keynesian school of thought

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KEYNESIAN THEORY

AND

CONTRIBUTION TO HISTORY OFECONOMIC THOUGHT

BY

SHOBANDE OLATUNJI

SUPERVISED BY

ANTHONIA T. ODELEYE


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INTRODUCTION

One of the greatest and the most controversial economists of the twentieth century was John Maynard

Keynes. Many major developments in modern economics are associated with his name. The term

Keynesian Revolution is often applied to describe the economic ideas of Keynes and it is also called

as New Economics. He was born in 1883, son of a noted British economist John Neville Keynes. He

graduated from the Cambridge University and served in the India Office. He was the leader of the

British delegation to the Bretto Woods Conference in 1944 and served as a Governor of the I.B.R.D.

and I.M.F. He served his country in various capacities and in appreciation of his services to the nation;

his Government made him the first Baron of Tilton in 1942. He died on April 21, 1946. His

publications include: Indian Currency and Finance (1913), the End of Laissez Faire (1926), A Treatise

on Money (1930), The Means to Prosperity (1933), the General Theory of Employment, Interest and

Money (1936), and How to pay for the War (1940), besides ten books and five booklets, he wrote

about 300 articles and about 50 reviews on official and non-official reports.

KEYNES ASSUMPTIONS AND CONTRIBUTIONS

CONSUMPTION THEORY

Keynes psychological law of consumption is of basic importance in the analysis of income, output and

employment. Keynes based his law on the general psychology of the people that when they find an

increase in aggregate real income there is a tendency to increase aggregate consumption too. In his

own words Men are disposed, as a rule and on the average, to increase their consumption as their

income increases, but not by as much as the increase in their income.


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This psychological law is a statement of common experience based up on three propositions:

1. When aggregate income increases consumption expenditure also increases. This is because as apersons income increases, more and more wants are satisfied.

2. The second proposition is that when income increases the additional income is spent betweenconsumption and saving. This is also a common experience that when income increases, people

spend only a portion of their additional income and save the remainder.

3. When income increases, both consumption and saving increase but consumption increases lessthan proportionately.

The three propositions form Keynes psychological law of consumption and it is based on the

following assumptions:

(i) It is assumed that the habits of the people regarding spending do not change. Thepropensity to consume is assumed to be stable. This means that we assume that only

income changes, whereas the other variables like price movements, income distribution,

growth of population etc., remain more or less constant.

(ii)

The second assumption is that the conditions remain normal and there are no abnormal

conditions like hyper inflation or war.

(iii) The third assumption is that of a capitalistic laissez-faire economy. The law not holdgood in an economy where the state interferes with consumption or productive

enterprise.

Keynes explained the concepts of propensity to consume namely average propensity to

consume (APC) and marginal propensity to consume (MPC). The average propensity to

consume is the ratio of absolute consumption to absolute income, i.e., C/Y. On the


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other hand the marginal propensity to consume refers to the ration of a small change in

consumption due to a small change in income i.e., C/Y.

Implications of Consumption Function

Most of the economists agree with Prof. Hansens view that the Keynesian formulation of

consumption function is an epoch making contribution to the tools of economic analysis. This is clear

from the implications of Keynes psychological law mentioned below:

1. Vital Importance of Investment: One of the most important implications of Keynespsychological law of consumption is that it brings about the crucial importance of investment if

we want to attain higher level of income and employment. The law says when income

increases the gap between income and consumption increases. The gap is to be filled by

bringing more and more investment failing which there will be shortage of effective demand

and the economy would slip down. Thus the law highlights the vital importance of investment.

2. General Over Production: Since the marginal propensity to consume is less than unity, withevery increase in income, consumption would tend to lag behind income which would result in

overproduction and unemployment. Thus the law tells us that there can occur a general

overproduction and unemployment.

3. Reproduction of Says Law: Keynes with the help of his law of consumption repudiates Sayslaw which states supply creates its own demand. Since the marginal propensity to consume is

less than unity all that is supplied is not automatically demanded. The supply fails to create its

own demand resulting in glut of products in the market.

