What is the Keynesian Economics theory?

January 19, 2017
Reject Keynesian Economics

John Maynard Keynes’s 1936 book The General Theory of Employment, Interest, and Money attempted to overthrow classical theory and revolutionize how economists think about the economy. Economists who build upon Keynes’s General Theory to analyze the economic problems of the twenty-first-century global economy are called Post Keynesians. Keynes’s “principle of effective demand” (1936, chap. 2) declared that the axioms underlying classical theory were not applicable to a money-using, entrepreneurial economic system. Consequently, the mainstream theory’s “teaching is misleading and disastrous if we attempt to apply it to the facts of experience” (Keynes 1936, p. 3). To develop an economic theory applicable to a monetary economy, Keynes suggested rejecting three basic axioms of classical economics (1936, p. 16).

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Unfortunately, the axioms that Keynes suggested for rejection are still part of the foundation of twenty-first-century mainstream economic theory. Post Keynesians have thrown out the three axioms that Keynes suggested rejecting in The General Theory. The rejected axioms are the ergodic axiom, the gross-substitution axiom, and the neutral-money axiom, which are explained below. Only if these axioms are rejected can a model be developed that has the following characteristics:

•Money matters in the long and short run, that is, changes in the money supply can affect decisions that determine the level of employment and real economic output.

•As the economic system moves from an irrevocable past to an uncertain future, decision makers recognize that they make important, costly decisions in uncertain conditions where reliable, rational calculations regarding the future are impossible.

•People and organizations enter into monetary contracts. These money contracts are a human institution developed to efficiently organize time-consuming production and exchange processes. The money-wage contract is the most ubiquitous of these contracts.

•Unemployment, rather than full employment, is a common laissez-faire situation in a market-oriented, monetary production economy.

•The ergodic axiom postulates that all future events are actuarially certain, that is, that the future can be accurately forecasted from an analysis of existing market data. Consequently, this axiom implies that income earned at any employment level is entirely spent either on produced goods for today’s consumption or on buying investment goods that will be used to produce goods for the (known) future consumption of today’s savers. In other words, orthodox theory assumes that all income is always immediately spent on producibles, so there is never a lack of effective demand for things that industry can produce at full employment … Post Keynesian theory rejects the ergodic axiom.

In Post Keynesian theory, however, people recognize that the future is uncertain (nonergodic) and cannot be reliably predicted. Consequently, people decide on how much of current income is spent on consumer goods and how much is not spent on consumption goods but is instead saved by purchasing various liquid assets.

Liquid assets are time-machine vehicles that savers use to store and transport savings to an indefinite future date or dates. Unlike savers in the classical system who can reliably predict their economic future, real-world savers do not know exactly what they will buy, and what contractual obligations they will incur, at any specific future date. As long as money discharges all contractual obligations and monetary contracts are used to organize production and exchange activities, the possession of money (and liquid assets that have small carrying costs and can be easily resold for money) means that holding one savings in the form of liquid assets gives savers the ability to demand products whenever they desire in the uncertain future and/or to meet a future unforeseen contractual commitment. Liquid assets are savers’ security blankets, protecting them from possible hard times …

Keynes (1936, chap. 17) argued that money (and all liquid assets) have two essential properties. First, money does not grow on trees, and hence labor cannot be hired to harvest money trees when income earners reduce consumption to save more in the form of money or liquid assets. Accordingly, the decision to consume rather than to save is a choice between an employment-inducing demand and a non-employment-inducing demand. When savings increase at the expense of the demand for producibles, sales and employment decline. Second, liquid asset prices will increase as new savings increase the demand for such assets. Because of high carrying and high resale costs, producible durables are not gross substitutes for liquid assets, contrary to the classical gross-substitution axiom where the latter assumes anything is a good substitute for anything else. Post Keynesians reject the gross substitution axiom as applicable to assets that savers use to store their savings. Consequently, higher liquid asset prices do not divert this savings demand for liquid assets to a demand for producibles whose relative price has declined …

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