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Notes from General Theory - Chapter 13

After Chapter 3, I have jumped directly to note taking from Chapter 13. This is where the more interesting part of the book begins. I will take the notes of Chapter 4 to 12 later.

• There are forces that cause the marginal efficiency of capital to be equal to the rate of interest, yet the marginal efficiency of capital is, in itself, a different thing than the ruling rate of interest. Marginal efficiency of capital governs the terms on which loanable funds are demanded for new investment. Rate of interest governs the terms on which funds are supplied. 
• Historically, rate of interest has been thought to depend on the interaction of the schedule of marginal efficiency of capital with the psychological propensity to save. However, according to Keynes, merely knowing the demand for investment and the supply of savings is insufficient to determine the rate of interest. 
• Any individual has two distinct set of decisions in his psychological time preference: a) Propensity to consume: how much of the income is consumed, and how much is saved. (b) Liquidity preference: in what form will he hold his savings. Historic theories are erroneous as they attempt to derive the rate of interest from the first of the psychological time preferences at the neglect of the second. 
• Rate of interest is not a return to saving or waiting. If a man hoards his saving as cash, he will earn nothing. Rate of interest is the reward for parting with liquidity for a specified period. 
• Rate of interest is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash. If rate of interest is lower, more people will be willing to hold saving as cash. If it is higher, there will be a surplus of cash which no one is willing to hold. Rate of interest is not the price which equilibrates saving and investment. 
• So, it is the quantity of money, along with the liquidity preference, that determines the rate of interest. 
• If r is the rate of interest, M the quantity of money, and L the function of liquidity preference, then M = L(r). This is where the quantity of money enters into the economic scheme. 
• There are three drivers of liquidity preference: (a) Transactions motive: i.e. the need of cash for the current transaction of personal and business exchanges (b) Precautionary motive: i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources, (c) Speculative motive, i.e. object of securing profit from knowing better than the market what the future will bring forth. 
• The existence of an organized debt market creates a dilemma. In the absence of an organized market, liquidity preference due to precautionary motive would be greatly increased, however, the existence of an organized market might create wild swings in liquidity preference due to the speculative motive.
• If there is negligible demand for cash from the speculative motive, an increase in quantity of money will have to lower the rate of interest, in whatever degree is necessary to raise employment and wage-unit to cause the additional cash to be absorbed by the transactions motive and the precautionary motive. This is what the Fed fought in 2009. 
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Notes from General Theory - Chapter 3

The Principle of Effective Demand:
In a given state of technique, resources and costs, employment of labor by an entrepreneur involves two kind of expense:
a) Factor cost: Amount paid out to the factors of production, ex other entrepreneurs.
b) User cost: Amount paid out to other entrepreneurs for what he has to purchase from them + the depreciation of capital equipment in excess of normal wear and tear if the equipment were left idle.

• Income or Profit = Value of output - factor cost - user cost. Factor cost is regarded as income by the factors of production.
• So total income generated by employment given by entrepreneur = profit + factor cost (but what about amount paid to other entrepreneurs, who have made profits and in turn generated employment?) 
• Entrepreneurs try to fix employment at a level which will maximize their profits.
• Let Z be the aggregate supply price of output from employing N men, i.e. Z = s(N). This is the Aggregate Supply Function. Let D be the proceeds which entrepreneurs expect to receive from the employment of N men, i.e. D = f(N). This is the Aggregate Demand Function. (Is there any difference between the two functions?)
• 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 profit is maximized. This point of intersection - the point D - is called the Effective demand. (But aren't both the curves upward sloping? Demand goes up when employment is higher, so does supply). 
• The classical theory assumes that the two functions s(N) and f(N) superimpose each other, so that whatever the value of employment N may be, the proceeds D are equal to Z. Implying that effective demand, instead of having a unique equilibrium value is an infinite range of values all admissible, and the amount of employment if indeterminate except in so far that the marginal disutility of labor sets an upper limit. (So is what Keynes saying that these two curves are not parallel, which is what Classical theory has always implicitly assumed. And it is easy to fall into this trap because both the curves are upward sloping.)
• If this were true, employment will expand up to the point at which supply of output as a whole ceases to be elastic. This is same as full employment. Thus Say's law, that aggregate demand price of output is equal to its supply price for all volumes of output, is equivalent to the proposal that there is no obstacle to full employment.