4. Need for State Intervention: As there is no automatic and self adjusting mechanism betweensupply and demand the government should interfere actively to ensure that aggregate effective

demand does not fall below aggregate supply.


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5. Over Saving Gap: Since the increase in consumption expenditure does not keep pace with theincrease in income, there arises the danger of over saving gap. This danger is more for rich

countries than for poor countries.

6. Decline in MEC: As a result of the propensity to consume remaining stable with an increase inincome the expected rate of profitability or the marginal efficiency of capital may tend to

decline. This can be prevented only by increasing consumption with an increase in income

because ultimately the decisions to undertake investments are guided by the volume of

consumption.

7. Income Propagation: Keynesian theory explains the slow nature of income propagation.Since the marginal propensity to consume is less than unity, injection of increasing purchasing

power into the income stream leads to smaller and smaller successive increments to income.

8. Under Employment Equilibrium: Equilibrium would be attained at full employment only ifinvestment demand happens to be equal to the gap between aggregate income corresponding to

full employment and aggregate consumption expenditure out of that income. But Keynes

believed that the typical investment demand would not be adequate to fill the gap between the

amount of income corresponding to full employment and the consumption demand out of that

income. As such the aggregate demand and supply schedules would intersect at a point less

than full employment.

9. Secular Stagnation: With the increase in income, since consumption cannot be easilyincreased and investment demand becomes weaker and weaker the economy may sooner or

later reach a stage where it may not be able to provide outlets for its growing savings which is

necessary for maintaining full employment. This stage is known as secular stagnation. Such a

situation could be avoided if the consumption function were not stable.


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10. Turning Points of Trade Cycle: Keynes psychological law of consumption is very helpful inexplaining the turning points of the trade cycle. When the business cycle reaches the highest

point of prosperity, income has increased, but the marginal propensity to consume being less

than unity, consumption does not increase correspondingly and the result is the downward start

of the cycle. Similarly when the business cycle reaches the lowest point, income has declined

very low but since people do not reduce their consumption to the full extent of decline in

income, the upward phase of the cycle starts. Thus consumption function occupies a very

important place in the theory of employment.

INVESTMENT

To Keynes investment refers to real investment which adds to capital equipment. It leads to increase in

the level of income and production by increasing the production and purchase of capital goods. Real

investment is to be increased to maintain stable national income growth. According to Keynes

investment depends on marginal efficiency of capital and rate of interest.

The Marginal Efficiency of Capital (MEC)

MEC refers to the expected profitability of a capital asset. It may be defined as the highest rate of

return over cost expected from the marginal or additional unit of a capital asset. First we must go to

the marginal unit of the capital asset and secondly its cost has to be deducted from its return. Now the

MEC in its turn depends on two factors: the prospective yield of the capital asset and the supply price

of the capital asset. The MEC is the ratio of these two factors.


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LIQUIDITY PREFERENCE THEORY

Keynes propounded his liquidity preference theory to explain rate of interest. Keynes rate of interest

is purely a monetary phenomenon. It is determined purely by the demand for and the supply of money.

He called the demand for money as liquidity preference. According to Keynes rate of interest is a

reward for accepting bonds and securities. In Keynes liquidity preference theory the demand for and

supply of money together determine the rate of interest. Given the supply of money at a particular time

it is the liquidity preference of the people which determines the rate of interest. This is the essence of

Keynes theory.

It refers to the demand for money for current transactions by households and firms. The former needs

cash to bridge the gap between the receipt of income and expenditure. Households have to keep cash

for meeting their daily needs. People are paid wages weekly or monthly. But they spend every day a

particular amount of cash. Hence they have to keep certain amount of money to carry on their day to

day activities. This amount depends on the size of the income, methods of expenditure and the time

interval after which the income is received. This is called as income motive.

THE CONCEPT OF LIQUIDITY TRAP

Keynes liquidity theory explains the implication regarding the infinite interest-elasticity of the

liquidity preference curve. The liquidity preference curve represents the demand for money arising out

of transaction, precautionary and speculative motives. Liquidity trap is a situation at which the

economy is trapped. Even though money income is reduced the rate of interest will not fall below a

certain level.


