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CONTRIBUTIONS AND LIMITATIONS OF KEYNESIAN THEORY BY KENNETH K. KURIHARA My general purpose in this essay1) is to delineate the essential contributions of Keynes' General Theory and its fundamental limitations,2)
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CONTRIBUTIONS AND LIMITATIONS OF KEYNESIAN THEORY BY KENNETH K. KURIHARA My general purpose in this essay1) is to delineate the essential contributions of Keynes' General Theory and its fundamental limitations,2) with a specific view to indicating the nature and direction of theoretical advance in the field of macrodynamic economics for greater generality and applicability. 1) The substance of this essay was given in my luncheon address before the New York State Economic Association Convention at Oneonta, New York, April 27, ) For controversial views, see S. E. Harriss (ed.), The New Economics, 1948; A. C. Pigou, Keynes' General Theory, 1950; R. F. Harrod, The Life of John Maynard Keynes, 1951; K. K. Kurihara (ed.), Post Keynesian Economics, 1954; W. Fellner, Keynesian Economics After Twenty Years, American Economic Review, May 1957; D. Dillard, The Influence of Keynesian Economics on Contemporary Thought, Ibid.; H. C. Wallich, Keynes Re-Examined: The Man, The Theory, New York Times Magazine, April 20, 1958; K. K. Kurihara, Prof. Hansen on America's Economic Revolution, Economic Journal, September 1958; H. G. Johnson, A. P. Lerner, L. R. Klein and D. M. Wright, The General Theory after Twenty-Five Years, American Economic Review, May 1961; H. L. McCracken, Keynesian Economics and the Future in Keynesian Economics in the Stream of Economic Thought, 961; A. Murad, Evaluation and Criticism of the General Theory in What Keynes Means, 1962; 1 G. Schwartz, The Keynes Formula Sweeps on, New York Times Magazine, September 8, 1963; K. K. Kurihara, The Keynesian Impact on American Economic Thinking and Policy, Michigan State University Centennial Review, Vol. 7, No. 1, 1963; R. Lekachman (ed.), Keynes' General Theory: Reports of Three Decades, 1964; A. H. Hansen, Keynes After Thirty Years, Weltwirtschaftliches Archiv, Vol. 97, No. 1, 1966; W. Heller, New Dimensions of Political Economy, 1967; and L. A. Hahn, End of the Era of Keynes?, Kyklos, Vol. XX, 1967, Fasc. 1, as translated by W. E. Kuhn, Nebraska Journal of Economics and Business, Vol. 7, No. 1, April 1969 K. K. Kurihara: Contributions and Limitations of Keynesian Theory The inequalities expressed by (1.1) are revolutionary in effect, for two reasons. First, they have invalidated Say's law that supply creates its own demand: Y*C I or I*S where Y stands for supply and C+I denotes demand, implying that + general overproduction and mass unemployment are theoretical impossibilities so as to justify laissez-faire. Keynes not only succeeded where Multhus and Marx failed in their attempts to repudiate Say's law, but also established the following condition of equilibrium to be satisfied (preferably by design): (1.2) Y-[C(Y)+I]=0; I-S(Y)=0, where C and I represent respectively consumption-demand and investment-demand. Second, and what is more, the general equilibrium condition specified by (1.2) is, when satisfied, likely to be associated with less than full employment in a peacetime market economy: (1.3) I=S(Yu); Y=Y =Yu Y_??_, where Y is equilibrium income, Yu underemployment income, and Y_??_ full-employment income. The relations expressed by (1.3) imply the full-employment equilibrium condition to be satisfied: (1.4) I_??_-S(Y_??_)=0; Y=Y =Y_??_, where I_??_ is autonomous investment in conditions of full employment. The Basic Mechanism of Income-Employment Fluctuations. Another theoretical contribution with important practical implications is the predictable and controllable multiplier mechanism of the basic form (1.5) *Y=s-1*I=k*I; *N=v*Y=vk*I, where N is the macro labor-input demanded or simply employment, s the marginal propensity to save, k the investment multiplier, and v the marginal labor-output ratio (reciprocal of marginal labor productivity), the other variables being the same as before. The policy implications of the relations expressed by (1.5) can be brought out by making the investment multiplicand the unknown: (1.6) *I=k-1*Y=(Y_??_-Ya)/s-1, where Y_??