Phillips Curve Musings: Second Addendum on Keynes and the Rate of Interest

In my two previous posts (here and here), I have argued that the partial-equilibrium analysis of a single market, like the labor market, is inappropriate and not particularly relevant, in situations in which the market under analysis is large relative to other markets, and likely to have repercussions on those markets, which, in turn, will have further repercussions on the market under analysis, violating the standard ceteris paribus condition applicable to partial-equilibrium analysis. When the standard ceteris paribus condition of partial equilibrium is violated, as it surely is in analyzing the overall labor market, the analysis is, at least, suspect, or, more likely, useless and misleading.

I suggested that Keynes in chapter 19 of the General Theory was aiming at something like this sort of argument, and I think he was largely right in his argument. But, in all modesty, I think that Keynes would have done better to have couched his argument in terms of the distinction between partial-equilibrium and general-equilibrium analysis. But his Marshallian training, which he simultaneously embraced and rejected, may have made it difficult for him to adopt the Walrasian general-equilibrium approach that Marshall and the Marshallians regarded as overly abstract and unrealistic.

In my next post, I suggested that the standard argument about the tendency of public-sector budget deficits to raise interest rates by competing with private-sector borrowers for loanable funds is fundamentally misguided, because it, too, inappropriately applies the partial-equilibrium analysis of a narrow market for government securities, or even a more broadly defined market for loanable funds in general.

That is a gross mistake, because the rate of interest is determined in a general-equilibrium system along with markets for all long-lived assets, embodying expected flows of income that must be discounted to the present to determine an estimated present value. Some assets are riskier than others and that risk is reflected in those valuations. But the rate of interest is distilled from the combination of all of those valuations, not prior to, or apart from, those valuations. Interest rates of different duration and different risk are embeded in the entire structure of current and expected prices for all long-lived assets. To focus solely on a very narrow subset of markets for newly issued securities, whose combined value is only a small fraction of the total value of all existing long-lived assets, is to miss the forest for the trees.

What I want to point out in this post is that Keynes, whom I credit for having recognized that partial-equilibrium analysis is inappropriate and misleading when applied to an overall market for labor, committed exactly the same mistake that he condemned in the context of the labor market, by asserting that the rate of interest is determined in a single market: the market for money. According to Keynes, the market rate of interest is that rate which equates the stock of money in existence with the amount of money demanded by the public. The higher the rate of interest, Keynes argued, the less money the public wants to hold.

Keynes, applying the analysis of Marshall and his other Cambridge predecessors, provided a wonderful analysis of the factors influencing the amount of money that people want to hold (usually expressed in terms of a fraction of their income). However, as superb as his analysis of the demand for money was, it was a partial-equilibrium analysis, and there was no recognition on his part that other markets in the economy are influenced by, and exert influence upon, the rate of interest.

What makes Keynes’s partial-equilibrium analysis of the interest rate so difficult to understand is that in chapter 17 of the General Theory, a magnificent tour de force of verbal general-equilibrium theorizing, explained the relationships that must exist between the expected returns for alternative long-lived assets that are held in equilibrium. Yet, disregarding his own analysis of the equilibrium relationship between returns on alternative assets, Keynes insisted on explaining the rate of interest in a one-period model (a model roughly corresponding to IS-LM) with only two alternative assets: money and bonds, but no real capital asset.

A general-equilibrium analysis of the rate of interest ought to have at least two periods, and it ought to have a real capital good that may be held in the present for use or consumption in the future, a possibility entirely missing from the Keynesian model. I have discussed this major gap in the Keynesian model in a series of posts (here, here, here, here, and here) about Earl Thompson’s 1976 paper “A Reformulation of Macroeconomic Theory.”

Although Thompson’s model seems to me too simple to account for many macroeconomic phenomena, it would have been a far better starting point for the development of macroeconomics than any of the models from which modern macroeconomic theory has evolved.

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38 Responses to “Phillips Curve Musings: Second Addendum on Keynes and the Rate of Interest”


  1. 1 Henry Rech July 11, 2019 at 4:14 am

    David,

    Isn’t Chapter 17 just making the argument that fiat money is not same as commodity money?

