The General Theory of Employment, Interest, and Money

john maynard keynes.

the general theory of employment, interest, and money.

curious about why governments intervene in economies during a crisis like the great depression or the 2008 recession?

the general theory of employment, interest, and money by john maynard keynes might have the answers.

first published in 1936, this book introduced fresh, unconventional ideas that shook the economic world.

instead of the then-popular idea that economies balance themselves out, keynes argued that lack of demand could lead to high joblessness for extended periods.

so he believed that governments needed to step in, let's say by spending money, to help boost demand.

the book dives deep into why we prefer to keep some cash handy—liquidity preference— the balance between wanting to spend or save—marginal utility—how demand affects economic output—principle of effective demand— and how spending can multiply and stimulate the economy—the multiplier effect.

think this all sounds too geeky?

don't worry.

in this chapter, we peel back the layers of these complex ideas and theories, giving you the chance to wrap your head around keynes' game-changing approach to economics.

classical economic theories misunderstand the causes of unemployment.

in his critique of traditional economic theory, keynes dissected a couple of core assumptions of classical economics.

let's dive deeper into his arguments.

first, classical economists argue that a worker's wage reflects the value they contribute to a business.

they believe that if a company decides not to employ someone, the company's loss is equal to the wage that the worker would have been paid.

in other words, they think that a worker's contribution to a company's value is directly tied to their wage.

the second assumption of classical economics is that a worker's wage is the lowest amount at which they'd be willing to work.

this is often seen as an equilibrium point where the demand for labor meets the supply.

but keynes took issue with these assumptions because he saw that they failed to account for a significant real-world phenomenon— involuntary unemployment.

keynes pointed out that there are situations where workers are both willing and able to work at the current wage, but they're unable to find employment.

traditional economists typically argue that this is actually a form of voluntary unemployment because they assume that workers are simply refusing to work for lower wages.

they believe that high unemployment during economic downturns is due to workers' refusal to accept wage cuts.

keynes challenged this view, arguing that the unemployment rate can fluctuate significantly without any corresponding changes in workers' wage demands or productivity.

this indicates that there are other factors at play influencing the unemployment rate— factors that the classical theory doesn't fully consider.

he believed that the classical theory's assumptions didn't accurately reflect the complexities of the real world, particularly in relation to involuntary unemployment and workers' attitudes towards wages.

his critique sought to expose these inadequacies and offer a more nuanced understanding of employment and wages.

employment and unemployment are directly related to overall consumption and investment.

so let's turn to keynes' own theory now.

it tries to explain how employment, income, and spending habits interact in an economy.

first off, the income a community earns, which can be in the form of money or real assets, depends on the number of people employed.

the total income is a function of the volume of employment.

next up, there's this term, propensity to consume.

this is basically a fancy way of saying how likely people are to spend their income.

the more people earn, the more they're likely to spend, but the increase in spending isn't usually as much as the increase in earnings.

it seems this discrepancy forms an integral part of the overall economic puzzle.

so how do businesses decide how much labor they should hire?

the theory suggests it depends on two things— the expected consumer spending and how much the community plans to invest in new ventures.

when you add these two together, you get what's referred to as effective demand.

now, there's equilibrium employment.

it's a sweet spot, determined by the volume of supply, propensity to consume, and the volume of new investments.

the catch here is that employment equilibrium can't go beyond a certain point, which is the point where actual wages equal the dissatisfaction workers feel from working.

this theory also contrasts with the classical one, which suggests that employment can be pushed to its maximum value through competition.

it asserts that increasing employment may not always lead to an increase in investment sufficient to fill the gap between supply price and what entrepreneurs can expect to receive from consumer spending.

so there you have it.

at the end of the day, the level of employment isn't just determined by how much people like or dislike work, but also by the propensity to consume and the rate of new investment.

interestingly, it seems that wealthier communities might actually have a bigger gap between their actual and potential production.

why?

well, they don't consume as much of their output, and they need to find more investment opportunities to provide full employment.

and if they can't find these opportunities, they might need to cut down their output to match their lower levels of consumption and investment.

in a nutshell, this theory is highlighting the importance of three things understanding our tendency to consume, defining the efficiency of capital, and figuring out how interest rates work.

once we've got these down, we can start to understand how prices fit into the bigger picture.

investment and employment are interrelated.

let's now look at the interactions of investment decisions and employment.

at the heart of our tale, we find two star-crossed concepts, the marginal propensity to consume, or mpc for short, and the economic multiplier.

they play pivotal roles in the grand theater of investment and employment dynamics.

the mpc is like a crystal ball, predicting how a society will slice the next piece of the economic pie between consumption and investment.

in a sense, it's the heartbeat of the community's consumption psychology.

let's say, for instance, a society consumes 9 out of 10 extra dollars it makes.

that's a high mpc.

in this case, the multiplier effect, an echo that tells us how much total income will surge with an increase in investment, also increases.

this multiplier has a twin, the employment multiplier.

this one measures how much total employment will leap up in response to an uptick in investment-related employment.