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Saving Investment Equality

According to Keynes, there is definitional equality between saving and investment (I) Income (y) is

distributed between consumption and saving (s) thus,

Y = C + I

Y = C + S

I = Y C

S = Y C

Investment is that portion of the aggregate output which is in excess of the aggregate value of

consumption goods. Likewise, saving is the excess of income over consumption expenditure. Hence

saving must be equal to investment in so far as both are equal to the excess of output and income over

consumption expenditure.

According to Keynesian theory, the economy will be in a state of equilibrium where saving is equal to

investment, because what the community withdraws from the aggregate income in the form of saving.

It adds to it in the form of investment expenditure. In a situation, where S = I the level if economic

activity remains stable, because the producers are left with no valid grounds to change the volume of

output and employment in the economy. In fact, the equality of saving and investment is an essential

prerequisite for the establishment of equilibrium in the economy. According to Keynes, the equality

between saving and investment is the resultant of changes in the level of income. If investment

exceeds saving, then income will rise till the saving out of the increased income is equal to the

increased investment. If, on the other hand, investment decreases, the income is equal to the

diminishing investment. Ultimately saving and investment become equal to each other. The economic


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system will be in equilibrium when saving equals investment, but that equilibrium may not necessarily

be at full employment level. It may be at a level less than full employment. It is quite possible for the

saving investment equality to be established at the underemployment equilibrium level of the

economic system.

MULTIPLIER

The concept of multiplier plays an important role in understanding the nature of cyclical fluctuations,

the process of income propagation and policy making. The concept of multiplier was first developed

by R.F. Kahn. Keynes borrowed this concept from him and developed income (or) investment

multiplier.

Keynes concept of investment multiplier expresses the relationship between an initial increase in

investment and the final increase in national income. In other words, multiplier is the ration of a

change in income to a change in investment. In order to find out the final increase in income, the initial

increase in investment should be multiplied by the value of multiplier, i.e., /Y = KI, where Y =

income, K = multiplier I = investment.

The value of multiplier depends on marginal propensity to consume. The general formula for

multiplier is K = 1/ [1-C/Y]. K stands for multiplier; C/Y is marginal propensity to consume. 1-

C/Y denotes marginal propensity to save. Multiplier is thus the reciprocal of marginal propensity to

save. K = 1/MPS.

THEORY OF MONEY AND PRICES

Keynes reformulation of the quantity theory of money is also known as Keynes Theory of Money

and Prices. Keynes, for the first time, integrated the theory of money with the theory of value and the

theory of output. Before 1930, Keynes considered the monetary theory as the theory of prices alone. It


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was in 1930 that his old conception of the monetary theory underwent a change. From a monetary

theory of prices, Keynes now shifted to a monetary theory of output. This is an important contribution

of Keynes. The old, classical economists had rigidly separated the monetary theory from the general

economic theory. For them, the monetary theory was only the theory of prices. It is on this account

that they established a direct link between monetary expansion and the price level. According to them,

monetary expansion led straight to an increase in the price level, without effecting an increase. For

Keynes, the process was quite different. Monetary expansion led first to an increase in the output. As

the output continues to expand, certain new factors come into existences which lead to a rise in costs.

Rise in costs, is due to the inelastic supply of certain factors of production. The net result is that a

successful integration of the quantity theory of money with the theory of output and the theory of

value.

Another great contribution of Keynes lies in doing away with the old classical notion that prices are

directly determined by the quantity of money. On the contrary, he pointed out that there existed only

an indirect relationship between prices and the quantity of money. The changes in the quantity of

money influenced the rate of interest, which in its turn, affected investment, income, output and prices.

Keynes thus brought to the core the real process which existed between the quantity of money and

price.