    It has different characteristics which make it unique.

    General Equilibrium Theory is the theory of the optimal allocation of scarce resources among competing uses. It is not a theory about the level of the utilization of resources. That is why it cannot constitute a macroeconomic theory.

    Capital theory deals with the allocation of limited financial resources among competing capital assets. It is similarly not a theory about the level of capital goods production. That is why such a theory won’t be found in Keynes’ macroeconomic model.

  2. 2 Henry Rech July 11, 2019 at 7:21 am

    One further thought.

    In Keynes’ world the rate of interest is not the mechanism by which resources are allocated intertemporarily. It is the mechanism (with expectations as a parameter) by which the level of capital goods production is determined.

    The rate of interest in the GE model is not comparable with the rate of interest found in the GT.

  3. 3 Henry Rech July 11, 2019 at 7:30 am

    I think I mean intertemporally, not intertemporarily. 🙂

  4. 4 David Glasner July 11, 2019 at 8:26 am

    Henry, We have been through this all before, so I will be brief. I view general-equilibrium theory as a method of taking into account the complexity and interdependence of economic activity. You may be right in your explanation of Keynes’s thought process, but that does not justify it. The rate of interest is an intertemporal price and Keynes in chapter 17 recognizes it as such. His explanation of interest in the GT as pure liquidity preference is simply indefensible, and I say that as an admirer of his contributions to economics

  5. 5 Rob Rawlings July 11, 2019 at 10:08 am

    While Keynes appears to have been deficient in spelling it out there is not necessarily a contradiction between claiming that ‘the market rate of interest is that rate which equates the stock of money in existence with the amount of money demanded by the public’, and that a ‘relationships …. must exist between the expected returns for alternative long-lived assets that are held in equilibrium’. In other words a major (but not the only) factor in people’s desire to hold money (either as a cash balance or in order to loan it out) will be the alternative returns available if they held their wealth in other forms.

    If the money rate of interest is too low compared to the alternatives available
    then a simple adjustment mechanism would be for people to attempt to move out of money and drive up the price level. With the resulting lower ‘real’ quantity of money higher interest rates on money will be needed to ‘equate the stock of money in existence with the amount of money demanded by the public’, which will (when it reached the appropriate level) equilibrate the money rate of interest with returns available elsewhere.

  6. 6 Inal July 11, 2019 at 11:20 am

    Very ingeniously, David, although some economists like M. G. Hayes [Hayes 2010] will probably defend Keynes on the grounds that:

    “…principle of effective demand, the backbone of The General Theory,
    represents an alternative definition of equilibrium.
    [Modern] …loanable funds theory can be no more separated from the
    Walrasian concept of general equilibrium than Keynes’s liquidity-preference theory can be
    from the principle of effective demand. Since these two concepts of system equilibrium are
    structural incompatible, it is no surprise that the loanable funds debate has been at cross-
    purposes.”

    Bibliography

    The loanable funds fallacy: saving, finance and equilibrium
    M. G. Hayes
    Cambridge Journal of Economics
    Vol. 34, No. 4 (July 2010)

    http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1004.3849&rep=rep1&type=pdf

  7. 7 Biagio Bossone July 12, 2019 at 1:12 am

    “The current rate of interest depends, as we have seen, not on the strength of the desire to hold wealth, but on the strengths of the desire to hold it in liquid and illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other.” (JM Kyenes, Collecgted Writings VII, p 213)

    It is not at all the case that Keynes asserted that the rate of interest is determined in a single market (the market for money).

    He understood money in a much broader sense (in fact, he spoke about “liquidity” preference), and was not concerned solely with the demand for money. The theory of liquidity preference is concerned with the demand for assets of various degrees of liquidity, and the rate of interest depends on both the demand for and supplies of assets across the whole of this spectrum.

    Liquidity preference is the decision about the degree of liquidity at which savings should be held. It is a decision concerning the stock of savings – wealth – at any point in time and its composition, rather than any new flow of saving alone or the stock of any particular asset called money.

