to the ‘margin of profit- ableness’. A short period equilibrium is thus envisaged for the economy as a whole. However, although Keynes’s analysis runs in terms of a short period, it does not preclude longer-run inferences. For a long period is a succession of short periods, each endowed with a different capital equipment and carrying the legacy of the past.1

Propositions supporting the Keynesian economics theory of involuntary unemployment can now be set forth.
(i) Money wage rate is fixed more or less conventionally between employers and trade unions. This given money wage rate provides the measure of the magnitudes involved in the analysis. Consumption, investment, prices etc., are measured in terms of ‘wage-unit’, i.e. the money wage received by a representative unit of labour.2
(ii) Prices of wage-goods, along with the general price level, are determined by the expenditure on consumption and investment.
(iii) Expenditure on consumption goods is limited, with reference to a given prospective income, by the extent to which income earners are inclined to spend rather than to save, (iv) Expenditure on investment is limited, given the market rate of interest, by the prospective marginal net yield of investment, (v) A decision not to spend on consumption does not necessarily mean a decision to invest; the rate of interest which is ordinarily supposed to be the connecting link between the two is determined not just by the propensity to save but by the preference of the people to hold cash.

(vi) The expenditure on consumption and the expenditure on investment, between them, make up the aggregate demand price of output as a whole, and short period equilibrium is struck at a point where the aggregate demand price is equated to the aggregate supply price.
(vii) Under conditions of equilibrium, therefore, the price level may be too low relatively to the given money wage rate, or, in other words, the real wage rate may be too high for full employment to be secured. More than full employment can be  ruled out, for the workers have the option not to work if the real wage rate fails to compensate for the disutility of labour. But less than full employment is a probability; indeed it tends to be a normal feature of an economy which suffers from a low marginal propensity to consume and a low marginal efficiency of capital.

(viii) The unemployment that emerges is ‘involuntary’ when it is found either (a) that the labourers, being under a ‘money illusion’, are prepared to put up with a higher price level, even though they are unwilling to accept a cut in money wage rate, or (b) that even with a cut in money wage rate, it is not possible to effect a reduction in the real wage rate. For, in either case, while the labourers are willing to accept a lower rate of real wage at which employers also find it worth while offering more employment, the mechanism by which this could be effected is absent, unless special measures are taken, (ix) These special measures include: (a) transference of income from the relatively rich to the relatively poor—thus causing a tendency to an increase in the propensity to consume;

(b) maintenance of a low rate of interest as an inducement for larger investment. The potency of these measures is, however, limited. A tax on higher’ incomes, in so far as it touches profits, would prejudice private investment. On the other hand, the effectiveness of interest policy is dubious, if only because the liquidity preference of the people being what it is, there is a limit below which the rate of interest cannot be brought down. Hence what is indicated is a more direct measure, namely public investment through deficit finance, unprofitable as it may appear at first sight. A dose of public investment, in so far as it is not at the expense of private investment, would release forces making for increased consumption, whereby the increment of aggregate output will be a multiple of the initial investment, the value of the multiplier depending upon the marginal propensity to consume.1

This is Keynes’s General Theory in its pristine form. I have tried to bring out the essentials of the theory and to put it in a form which makes it inevitable that any pushing up of employment should be accompanied by a reduction in the real rate of wages. And of course this is what Keynes had in mind; the hypothesis is one of diminishing returns at or near full employment.

Thus “employment increases, then, in the short period, the reward per unit of labour in terms of wage-goods must, in general, decline and profits increase.’1 This, indeed, as Keynes takes care to point out, is one of the postulates of classical theory with which his own analysis is in accord.

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