Explaining the aggregate price level with Keynes's principle of effective demand

Abstract

The mainstream view of Keynes's principle of effective demand is that it states something about quantities—and about quantities only. The principle is held to determine the levels of output and employment in a world not governed by Say's law. This paper argues that the principle of effective demand goes beyond this to explain not only ‘real’ activity levels but also the aggregate price level. A variant of the post-Keynesian D/Z-model is brought together with Marxian reproduction schemes to derive this result.

Keywords:

• effective demand
• multiplier
• post-Keynesianism
• D/Z-model
• reproduction schemes

Acknowledgements

I would like to thank Michael E. Brady, Dany Lang, Marc Lavoie, Roy Rotheim, Mark Setterfield, and two anonymous referees of this journal for helpful comments and suggestions. Any remaining errors are my own.

Notes

1 Keynes takes as “given”“the existing skill and quantity of available labour, the existing quality and quantity of available equipment, the existing technique, the degree of competition, the tastes and habits of the consumer, the disutility of different intensities of labour and of the activities of supervision and organisation, as well as the social structure including the forces, other than our variables set forth below [i.e. the independent variables], which determine the distribution of income” (Keynes 1973a: 245). His “independent” variables are “the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest” (ibid.). In this context, Keynes mentions that to classify a factor as “given” does not mean that this factor is assumed to be constant. This is important since the provisional inclusion of the nominal wage rate among the “given” variables by Keynes (cf. Keynes 1973a: 27) has been interpreted by many as an indication that his theory relied on the assumption of wage rigidity.

2 King (1994) scrutinizes the early stages of non-post-Keynesian aggregate supply and demand analysis. “To conclude that there was some confusion about aggregate supply and demand analysis in the early 1950s would be a grotesque understatement”, he resumes (14).

3 This distinction is also made by Wells (1962, 1978, 1987), Chick (1983), and Amadeo (1989). “Two-price approaches” can also be found in Minsky (1975: Ch. 5), who distinguishes demand prices and supply prices of capital assets in order to explain the level of investment spending, and in Dalziel (2001: Ch. 6), who sketches a two-price multiplier.

4 Fontana (2004: 79) notes: “Besides, as he [Hicks] explains, when agents make decisions they have in mind a stage-by-stage temporal frame. It was not only for theoretical convenience but also for the realism of the study that period analysis had to be considered superior to continuous analysis.”

5 Nell presents the same argument somewhat differently: “‘Continuous output’ should not be overstressed. Even under Mass Production the seasons, traditional holidays and social customs provide a framework that sets definitive marketing dates toward which manufactures aim. … So, while under continuous production there need be no common starting and finishing points, these will often exist, nevertheless” (Nell 1998: 205).

6 Victoria Chick was right to point out: “Effective demand is an unfortunate term, for it really refers to the output that will be supplied; in general there is no assurance that it will also be demanded” (Chick 1983: 65).

7 Price reactions that clear goods markets can be expected mainly in case of underproduction, whereas an addition to stocks should be entrepreneurs' typical short-run response to an overproduction, cf. also Keynes (1973a: 51, fn. 1).

8 As is well known, Keynes adhered to several (neo)classical assumptions. His acceptance of the “first classical postulate” (cf. Keynes 1973a: 17 – 18) implies three assumptions that stem from (neo)classical theory. First, competition is assumed to be perfect or at least “free” (in a Marshallian sense). This means that firms are unable to dictate the market price for the commodities they produce—or, put another way, that entrepreneurs expect to face an infinitely price-elastic demand. The second assumption is that firms maximize profits. Finally, decreasing marginal returns to labour are assumed; cf. Roberts (1978: 558), Koenig (1980: 447), Amadeo (1989: 13), and Palley (1997: 296).

9 Cf. Davidson (1962: 454).

10 As has been pointed out by Wells (1962) and Amadeo (1989: 105), the slopes of D and Z depend crucially on the assumptions made about the “production function”—in other words: about the marginal product of labour.

