Posted by: Dirk | February 18, 2016

Why is the General Theory “general”? Take two

I have recently commented on why the General Theory by Keynes (1936) is a general theory. Reading chapter 3, I might change my mind:

The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. For “Supply creates its own Demand” must mean that f(N) and φ(N) are equal for all values of N, i.e. for all levels of output and employment; and that when there is an increase in Z( = f(N)) corresponding to an increase in N, D( =f(N)) necessarily increases by the same amount as Z. The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.

If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment. In the previous chapter we have given a definition of full employment in terms of the behaviour of labour. An alternative, though equivalent, criterion is that at which we have now arrived, namely a situation, in which aggregate employment is inelastic in response to an increase in the effective demand for its output. Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.

This seems to imply that Say’s Law is the special case, whereas the General Theory allows for supply/demand imbalances, mostly supply being limited by demand. Rereading chapter 1 …

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. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

… I now conclude that the postulates of classical theory are more or less “similar” to Say’s Law of supply being always equal to demand. At least Say’s Law is made plausible by the discussion of these assumptions, so the two are intertwined.

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