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8.2 The Significance of the Principle of Effective Demand

Post Keynesian economics accepts Keynes’s (1936, chap. 2) ‘Principle of

Effective Demand’ as the basis for all macroeconomic theory that is applicable

to an entrepreneurial economy. Keynes was primarily a monetary theorist.

The words money, currency and monetary appear in the titles of most of his

major volumes in economics. Post Keynesian theory evolves from Keynes’s

revolutionary approach to analysing a money-using, entrepreneur economy.

Addressing the General Theory chiefly to his ‘fellow economists’ (Keynes,

1936, p. v), Keynes insisted that:

the postulates of the classical theory are applicable to a special case only and not

to the general case … Moreover, the characteristics of the special case assumed by

the classical theory happen not to be those of the economic society in which we

actually live, with the result that its teaching is misleading and disastrous if we

attempt to apply it to the facts of experience. (Keynes, 1936, p. 3)

Elsewhere I (Davidson, 1984) have argued that all variants of mainstream

macroeconomic theory, whether it be rational expectations (new classical)

theory, monetarism (old classical theory), old (neoclassical synthesis)

Keynesian or new Keynesian theory, are founded on three fundamental classical

postulates and, as Keynes specifically noted:

the classical theory is only applicable to full employment, [and therefore] it is

fallacious to apply it to the problems of involuntary unemployment. … The

classical theorists resemble Euclidean geometers in a non-Euclidean world, discovering

that in experience straight lines apparently parallel often meet, rebuke

the lines for not keeping straight – as the only remedy for the unfortunate collisions

that are occurring. Yet in truth there is no remedy except to throw over the

axiom of parallels and to work out a non-Euclidean geometry. Something similar

is required today in economics. (Keynes, 1936, p. 16)

Keynes’s principle of effective demand basically overturned three restrictive

classical postulates. Once freed of these postulates, Keynes (1936, p. 26) could

logically demonstrate why Say’s Law is not a ‘true law’ when we model an

economy which possesses real-world characteristics; and until we get our

theory to accurately mirror and apply to the ‘facts of experience’, there is little

hope of getting our policies right. That message is just as relevant today.

To throw over an axiom is to reject what the faithful believe are ‘universal

truths’. Keynes’s revolution in economic theory was therefore truly a revolt

since it aimed at rejecting basic mainstream axioms in order to develop a

logical foundation for a non-Say’s Law model more closely related to the real

world in which we happen to live. In the light of Keynes’s analogy to

geometry, Post Keynesian theory might be called non-Euclidean economics!

The restrictive classical axioms rejected by Keynes in his revolutionary

logical analysis were (i) the gross substitution axiom, (ii) the neutrality of

money axiom and (iii) the axiom of an ergodic economic world. The characteristics

of the real world which Keynes believed could be modelled only by

overthrowing these axioms are:

1. money matters in the long and short run; that is money and liquidity

preference are not neutral, they affect real decision making;

2. the economic system is moving through calendar time from an irrevocable

past to an uncertain future. Important decisions involving production,

investment and consumption activities are, therefore, often taken in an

uncertain environment;

3. forward contracts in money terms 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.

Modern production economies are on a money-wage contract based system,

or what Keynes called an ‘entrepreneur system’; and

4. unemployment, rather than full employment, is a common laissez-faire

situation in a market-oriented, monetary production economy.