11 Few scholars have so far considered this solution. It is implied in Koenig (1980: 437, 454) and explicit in Wells (1978: 319). But Casarosa (1981: 192) believes the solution to be “completely incompatible with the theory of the firm operating in an atomistic (let alone perfectly competitive) market”, and claims that “the notion that the expected demand function is the producers' estimate of the expenditure function is clearly a theoretical aberration which has strangely survived” (ibid.). Casarosa is right that the notion of firms forming ex ante expectations about their market share is incompatible with the microeconomic theory of the small firm operating under perfect competition, cf. also Asimakopulos (1991: 43 – 44). But Keynes—who was concerned with the real world—did not have such firms in mind. In his theory, firms are not “atomistic”, but also not powerful enough to dictate the price. They have to form expectations about the price for their products the market will accept and about the market share that might be attributable to them, cf. also Torr (1984: 939). Chick (1983: 24 – 26) and elaborated in Chick (1992) points out that price-taking is impossible, even for the small firm, under uncertainty and in the latter proposes an approach which keeps the small firm but scraps price-taking. This resembles Richard Kahn's (1989: 12 – 13—although written 1929) notion of “polypoly”, where there are many small firms in a market, but differences of market prices may nevertheless persist over an appreciable period of time. (I am indebted to a referee for pointing this out to me.)

12 As to the shapes of D and Z the following should be noted: Z may be a linear function of N even under decreasing marginal returns (see above). It will be a straight line under constant returns, with the slope given by the wage rate. In this case, the D-curve, too, will be a linear function of N, with the slope given by the marginal propensity to consume multiplied by the expected demand price level and by the (constant) marginal product of labor. Note that the case of increasing returns cannot be handled well with the D/Z-diagram because if the Z-curve becomes concave, and the D-curve becomes convex, then the two curves do not intersect, and there is no point of effective demand.

13 In terms of Marx (1973b: Chs 20 – 21) Department I produces investment goods, and Department II produces consumption goods. c denotes the average rate of consumption (which equals the marginal propensity to consume if there is no “autonomous consumption” and no non-linearity in the consumption function).

14 Note that, in the absence of productivity growth and cuts in the wage unit, entrepreneurs will only expand employment in reaction to a higher (expected) aggregate demand if they expect that the higher marginal costs can be covered by a higher demand price per unit of output. We can conclude that the D-curve can only shift to the top if there is (also) a shift in the price component inherent in it (cf. Koenig 1980: 445). Keynes seems to have believed that the higher supply price necessary to accommodate higher marginal costs would always be accepted by the market if the economy was to expand. He wrote: “(T)here cannot be rising output without rising prices” (Keynes 1965: 33).

15 Accumulation of inventories is a feasible short-run reaction, but it cannot be sustained forever. Sooner or later, the entrepreneurs will have to revise their expectations as to the price level that is accepted by the market downward in the situation depicted here—or else they will be out of business. Concomitantly, demand prices will go down.

16 Hartwig (2004) relaxes this simplifying assumption and also incorporates constant capital into the scheme; but for the purpose of the present paper it is not necessary to introduce these complications. Also, we assume away the government and foreign sectors for expositional ease.

17 Indeed, it is a precondition for “completely successful reproduction” that no-one hoards, cf. Rochon (1999: 35)—or Marx (1973a: 127 – 128, 487), who points out that interruption to the circulation of money will result in crisis.

18 Note that in Marx's examples in Ch. 21 of Capital, Volume 2, the marginal propensities to save are not equal for the capitalists of Departments I and II. (Workers do not save here.) While, in Marx's schemes, the propensity to save remains constant for the capitalists of Department I, it has to grow continually for the capitalists of Department II to finance accumulation. This seems to be hardly a realistic assumption.

19 Nell (2002: 523) argues that, as a minimum requirement for completing the circuit of payments in each period, only the wage bill of Department I needs to be advanced. The entrepreneurs of Department II need not start paying their own workers until they have received revenue from the sale of consumption goods to Department I. In this case the entrepreneurs of Department II can economize on borrowing costs.

20 Authors who aim at marrying the income-expenditure circuit, credit-money, and the multiplier include Chick (1997), and Dalziel (2001).

21 The value of constant capital transferred onto the output (i.e. total depreciation) equals (in terms of Ch. 6 of the General Theory) the sum of user cost and supplementary cost minus what modern production accounts (not Keynes) call ‘intermediate transactions'. Millar (1972) has translated Keynes's Chapter 6 definitions into the terms of modern national accounts.