_ is potential full-employment income, Ya actual income, and *Y the income gap to be wiped out in order to attain full employment. Equation (1.6) enables the policy-makers to know how much more investment is needed to close the gap between potential full-employment income and actual income, when the saving ratio remains constant. Moreover, the burden on the extra autonomous investment to be found is reduced if induced investment is also present, for we have the super multiplier of the form k'=(s-v)-1, where v is the positive marginal propensity to invest. Econometric parameter-estimation of s and v could help forecast the exact amount of autonomous investment needed at some future time: (1.7) *It+n=*Yt/(s-v)-1 (n*1). We know that the basic equations given by (1.5)-(1.7) can be expanded to embrace the foreign-trade multiplier in an open economy, the government-expenditure multiplier in a mixed economy, and the price multiplier in a full-employment economy. Keynes credited R. F. Kahn with the discovery of the multiplier principle, but it was Keynes who put the idea across for general acceptance and universal practice. Be that as it may, Keynes' multiplier principle made classical (if unorthodox) murmers about commercial crises and other cyclical disturbances operationally significant for both analysis and policy. The Static Investment-Saving Equilibrium Condition as a Preliminary to the Dynamic Counterpart. Another basic contribution lies in the retrospective fact that Keynes' static investment-saving equilibrium condition paved the way to Harrod's dynamic counterpart, that is, Harrod's dynamised version of Keynes' excess or deficiency of aggregate effective demand 3) running in terms of ratios: The investment-saving equilibrium condition in terms of ratios (instead of levels) specified by (1.8) does not in itself reveal its dynamic nature, but Harrod has made the net investment ratio the product of one dynamic variable (Gw or the warranted rate of growth of income) and one parameter (Cr=const.).4) Substituting (1.9) in (1.8) yields which tells us that the marginal capital coefficient (Cr) times the warranted rate of growth (Gw) must, in equilibrium, equal the average saving ratio (s) if the economy's inducement to invest is to be in harmony with its propensity to save in terms of ratios. Equation (1.10) implies that the rate of growth of effective demand necessary for the full utilization of capital is given by which indicates the possibility of the required rate of growth of effective demand changing directly with the saving ratio and inversely with the capital coefficient. Since Harrod holds s and Cr constant, Gw given by (1.11) signifies the line of steady advance, albeit with involuntary unemployment. 5) Failure to satisfy the dynamic equilibrium condition expressed by (1.10) would impiedly entail an inflationary tendency over time (t) due to (I/Y)t-(S/Y)t 0 or a stagnationary tendency due to (I/Y)t -(S/Y)t 0. The Dynamic Investment-Saving Relation and Global Economic Development. Keynes' static investment-saving equilibrium condition for a closed economy has also led to a dynamic post-keynesian formula for narrowing the standard-of-living gap between 3) R. F. Harrod, Domar and Dynamics, Economic Journal, September ) R. F. Harrod, Towards a Dynamic Economics, ) Ibid., p April 1969 K. K. Kurihara: Contributions and Limitations of Keynesian Theory the advanced and the underdeveloped economies. Keynes' remark that a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members 6) can be paraphrased to read: The world economy will have to provide a mechanism whereby the excess saving of its advanced sectors is utilized by its underdeveloped sectors, to the mutual benefit of the former's stable growth and the latter's rapid growth. Such a mechanism on a purely technical and non-political basis was suggested in Keynes' proposal for a World Bank for Reconstruction and Development.7) Instead of leaving global economic development to the vagaries of laissez-faire capital movements, Keynes would have us provide autonomous and anonymous developmental capital free from traditional political strings. Accordingly, a dynamic extension of Keynes' static investment-saving equilibrium condition to an open economy can be shown in two ways: on the assumptions that I=*K, I=S+B, s=s/yu, and b=k/yu, **B/Yu; on the assumption that I+L=S, ga**ya/ya, s'*s/ya, b'=*i/*ya, and **L/Ya. Here Yu is an underdeveloped economy's productive capacity, Ya an advanced economy's effective demand, K real capital, I net investment, S domestic saving, B autonomous net foreign borrowing (representing capital imports), L autonomous net foreign ending (representing capital exports), gu the rate of growth of capital, ga the lrate of growth of effective demand, b or b' the average-marginal capital coefficient, s or s' the domestic saving ratio, * the ratio of autonomous foreign borrowing to domestic productive capacity, and * the ratio of autonomous foreign lending to domestic effective demand. Equation (1.12) is for the rapid growth of capital in an underdeveloped open economy, while equation (1.13) is for the stable growth of effective demand in an advanced open economy. It is to be noted that (1.12) involves I=S+B as the investment -saving equilibrium condition to be satisfied by an underdeveloped economy, and that (1.13) includes I+L=S as the counterpart to be satisfied by an advanced economy. To the former economy foreign borrowing (*) is a force tending to accelerate its capital formation; to the latter economy foreign lending (*) is a force tending to stabilize its effective demand (by serving as an additional offset to its excess saving in terms of ratios). Flexible Fiscal-Monetary Policy Parameters. Keynes made