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2.8 Keynes’s Main Propositions

In the General Theory Keynes sets out to ‘discover what determines at any

time the national income of a given system and (which is almost the same

thing) the amount of its employment’ (Keynes, 1936, p. 247). In the framework

he constructs, ‘the national income depends on the volume of

employment’. In developing his theory Keynes also attempted to show that

macroeconomic equilibrium is consistent with involuntary unemployment.

The theoretical novelty and central proposition of the book is the principle of

effective demand, together with the equilibrating role of changes in output

rather than prices. The emphasis given to quantity rather than price adjustment

in the General Theory is in sharp contrast to the classical model and

Keynes’s own earlier work contained in his Treatise on Money (1930), where

discrepancies between saving and investment decisions cause the price level

to oscillate.

The development of the building-blocks that were eventually to form the

core ideas of Keynes’s General Theory began to emerge several years before

its construction. As noted above, in 1929 Keynes was arguing in support of

government programmes to expand aggregate demand via deficit financing.

In his famous pamphlet co-authored with Hubert Henderson (1929) Keynes

argued the case for public works programmes in support of Lloyd George’s

1929 election pledge to the nation to reduce unemployment ‘in the course of

a single year to normal proportions’ (see Skidelsky, 1992). However, Keynes

and Henderson were unable to convincingly rebuff the orthodox ‘Treasury

dogma’, expressed by the Chancellor of the Exchequer in 1929 as ‘whatever

might be the political or social advantages, very little additional employment

can, in fact, and as a general rule, be created by State borrowing and State

expenditure’. Implicit in Keynes and Henderson’s arguments in favour of

public works programmes to reduce unemployment was the idea of demanddetermined

output and the concept of an employment multiplier.

The principle of effective demand states that in a closed economy with

spare capacity the level of output (and hence employment) is determined by

aggregate planned expenditure, which consists of two components, consumption

expenditure from the household sector (C) and investment expenditure

from firms (I). In the General Theory there is no explicit analysis of the

effects of variations in spending stimulated either directly by government

expenditure or indirectly via changes in taxation. Hence in the General

Theory there are two sectors (households and firms), and planned expenditure

is given by equation (2.18):

E C I (2.18)

The reader will recall that in the classical model, consumption, saving and

investment are all functions of the interest rate – see equations (2.10) and

(2.11). In Keynes’s model, consumption expenditure is endogenous and essentially

passive, depending as it does on income rather than the interest rate.

Keynes’s theory of the consumption function develops this relationship.

Investment expenditure depends on the expected profitability of investment

and the interest rate which represents the cost of borrowing funds. Keynes

called expected profits the ‘marginal efficiency of capital’. Thus, unavoidably,

in Keynes’s model employment becomes dependent on an unstable

factor, investment expenditure, which is liable to wide and sudden fluctuations.

The dependence of output and employment on investment would not be

so important if investment expenditure were stable from year to year. Unfortunately

the investment decision is a difficult one because machinery and

buildings are bought now to produce goods that will be sold in a future that is

inevitably uncertain. Expectations about future levels of demand and costs

are involved in the calculation, allowing hopes and fears, as well as hard

facts, to influence the decision. Given the volatility of expectations, often

driven by ‘animal spirits’, the expected profitability of capital must also be

highly unstable. That investment decisions could be influenced by tides of

irrational optimism and pessimism, causing large swings in the state of business

confidence, led Keynes to question the efficacy of interest rate adjustments

as a way of influencing the volume of investment. Expectations of the future

profitability of investment are far more important than the rate of interest in

linking the future with the present because: ‘given the psychology of the

public, the level of output and employment as a whole depends on the

amount of investment’, and ‘it is those factors which determine the rate of

investment which are most unreliable, since it is they which are influenced by

our views of the future about which we know so little’ (Keynes, 1937).

The ‘extreme precariousness’ of a firm’s knowledge concerning the prospective

yield of an investment decision lies at the heart of Keynes’s explanation

of the business cycle. In his analysis of instability, ‘violent fluctuations’ in the

marginal efficiency of capital form the shocks which shift real aggregate

demand; that is, the main source of economic fluctuations comes from the

real side of the economy, as described by the IS curve; see Chapter 3, section

3.3.1. From his analysis of the consumption function Keynes developed the

concept of the marginal propensity to consume which plays a crucial role in

determining the size of the multiplier. Because of the multiplier any disturbance

to investment expenditure will have a magnified impact on aggregate

output. This can be shown quite easily as follows. Letting c equal the marginal

propensity to consume (C/Y) and a equal autonomous consumption,

we can write the behavioural equation for consumption as (2.19):

C a cY (2.19)

Remember in Keynes’s model the amount of aggregate consumption is (mainly)

dependent on the amount of aggregate income. Substituting (2.19) into (2.18)

we get the equilibrium condition given by (2.20):