but the two aren't always perfectly synced due to potential variations across different industries.

a twist in the tale happens when people don't change their consumption despite an income rise.

this scenario will only echo the direct employment boost from increased investment, like public works.

but if people spend all their additional income, there's a risk of limitless price inflation, a beast nobody wants to awaken.

the tale takes a remarkable turn when the value of the mpc is near to 1.

even minor tweaks in investment can trigger massive employment fluctuations.

but just a tiny investment hike might be enough to achieve full employment.

on the flip side, if the mpc is slightly above zero, minor investment jitters will cause employment tremors, but reaching full employment might need a hefty investment push.

we can get a sense of how these interactions play out in practice by looking at public works, that is, large-scale projects financed and procured by the state.

say a government hires 100,000 new workers with a multiplier of 4.

you'd think employment would surge by 400,000, right?

not quite.

different elements can either amplify or dampen the impact.

for instance, the new policies' financing method could cause interest rates to climb, slowing other investments.

also, the government's program could alter confidence, potentially impacting the efficiency of capital.

in a global economy, some of the benefits of increased investment might also flow into other countries, shifting domestic employment impacts.

as employment soars, people might decide to spend less of their additional income.

plus, factors like increased income for entrepreneurs or a decrease in negative savings associated with re-employment could also tweak the mpc.

the scale of investment also influences the multiplier effect.

in general, it tends to be higher for small investment increases than larger ones.

and for significant changes, we need to consider the average multiplier over the range in question.

in short, even small investment ripples can generate significant shifts in employment and income, thanks to the magic of the multiplier principle.

it all shows us that understanding the intricate ballet of investment, consumption, and employment is critical for smart policy decisions and accurate forecasts.

fascinatingly, even activities like burying money in old coal mines and paying people to dig it up can stimulate the economy by increasing employment and consumption, especially during times of high unemployment.

but, as keynes insists, if there are less wasteful ways of increasing employment— building houses, say— those should be pursued first.

so while it may sound counterintuitive, sometimes even seemingly useless spending can be a kind of economic magic trick, enriching a community by bolstering employment and consumption.

understanding the delicate relationship between investment, consumption, and employment isn't just vital for economists and policymakers, but also for all of us to navigate our complex world better.

investment decisions aren't always rational.

all right, let's wrap things up by talking about the role of conventions in economic behavior.

we can start by looking at how we form expectations about the future.

we give more weight to what we're confident about, even if it may not directly apply to the situation.

so our present situation shapes our future expectations.

for instance, if we see big changes on the horizon but don't know the details, our confidence can wobble.

next, we touch on the influence of confidence in the economy, particularly on investment profitability.

confidence influences how we make investment decisions.

this is because predicting future profits from investments isn't always rock solid.

take a railway or a copper mine.

can you guess what they'll yield in ten years?

probably not.

it's practically a gamble.

in the olden days of 19th century industrial capitalism, business was like a game of skill and chance.

investments were often gambles, influenced by ambition and gut feelings more than calculations.

but nowadays, things are different.

markets let us reevaluate investments and change our commitments as we please.

it's like a farmer deciding whether to farm based on the day's weather.

but this approach can influence new investments too, and sometimes not in the best way.

here's the twist.

our investment evaluations are based on a convention, an agreement to assume things will stay the same unless we expect a change.

but we know life is unpredictable.

this convention does bring some stability, though, as long as we stick to it.

short-term investments become safer, as we can change them before much happens.

the convention isn't perfect and can create uncertainty for large investments.

who wants to gamble with huge amounts when the future is murky?

at the same time, there's been a decline in real knowledge because of an increase in ownership by individuals who don't manage or know much about the businesses they invest in.

this trend weakens the market's ability to make truly informed decisions.

investors also have a tendency to overreact to temporary fluctuations in investment profits, which might not significantly influence long-term outcomes.

for example, shares of ice manufacturing companies may fetch higher prices in summer due to high profits, and the british railway system might increase in value due to a bank holiday.

these examples reveal an unrealistic market tendency to overreact to transient circumstances.

market valuations can also swing wildly due to mass psychology, often caused by factors that don't significantly affect the expected yield.

these swings can lead to waves of optimism and pessimism that aren't grounded in concrete investment calculations.

instead of correcting market inaccuracies, professional investors often focus on anticipating short-term changes in valuation, playing into the same psychological dynamics as the general public.

keynes criticizes this behavior, suggesting that skilled investments should aim to overcome future uncertainties, rather than just outwitting others in the market.

keynes concludes by discussing the complex interplay between investor sentiment, lending institutions, and the overall health of the market, underlining the need for a delicate balance between speculation and enterprise and the role of spontaneous optimism.

he leaves us with a caution.

economic activities, being deeply human endeavors, are often driven by more than just cold, hard numbers.

in this chapter to the general theory of employment, interests, and money, you've learned that keynes' effective demand theory posits that employment levels are determined not just by worker preferences, but also by societal consumption habits, new investment rates, and complex economic multipliers, emphasizing that even seemingly wasteful spending can stimulate economic growth by increasing employment and consumption.

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