it possible to include what J. Tinbergen calls instrument variables in relevant behavioral functions so as to promote economic stability or growth.8) Specifically he made powerful sugges- 6) General Theory, p ) The Keynes Plan advocating, among other things, an International Investment or Development Corporation (reprinted in S. E. Harris (ed.), The New Economics, p. 339). tions about the possibility and desirability of manipulating government expenditure and income taxes in a manner that compensates for destabilizing private consumption and investment activities, as A. P. Lerner's functional finance and A. H. Hansen's compensatory fiscal policy, and more recently W. Heller's New Dimensions of Political Economy attest. Thus we can now have the government-expenditure multiplier equation of the expanded form thus: (1.14) *Y=c(*Y-*T+*R)+i(*Y-*T'+*R')+*G, dividing which equation through by *Y yields solving which equation for *Y gives the government-expenditure multiplier equation in question (1.16) *Y=[1-c(1-t+r)-i(1-t'+r')]-1*G. Here Y is national income, T personal income taxes, R autonomous consumer subsidies, T' corporate income taxes, R' autonomous business subsidies, G autonomous government expenditure, t=*t/*y or the marginal personal-income tax rate, t'=*t'/*y or the marginal corporate-income tax rate, r=r/*y or the government transfer payments ratio for the consumers, r'=*r'/*y or the government transfer payments ratio for the producers, c the marginal propensity to consume out of disposable income, and i the marginal propensity to invest out of disposable income. Equation (1.16) derived from (1.14) and (1.15) includes t, t', r, and r' as manipulative fiscal-policy parameters to influence private consumption expenditure and investment, as well as flexible *G-albeit subject to the parliamentary constraint. Moreover, Keynes' marginal efficiency of capital theory and liquidity-preference theory have, between them, inspired a cheap money or dear money policy as a countercyclical measure. For we have from these theories implying: If r-e 0 If r-e 0 (cheap money policy), then *I(t) 0. (dear money policy), then *I(t) 0. Here I is real investment (in contradistinction to financial investment in securities), L the demand for money or liquidity-preference, M the autonomous supply of money (via central bank policy), r the rate of interest, e the marginal efficiency of capital, y the annual yield of capital in general, c the replacement cost of that capital, and t time. Equation (1.17) expresses the equilibrium investment condition to be satisfied by the producers of capital goods in a money economy with a positive rate of interest. 8) For applications to a growing economy see J. G. Gurley, Fiscal Policy in a Growing Economy, Journal of Political Economy, December 1953; my Growth Models and Fiscal-Policy Parameters, Public Finance, No. 2/1956; A. T. Peacock, The Public Sector and the Theory of Economic Growth, Scottish Journal of Political Economy, February 1959; and R. Musgrave, The Theory of Public Finance, April 1969 K. K. Kurihara: Contributions and Limitations of Keynesian Theory Income as the Central Variable and the Strategic Division of Aggregate Demand. The substitution of income for price as the key variable and the division of aggregate demand into consumption-demand and investment-demand constitute Keynes' permanent methodological contribution to macro analysis and policy. For these methodological innovations sharply and fundamentally distinguish the Keynesian theory of macro equilibrium from the classical Walrasian general equilibrium system and the neoclassical quantity theory of money. Compare the following three constitutions of general equilibrium: (1.18) Y-(C+1)=0; I(Y)-S(Y)=0 (Y Y_??_), Here Y is national income, Y_??_ full-employment income, C consumption-demand, 1 investment-demand, S saving, Di the i-th good demanded, Si the i-th good supplied, Q constant output (on the assumption of Y=Y_??_), M the total supply of money, pi the price of the i-th good demanded and supplied, p the index of general prices, and v the velocity of circulation of money. The equations expressed by (1.18) are familiarly the Keynesian crosses I and II. Two things deserve special attention, namely, (a) variable income at less than full employment as compared with constant fullemployment income assumed by Walras to justify variable price as the equilibrating factor, and (b) consumption expenditure and investment regarded as the most strategic components of total demand.9) System of equations (1.19) expresses Walras' general equilibrium condition inferentially involving Di=*i(p1, p2,, pn) and S:=*i (pl, p2,, pn) (where i=1,, n). This system is an improvement over Say's law, to be sure, but it implies the pious hope that milliards of individual demand and supply equations would be equilibrated through laissez-faire price change (as in the absence of government intervention and monopolistic or oligopolistic market rigidities). By contrast, Keynes makes income change as the modus operandi of the whole economy, and also specifies consumption expenditure and investment as predictable and controllable components of aggregate demand (irrespective of market conditions). As for equation (1.20), we need not belabor it beyond reminding ourselves of the catch-all nature of vm that represents total money expenditure or demand and the unrealistic constancy assumption about v (in a short period) and Q (even in a longer period). The monetary counterpart of equation (1.18) is of greater theoretical significance and practical importance for the study and control of general prices: where Ym is money national income, Y_??