Understanding Keynes’s Ideas on Depressions in His General Theory

John Maynard Keynes, considered one of the most influential economists of the 20th century, developed hisGeneral Theory of Employment, Interest, and Moneymainly as a response to the prevailing "classical" economic theories that dominated the field at the time. These classical theories, pioneered by great figures like Adam Smith, David Ricardo, and John Stuart Mill, were based on the notion that market forces would naturally bring the economy to full employment and balance. However, the Great Depression of the 1930s exposed the limitations of these theories, prompting Keynes to formulate a new framework to address the issues at hand.

The Classical System: A Brief Overview

Before delving into Keynes' ideas, it is helpful to understand the framework he was contesting. The classical model, as crafted during the early 20th century, posited that savings and investment were in balance (SI), and the economy would self-correct to full employment. Other key equations:

S Dr, where S is savings and r is the interest rate. Md kY, where Md is the demand for money and k is the proportion of income that people keep for future use. Y f(N), where Y is national income and N is labor, with the assumption that employment is determined by aggregate production. Nd f(W/P), where Nd is the demand for labor and W is the wage rate. Ns g(WP), where Ns is the supply of labor.

In this system, the interest rate (r) determines the quantity of money demanded, which when balanced with money supplied (Ms Md) determines the price level (P).

The Keynesian Shift: The Role of Expectations and Investment

Keynes argued that the central driving force in an economy is not merely the balance between savings and investment, but rather the level of investment. Investment, Keynes contended, is influenced by expectations, which he termed "animal spirits" — these can be described as a combination of instincts, emotions, and habits that fundamentally affect how people make financial decisions.

According to Keynes, the supply price of capital (PKS) and expectations (E) determine the Marginal Efficiency of Capital (MEC), denoted by ρ:

"The marginal efficiency of capital is equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital asset during its life just equal to its supply price."

(General Theory, Chapter 11)

The interest rate (r) and the MEC together determine the volume and level of investment. In an aggregated form, the equations become:

S sY, where S is savings and Y is national income. I h0r h1E, where I is investment, r is the interest rate, and E represents expectations. Md L1Y L2r, where Md is the demand for money, and L2 is an unstable factor during times of uncertainty. N f1(Y), where N is employment determined by aggregate demand. Nd f2(W/P), where Nd is the demand for labor. Ns g1(WP), where Ns is the supply of labor. Y f1(I) f2(C), where C is consumption, and I is investment, driving national income Y.

When expectations of the future are low, the marginal efficiency of capital (MEC) tends to fall, leading to lower investment levels. This can create a vicious cycle where lower investment reduces national income (Y), which in turn leads to lower employment (N), reducing higher consumption, further reducing investment. The key factor in this cycle is the "animal spirits," which can fluctuate wildly, especially in times of economic crisis, leading to a sustained downturn in the economy.

Keynesian Policies: Fiscal and Monetary Interventions

Given the inherent instability in expectations, Keynes argued that fiscal and monetary policies must play a role in maintaining economic stability. Fiscal measures, such as government spending, can inject the necessary demand into the economy, while monetary policy can stabilize interest rates and the money supply.

In short, Keynes believed that the classical theories of the time were insufficient to address economic depressions and crises. By emphasizing the role of investment and expectations, he introduced a framework in which the state could actively intervene to ensure economic stability and growth through strategic government spending and monetary policies.

Understanding Keynes' ideas on depressions, as outlined in his General Theory, is crucial for both historians and contemporary economists. His theories remain relevant and provide a useful theoretical basis for understanding modern economic policies and their implications in the face of economic downturns.