The General Theory of Employment, Interest, and Money

1. Classical Economics: A Special Case, Not General Reality

I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium.

Challenging orthodoxy. Keynes fundamentally challenges the prevailing "classical" economic theory, which assumed that markets naturally tend towards full employment. He argues that this classical view, based on postulates like wages equaling the marginal product of labor and the utility of wages equaling the disutility of work, only holds true under very specific, ideal conditions—conditions rarely met in the real world. This narrow applicability makes classical theory misleading and potentially disastrous when applied to actual economic problems.

The flaw in the postulates. The classical theory implicitly assumes that any unemployment is either "frictional" (temporary, between jobs) or "voluntary" (people choosing not to work at the prevailing wage). Keynes introduces the concept of "involuntary unemployment," where people are willing to work at the current money wage but cannot find jobs. This crucial distinction highlights the classical theory's failure to explain persistent unemployment, as it overlooks the possibility that the economic system can settle into an equilibrium below full employment.

A new geometry. Keynes likens the classical economists to "Euclidean geometers in a non-Euclidean world." Just as a new geometry was needed to describe a curved space, a new economic theory is required to understand a world where involuntary unemployment is possible. His "General Theory" aims to provide this broader framework, moving beyond the restrictive assumptions of the classical school to explain how employment, interest, and money interact in a more complex, real-world economy.

2. Effective Demand: The True Driver of Employment

The volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised.

Beyond Say's Law. Keynes refutes Say's Law, the classical tenet that "supply creates its own demand." This law implies that all production costs are necessarily spent on purchasing products, ensuring full employment. Keynes argues that this is a fallacy, as aggregate demand (total spending) does not automatically adjust to aggregate supply (total output). Instead, the actual level of employment is determined by "effective demand"—the total expected spending by consumers and investors.

Components of demand. Effective demand is the sum of two key components:

• Consumption (D1): Spending by individuals on goods and services.
• Investment (D2): Spending by entrepreneurs on new capital goods.
  Entrepreneurs decide how much to produce and employ based on their expectations of these two components. If expected demand falls short of the cost of producing full employment output, they will reduce production, leading to unemployment.

Equilibrium below full employment. Unlike the classical view, Keynes demonstrates that the economy can reach a stable equilibrium at a level of employment below full employment. This occurs when effective demand is insufficient to absorb the output that a fully employed workforce could produce. The "paradox of poverty in the midst of plenty" arises because production is inhibited not by a lack of productive capacity or willingness to work, but by a deficiency in the demand for goods and services.

3. The Multiplier: Investment's Amplified Impact

An increment of investment in terms of wage-units cannot occur unless the public are prepared to increase their savings in terms of wage-units.

The ripple effect. Keynes introduces the concept of the "multiplier," which explains how an initial change in investment leads to a much larger change in aggregate income and employment. When new investment occurs, it generates income for those directly involved (primary employment). A portion of this new income is then spent on consumption, which becomes income for others, who in turn spend a portion, and so on. This chain reaction amplifies the initial investment's impact.

Marginal propensity to consume. The size of the multiplier depends critically on the "marginal propensity to consume" (MPC)—the proportion of any additional income that individuals choose to spend on consumption. If the MPC is high (e.g., 90%), a small increase in investment can lead to a large increase in total income and employment. Conversely, a low MPC means a smaller multiplier effect.

Saving as a residual. Keynes emphasizes that saving is not an independent decision that drives investment. Instead, saving is a residual outcome of income and consumption decisions. When investment increases, income must rise until the community's increased saving matches the increased investment. This means that efforts to save more by reducing consumption can paradoxically lead to a fall in overall income and employment, as there isn't enough investment to absorb the reduced consumption.

4. Investment Decisions: Driven by Volatile "Animal Spirits"

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 the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Beyond cold calculation. Investment decisions, particularly for long-term projects, are not solely based on precise, rational calculations of prospective yields. Keynes argues that "animal spirits"—a spontaneous urge to action, optimism, and confidence—play a crucial role. This psychological element means that investment is inherently precarious and subject to sudden, violent shifts, as the basis for long-term expectations is often vague and unreliable.