Keynes reformulated quantity theory of money and was not based on the wrong and unreal classical

assumption of full employment. On the contrary, his version of the quantity theory was based on the

realistic assumption of underemployment. To him unemployment was the rule, and full employment

an exception. It was on account of the existence of underemployment that an expansion of money

supply in the initial stages did not result in a rise in the price level. Therefore Keynes reformulated

quantity theory has spotlighted the process of causation and the factors determining the value of


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money, giving due recognition to the part played by the rate of interest and integrating the theory of

money with the theory of value which had been kept separate by the traditional theorists.

KEYNES THEORY OF TRADE CYCLES

Keynes doesnt develop a complete and pure theory of trade cycles. According to Keynes, effective

demand is composed of consumption and investment expenditure. It is effective demand which

determines the level of income and employment. Therefore, changes in total expenditure, i.e.,

consumption and investment expenditures, affect effective demand and this will bring about

fluctuation in economic activity. Keynes believes that consumption expenditure is stable and it is the

fluctuation in investment expenditure which is responsible for changes in output, income and

employment.

Investment depends on rate of interest and marginal efficiency of capital. Since rate of interest is more

or less stable, marginal efficiency of capital determines investment. Marginal efficiency of capital

depends on two factors prospective yield and supply price of the capital asset. An increase in MEC

will create more employment, output and income leading to prosperity. On the other hand, a decline

sin MEC leads to unemployment and fall in income and output. It results in depression.

INFLATION

Keynes has analyzed inflation as a phenomenon of full employment. To Keynes, true inflation begins

when the elasticity of supply of output does not change in response to increase in money supply. In

other words an inflationary rise in the price level cannot take place before the point of full

employment. An expansion of money supply before point of full employment will go to increase

output and employment and the price level will increase only if the expansion of money supply is


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continued even beyond the point of full employment. Hence in the Keynesian sense inflation refers to

a rise in the price level after fill employment is reached.

MONETARY POLICY

He expressed in favour of a cheap money policy because he was afraid of idle stocks of capital. In an

underdeveloped economy cheap money would increase the demand for capital which is already scare.

This policy may encourage capital-intensive production in a situation where due to surplus labour, the

need of the hour is to save more capital, by capital-saving devices. Deficit financing is one of the

methods of utilizing idle capital through the cheap money policy, but the two situations are different.

Keynes suggested deficit financing during the period of depression; and in an under-developed

economy capital is needed for the implementation of the scheme of economic development. In India,

deficit financing has been resorted to not for pulling the economy out of depression but for the

implementation of the various schemes of economic development.

FISCAL POLICY

It has been suggested that direct progressive tax is highly desirable. It will increase consumption and

reduce individual saving because tax payers begin to feel that there is no incentive for earning more. It

will badly affect saving and investment. Chequer; and are transferred to the low income groups, i.e.,

these are spent on the schemes of common benefit. This goes to maintain total effective demand at a

time when the economy is threatened by diminishing investment opportunities.

KEYNES AND THE UNDERDEVELOPED COUNTRIES

Keynesian economics is applicable to the underdeveloped countries. Directly, Keynes has nothing to

do with these of economically advanced countries, and therefore said little about the underdeveloped


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countries. The General Theory is not general in eth sense that it is applicable in all places and at all

times. As Harris said; Those who seek universal truths, applicable in all places and at all times had

better not waste their time on the General Theory. The General Theory was written in the environment

of developed countries, was meant to solve the problems of these countries and, thus, it is not without

risk to apply it to the diametrically different problems of eth underdeveloped countries. Schumpeter

has rightly observed: Practical Keynesianism is a seedling which cannot be transplanted into foreign

soil; it dies there and becomes poisonous before it dies. It is explained that neither Keynesian Problem,

nor Keynesian theory, nor Keynesian policy has relevance to the conditions prevailing in the

underdeveloped countries.

On the face of it, Keynes theory seems to be very useful to the underdeveloped countries, because it

deals with the problem of unemployment which is also the basic problem of these countries. But, at the

root of it, the nature of unemployment here is quite different from that prevailing in the advanced

countries and with which Keynes was concerned.