    And the rate of interest is not determined by the supply of and demand for (flows of) saving or the supply of and demand for the stock of one particular asset called money, but by the supply of and demand for all assets into which holdings of (stocks of) wealth can be placed. Money is just one of these assets.

    Why is all this so “undefensible”, as you say?

  8. 8 Biagio Bossone July 12, 2019 at 4:05 am

    In practice, the interest earned on assets held as stores of value is the reward for their relative illiquidity and can alternatively be seen as a premium on liquidity.

    According to Keynes’ liquidity preference theory (LPT), money is a store of value, liquidity may include money as well as non-money liquid assets, and wealth allocation decisions are made by comparing all existing assets based on the cost to exchange them and their capacity to protect the value stored in them.

    The interest rate, therefore, rests on a general equilibrium analysis of the whole spectrum of assets across the domestic and international economy (in the case of international financially integrated and open economies).

    Essentially based, as it is, on preferences toward liquidity (vs illiquidity), LPT, by its very construction, cannot be a partial equilibrium analysis and must on the contrary reflect a general equilibrium approach.

  9. 9 Biagio Bossone July 12, 2019 at 4:59 am

    Finally, as regards the interest rate and capital assets, in the General Theory Keynes clarified that, “investment depends on a comparison between the marginal efficiency of capital and the rate of interest” (JMK, Collected Writings VII, p 151, fn 1), and denied any unique and stable relationship between debt and equity markets.

    His account of “spot-the-convention-type” of asset-market play in Chapter 12 is clearly relevant to securities and derivative markets in general, including also FX and property markets, etc.

    LPT is indeed a theory of asset prices more generally, not just of the price of one asset in one market.

  10. 10 David Glasner July 12, 2019 at 5:54 am

    Biaggio, Many thanks for your very astute comments.I completely agree that the theory of liquidity preference can be expressed in an appropriate general equilibrium framework, as Keynes himself in chapter 17 and elsewhere did. My point is that he sometimes lapsed from that appropriate general equilibrium view of interest into a more extreme partial equilibrium view in which liquidity preference became the sole factor explaining the essence of the rate of interest which then governed his application of the simplified model (IS-LM) and governed his applied analysis in an aggregated macro model.

  11. 11 Biagio Bossone July 12, 2019 at 7:27 am

    Totally agree, David. Many thanks for your reply!

  12. 12 Henry Rech July 16, 2019 at 12:56 am

    David, Biagio,

    I don’t believe there is any question of Keynes taking a partial or general equilibrium approach in the GT. Keynes was concerned with how changes in income and spending shift the equilibrium level of output and employment.

    Relative price changes (that is partial or general equilibrium analysis), in his world, have no relevance to macroeconomic considerations, other than perhaps where output was at the full employment level.

    That there might be a panoply of financial assets with characteristics of near money was not of critical interest to him, even though their existence might have been considered or implied in his analysis.

  13. 13 Biagio Bossone July 16, 2019 at 6:51 am

    Henry,

    By combining 1) the theory of consumption (determined as a fraction of current income), 2) animal spirits (as the fundamental source of irreducible or radical uncertainty underpinning the process of capital accumulation), and 3) liquidity preference theory (LPT) (to explain the rate of interest as a “highly conventional…phenomenon” – to use his own words), JMK intended to demonstrate that capitalist economies may be charcaterized by permanent states of underemployment equilibrium.

    You may not refer to Keynes’ analysis as General Equilibrium; in fact, one might call it General Disequilibirum Analysis (where disequilibrium may persist due to the lack of endogenous incentives to eliminate it). Yet Keynes’ analysis involved all relevant markets in the economy and it was certainly not partial equilibrium analysis. In this sense, “general” is used as opposed to “partial,” and not on whether the underlying adjustment mechanism is based on quantities rather rather than prices.