II: Brief Summary of Theory of Employment:

• When employment increases, real income increases. Consumption goes up, but lesser than income. So employers will make a loss if the whole of increased employment was for satisfying the demand for immediate consumption. So, to justify and amount of employment, there must be an amount of current investment sufficient to absorb the excess of total output over consumption. So, given the community's propensity of consume, the equilibrium level of employment will depend on amount of current investment. The amount of current investment will depend on the inducement to invest, which is a function of marginal efficiency of capital and interest rates.
• Given the propensity to consume and rate of new investment, there will be only one level of employment consistent with equilibrium, otherwise there will be inequality between the aggregate supply price of output and its demand price. The level of employment cannot be greater than full employment. But it is not necessary that it is always equal to full employment.

Notes from General Theory - Chapter 1 and 2

There is nothing in Chapter 1.

Chapter 2: Classical theory depends on three crucial assumptions:

a) Real wage is equal to the marginal disutility of existing employment,
b) There is no such thing as involuntary unemployment in the strict sense
c) Supply creates its own demand in that aggregate demand price is equal to aggregate supply price for all levels of output and employment.

Classical theory of employment depends on two fundamental postulates:
a) Wage is equal to the marginal product of labor, i.e. wage of an employed person is equal to the value which would be lost if employment were to be reduced by one unit. This gives us the demand schedule for employment.

b) The utility of wage when a given volume of labor is employed is equal to the marginal disutility of that volume of employment, i.e real wage of an employed person is that which is just sufficient to induce the volume of labor actually employed to be forthcoming. Disutility covers every reason why men would withhold their labor rather than accept a wage. This gives us the supply schedule for employment.

Equilibrium happens where the utility of the marginal product balances the disutility of the marginal employment.


There can be only two forms of unemployment in the classical theory:
a) Frictional unemployment: due to various factors like time lags between job findings etc
b) Voluntary unemployment: refusal of work due to legislation or social practices.

Keynes postulated there can be a third form of unemployment, viz involuntary unemployment.

So, there can be only four means of increasing employment, which Professor Pigou described in his Theory of Unemployment:
a) Decreasing frictional unemployment, through improvement in organization or foresight.
b) Decrease in marginal disutility of labor
c) Increase in marginal physical productivity of labor in the wage-goods industries
d) An increase in the prices of non-wage goods compared with the prices of wage goods, associated with a shift in the expenditure of non-wage earners from wage-goods to non-wage goods. Didn't get this.


Why does unemployment exist? Classical theory argues that full employment could always be reached by making real wages sufficiently low. Keynes disputes that, for two reasons.

a)  Labor focuses on money wages, not real wages. If inflation were to increase prices, that is equivalent to a reduction in real wages. But labor does not strike because of this, unless the inflation is gargantuan. So supply of labor is not a function only of real wages, which is what classical theory assumes.

b) Look around during Depression years in 1932. Can it really be argued that unemployment exists because labor is unwilling to work at a low wage?  


Also, classical theory assumes that a fall in money wages is accompanies by a fall in real wages. In a short period of time, that is not true. A fall in money wages might very well be accompanies by a rise in real wages, and vice versa. One can argue that nominal wages will fall only during a pronounced deflation, during which real wages might actually rise. And conversely, nominal wages track inflation with a lag, so real wages might actually fall during a boom.


Classical theory assumes that there is a collective bargaining that labor does to bring its real wages in line with the marginal disutility of employment. Keynes argues that something like this doesn't exist at all. Employment and real wages are determined in ways other than the demand-supply curve of labor.  


The struggle on nominal wages primarily affects the distribution of aggregate real wage between different labor groups, and not its average amount per unit of employment, which depends on different set of forces. The effect of combination on the part of a group of workers is to protect their real relative wage. The general level of real wages depends on other forces of the economic system. Didn't get this.


