The Failure of Classical Theory According to Keynes
In John Maynard Keynes' The General Theory of Employment, Interest and Money, he writes with a retrospective view on classical capitalist theory and its possible correlation to the depression in the U.S. and Europe in the 1920's and 30's. Keynes believes, contrary to classical theorists such as Smith and Ricardo, the contention of an automatic linkage between supply and demand, most notably proposed by Say's Law, applies only to "special circumstances" and not "those of the economic society in which we actually live." In addition to its inapplicability, classical theory, he argues, which encourages the market to strive for the condition of full employment, in which wage rates bring into equilibrium the supply and demand for labor in conjunction with the point at which subsequent increases in capital equipment will cease to yield greater returns, inevitably leads to high unemployment and low investment. Keynes' argument, despite its complex rhetoric, conveys a relatively simply message, namely that classical capitalist theory ignores two key elements of the market, those being: aggregate supply is a function of effective, not effectual demand and is determined by the expectations of the producer; and propensity to consume does
Thus, a change in any of these variables, which clearly exist in a state of interdependence, undoubtedly affects the market as a whole. Since every dollar not earned from the sale of goods becomes savings, the money supply remains constant, thus maintaining the equilibrium interest rate at the level at which capitalists' propensity to invest remains at its highest point. Keynes writes that the desire to hold money, while indicated by the interest rate, also depends on three motives: the transactions-motive, the precautionary motive, and the speculative motive. Liquidity preference determines the propensity of the consumer to not save excess income, but rather hold it in the form of liquid currency (cash), and fluctuates inversely with the rate of interest. Keynes does not argue that, should these conditions be met, classical theory would remain defunct. For due to an increase or decrease in total income, consumption will vary accordingly, and from the expectations of the market as a whole, so aggregate supply does as well. In conclusion, classical capitalist theory, as viewed by Keynes, fails to recognize the significance of the psychological factors of the market that determine actual supply and demand. Indeed, these prerequisites provide the framework for classical capitalist theory; for without such conditions, full employment would not provide maximum gains, as a gap between the wage rate and marginal productivity would, by definition, result in a loss somewhere between production and consumption. Thus, the behavior of the market, guided by propensity to consume, effective demand, and the level of employment, reflects the respective influence of each of these factors on the others. Thus, the levels of output and employment vary respectively, and according to, those amounts that will achieve the greatest possible returns for the producer and do so without the necessity of coincidence with subsequent fluctuations in the actual desire to consume. The decrease in employment or the wage rate results in a lower total income, and in turn, propensity to consume falls as well. This point, referred to by Keynes as the propensity to consume, does not fluctuate as a result of quantitative changes in supply, but rather due to the uncertainty or optimism of the consumer with regard to personal or economic future. According to Keynes, the propensity to consume fluctuates most directly with the amount of money present in the economy, an amount determined almost solely by the level of employment.
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