  14. 14 Biagio Bossone July 16, 2019 at 6:53 am

    Henry,

    In an earlier comment, you had noted (correctly, in my view) that “in Keynes’ world the rate of interest…is the mechanism (with expectations as a parameter) by which the level of capital goods production is determined.” If you re-read carefully what I wrote in my comments, you will notice that a) they are consistent with that statement and b) they nowhere suggest that Keynes was concerned with “a panoply of financial assets with characteristics of near money”.

    Keynes’ use of the term “liquidity” indicates that he was not concerned exclusively with the demand for money; he considered the demand for assets of various degrees of liquidity, and in his LPT the rate of interest depends on both the demand for and supplies of assets across the whole of this spectrum.

    “Money,” however, does have a particularly crucial role in LPT and, more broadly, in Keynes’ general (dis)equilibrium approach; while illiquid assets offer holders a reward in the form of interest, the reward for holding money is the essence of liquidity itself: the rate of interest is the price of illiquidity.

    To such extent, and to the extent that such a price determines the level of capital accumulation (and hence of future wealth creation), it inevitably plays a key role also in the economy’s process of intertemporal resource allocation. In fact, one cannot (I would even say, “may not”) think of Keynes’ interest rate theory as disjointed from its intertemporal dimension: time and the uncertainty that comes with it are of the essence in Keynes’ view of the inherent instability of a monetary production economy.

    In Keynes, time, uncertainty, and liquidity are essentially interwoven.

  15. 15 David Glasner July 16, 2019 at 8:45 am

    Henry and Biagio, I think Keynes at his best was reasoning in terms of a complex intertemporal general-equilibrium system in which markets are all interrelated but are not necessarily in equilibrium and the equilibrating forces are not necessarily very powerful. But to make his system tractable he also argued in terms of a highly aggregated model single period model that was not capable of accommodating the full complexity of the relationships underlying his analysis. My criticism of Keynes focuses mainly on his overly aggregated and overly simplified one period model, not his more complex understanding of how the economy works.

  16. 16 Biagio Bossone July 16, 2019 at 10:14 am

    David,

    I think you are right and I tend to share your criticism (with all the humbleness that I feel due in being critical of such a gigantic master).
    But while Keynes’ highly aggregate model was incapable of accommodating the full complexity of his vision, as you say, he did point to a fundamental way of how to turn (neo)classical economics on its head, and most of all he recognised that this was in fact necessary in order for Economics to become a useful social discipline.

    The troubles of Economics, today, derive from the ineptitude of Keynes’ followers to build on his extraordinary intuition and complete what he was unable to complete, and the inability of contemporary economists to combine – as he successfully did – a vast theoretical knowledge with a high sense of realism and history.

  17. 17 Henry Rech July 16, 2019 at 11:53 am

    Biagio,

    The word :”general” is problematic in the sense that it appears in the title of Keynes book and in part forms the name given to a theory of optimal resource allocation (General Equilibrium Theory – GET). So we have to be careful not to mix the two uses of the word. Keynes meant by “general” that he was considering all possible macro equilibrium points whereas the “general” in the GET applies to all markets in simultaneous equilibrium at only one point, viz., full employment.

    I’m sure I’m not telling you anything new, but we have to be careful not to mix the two meanings as you almost seem to be doing above (?).

    So while Keynes used the word “general” he of course was not referring to GET.

    And I don’t agree that Keynes theory might have implications for intertemporal resource allocation. He was interested in the level of capital goods production in a given period. And in any event, it is relative prices which are the mechanism by which capital is allocated across time, not “price”.

    Keynes specifically stated that the rate of interest was not the reward for not spending now but the reward for not hoarding. This is where the notion of liquidity preference is unique and plays into the question of uncertainty.

    There was an intertemporal dimension to Keynes’ theorizing but not in the sense of optimal resource allocation.

  18. 18 Henry Rech July 16, 2019 at 12:05 pm

    David,

    Keynes was concerned with how an economy could be stable at levels of output and employment below the full employment level. He argued that the process of adjustment was driven by changes in income and spending not changes in relative prices (the mechanism of the GET). These are entirely two different adjustment mechanisms.