INVOLUNTARY UNEMPLOYMENT

For the efficient working of the multiplier, involuntary unemployment must exist. Involuntary

unemployment means an elastic supply of labour at the going wage rate. But, in the underdeveloped,

countries, the unemployment is, to a large extent, disguised. This means, (a) those who are

unemployed are not aware that they are unemployed and (b) considerably higher wages are required to

induce them to accept a job. And yet they are unemployed in the economic sense, i.e. though they are

employed somewhere, their marginal productivity is zero or even negative, meaning thereby, that total

production will not fall if a worker, coming under the category of disguised unemployment, is

withdrawn from his existing job.


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UNDER EMPLOYMENT EQUILIBRIUM

The greatest contribution which Keynes has made to economic analysis is his demonstration that

equilibrium of free capitalist economy is possible only at less than full employment level. The word

equilibrium meant full employment and less than full employment meant disequilibrium for the

classical. It was Keynes who gave a systematic account of under employment equilibrium.

The classical are of the view that the rate of interest is the equilibrating mechanism between saving

and investment. When S is greater than 1 rate of interest brings about equality between the two. The

classical also suggested wage cut was a remedy for unemployment. Whenever there is unemployment

wages should be reduced which will bring about a fall in cost and prices. This in its turn increases

aggregate demand which created additional employment opportunities.

Criticism of The Marginal Efficiency of Capital

Keynes used the term marginal efficiency of capital in a vague manner. Secondly, Keynes failed to

recognize that interest rates are also governed by expectations like the marginal efficiency of capital.

He considered marginal efficiency of capital in the field of dynamic economics and rate of interest in

the field of static economics.

Marginal Efficiency of Investment

The rate of discount or yield i.e., r is conventionally called the Marginal Efficiency of Investment

(MEI). Keynes originally called it the Marginal Efficiency of Capital. Brooman says that it is

preferable to use a term which refers explicitly to investment (i.e MEI). The MEI (or MEC) ought to

be distinguished from the Marginal product of capital which refers to the increase in current output

resulting from the addition of one more unit of capital. It is clear that the marginal product of capital is

a physical quantity similar to the marginal product of any other factor. The MEI is a percentage rate,


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and not the physical quantity. Again the marginal product of capital does not involve expectations

about the yield from the unit of capital during the remainder of its life. But the MEI is very much

concerned with such expectations about the yield.

Criticisms

Keynes theory of liquidity preference has been severely criticized on the following grounds.

1. Professor Hansen has pointed out that the Keynesian theory of interest is not free fromcriticisms. He pointed out that the liquidity preference theory is indeterminate. Rate of interest

is determined by liquidity preference and supply of money. Liquidity preference itself is

determined by the income level. Therefore, liquidity preference cannot be known unless

income is known. Further rate of interest plays an important part in the determination of

income level. Thus Prof. Hansen says that the Keynesian theory is indeterminate.

2. To Prof. Hazlitt, Keynesian liquidity preference theory is only a monetary theory and it doesnot consider real factors like thrift, marginal productivity of capital and saving. Therefore,

Keynes theory of interest is one sided.

3. Keynes says that interest is the reward for money. But Robertson says that the term money inthis theory is too general.

4. Keynes concept of demand for money is not comprehensive. To Keynes the demand for moneymeans liquidity preference. But money is demanded also for consumption and investment.

5. To Keynes rate of interest is a reward for parting with liquidity. Keynes has omitted saving asthe basis of liquidity. Without saving there is no liquidity to surrender.


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6. Keynes says that liquidity is essential for interest rates. But this need not be so. If a personkeeps his funds in the form of time deposits or short term treasury bills they will fetch him

interest.

7. This is one sided theory because it explains the determination of interest by keeping the supplyof money constant.

8. Keynes theory of interest is applicable only to short period and not for long period.9. To Keynes liquidity preference is the outcome of three motives. But there are other factors

which are not stressed by Keynes.

