On the Monetary Nature of the Principle of Effective Demand

Abstract

Since the publication of The General Theory the relationship between money and the principle of effective demand has been a matter of never-ending studies by the Keynesian economists. There are at least three different ways to explain this relationship. The first explanation lies in the liquidity preference theory. The second, points out that the decisions to accumulate a kind of money differing from a commodity obtained by labor may cause a level of aggregate demand insufficient to absorb the level of income corresponding to full employment. Finally, the third explanation is associated with the endogenous money theory. The first aim of this paper is to highlight the limits of these analyses. The second aim is to present a different explanation of the monetary nature of the principle of effective demand based on Schumpeter’s analytical approach which underlines the role of bank money in a capitalist economy.

KEYWORDS:

• Bank money
• innovations
• Keynes
• Schumpeter
• uncertainty

JEL CLASSIFICATION:

• E12
• E44
• O11

Acknowledgements

The authors would like to thank the two anonymous referees for their very helpful comments that allowed improving significantly this article.

Notes

1 “If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage. […] The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.” (Keynes 1936, 30–31)

2 Pasinetti (2001, 384) forcefully stresses this point: “[…] the principle of effective demand finds no place within the context of the models of mainstream economics, simply because these models are basically shaped on the characteristics of pure exchange (and thus more primitive) economies. […] [the principle of effective demand] emerges as crucial in monetary production economies, by which I mean economies where the economic activity is aimed at the production of commodities, which are normally transacted by means of non produced means of exchange, which may at any moment be spent or simply held as a store of abstract (and thus non effective) purchasing power.”

3 Many economists have stressed the limits of the liquidity preference theory. Kurz (2013, 67–68), for example, recalls Sraffa’s doubts about the relevance of a criticism of the neoclassical theory based on the liquidity preference theory. Also Kaldor (1982: 26) concludes that the liquidity preference theory has no role in the explanation of the existence of involuntary unemployment. On this point, see Bertocco (2001, 2010).

4 See, for example, Bernanke (2015), Constâncio (2016), Draghi (2016a, 2016b), and Bertocco and Kalajzić (2018a).

5 “I would suggest that what has gone on, certainly in recent years, and for quite long time, is that there have been a variety of structural changes in the economies of the industrial world that lead to an increasing propensity to save, a decreasing propensity to invest, and, as a consequence, lower equilibrium rates; as a consequence, less aggregate demand and disappointing growth performance; and, as a consequence, less upward inflationary pressure.” (Summers 2015, 10; see also Summers (2018), Eichengreen (2015), Seccareccia and Lavoie (2016), and Bresser-Pereira (2019).

6 Since the ‘natural’ rate of interest is not observable, economists have developed some methodologies to estimate its value. As explained by Summers, these methodologies are based on the following immutable idea: “You look at what the real rate is and if the economy is soft and inflation is falling, then you say the actual equilibrium rate is lower. If the economy is fast and inflation is accelerating, then you say that the rate we see is below the equilibrium real rate […].” (Summers 2015, 14)

7 “In actual fact under a gold standard gold can be produced, and in a slump there will be some diversion of employment towards gold mining. If, indeed, it were easily practicable to divert output towards gold on a sufficient scale for the value of the increased current output of gold to make good for the deficiency in expenditure in other forms of current output, unemployment could not occur […].” (Keynes 1933b, 85–86)

8 Davidson (1994, 95) has explained this thesis with the following example: “Suppose because the future suddenly appears more uncertain, people decide to buy fewer space vehicles (automobiles) to transport themselves geographically and instead demand more time vehicles to convey their purchasing power to an unspecified future time to meet possible liquidity needs. The decreased demand for space vehicles causes unemployment in the economy’s auto factories. The increased demand for liquidity does not induce an offsetting increase in employment in the production of money or any good producible in the private sector. Of course, if peanuts were money […] then unemployment in the auto industry would be offset by increased employment in the peanut farms. Uncertainty and unwillingness to commit earned income to current purchases of producibles (a process that the layperson terms savings) will cause unemployment, if, and only if, the object of the savers’ desire is a resting place for their savings that is non producible and not readily substitutable for producibles—even if prices are flexible.”

9 See, for example, Palley (2002) and Bertocco (2010).

10 “[…] a Monetary Circuit perfectly fits the major characteristics of the Monetary Production economy Keynes had in mind in the Treatise, in the first draft of the General Theory, and in the General Theory itself […].” (Parguez 1996, 158)

11 “In the perspective of the circuit theory […] the starting point for a construction of a macroeconomic model can only be the identification of the social groups present in the community. […] circuit theorists introduce a preliminary distinction between producers and wage earners, producers having access to bank credit and wage earners being excluded from it. The two groups enter the market having different initial endowments.” (Graziani 2003, 19)

12 For a description of the monetary circuit, in addition to Graziani’s works, see, for example: Parguez and Seccareccia (1999) and the essays contained in Deleplace and Nell (1996), Arena and Salvadori (2004), Fontana and Realfonzo (2005), Rochon and Rossi (2003), and Rochon and Seccareccia (2013).