    Whilst some of the elements of Keynes theory may have been “in the air” prior to the GT, he added to these elements and combined them in such a way that he could explain how an economy could be stable at a level of output below full employment.

    This was the genius of Keynes and the essence of his revolution. A mantle unreasonably denied him by people like David Laidler. (I’m referring to Laidler’s ambiguously titled “Fabricating the Keynesian Revolution”).

  19. 19 Blue Aurora August 5, 2019 at 6:15 am

    David Glasner: This comment might be belated, and I am no longer following the econoblogosphere as closely as I used to…but have you tried to decipher the equations found in Chapters 20 and 21 of The General Theory of Employment, Interest, and Money?

    If not…I would like to redirect your attention to the following articles.

    http://www.hetsa.org.au/pdf-back/21-A-4.pdf

    http://www.hetsa.org.au/pdf-back/24-A-4.pdf

    http://www.hetsa.org.au/pdf-back/25-A-13.pdf

  20. 20 George H. Blackford August 7, 2019 at 8:56 pm

    I believe that the fundamental confusion here arises from an attempt to understand Keynes from a Walrasian, general equilibrium perspective rather than from that of Marshall and the belief that, somehow, Walras’ Law is relevant to Keynes or in the real world that Keynes attempted to explain.

    Keynes attempted to identify those factors that in themselves directly determined each of the variables in the system at each point in time, not just when the system was in equilibrium. This made it possible for Keynes to view the system as recursive in that it was possible for him to establish the temporal order in which events must occur, and thus to separate cause and effect. This made it possible for him to provide a logically consistent, causal explanation as to how the system changes through time.

    His method of analysis in doing this was through a partial equilibrium analysis of each variable that does not assume that the rest of the system is in equilibrium or that Walras’ Law applies. The key to his being able to do this was his realization that the rate of interest is determined by the supply and demand for money, not saving and investment or the supply and demand for loanable funds, and that income is determined by saving and investment, not by the supply and demand for money.

    I do not have the space to defend this view here, but I do have a paper posted online that attempts to explain the causal nature of Keynes’ theory of interest ( http://rweconomics.com/CIKGT.pdf ) and another that attempts to explain the recursive nature of Keynes’ methodology ( http://rweconomics.com/MKATN.pdf ) if anyone is interested.

  21. 21 David Glasner August 8, 2019 at 1:21 pm

    That may well have been Keynes’s view of causality, it is certainly not mine, and I think it would be hard — if not impossible — to defend such a view of causality. And few if any contemporary economists would subscribe to that view.

  22. 22 George H. Blackford August 8, 2019 at 2:24 pm

    It’s not at all clear to me that why you believe that it is hard to defend the notion that a cause must precede its effect. It seems to me that this has been the fundamental understanding of causality since the 18th century. I don’t know of anyone who would reject this proposition.

  23. 23 David Glasner August 8, 2019 at 2:42 pm

    There are many causes operating simultaneously one many variables, not one cause for each variable.

  24. 24 George H. Blackford August 8, 2019 at 3:12 pm

    There are many factors that determine the value of a variable at any particular point in time, but those factors do not necessarily change simultaneously in response to an exogenous change in the system. The factors that determine the values of individual variables will tend to change sequentially as the system evolves through time. Keynes’ methodology involved attempting to establish the sequential order in which those changes occur in order to establish cause and effect with regard to the way in which those changes occur through time. This kind of analysis may be difficult, but I do not see any reason to believe that it is impossible or that it can’t be fruitful. The only barrier I can see to this kind of analysis is Walras’ Law, a law that I personally view as nonsense. ( http://rweconomics.com/CIKGT.pdf pp. 2-4 )

  25. 25 David Glasner August 8, 2019 at 5:31 pm

    There are theories of equilibrium in which causation is simultaneous. There is no theory of sequential change derived from any basic principles in the way that equilibrium theory is derived from basic principles. There is no compelling reason to think that Keynes had any special insight into the sequence of change. His rejection of wage cuts makes sense only insofar as it is based on a rejection of partial equilibrium analysis of the labor market.

