Question 1: It has been argued that the General Theory initiated a methodological "revolution" in economic theory. The assumption set adopted and the methods of analysis used in this book constituted a sharp break with those associated with Classical theory, Neoclassical theory, New classical theory, or New Keynesian theory. These innovations led to a qualitatively different vision of the laws of motion of modern capitalism, a fact perhaps easiest to appreciate when reading his essay on the GT in the QJE 1937 article.
Keynes presents his theory of the determination of investment spending, the cornerstone of his theory of macro dynamics, in chapters 11-15 of the GT. Chapters 11 and 12 analyze the demand for capital goods holding the cost of capital- here the long-term rate of interest- constant. Chapters 13-15 constitute a uniquely Keynesian theory of financial markets. They contain a sharp attack on the mainstream theory of financial markets and the determination of interest rates, and present an alternative theory. Keynes's theory helped explain the extreme volatility of financial markets in the late 1920s and early 1930s and the collapse of investment spending after the 1920s boom. In your answers show how chapters 11-15 reflect Keynes's methodological revolution:
a.) Present the main arguments used by Keynesian in Chapters 11 and 12 to discredit the received theory of investment demand. Be specific. Then show precisely how this alternative approach leads to a theory of investment demand with dramatically different static and dynamic properties than mainstream theory.
In Chapter 11 of the GT, Keynes reject the dominant theory of investment demand by asserting that investment decisions (and all decisions) are made under conditions of fundamental uncertainty- a dramatic departure from Classical and neoclassical theory- and the related concepts of expectations and confidence.
Keynes explains that classical and neoclassical theories of investment rely on assuming that the present is a stationary state and that the future is assumed to look like the present. He explains that the neoclassical assumptions rely on the assumption that there are known and certain probability distributions associated with the investment decision, over which the rational investor maximizes given a certain marginal product of capital calculated by a production function, and a fixed amount of labor and output (the market clearing level guaranteed by Says's Law). With this in aggregate, the value of the MP of capital is a declining function of K, and the firm and the whole economy, select the value of K for which the MP of K equals the price of user cost of capital- also known as optimization.
But Keynes notes, very seriously, that these assumptions are unrealistic. In fact, the future is unknown and it is uncertain whether or not it will at all resemble the present.
He proposes instead, in light of uncertainty, that we need to instead calculate the value of a variable he calls the "marginal efficiency of capital" (MEC or m), which as Crotty describes:
The MEC is that value of m for which the following equation holds: ∑ QtE /(1 + m)t = PS, where t is a time index from 1 to T that represents the T periods in the future that cover the expected life of the investment good, QtE is the net cash flow expected to be generated by this investment in future period t, and PS is the cost (or supply price) of the investment good. The MEC is clearly a profit rate of some kind since it will be higher the larger the expected QtEs, the more the total expected cash flow is front-loaded, and the lower PS.
Basically, the MEC is the risk adjusted cost of capital based on expectations rather than certain optimization. For Keynes, the future does not exist yet and it is impossible to know the present. Therefore, expectations about the future are formed, even though the MEC is essentially unknown and unknowable at the time of investment. This departs from the mainstream assumption that the probability distribution of the QtEs(the expected net cash flow to be generated by the investment in the future period t). These expectations are loosely based on heuristics (rules of thumb), and investors may have varying levels of confidence in those expectations themselves.
This acceptance of uncertainty is Keynes's methodological breakthrough.As he says in the QJE 1937 article --“about such matters [as the state of the economy in the future], we simply do not know”.
Keynes links expectations to the present, since investors form their expectations about the unknowable future from the conditions of the present. For Keynes, this means that the trajectory of the economy is path dependent and linked to the present. In this way, Keynes links both the passage of time and uncertainty of the future to economic methodology.
b.) Present the main argument used by Keynes in chapters 13-15 to discredit the received theory of financial markets and the role this theory plays in sustaining the conclusion that free markets always remain at or near full employment. Be specific.
In these chapters, Keynes extends his methodological intervention regarding uncertainty to the theory of financial markets. Keynes again attacks the mainstream theory of financial markets, their self-correcting mechanism of AD shocks responded to with swift changes in the interest rate to restore AD to the level needs to keep AS moving too far away from full-employment or market clearing levels. He rejects also the implication that this accepts Say's law.
JMK instead proposes that long-term interest rates are based on a uncertainty, with a psychologically complex agent and the use of conventions to form expectations and confidence.
The theory of liquidity preference is based on this idea. He also asserts that bond prices are inherently restless (Shackle), highly psychological, and highly conventional variables. For Keynes, investment decisions, interest rates, and then prices are dependent on the conventions, expectations, and confidence of capitalist investors rather than intrinsic prices or calculable probability distributions. In fact, because the financial markets face fundamental uncertainty about the future, Keynes concludes then that this uncertainty leads to volatility and instability. For JMK, financial markets might initiative instability, magnify instability in the real sector, or reduce it. It all depends.
Upon introducing uncertainty, Keynes shows that uncertainty in relation to the future rate of interest is necessary to explain the existence of liquidity preference for holding wealth.
Keynes has a two-pronged attack on the classical theory of financial markets. He insists that AS depends on and quickly reacts to AD, and when AD falls so does AS, therefore Say's law does not hold. For Keynes then, AS is endogenous as it moves with AD, which is a complete departure from classical financial market theory. On example of this should be in the IS-LM model where S= S(r, Y) and Y is endogenously determined by AD. A negative shock to investment shifts the I function down, and to the left, and also lowers AD and therefore Y. Since Y has fallen, so has S (because it's not exogenous!!, unlike classical models). How far Y shifts down depends on expectations. The new equilibrium S and I have fallen by the same amount, but C (r,Y) has declined because r is the same as before and Y is smaller. Now AD and Y are below Y full employment! The fall in C gives a multiplier impact to the initial negative I shock (if expectations are endogenous), i.e. collapsing income and rising unemployment. All due to a shock in investment, from unstable financial markets.
Therefore, in Keynes's new theory, fundamental uncertainty leads to instability in financial markets. This instability may lead to shocks in investment. With AD and Y endogenous, this means that the shocks to I can result in a downward spiral in the economy of declining AD, Y, C, and Y under full employment. Unless there is intervention in financial markets and planning of investment.
Then show precisely how his alternative approach leads to a theory of financial markets and capital investment with dramatically different static and dynamic properties than mainstream theory.
By developing a theory of financial markets and capital investment based on the realistic assumption of fundamental uncertainty, Keynes concludes that these markets are inherently unstable, the interest rate is inherently restless, and this instability necessarily leads to unfavorable outcomes (crises). For Keynes, the static present impacts the unknowable only in that expectations and confidence are informed by the present state, but the dynamic time variable component of this means that negative feedback loops may occur when expectations are inconsistent with what actually happens.
Is there a (temporary) equilibrium at the end of the process of decline? Keynes took the following position on this question. “I should, I think, be prepared to argue that, in a world ruled by uncertainty, with an uncertain future linked to an actual present, a final position of equilibrium, such as the one we deal with in static economics, does not properly exist” (Collected Works, Volume XXIX, p. 229). However, a deep depression that lasts a long time might well be considered a relatively stable equilibrium.