Involuntary employment: Men are involuntary unemployed if in the event of a small rise in the price of wage-goods relative to the money wage, both the aggregate supply of labor willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment. i.e. if marginal profitability were to increase and entrepreneurs were to hire labor, there is labor available. 


So the second postulate - that real wage is equal to marginal disutility of employment - corresponds to absence of involuntary unemployment.  Classical theory is the theory of distribution under conditions of full employment.

Axiom of parallels: Demand price of output as a whole is equal to its supply price. Didn't get this. 

Notes from General Theory: Preface

I am attempting to read Keynes signature book - General Theory of Employment, Interest and Money - for the first time. It is a very complicated book, so I am planning to take lots of notes.

My biggest challenge while learning Economics has been a lack of understanding of the chronological order in when different theories emerged. Economics textbooks present theories in a logically cohesive way, rather than in a chronological order. So, I have only a vague understanding of what the prevailing theory of the day was in the 1930's, when Keynes wrote his book. Several elements of the "Classical theory" as we now understand were certainly developed after the 1950's. So what exactly was it that Keynes disproved?

The book is so complicated that I can make notes starting right from Preface. There are actually four prefaces - one each for the British, German, Japanese and French reader.

• "Classical theory": I guess Keynes himself labelled the pre-Keynesian theory as Classical theory.
• "A monetary economy is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction." I guess classical economics did not include the influence of expectations. Which leads to the question - Does neo-classical synthesis postulate that people are rational in their expectations, hence future expectations are already built into today's prices, so lets get back to classical economics? Will explore this later.
• Alfred Marshall wrote a book "Principle of Economics" in 1890. It was probably the equivalent of Samuelson's Economics today - the standard text book of economics. Why does wikipedia say he is one of the founders of neoclassical economics. I thought it came after Keynes.
• "The Manchester School and Marxism both derive ultimately from Ricardo." Didn't get this.
• "While Germany has had its school of economists, they are content with historical and empirical analysis, so there isn't any predominant theoretical framework of economics in Germany."
• "This book traces its descent from Malthus rather than Ricardo." Didn't get this.
• "Savings = Investment is a controversial statement. What is true at individual level is not true at the system level, and vice versa."
• "Many economists believe that the rate of interest is determined by the point of intersection of the supply curve of savings and demand curve of investment. But if aggregate S = I, then this explanation collapses. Interest rate preserves equilibrium between demand and supply of money, not capital goods."
• Montesquieu was the French equivalent of Adam Smith.
• "Economics everywhere has been dominated by the doctrines of J.B. Say. His basic fallacy was the assumption that demand is created by supply. Saw implicitly assumed that the economic system was always operating up to its full capacity, so that a new activity was always in substitution for, and never in addition to, some other activity."
• "This book breaks away from the doctrines of JB Say in the theory of production, and returns to the doctrines of Montesquieu in the theory of interest."

And that's it.

Fed should destroy 2mn homes

If Fed were to buy 2 mn. homes in US at $200K apiece, and destroy them, it will cost $400bn. After that, housing inventory is gone. Housing starts will rise from current 300K odd level to 600K level, and housing growth (to which a lot of things get ultimately linked) will lead to rebound in economy. It will increase employment without a doubt, as construction generates employment.

This is much better than the cost of any other alternative that is being proposed. Print money and we don't know whether it leads to inflation over time. Increase fiscal deficit and we don't know what taxes are over long-term. In this solution, US government will take a one-time hit of $400bn. Because economy will start growing robustly again, that should be more than offset by the reduction in fiscal deficit and anxiety.

Facebook vs Google

We are probably at one of the tipping points in the evolution of the Internet. That tipping point is Facebook. And the question is - as more people spend more time on Facebook, and the number of clicks on Facebook surpasses Google, is it possible that Facebook itself replaces Google? Particularly as traffic moves from desktop to mobile, where the first thing consumers use is Facebook and not Google.

It is certainly possible. And over the next 2 years, Facebook might start eroding Google's search business. But, the first thing that Facebook will hit is display, not search. It is probably already happening - Yahoo is barely growing its ad revs. Maybe, it is time to short some of the traditional display focussed ad biz on the Internet. Yahoo is so cheap that there is no point shorting it.