  26. 26 Henry Rech August 8, 2019 at 6:34 pm

    “His rejection of wage cuts makes sense only insofar as it is based on a rejection of partial equilibrium analysis of the labor market.”

    Partial equilibrium analysis relies on the assumption that supply and demand functions are independent.

    Keynes’ analysis suggests to me he believed this to be not the case.

    The issues of casuality, simultaneity, temporality are important – any model can be constructed on the basis of assumptions about these considerations. The question, in the end, is what is the relationship of the model to reality.

    The fundamental problem with GET as a basis for macroequilibrium analysis is that it runs with changes in relative prices. I would like to see an explanation as to how changes in relative prices gives effect to a change in the general level of output and employment.

  27. 27 David Glasner August 8, 2019 at 6:49 pm

    You constantly, and without basis, identify GET with a particular set of assumptions. The framework can be adapted to different assumptions in which absolute prices, not only relative prices, can matter.

  28. 28 Henry Rech August 8, 2019 at 6:54 pm

    “The framework can be adapted to different assumptions in which absolute prices, not only relative prices, can matter.”

    If so, you have entered a Keynesian world.

  29. 29 Henry Rech August 8, 2019 at 6:57 pm

    And to be complete, I would say you have entered a Keynesian world where Walras’ Law does not apply.

  30. 30 David Glasner August 8, 2019 at 7:01 pm

    You are free to use whatever terminology you like. I greatly admire Keynes; that doesn’t mean I endorse or accept everything he wrote.

  31. 31 George H. Blackford August 9, 2019 at 12:33 am

    It is a mistake to believe that general equilibrium theory is based on basic principles and there is no theory of sequential change derived from any basic principles. This ignores Marshall’s fundamental contribution of marginalism to the theory of supply and demand, and Marshall’s use of these concepts to explain sequential change.

    It is of course true that Marshall’s sequential analysis is not derived from the same basic principles as those of Walras, but that is because of the limitations of Walras, not a deficiency of Marshall. Walras’ basic principles shed no light at all on the determination of any variable at any point in time other than when the system is in a state of general equilibrium (a situation that seems to me to never exists in the real world), whereas, Marshall explicitly attempted to explain the determination of variables at any point in time in the real world in accordance with the basic principles of supply and demand. (See Hayes, 2006, The Economics of Keynes: A New Guide to The General Theory).

    As I explain in http://rweconomics.com/CIKGT.pdf (pp. 2-4 ) the fundamental difference between Marshal and Walras arises from the fact that the Walrasian budget constraint assumes the choices of decision-making units are made simultaneously at a point in time and are constrained by realized income. This may be the way in which budgets are created in the real world, but it is not the way in which choices are made. Real-world choices are made sequentially through time, not simultaneously at a point in time, and neither households nor firms are constrained in their choices by income, realized or otherwise, at the point in time at which a choice must be made.

    The real-world choices of decision-making units are constrained by:

    a) the value and liquidity of their assets,

    b) the availability of sellers of goods and assets at various prices,

    c) the availability of buyers of goods and assets at various prices, and

    d) by their access to credit.

    The rate at which decision-making units receive or earn income at the point in time at which a choice must be made has no way of affecting that choice other than through its effects on expectations as anyone who has purchased a home, a car, or has simply walked the aisles of a supermarket knows implicitly, and as any business owner who has had to meet a payroll knows implicitly as well.

    These are the kinds of basic principles on which Marshall’s (and Keynes’) theory of sequential change are based, and it seems to me that they make much more sense and can be used to explain and understand a great deal more of economic reality than those that underlie Walrasian general equilibrium theory.

    While it is true that Keynes’ rejection of wage cuts makes sense only insofar as it is based on a rejection of the classical partial-equilibrium analysis of the labor market Keynes’ reason for rejecting this methodology in the labor market, as he explained in Chapter 2 of the GT, is that it doesn’t make sense to try to explain how the actions of demanders and suppliers of labor determine the real wage or level of employment by way of a partial-equilibrium model. And as I explain in the paper linked to above (pp. 8-13) it also doesn’t make sense to try to explain how the actions of savers and investors or suppliers and demanders for the flow of loanable funds can determine the rate of interest by way of a partial-equilibrium model, but it does make sense (pp. 21-5) to explain how the actions of suppliers and demanders of money determine the rate of interest by way of a partial-equilibrium model.