10. Keynes theory of interest is of limited value from the supply side. It is not only possible toreduce the rates of interest by increasing the supply of money. If the liquidity preference of

people also increases in the same proportion in which the supply of money increases then the

rate of interest will remain unaffected.

Criticisms

Keynes multiplier theory has been subject to severe criticisms by post-Keynesian economists.

1. Prof. Haberler has criticized Keynes multiplier as tautological. It is a mere truism. Accordingto Hansen, such a co-efficient is a mere arithmetic multiplier is tautological.

2. Keynes multiplier theory is an instantaneous process without time lag. It is a timeless staticequilibrium analysis because the effect of a change in investment on income is instantaneous.

But this is not correct because a time lag is always involved between the receipt of income and

its expenditure on goods. Therefore it is unrealistic.


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3. Prof. Hazlitt considers multiplier as a strange concept about which the Keynesians have madeunnecessary fuss. He calls the idea of multiplier a myth and considers it as a worthless

theoretical tool popularized by the supporters of Keynes.

4. Multiplier analyses only the effect of investment on income but does not take into account theeffect of consumption on investment. In other words, Keynes has been criticized of neglecting

accelerator principle.

5. Keynes has given too much importance to consumption. He also assumes that MPC is stable.Prof. Gordon prefers the concept of marginal propensity to spend instead of MPC. He also

points out that in a dynamic economy, MPC will not remain constant.

6. Keynes established a linear relationship between consumption and income. But the relationshipbetween the two is non-linear.

COMPARING AND CONTRASTING KEYNES AND THE CLASSICAL

SCHOOL OF ECONOMIC THOUGHT

Keynes differs from the classical school in almost all ideas and has severely criticized each and every

concept.

1. The classical believed in laissez faire policy. But according to Keynes free enterprises systemleads to fluctuations in trade cycles, so government intervention is a must.

2. The classical assumed full employment and there is no deviation from full employment. Evenif there are temporary deviations, the economy has the tendency to reach full employment.

Whereas Keynes stated that under employment equilibrium is in the reality and full


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employment is a distant goal. Achievement of full employment is very difficult and

maintenance of it on a permanent basis is still more difficult.

3. The classical said that there exists in the economy a state of perfect competition whichallocates resources ideally and ensures maximization is a myth. Todays market structure is

characterized by imperfect market which restricts output leads to wastage of resources, and

exploitation of consumers. Ideal allocation of resources is not ensured.

4. The classical believed in invisible hand or flexible price mechanism which ensuresmaximization in all market and also in allocation of resources and distribution of resources and

national income. Keynes said that private motives do not coincide with public welfare.

Indiscriminate attachment to profit leads to depression, unemployment and other evil

consequences. So there are no invisible hands, or automatic price mechanism which ensures

the welfare of one and all in society. An artificial hindrance in the price mechanism has led to

exploitation, misallocation and improper distribution of income.

5. According to the classical economists there is automatic self adjusting character of theeconomy. There is no such automatic or self adjusting system in Keynesian economics. If such

a force is there, depressions and booms can be easily avoided and fluctuations averted.

6. The classical contributions constitute the core of Micro Economics. The classical assumed afixed quantity of resources and concentrated on ideal allocation among firms, industries and

individual units in the economy. They studied micro elements and implicitly believed that

what principles and rules govern the micro problems are completely valid for macro problems

also. Therefore, no separate theory is required for macro problems. Keynesian contribution

relates to macro problems and according to him, micro problems require one set of policies and

for macro problems, another set of policies is required. The same policy tools or instruments


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cannot be applied for both. Macro is not a mere addition of micro elements. The nature,

magnitude and intensity of macro problems vary from that of micro problems.

