Keynes’ treatment of dynamics and stability in a monetary economy: the role played by expectations from the Tract on Monetary Reform to the General Theory

Abstract

Contrary to the commonly accepted view, Keynes’ static treatment of the effective demand principle in his General Theory should be considered more as an achievement than as an incomplete proof. The Tract investigated the fluctuations due to short-term forecasting errors. Next, the Treatise extended the analysis of expectations’ mismatches to the determination of the level of investment. Hence the major achievement of the General Theory can be located in its demonstration of the possible existence of an underemployment equilibrium due to the indeterminacy of long-term expectations.

Keywords:

• Dynamics
• equilibrium
• expectations
• stability
• trade cycle

JEL codes:

• B22
• B31
• E12

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 As the title suggests, the Tract proposes practical remedies for the monetary disturbances faced by Great Britain in the early 1920s. Any return to the gold standard at a pre-war parity implied a large internal adjustment through significant cuts in retail prices and costs of production.

2 Keynes’ Q₂ (i.e. the level of profit in the investment goods sector) then resembles Tobin’s q (Tobin 1969), which is the ratio of the investment value to its costs of production (I/I’ in Keynes’ notation, with I the market value of investment and I’ its production cost).

3 See Harrod (1939, 1948) and Domar (1947).

4 “For if competition between unemployed workers always led to a very great reduction of the money-wage, there would be a violent instability in the price-level. Moreover, there might be no position of stable equilibrium expect in conditions consistent with full employment; since the wage-unit might have to fall without limit until it reached a point where the effect of the abundance of money in terms of the wage-unit on the rate of interest was sufficient to restore a level of full employment” (General Theory, p. 253). On this issue, see Dos Santos Ferreira (2000, 2014) and Leijonhufvud (1968).

5 “Even those degrees of recovery and recession, which can occur within the limitations set by our other conditions of stability, will be likely, if they persist for a sufficient length of time and are not interfered with by changes in the other factors, to cause a reverse movement in the opposite direction, until the same forces as before again reverse the direction” (General Theory, p. 254).

6 “It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all if we know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ” (General Theory, p. 172).

7 As a matter of fact, “Samuelson used it, between 1937 and 1940, in Harvard’s Fiscal Policy Seminars to show people like Alvin Hansen what their insights really were” (Backhouse 2002, 410). In addition, see Boianovsky (2009) for an analysis of Samuelson’s treatment of dynamic issues.

8 On this issue, see Boianovsky (2002).

9 But as noted by Backhouse (2002, 410): “Though he did not draw a graph to show these two functions [the aggregate supply function Z = Φ(N) and the aggregate demand function D = f(N)], [Keynes] argued that D would rise less than income, and that the gap between Φ(N) and f(N) would increase as employment and output rose. It can therefore be argued that the revolutionary element in Keynes’ analysis is the part described by the Keynesian cross”.

10 See Tobin (1975).

11 In Leijonhufvud’s words: “The essence of Keynes’s diagnosis of depression is this: the actual disequilibrium price vector initiating the contraction differs from the appropriate, hypothetical equilibrium vector in one major respect – the general level of long-term asset prices is lower than warranted” (Leijonhufvud 1968, pp. 335-6; emphasis in the original).

12 Leijonhufvud (1973) had already argued for the existence of a “corridor” of stability in a decentralised market-economy; the system might be able to absorb ‘small’ shocks by itself. In that case private agents, and crucially investors and entrepreneurs, are expecting the end of the deflationary process; the fall in wages and prices is viewed as definitive. But the problem becomes much more serious in the case of large and protracted shocks.

13 Bruno and Dimand (2009) provide Tobin’s stability conditions, which depend on the level of the nominal rate of interest.

14 While De Long and Summers followed in the footsteps of Fisher (1923, 1925) to argue that increased wage and price stability can easily been destabilising, Driskill and Sheffrin (1986) argued the contrary by introducing a real interest rate into aggregate demand. The latter showed that an increase in expected inflation can lower the current interest rate, thus increase output and employment. Later on, Minsky (1982, 1986) also argued that the width of the corridor depends on the evolution of the economic system’s financial structure through the trade cycle (Dimand 2005).