    Finally, I would note in the other paper I linked to in my original post above ( http://rweconomics.com/MKATN.pdf ) demonstrates exactly how Keynes’ use of Marshall’s basic principles of supply and demand can be used to provide a causal explanation of the way in which the economic system moves from one short-run equilibrium position to another (pp. 22-6), and it explicitly includes non-debt assets as well as money and debt. This paper also explains how the level of employment is determined in Keynes’ general theory by way of a partial-equilibrium model and how a change in the money wage can be expected to effect the level of employment in this model (pp. 36-44).

  32. 32 Biagio Bossone August 9, 2019 at 11:33 pm

    George,
    I am very much interested in what you’re saying and will read your suggested contributions as soon as I can.
    One question: are you familiar with monetary circuit theory, a branch of Keynesianism that has evolved from Keynes’ emphasis on money and time in a production economy, and has tried to combine a multi-market (general (dis)equilibrium) perspective with sequential time in choices?
    If so, I’d be interested in hearing your views on it (even bilaterally, if you prefer; my email is biagio.bossone@gmail.com).
    Thanks again, and thanks to David for hosting and nurturing this interesting debate.

  33. 33 Henry Rec h August 12, 2019 at 1:33 am

    George,

    I have printed out your papers and am looking forward to reading them.

    For the time though I can’t see how partial equilibrium supply demand analysis can apply.

    Supply and demand curves display a relationship between price and quantity.

    At the level of macro analysis, it is changes in income and spending which shifts the economy from one level of output to another.

    How is it that price is relevant? Did not Keynes assume a constant level of prices in the GT?

    Also does not partial equilibrium analysis require that supply and demand curves be independent? At the macro scale, it would seem they are not.

  34. 34 George H. Blackford August 15, 2019 at 11:12 am

    Henry,

    Re: “For the time though I can’t see how partial equilibrium supply demand analysis can apply. Supply and demand curves display a relationship between price and quantity. At the level of macro analysis, it is changes in income and spending which shifts the economy from one level of output to another. How is it that price is relevant? Did not Keynes assume a constant level of prices in the GT?”

    Income is the value of output produce in the GT which is given by the sum of prices times the quantities produced, and Keynes did not assume prices are constant. Keynes assumed that prices are determined by ordinary Marshallian supply and demand curves where the demand for consumer goods depends on income. The way in which this is accomplished is shown in Figure 1 and Figure 2 of http://rweconomics.com/MKATN.pdf .
    Re: “Also does not partial equilibrium analysis require that supply and demand curves be independent? At the macro scale, it would seem they are not.”

    Walrasian supply and demand curves are not independent at the macro scale because it is assumed that all choices are made simultaneously at a point in time and that choices are constrained by income. I argue that in the real world choices are not made simultaneously and are not constrained by income and that Keynes assumed choices are made sequentially through time rather than simultaneously at each point in time and that choices are not constrained by income. As a result, at any given point in time Keynes’ supply and demand schedules are independent at the macro scale.

    Only the supply and demand for loanable funds schedules are not independent in the real world when these schedules are defined in terms of the flows of saving and investment. This is the reason Keynes rejected the LF theory of interest in favor of the LP theory of interest since the S and D for money are independent at the macro scale. This is explained in http://rweconomics.com/RTVK.pdf . I would also note that a formal model of Keynes’ LP theory that does not conflate stocks and flows is presented in: http://rweconomics.com/SFM.pdf .

  35. 35 George H. Blackford August 15, 2019 at 11:18 am

    Henry:

    Sorry. Wrong link:
    . . . . This is the reason Keynes rejected the LF theory of interest in favor of the LP theory of interest since the S and D for money are independent at the macro scale. This is explained in http://rweconomics.com/RTVK.pdf . I would also note that a formal model of Keynes’ LP theory that does not conflate stocks and flows is presented in: http://rweconomics.com/CIKGT.pdf .