Y a cY I (2.20)

Since Y – cY = a + I and Y – cY = Y(1 – c), we obtain the familiar reducedform

equation (2.21):

Y (a I) /(1−c) (2.21)

where 1/1 – c represents the multiplier. Letting symbolize the multiplier,

we can rewrite equation (2.21) as Y = (a + I). It follows that for a given

change in investment expenditure (I):

Y I(2.22)

Equation (2.22) tells us that income (output) changes by a multiple of the

change in investment expenditure. Keynes defines the investment multiplier

() as the ratio of a change in income to a change in autonomous expenditure

which brought it about: ‘when there is an increment of aggregate investment,

income will increase by an amount which is times the increment in investment’

(Keynes, 1936, p. 115).

Ceteris paribus the multiplier will be larger the smaller the marginal propensity

to save. Therefore the size of the multiplier will depend on the value

of c, and 1 > c > 0. The multiplier effect shows that for an autonomous

demand shift (I) income will initially rise by an equivalent amount. But this

rise in income in turn raises consumption by cI. The second-round increase

in income again raises expenditure by c(cI), which further raises expenditure

and income. So what we have here is an infinite geometric series such

that the full effect of an autonomous change in demand on output is given by

(2.23):

Y I cI c2II(1c c2 c3 ) (2.23)

and (1 + c + c2 + c3 + …) = 1/1 – c. Throughout the above analysis it is

assumed that we are talking about an economy with spare capacity where

firms are able to respond to extra demand by producing more output. Since

more output requires more labour input, the output multiplier implies an

employment multiplier (Kahn, 1931). Hence an increase in autonomous spending

raises output and employment. Starting from a position of less than full

employment, suppose there occurs an increase in the amount of autonomous

investment undertaken in the economy. The increase in investment spending

will result in an increase in employment in firms producing capital goods.

Newly employed workers in capital-goods industries will spend some of their

income on consumption goods and save the rest. The rise in demand for

consumer goods will in turn lead to increased employment in consumergoods

industries and result in further rounds of expenditure. In consequence

an initial rise in autonomous investment produces a more than proportionate

rise in income. The same multiplier process will apply following a change

not only in investment expenditure but also in autonomous consumer expenditure.

In terms of Samuelson’s famous Keynesian cross model, a larger

multiplier will show up as a steeper aggregate expenditure schedule, and vice

versa (see Pearce and Hoover, 1995). Within the Keynesian IS–LM model the

multiplier affects the slope of the IS curve. The IS curve will be flatter the

larger the value of the multiplier, and vice versa (see Chapter 3).

Keynes was well aware of the various factors that could limit the size of

the multiplier effect of his proposed public expenditure programmes, including

the effect of ‘increasing the rate of interest’ unless ‘the monetary authority

take steps to the contrary’ thus crowding out ‘investment in other directions’,

the potential for an adverse effect on ‘confidence’, and the leakage of expenditures

into both taxation and imports in an open economy such as the UK

(see Keynes, 1936, pp. 119–20). In the case of a fully employed economy,

Keynes recognized that any increase in investment will ‘set up a tendency in

money-prices to rise without limit, irrespective of the marginal propensity to

consume’.

Although the concept of the multiplier is most associated with Keynes and

his General Theory, the concept made its first influential appearance in a

memorandum from Richard Kahn to the Economic Advisory Council during

the summer of 1930. Kahn’s more formal presentation appeared in his famous

1931 paper published in the Economic Journal. This article analysed

the impact of an increase in government investment expenditure on employment

assuming that: (1) the economy had spare capacity, (2) there was

monetary policy accommodation, and (3) money wages remained stable.

Kahn’s article was written as a response to the Treasury’s ‘crowding-out’

objections to loan-financed public works expenditures as a method of reducing

unemployment. The following year Jens Warming (1932) criticized, refined

and extended Kahn’s analysis. It was Warming who first brought the idea of a

consumption function into the multiplier literature (see Skidelsky, 1992,

p. 451). The first coherent presentation of the multiplier by Keynes was in a

series of four articles published in The Times in March 1933, entitled ‘The

Means to Prosperity’, followed by an article in the New Statesman in April

entitled ‘The Multiplier’. However, the idea of the multiplier met with considerable

resistance in orthodox financial circles and among fellow economists

wedded to the classical tradition. By 1933, Keynes was attributing this opposition

to the multiplier concept to

the fact that all our ideas about economics … are, whether we are conscious of it

or not, soaked with theoretical pre-suppositions which are only applicable to a

society which is in equilibrium, with all its productive capacity already employed.

Many people are trying to solve the problem of unemployment with a theory

which is based on the assumption that there is no unemployment … these ideas,

perfectly valid in their proper setting, are inapplicable to present circumstances.