7. Wage-price flexibility is advocated by classical for solving unemployment problem. If at anytime the economy slips down from the level of full employment it can be restored by cutting

down real wages. Since wages are determined by marginal physical product of labor and MPC

is subject to the operation of the Law of diminishing returns, more labor can be employed only

if wages are reduced. As long as wages are flexible downwards, full employment can be easily

achieved. The classical school assumed that workers will accept a lower wage. Thus wages are

flexible both ways for them. According to Keynes, wage flexibility is not found in the modern

economy, especially downward flexibility of wages. Modern trade unions never accept wage

cut for solving disequilibrium. Keynes has explained the following consequences if real wages

are reduced:

a. In modern economy where there are strong trade unions, workers will not accept areduction in real wage. The union may resort to strike in which case production will be

completely affected.

b. When wages are reduced, it may affect the consumption level of workers. A distributionof income takes place from wage earners, whose MPC is high, to propertied class (low

MPC) which means overall reduction in consumption. Since consumption is an

important element of aggregate demand, effective demand will fall short of aggregate

supply and employment, instead of increasing, will decline further.

c. Even accepting that wage reductions can solve unemployment, this reduction in realwage can be accomplished in a different and painless manner than what the classical

school thinks of. By keeping the money wage constant, a gradual and unnoticeable

increase in price level will bring down the level of real wage and such a reduction in real


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wage will promote employment. The workers will be happy that they continue to get the

same money income and feel that they are not aware of the fact that because of the

gradually increasing price levels, their real income has come down. When people have

such a false satisfactions, they are said to be subject to money illusion. Taking

advantage of this illusion the economy can reach full employment.

d. Keynes raises one more objection to wage cut policy of the classical. When wages arecut, more employment is offered, output increases and prices fall. If the fall in prices is

in proportion to the fall in money wage, then real wages of workers will remain the

same. When there is no fall in real wage how can the economy reach a state of full

employment. So for Keynes wage cut is not an advisable policy for removal of

unemployment or for reaching full employment.

8. The classical school believed in the flexibility of interest rate in bringing about equilibriumbetween savings and investment. Saving is a function of interest rate and higher the rate of

interest higher will be the level of savings and vice versa. Investment is also a function of

interest rate, lower the interest, higher the level of investment and vice versa. Interest rate

because of its flexibility restored equilibrium between S and I at full employment equilibrium.

Too much importance was given by classical for interest rate mechanism. Keynes explained

that neither savings nor investments are functions of interest rate. Savings depend on the

capacity of the people to save and this capacity is determined by income. So S = f (y) and not

interest rate. Just because the rate of interest is high, people will not starve and save money

when their incomes are low. Investment is also not a function of interest rate. It is the rate of

return or profit which determines the level of investment. Investment is a function of MEC

and not interest. So mere interest rate flexibility cannot bring about equality between savings

and investment.


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9. Money plays a passive role for classical. It has only one function, viz., medium of exchange.The store of value function of money was not given due attention. Moreover money being a

precious commodity can never be kept idle as liquid cash. Either it should be spent for

consumption or invested immediately. Money is demanded for three motives for Keynes

transaction motive, precautionary motive and for speculative motive. No asset is as liquid as

cash. So if interest rates are very low people may prefer to hold their savings in the form of

idle cash than in the form of interest earning assets like bonds and shares. Their expectations

about future changes in the rate of interest influence this volume of liquid cash which in turn

exercise tremendous influence on the level of investment, employment and output in the

economy.

10. The classical economists did not integrate the theory of value with the theory of prices ormoney. By inventing the concept of speculative demand for money, Keynes successfully

integrated the theory of value with the theory of prices. Both money and real markets are

interdependent and not independent. Money causes much confusion in the economy. Liquidity

preference has a major impact on the level of investment and other variables in the system. So

money plays a very active role and not a passive role.

11. The classical considered only real variables like MPP, real profit, real wage and real sacrifice.Keynes considered monetary variables and at the same time connected them with real

variables.


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REFERENCE

Fishburn, P.: Utility Theory for Decision Making. New York: McGraw Hill Publishers, 1998.

Gregory, M.: Principles of Microeconomics. New Jersey: Prentice Hall Publishers, 2004.

Hardwick, P.: Introduction to Modern Economics, New York: Mcgraw Hill Publishers, 2002.

Neumann, J.: Theory of Games and Economic Behaviour. New Jersey: Princeton Publishers,

2000.

keynesian school of thought

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