  36. 36 George H. Blackford August 15, 2019 at 2:32 pm

    Darn! I’m having trouble getting this right today.

    That the S and D for money are independent at the macro scale is demonstrated in:http://rweconomics.com/CIKGT.pdf

    The formal model of Keynes’ LP theory that does not conflate stocks and flows is presented in: http://rweconomics.com/SFM.pdf

    I should also note that, as you pointed out, Keynes also demonstrated that the supply and demand in the aggregate labor market are not independent just as he demonstrated that the supply and demand for loanable funds are not independent.

  37. 37 Henry Rech August 17, 2019 at 4:26 pm

    George,

    Firstly, I have to say I have not yet read in depth your referenced papers – just skated through them – so I do not fully appreciate the reasoning behind your comments, if at all.

    However, I find I am in disagreement with several of the fundamental points made in your comments above.

    “Walrasian supply and demand curves are not independent at the macro scale because it is assumed that all choices are made simultaneously at a point in time….”

    This is a tricky one. In Walrasian general equilibrium there is no time, there is only a point of equilibrium. Once equilibrium is determined, it remains immovable. There is no time before or afterwards, so there cannot be a point in time.Tatonnement is a sequential multi-event process which occurs with no reference to any point of time. It is a complete nonsense, compared to what occurs in the real world. I am sure you would agree. To talk of time in Walrasian equilibrium is not appropriate. A minor but important point.

    Staying with the tatonnement process, it seems to me this has similarities to your real world sequential choice making. If so, if you believe that S and D curves are independent in this case then it has to be concluded that in Walrasian tatonnement, S and D curves are also independent, not not independent as you say in your comment referenced immediately above. So I would argue that your logic is inconsistent.

    ” I argue that in the real world choices are not made simultaneously and are not constrained by income and that Keynes assumed choices are made sequentially through time rather than simultaneously at each point in time and that choices are not constrained by income. ”

    Whether considering the tatonnement process or your real world time sequential characterization of choice making, I cannot agree that income is no longer relevant to choice making. Choices are always influenced by income and expectations of future income.

    In support of this I offer an extract from the preface to the French edition of the GT:

    “My contention that for the system as a whole the amount of income which is saved, in the sense that it is not spent on current consumption, is and must necessarily be exactly equal to the amount of net new investment has been considered a paradox and has been the occasion of widespread controversy. The explanation of this is undoubtedly to be found in the fact that this relationship of equality between saving and investment, which necessarily holds good for the system as a whole, does not hold good at all for a particular individual. There is no reason whatever why the new investment for which I am responsible should bear any relation whatever to the amount of my own savings. Quite legitimately we regard an individual’s income as independent of what he himself consumes and invests. But this, I have to point out, should not have led us to overlook the fact that the demand arising out of the consumption and investment of one individual is the source of the incomes of other individuals, so that incomes in general are not independent, quite the contrary, of the disposition of individuals to spend and invest; and since in turn the readiness of individuals to spend and invest depends on their incomes, a relationship is set up between aggregate savings and aggregate investment which can be very easily shown, beyond any possibility of reasonable dispute, to be one of exact and necessary equality. Rightly regarded this is a banal conclusion. But it sets in motion a train of thought from which more substantial matters follow. It is shown that, generally speaking, the actual level of output and employment depends, not on the capacity to produce or on the pre-existing level of incomes, but on the current decisions to produce which depend in turn on current decisions to invest and on present expectations of current and prospective consumption.”

    “…and Keynes did not assume prices are constant. ”

    Perhaps, but he did say this on p. 27 of the GT:

    “In this summary we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, with which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money-wages, etc., are liable to change.”

    I am willing to concede your point for the time being, but it seems to me that the above comes close to saying prices are assumed constant, given the relationship between prices and costs.


  1. 1 Irving Fisher Demolishes the Loanable-Funds Theory of Interest | Uneasy Money Trackback on August 7, 2019 at 6:31 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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