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8.5 Can Relative Price Changes Induce D2 to Fill the Gap?

Keynes’s primary level of attack on classical theory involved the expansion

of demand into two distinct classes with different determinants. Keynes’s

claim that the classical demand relationship, where all spending was related

and equal to income, is required to validate Say’s Law and this classically

assumed demand relationship was not compatible with ‘the facts of experience’.

The next step required Keynes to demonstrate that a change in relative

prices via a gross substitution effect could not resurrect Say’s Law. In classical

theory, all income earned in any accounting period is divided – on the

basis of time preference – between spending income on currently produced

consumption goods and services and spending on current investment goods

that will be used to produce goods for future consumption. In other words, all

income earned in this period is always spent on the current products of

industry. In Keynes’s analysis, however, time preference determines how

much of current income is spent on currently produced consumption goods

and how much is not spent on consumption goods but is instead saved by

purchasing liquid assets. Accordingly, in Keynes’s system, there is a second

decision step, liquidity preference, where the income earner determines in

what liquid assets should his/her saved income be stored in order to be used

to transfer purchasing power of saving to a future time period. Since all

liquid assets have certain essential properties (Keynes, 1936, chap. 17) –

namely they are non-producible and non-substitutable for the products of

industry, the demand for liquid assets does not per se create a demand for the

products of industry.

Keynes developed his theory of liquidity preference in order to demonstrate

that any explanation of involuntary unemployment required specifying

‘The Essential Properties of Interest and Money’ (Keynes, 1936, chap. 17),

which differentiates his theory from old classical, new classical, old Keynesian

and new Keynesian theory, that is, from all mainstream macroeconomic

theories not only in Keynes’s time but in mainstream economics of the

twenty-first century.

These essential properties are:

1. the elasticity of productivity of all liquid assets including money was

zero or negligible; and

2. the elasticity of substitution between liquid assets (including money) and

reproducible goods was zero or negligible.

The zero elasticity of productivity of money means that when the demand

for money (liquidity) increases, entrepreneurs cannot hire labour to produce

more money to meet this change in demand for a non-reproducible (in the

private sector) good. In other words, a zero elasticity of productivity means

that money does not grow on trees! In classical theory, on the other hand,

money is either a reproducible commodity or the existence of money does not

affect, in any way, the demand for producible goods and services; that is,

money is neutral (by assumption). In many neoclassical textbook models,

peanuts are the money commodity or numeraire. Peanuts may not grow on

trees, but they do grow on the roots of bushes. The supply of peanuts can

easily be augmented by the hiring of additional workers by private sector

entrepreneurs.

The zero elasticity of substitution ensures that the portion of income that is

not spent on consumption producibles will find, in Frank Hahn’s terminology,

‘resting places’ in the demand for non-producibles. Some forty years

after Keynes, Hahn rediscovered Keynes’s point that Say’s Law would be

violated and involuntary unemployment could occur whenever there are ‘resting

places for savings in other than reproducible assets’ (Hahn, 1977, p. 31).

The existence of non-reproducible goods that would be demanded for stores

of new ‘savings’ means that all income earned by engaging in the production

of goods is not, in the short or long run, necessarily spent on products

producible by labour.

If the gross substitution axiom were applicable, however, any new savings

would increase the price of non-producibles (whose supply curve is, by

definition, perfectly inelastic). This relative price rise in non-producibles

would, under the gross substitution axiom, induce savers to substitute reproducible

durables for non-producibles in their wealth holdings and therefore

non-producibles could not be ultimate resting places for savings. As the price

of non-reproducibles rose the demand for these non-producibles would spill

over into a demand for producible goods (see Davidson, 1972, 1977, 1980).

Thus the acceptance of the gross substitution axiom denies the logical possibility

of involuntary unemployment as long as all prices are perfectly flexible.

To overthrow the axiom of gross substitution in an intertemporal context is

truly heretical. It changes the entire perspective as to what is meant by

‘rational’ or ‘optimal’ savings, as to why people save or what they save. For

example, it would deny the life cycle hypothesis. Indeed, Danziger et al.

(1982–3) have shown that the facts regarding consumption spending by the

elderly are incompatible with the notion of intertemporal gross substitution

of consumption plans which underlie both life cycle models and overlapping

generation models currently so popular in mainstream macroeconomic theory.

In the absence of a universal axiom of gross substitution, however, income

effects (for example the Keynesian multiplier) predominate and can swamp

any hypothetical classical substitution effects. Just as in non-Euclidean geometry

lines that are apparently parallel often crash into each other, in the

Keynes–Post Keynesian non-Euclidean economic world, an increased demand

for ‘savings’, even if it raises the relative price of non-producibles, will

not spill over into a demand for producible goods.