_ constant or variable full-employment real income, cm the marginal propensity to consume out of money income, im the marginal 9) Keynes may have tacitly borrowed from Marx the idea of dividing total demand into consumption and investment (the Marxian counterparts being Departments I and II). See in this respect, a symposium on Das Kapital: a Centenary Appreciation, American Economic Review, May 1967 (including such participants as P. A. Samuelson, E. D. Domar, and M. Bronfenbrenner). propensity to invest out of money income, and p the general price index. Equation (1.21) would enable the policy-makers to stabilize general prices by influencing or/and controlling the cyclical behavior of cm and im, instead of by estimating the parametric value of v alone relatively to Y, Q, and M. The Full Employment Inelasticity of Output as the Criterion of Demand-Pull Inflation.10) The last contribution to be mentioned here is Keynes' conceptual provision of an unequivocal criterion by which to judge whether rising general prices do or do not constitute true inflation 11) in a fairly short period with the given size of population and the given state of technology. And that criterion is the full-employment inelasticity of output with respect to aggregate demand: where Y is output from full employment, N labor-input, D total demand comprising real consumption-demand (C) and real investment-demand (I), Y_??_ constant full-employment real income, and t time. The partial derivatives in equation (1.22) suggest the reservation that even in a relatively short period total output from full employment might conceivably increase if labor productivity affecting Y(N) or total population affecting N could be supposed to rise significantly. Given the demand inelasticity of output in conditions of full employment expressed by (1.22), general prices will, cet. par., rise in a truly inflationary manner according to the mechanism of the form as equation (1.18) implies. Equation (1.23) indicates that general prices can rise at the same rate as the rate at which money national income increases: Equations (1.23) and (1.24) show the possibility of general prices rising in a genuinely inflationary way as a consequence of increasing money national income (which, in equilibrium, equals total demand or expenditure in money terms: Ym-(Cm+Im,) 0, Ym=pY_??_) respectively in terms of levels and in terms of rates. These equations represent a Keynesian antidote for the anti-inflation obscurantism of those who are alarmed by every small rise of general prices irrespective of whether total output can or cannot be increased to meet the increasing demand for goods and services, and who are therefore blindly biased in favor of deflationary measures even at the risk of provoking a recession.. The II Limitations Turing now to the limitations of Keynesian theory, I might preface the subsequent 10) Cost-push inflation will be discussed in Part II. ) General Theory, p. 119, p April 1969 K. K. Kurihara: Contributions and Limitations of Keynesian Theory discussions by making the observation that post-keynesian economists including myself have been more or less aware of those limitations and have made various attempts to begin where Keynes left off. For those limitations are a reflection of historical circumstances in which Keynes lived and worked, circumstances that historically delimited the generality and applicability of the General Theory. To point up the limitations of Keynesian theory here or elsewhere is not to slight its contributions as some readers might suppose, but to stress the need for imaginative and perceptive extensions of a Master Economist's seminal insights12) in such a way as to render the economic discipline increasingly serviceable to all mankind and the rapidly changing world. Overaggregative Income-Expenditure Variables. The first limitation of Keynesian theory to be mentioned consists in the methodological inadequacy of income-expenditure aggregates. The basic equation of the form Y=C+I, while it is a pedagogically useful simplification, nevertheless is inadequate for the specific purpose of singling out inefficient units which militate against overall stability and growth. For that purpose W. W. Leontief's multisectoral approach13) is more helpful. Let Leontief's intermediate demand supp
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