The principle of effective demand and the state of post-Keynesian monetary economics

Abstract

Keynesians of all shades have generally misunderstood the theoretical structure of the General Theory. What is missing is an appreciation of the principle of effective demand. As Laidler (1999) has documented, Old Keynesians largely fabricated the theoretical basis of the Keynesian Revolution and retained the 'classical' analysis of longperiod equilibrium. Old Keynesians generally took Frank Knight's (1937) advice to ignore the claim to revolution in economic theory and interpreted the General Theory as another contribution to the theory of business cycles. This is most obvious from the Old Keynesian reliance on wage rigidity to generate involuntary unemployment. But for Keynes (1936, chapter 19), wage and price stickiness is the 'classical' explanation for unemployment to be contrasted with his explanation, in terms of the principle of effective demand, where the flexibility of wages and prices cannot automatically shift longperiod equilibrium to full employment. New Keynesians have continued the 'classical' vision by providing the microeconomic foundations for the 'ad hoc' rigidities employed by Old 1 Keynesians. Generally, New Keynesians do not question the underlying 'classical' vision. Post Keynesians have always questioned the 'classical' vision but have not succeeded as yet in agreeing on what the principle of effective demand is 1. There should, however, be no grounds for misunderstanding of the principle of effective demand given Keynes's exposition in the General Theory and Dillard's (1948) synopsis. As Dillard (1948) explained, the principle of effective demand is the key theoretical innovation of the General Theory. In its most general form the principle of effective demand demonstrates that the rate of interest sets a limit to the profitable expansion of output before full employment is achieved. Keynes also argued in the General Theory that there was no mechanism in a laissez faire monetary economy for automatically generating the natural rate of interest consistent with full employment; as he had believed when writing the Treatise. Consequently, a monetary entrepreneur economy (laissez faire capitalism) is one where the rate of interest would be too high to achieve full employment. This is a structural and not a cyclical problem. 2 Keynes's diagnosis of a laissez faire monetary economy is that it suffers from two related structural flaws. These can be summarized crudely by the statement that the expected or 'normal' rate of interest is too high and the rate of investment is too low. As it is the rate of interest that ultimately determines the point of effective demand and longperiod

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“…It is noteworthy, however, that this is the very basic principle of Keynes's e ective demand principle. There are, however, di erent concepts of the PED (see (ROGERS, 2008;HEIN, 2015)). For simplicity we will be only referring to that of Keynes as described by Davidson (2001).…”