Keynes refuted Say’s Law of markets that supply always created its own demand. He maintained that all income earned by the factor owners would not be spent in buying products which they helped to produce. A part of the earned income is saved and is not automatically invested for the reason that saving and investment are distinct functions. So, when all earned income is not spent on consumption goods and a portion of it is saved, results in a deficiency of aggregate demand.
This leads to general over production for the reason that all that is produced is not sold. This in turn, leads to general unemployment. Thus Keynes rejected Say’s law that supply is created its own demand. Instead he argued that it was demand that created supply. When aggregate demand rises, to meet that demand, firms produce more and employ more people.
- Self-Adjustment not Possible
Keynes did not agree with the classical view that the laissez faire policy was essential for an automatic and self adjusting process of full employment equilibrium. He pointed out that the capitalist system was not automatic and self adjustment for the reason that the non-egalitarian structure of its society. There are two principal classes, the rich and the poor. The rich posses much wealth but they do not spend the whole of it on consumption. The poor lack money to purchase consumption goods.
Thus there is general deficiency of aggregate demand in relation to aggregate supply which leads to over production and unemployment in the economy. This in fact, led to the great depression. Had the capitalist system been automatic and self adjusting, this would have not have occurred. Keynes therefore, advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures.
- Equality of Saving and Investment through Income Changes
The classicists believed that saving and investment were equal at the full employment level and in case of any divergence; the equality was brought about by the mechanism of rate of interest. Keynes held that the level of saving depended upon the level of income and not on the rate of interest. Likewise, investment is determined not only by rate of interest but by the marginal efficiency of capital.
A low rate of interest cannot increase investment if business expectations are low. If saving exceeds investment means people are spending less on consumption. As a result, demand declines. There is overproduction and fall in investment, income, employment and productivity. It will lead to reduction in saving and ultimately the equality between saving and investment will be attained at a lower level of income. Thus it is variations in income rather than in interest rate that bring the equality between saving and investment.
- Importance of Speculative Demand for Money
The classical economists believed that money was demanded for transactions and precautionary purposes. They did not recognise the speculative demand for money for the reason that money held for speculative purposes related to idle balances. But Keynes did not agree with this view. He emphasised the importance of speculative demand for money.
He pointed out that the earning of interest from assets meant for transactions and precautionary purposes may be small at a low rate of interest. Thus the rate of interest will not fall below a certain minimum level and the speculative demand for money would become perfectly interest elastic. This is Keynes ‘Liquidity trap’ which the classicists failed to analyse.
- Rejection of Quantity Theory of Money
Keynes rejected the Classical Quantity Theory of Money on the ground that increase in money supply will not necessarily lead to rise in prices. It is not essential that people may spend all extra money. They may deposit it in the bank or save. So the velocity of circulation of money (V) may slow down and not remain constant.
Thus V in the equation MV = PT may vary. Moreover, an increase in money supply, may lead to increase in investment, employment and output if there are idle resources in the economy and the price lelvel P may not be affected.
- Money not Neutral
The classical economists regarded money as neutral. Therefore they exclude the theory of productivity, employment and interest rate from monetary theory. According to them, the level of productivity and employment and the equilibrium rate of interest were determined by real forces. Keynes criticised the classical view that monetary theory was separate from value theory. He integrated monetary theory with value theory and brought the theory of interest in the domain of monetary theory by regarding the interest rate as a monetary phenomenon.
He integrated the value theory and the monetary theory through the theory of output. This he did by forging a link between the quantity of money increases, the rate of interest falls, investment increases income and output increases, demand increases, factor costs and wages increase, relative prices increase and ultimately the general price level rises. Thus Keynes integrated monetary and real sectors of the economy.
- Refutation of Wage-Cut
Keynes refused the Pigovian formulation that a cut in money wage could achieve full employment in the economy. The greatest fallacy in Pigou’s analysis was that he extended the argument to the economy which was applicable to a particular industry.
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- Classical Theory of Employment
- Determination of Effective Demand
- Determination of Equilibrium Income or Output in a Three Sector Economy
- Keynesian Model of Income Determination in A Two Sector Economy
- Keynesian Model of Income Determination in a Four Sector Economy
- Principle of Effective Demand: Aggregate Demand and Aggregate Supply
- Propositions and Implications of the Law
- Say's Law of Market
- Shifts In The Aggregate Demand and The Multiplier