Speculation vs. enterprise. Keynes distinguishes between "speculation" (forecasting market psychology) and "enterprise" (forecasting the true prospective yield of assets over their life). He laments that in organized investment markets, speculation often predominates, leading to decisions based on anticipating short-term market sentiment rather than genuine long-term value. This "casino-like" behavior makes capital development ill-done and contributes significantly to economic instability.

The dilemma of liquidity. The very "liquidity" of investment markets, which allows individuals to easily buy and sell assets, paradoxically contributes to instability. While it makes individual investments seem "safe" over short periods, it encourages speculative behavior and rapid shifts in market valuation. This means that the market's estimation of capital's marginal efficiency can fluctuate wildly, making it difficult to maintain a stable rate of new investment.

5. The Rate of Interest: Reward for Parting with Liquidity

The rate of interest is not the “price” which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.

A new definition of interest. Keynes fundamentally redefines the rate of interest, rejecting the classical view that it is the price balancing saving and investment. Instead, he asserts that the rate of interest is the "reward for parting with liquidity for a specified period." It is the price that balances the public's desire to hold wealth in the form of money (liquidity preference) with the actual quantity of money available.

Motives for holding money. Keynes identifies three main motives for liquidity preference:

• Transactions motive: Holding cash for everyday personal and business exchanges.
• Precautionary motive: Holding cash for unforeseen contingencies or opportunities.
• Speculative motive: Holding cash to profit from expected changes in the price of assets (especially bonds), driven by uncertainty about future interest rates.

Monetary policy's leverage. Monetary authorities influence the rate of interest primarily by affecting the quantity of money available to satisfy the speculative motive. By increasing the money supply (e.g., through open-market operations), they can lower interest rates, making investment more attractive. However, this influence has limits, especially if liquidity preference becomes "virtually absolute" at very low interest rates (a "liquidity trap"), where people prefer to hoard cash rather than lend it.

6. Money's Peculiar Power: Setting the Investment Floor

The money-rate of interest, by setting the pace for all the other commodity-rates of interest, holds back investment in the production of these other commodities without being capable of stimulating investment for the production of money, which by hypothesis cannot be produced.

Beyond a mere numeraire. Keynes argues that money is not merely a neutral medium of exchange. It possesses unique characteristics that give its "own-rate of interest" (the return on holding money) a peculiar significance in the economy. Unlike other commodities, money typically has:

• Zero or very small elasticity of production: It cannot be easily produced by diverting labor, especially fiat money.
• Zero or very small elasticity of substitution: There's no easy substitute for money when its value rises.
• Low carrying costs: Holding money incurs negligible storage or depreciation costs.
• High liquidity premium: People value money for its convenience and security.

The "sting" of money. This combination means that money's own-rate of interest is "reluctant to fall" even when its quantity increases relative to other forms of wealth. This reluctance sets a floor for the marginal efficiency of capital that new investments must achieve to be profitable. If the marginal efficiency of capital falls below this money-rate of interest, investment will cease, leading to unemployment.

The "green cheese" factory. Keynes famously illustrates this by suggesting that if people desire "the moon" (money), which cannot be produced, unemployment will persist. The solution is to persuade the public that "green cheese" (a substitute with similar properties) is just as good and to have a "green cheese factory" (a central bank) under public control to produce it. This highlights the need for monetary policy to manage the money supply and its interest rate to stimulate investment.

7. Money Wages: Stability Over Flexibility

Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter.

Challenging wage cuts. Keynes directly confronts the classical belief that reducing money wages is a primary cure for unemployment. He argues that while a wage cut might reduce costs for an individual firm, a general wage reduction across the economy has complex and often detrimental repercussions on aggregate demand, the marginal efficiency of capital, and the rate of interest. The expectation of further wage cuts, for instance, can lead to postponed investment and consumption.

Instability and injustice. A policy of flexible money wages leads to:

• Price instability: Wages and prices would fluctuate wildly, making business calculations futile.
• Social injustice: Wage reductions are rarely uniform, disproportionately harming those in weaker bargaining positions.
• Increased debt burden: Falling wages increase the real burden of existing money-denominated debts, potentially leading to insolvencies and further depressing confidence.

Preferring monetary policy. Keynes concludes that maintaining a stable general level of money wages is the most advisable policy for a closed system. Instead of wage flexibility, he advocates for a "flexible money policy"—manipulating the quantity of money and interest rates—as a more effective, less disruptive, and more equitable means of influencing employment. This approach avoids the "double drag" on investment caused by falling wages.