(Quoted by Meltzer, 1988, p. 137; see also Dimand, 1988, for an excellent survey

of the development of the multiplier in this period)

There is no doubt that the multiplier process plays a key role in Keynesian

economics. In Patinkin’s (1976) view the development of the multiplier represented

a ‘major step towards the General Theory’ and Skidelsky (1992)

describes the concept of the multiplier as ‘the most notorious piece of

Keynesian magic’. We should also note that the multiplier came to play a key

role in the early post-war Keynesian approach to business cycles. Following

an initial increase in autonomous investment, the rise in income due to the

multiplier process will be reinforced by an increase in new investment, via

the ‘accelerator’ mechanism, which will in turn have a further multiplier

effect on income and so on. Combining the so-called multiplier–accelerator

model with an analysis of ‘ceilings’ and ‘floors’ allows exponents of the

Keynesian approach to business cycles to account for both upper and lower

turning points in the cycle.

Keynes’s explanation of interest rate determination also marked a break with

his classical predecessors. Keynes rejected the idea that the interest rate was

determined by the real forces of thrift and the marginal productivity of capital.

In the General Theory the interest rate is a purely monetary phenomenon

determined by the liquidity preference (demand for money) of the public in

conjunction with the supply of money determined by the monetary authorities.

To the transactions motive for holding money, Keynes added the precautionary

and speculative motives, the last being sensitive to the rate of interest (see

Chapter 3, section 3.3.2). Keynes rejected the classical notion that interest was

the reward for postponed current consumption. For him the rate of interest is

the reward for parting with liquidity or not hoarding for a specified period. In a

world characterized by uncertainty there will always be a speculative motive to

hold cash in preference to other financial assets (such as bonds), and in Keynes’s

view ‘liquidity preference’ will always exert a more powerful influence on the

rate of interest than saving decisions. By introducing the speculative motive

into the money demand function, Keynes made the rate of interest dependent

on the state of confidence as well as the money supply (see Chapter 3). If

liquidity preference can vary, this undermines the classical postulate relating to

the stability of the money demand function. This in turn implies that the

velocity of circulation of money is liable to vary.

The basic structure of Keynes’s theory of effective demand can be understood

with reference to Figure 2.5. From this the reader can see that the

dependence of aggregate output and employment on aggregate expenditure

(C + I) creates the potential for instability, since investment expenditure is

typically unstable owing to the influence of business expectations relating to

an uncertain future. An uncertain future also creates the desire for liquidity,

so that variations in the demand for money as well as changes in the money

supply can influence output and employment. Therefore in Keynes’s model

the classical proposition that the quantity of money is neutral is rejected. An

increase in the money supply, by reducing the rate of interest, can stimulate

aggregate spending via an increase in investment and the subsequent multiplier

effect – see equation (2.22). The relationship can be depicted as follows:

M→−r→I →Y,L (2.23)

It should now be obvious why the title of Keynes’s book is The General

Theory of Employment, Interest and Money. For Keynes it was General

because full employment was a special case and the characteristics of this

special case assumed by classical theory ‘happen not to be those of the

economic society in which we actually live’ (Keynes, 1936, p. 3). However,

Keynes recognized that the power of monetary policy may be limited, particularly

in a deep recession, and there ‘may be several slips between the cup

and the lip’ (Keynes, 1936, p. 173). Should monetary policy prove to be weak

or ineffective, aggregate expenditure could be stimulated directly via government

expenditure or indirectly via tax changes which stimulate consumer

spending by raising household disposable income. In the concluding notes of

the General Theory we get some hints on Keynes’s policy conclusions: ‘The

State will have to exercise a guiding influence on the propensity to consume

partly through its scheme of taxation, partly by fixing the rate of interest, and

partly, perhaps, in other ways’ (Keynes, 1936, p. 378).

But what are the ‘other ways’? In Keynes’s view, because of the chronic

tendency for the propensity to save to exceed the inducement to invest, the

key to reducing aggregate instability was to find ways of stabilizing investment

Figure 2.5 The determination of output and employment

expenditure at a level sufficient to absorb the full employment level of savings.

Keynes’s suggestion that ‘a somewhat comprehensive socialisation of

investment’ would prove the ‘only means of securing an approximation to

full employment’ is open to a wide variety of interpretations (see Meltzer,

1988). That Keynes saw his theory as having ‘moderately conservative’ implications

and at the same time implying a ‘large extension of the traditional

functions of government’ is a perfect example of the kind of ambiguity found

in the General Theory which has allowed for considerable variation of interpretation

in subsequent work.

In our discussion of the classical model we drew attention to three main

aspects of their work: the theory of employment and output determination,

Say’s Law of markets and the quantity theory of money. We can now briefly

examine how Keynes rejected the basic ideas relating to each of these foundations

of classical economics.