13 “The principle of consumers’ preferences […] is unknown to the theory of the circuit. Here the traces of Schumpeter’s teaching can be detected once more.” (Graziani 1989, 22)

14 “An important point […] is that finance requirements […] are not specifically connected with investment activity. The problem of financing investment is a different one, appearing […] not at the beginning but at the end of the economic circuit.” (Graziani 1989, 6)

15 “… it is the carrying out of new combination that constitutes the entrepreneur’ (Schumpeter 1912, 74)

16 Many circuit theorists recognize the importance of Schumpeter’s analysis. See, for example, Zazzaro (2003), Messori (2004, 2014), Messori and Zazzaro (2005), Bellofiore (2005), and Rochon (2005).

17 “[O]utside these accustomed channels the individual is without those data for his decisions and those rules of conduct which are usually very accurately known to him within them. Of course he must still foresee and estimate on the basis of his experience. But many things must remain uncertain, still others are only ascertainable within wide limits, some can perhaps only be “guessed”. In particular this is true of those data which the individual strives to alter and of those which he wants to create. […] Carrying out a new plan and acting according to a customary one are things as different as making a road and walking along it.” (Schumpeter 1912, 84–85)

18 On this point, Graziani (1991, 17) for example observes that: “It is now accepted that there is a link of interdependence between liquid stocks and uncertainty. In the sense that in a world without uncertainty and frictions […] there would be no valid reason to demand a liquid stock. But, once the link between money demand and uncertainty has been accepted, it remains doubtful whether it should be understood that uncertainty imposes the transition to an economy based on money exchanges, or whether the shift to monetary exchanges has led to the economy of uncertainty.”

19 Even in a corn economy farmers can go bankrupt because of bad weather, wars, earthquakes or plagues, phenomena that Schumpeter (1939, 1) defined as “factors which act without the economic sphere (external factors)”. These factors should thus be excluded from the economic analysis.

20 “In a real-wage and co-operative economy there is no obstacle in the way of the employment of an additional unit of labour if this unit will add to the social product output expected to have an exchange value equal to 10 bushels of wheat, which is sufficient to balance the disutility of the additional employment. But in a money-wage or entrepreneur economy the criterion is different. Production will only take place if the expenditure of £100 in hiring factors of production will yield an output which is expected to sell for at least £100.” (Keynes 1933b, 78)

21 The prospective returns of capital consist of: “… the series of prospective returns which a [man] expects to obtain from selling its output […]” (Keynes 1936, 135).

22 “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London, amounts to little and sometimes to nothing; or even five years hence.” (Keynes 1936, 149–150)

23 The number of agricultural workers will be defined later on.

24 Many circuit theorists have underlined the need to build models in which the initial finance does not fund only production, but also investments. See, for example, Rochon (2005), Gnos (2005), Bougrine and Seccareccia (2013), Sardoni (2017), and Cesaratto (2017).

25 Even the production decisions of farmers are taken under conditions of uncertainty. In fact, farmers take their decision on the employment of agricultural workers based on their expectations about the number of workers that will be hired to carry out investments-innovations. Equation 4), which specifies $N_{ag},$ should therefore include the level of income expected by the farmers $\left(Y^e\right)$ instead of the actual level of income $\left(Y\right).$ For the sake of simplicity, the model was built under the assumption that $Y^e=Y.$

26 Given that $Y=C+I,$ that $C=w{N}_{ag}$ and that $I=L^{*}=w{N}_i,$ we obtain $Y=w(N_{ag}+N_i)$ and $Y/w=N.$

27 This result is consistent with the conclusions reached by Kalecki (1954).

28 After criticizing the concept of ‘forced savings’, in the General Theory Keynes describes the relationship between bank money, investment decisions and saving decisions in the following way: “The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequence of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased. […] Moreover, except in conditions of full employment, there will be an increase of real income as well as of money-income. The public will exercise a ‘free choice’ as to the proportion in which they divide their increase of income between saving and spending. […] Moreover, the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold money rather than some other form of wealth.” (Keynes 1936, 82–83)

29 In the example described in this paragraph investments coincide with innovations. It is obviously possible to consider investments consisting of capital goods. However, the objective of the example is to show that the presence of innovations represents a necessary condition within a monetary economy where the ‘natural’ rate of interest does not exist and the principle of effective demand holds.

30 The first two characteristics of a monetary economy can be synthesized as follows: i) the availability of money represents the necessary condition to produce goods and to introduce innovations; ii) the use of money changes the characteristics of productive processes and monetary values constitute the necessary and sufficient elements to define costs, revenues, and profits.

31 As underlined by Keynes, a saver is a wealth holder who first chooses how much to save, and then chooses “in what form he will hold the command over future consumption which he has reserved, whether out of his current income or from previous savings” (Keynes 1936, 166).

32 For an analysis of the endogenous nature of economic crises, see Bertocco (2017), and Bertocco and Kalajzić (2018b).

Additional information

Notes on contributors

Giancarlo Bertocco

Giancarlo Bertocco is senior professor of Macroeconomics and Monetary Economics at the Department of Economics, University of Insubria, Varese, Italy.

Andrea Kalajzić

Andrea Kalajzić, PhD, is at the University of Insubria, Varese, Italy.