8. The Trade Cycle: A Fluctuation of Capital's Efficiency

The Trade Cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated. and often aggravated by associated changes in the other significant short-period variables of the economic system.

The core of the cycle. Keynes attributes the cyclical nature of economic booms and slumps primarily to fluctuations in the "marginal efficiency of capital" (MEC). During a boom, optimistic expectations about future yields of capital assets drive new investment, often overriding rising costs and interest rates. However, these expectations are fragile and based on precarious knowledge.

The crisis and slump. The "crisis" is typically a sudden, even catastrophic, collapse in the MEC, rather than primarily a rise in interest rates. This disillusionment, often triggered by doubts about prospective yields as new capital goods become abundant, leads to a sharp increase in liquidity preference and a rise in interest rates, further aggravating the decline in investment. The slump becomes intractable because it's difficult to revive the "uncontrollable and disobedient psychology of the business world."

Time-bound recovery. The duration of the slump is not random but related to the average durability of capital assets and the time needed to absorb surplus stocks. Negative investment (e.g., stock reduction) further deters employment. Recovery only begins when the shortage of capital through use, decay, and obsolescence becomes sufficiently obvious to increase the MEC. Keynes argues that a lower interest rate, rather than a higher one, is the appropriate remedy for a boom, as it might allow the boom to last on a sounder basis.

9. Laissez-Faire's Limits: The Need for State Intervention

I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.

Market failures. Keynes argues that the inherent instability of investment, driven by volatile "animal spirits" and the peculiar properties of money, means that a purely laissez-faire system cannot reliably achieve or maintain full employment. The market's estimation of the marginal efficiency of capital can fluctuate too widely to be offset by practical changes in the rate of interest alone. This leads to chronic under-employment and economic waste.

Beyond monetary policy. While monetary policy (managing interest rates) is important, Keynes expresses skepticism about its sole ability to continuously stimulate the appropriate volume of investment. He suggests that the State, with its ability to take "long views" and consider "general social advantage," should take "an ever greater responsibility for directly organising investment." This implies a role for public works and other forms of state-directed investment to stabilize the economy.

Dual approach. Keynes advocates for a two-pronged policy approach:

• Promote investment: Through state organization and management of interest rates.
• Promote consumption: Through policies like income redistribution, to ensure that a given level of employment requires a smaller volume of current investment.
  He believes that advancing on both fronts simultaneously is the wisest course to achieve and maintain full employment.

10. Rehabilitating Old Wisdom: Mercantilism and Under-Consumption

It is impossible to study the notions to which the mercantilists were led by their actual experiences, without perceiving that there has been a chronic tendency throughout human history for the propensity to save to be stronger than the inducement to invest.

Mercantilist insights. Keynes surprisingly rehabilitates aspects of Mercantilist thought, which classical economists had dismissed as confused. He argues that the Mercantilists' preoccupation with a favorable balance of trade and keeping interest rates low was not entirely irrational. In a world without direct control over domestic interest rates or home investment, a trade surplus was a practical means to:

• Increase foreign investment (accumulation of precious metals).
• Indirectly reduce domestic interest rates (by increasing the money supply).
  This suggests a historical awareness of the problem of insufficient effective demand.

The "fear of goods" and usury laws. Mercantilists also understood the "fallacy of cheapness" and the danger of "scarcity of money" leading to unemployment, a concept later ridiculed by classical economists. Furthermore, Keynes defends the historical practice of usury laws, seeing them as an "honest intellectual effort" to curb an inherently high rate of interest that would otherwise stifle investment. This reflects a long-standing recognition that the desire to save often outstrips the inducement to invest.

Under-consumption theories. Keynes also champions the "under-consumption" theories of thinkers like Malthus and Hobson, who argued that insufficient consumption (or excessive saving) could lead to economic stagnation. He quotes Mandeville's "Fable of the Bees" to illustrate how "private vices" (luxury spending) could lead to "public benefits" (employment), contrasting it with the "austere doctrine" of thrift. These "heretical" views, dismissed by orthodoxy, contained vital truths about the chronic tendency for saving to exceed investment, leading to unemployment.

Last updated: August 21, 2025