Alfred Marshall Principles of Economics (1890) vs John Maynard Keynes The General Theory (1936)

ALFRED MARSHALL Mr. Supply & Demand JOHN M. KEYNES Mr. Income-Expenditure

For a wholly private economy……………..……………. Marshall Keynes Does “equilibrium” entail an equality between S and I? Is there a market process that results in that equality? How does a market economy make the adjustment? Is the adjustment consistent with prosperity? What should the government do about it? YES Interest rateIncome YESDoubt it. Nothing (Laissez Faire) Manipulate

I = I o S = -a + (1-b)Y Y = E S = I It’s not just that S = -a + (1 – b)Y, It’s that S = -a + (1 – b)Y, PERIOD!!! S doesn’t depend on the rate of interest. And I doesn’t depend on the interest rate either!

The Market for Loanable Funds “Loanable funds” is the generic term that refers to both lending (which constitutes the supply side of the market) and borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds.

The Market for Loanable Funds “Loanable funds” is the generic term that refers to both lending (which constitutes the supply side of the market) and borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds. Borrowing by the business community constitutes the demand.

The Market for Loanable Funds “Loanable funds” is the generic term that refers to both lending (which constitutes the supply side of the market) and borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds. This market is better thought of as the market for investable resources. It keeps the macroeconomically relevant concepts of saving (S) and investment (I) in balance. The quantity axis measures saving (and investment) as the amount of output produced in a given period and made available for (and actually used for) the expansion of the economy’s productive capacity. S = I Borrowing by the business community constitutes the demand.

Suppose that people become more thrifty; they choose to save more.

-a -a’

Suppose that people become more thrifty; they choose to save more. -a’ -a

The market at work for you and for me. The market at work to the detriment of us all. -a -a’ “Every... attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.” --from The General Theory, In other words, by trying to increase your saving out of a given income, you will only decrease your income and struggle to save as much as you saved before. This is Keynes’s “Paradox of Thrift.

The General Theory of Employment, Interest, and Money John Maynard Keynes 1936

John Maynard Keynes on Consumption

“The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.” John Maynard Keynes, The General Theory, 1936, p. 96.

...men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. C = a + bY, where “b” is less than 1 If income (Y) increases by  Y, then consumption (C) increases by b  Y. For b = 0.75, if income increases by 200, consumption increases by 150.

John Maynard Keynes on Saving

“The influence of [the interest rate] on the rate of spending [and hence on the rate of saving] out of a given income is open to a good deal of doubt.” John Maynard Keynes, The General Theory, 1936, p. 93.

“It has long been recognized … that the total effect of changes in the rate of interest on the readiness to spend on present consumption is complex and uncertain, being dependent on conflicting tendencies, since some of the subjective motives towards saving will be more easily satisfied if the rate of interest rises, whilst others will be weakened.” John Maynard Keynes, The General Theory, 1936, p. 93.

“There are not many people who will alter their way of living because the rate of interest has fallen from 5 to 4 percent....” “[T]he main conclusion suggested by experience is, I think, that the short-period influence of the rate of interest on individual spending [and hence on individual saving] out of a given income is secondary and relatively unimportant…” John Maynard Keynes, The General Theory, 1936, p. 94.

What Keynes might well have written: Though not responsive to changes in the interest rate, men are disposed, as a rule and on the average, to increase their saving as their income increases, but not by as much as the increase in their income. In other words, when people earn more, they spend more and they save more.

...men are disposed, as a rule and on the average, to increase their saving as their income increases, but not by as much as the increase in their income. S = -a + (1 - b)Y, where “b” is less than 1 If income (Y) increases by  Y, then saving (S) increases by (1 - b)  Y. For b = 0.75 (and hence 1 - b = 0.25), if Y increases by 200, S increases by 50.

[When their incomes fall temporarily to zero]...men are disposed, as a rule and on the average, to do some spending (a) out of accumulated savings, which means that they dissave (-a) by that same amount. C = a + bY, where “a” is greater than 0 S = -a + (1 - b)Y, where “-a” is less than 0 When income is temporarily zero, then consumption is “a” and (dis)saving is “-a.”

John Maynard Keynes on Investment

“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits ---of a spontaneous urge to action rather than inaction, and not as an outcome of [economic calculation].” John Maynard Keynes, The General Theory, 1936, p. 161.

“Only a little more than an expedition to the South Pole is [investment] based on exact benefits to come. Thus if the animal spirits are dimmed and spontaneous optimism falters, leaving us to depend upon nothing but a mathematical expectation, enterprise will fade and die;--though fears of loss may have a basis no more reasonable than hopes of profit had before.” John Maynard Keynes, The General Theory, 1936, p. 162.

“[I]ndividual initiative will be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience ultimately tells us and them, is put aside as a healthy man puts aside the expectation of death.” John Maynard Keynes, The General Theory, 1936, p. 162.

So, we have it from Keynes that C is based solely on Y. S is what’s left over; it’s a residual. I is determined by “animal spirits.” Where do we go from here?

The General Theory of Employment, Interest, and Money John Maynard Keynes 1936