The General Theory (Keynes)

8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : contents
General Theory of Employment,

Interest, and Money, by Keynes
T C
Preface
Preface to the German Edition
Preface to the Japanese Edition
Preface to the French Edition
Chapter:
1. The General Theory
2. The Postulates of the Classical Economics
3. The Principle of Effective Demand
4. The Choice of Units
5. Expectation as Determining Output and Employment
6. The Definition of Income, Saving and Investment
Appendix on User Cost
7. The Meaning of Saving and Investment Further Considered
8. The Propensity to Consume: I. The Objective Factors
9. The Propensity to Consume: II. The Subjective Factors
10. The Marginal Propensity to Consume and the Multiplier
11. The Marginal Efficiency of Capital
12. The State of Long-Term Expectation
13. The General Theory of the Rate of Interest
14. The Classical Theory of the Rate of Interest
Appendix on the Rate of Interest in Marshalls Principles of
Economics, Ricardos Principles of Political Economy, And
Elsewhere
15. The Psychological and Business Incentives to Liquidity
16. Sundry Observations on the Nature of Capital
17. The Essential Properties of Interest and Money
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8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : contents
18. The General Theory of Employment Re-Stated

19. Changes in Money-Wages
Appendix: Professor Pigous theory of Unemployment
20. The Employment Function
21. The Theory of Prices
22. Notes on the Trade Cycle
23. Notes on Mercantilism, the Usury Laws, Stamped Money and
Theories of Under-Consumption
24. Concluding Notes on the Social Philosophy Towards which the
General Theory Might Lead
Appendix:
1. Printing Errors in the First Edition Corrected in the Present Edition
2. Fluctuations in Net Investment in the United States
3. Relative Movements of Real Wages and Output
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8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : PREFACE

This book is chiefly addressed to my fellow economists. I hope that it will

be intelligible to others. But its main purpose is to deal with difficult
questions of theory, and only in the second place with the applications of
this theory to practice. For if orthodox economics is at fault, the error is to
be found not in the superstructure, which has been erected with great care
for logical consistency, but in a lack of clearness and of generality in the
pre misses. Thus I cannot achieve my object of persuading economists to
re-examine critically certain of their basic assumptions except by a highly
abstract argument and also by much controversy. I wish there could have
been less of the latter. But I have thought it important, not only to explain
my own point of view, but also to show in what respects it departs from the
prevailing theory. Those, who are strongly wedded to what I shall call the
classical theory, will fluctuate, I expect, between a belief that I am quite
wrong and a belief that I am saying nothing new. It is for others to
determine if either of these or the third alternative is right. My
controversial passages are aimed at providing some material for an
answer; and I must ask forgiveness If, in the pursuit of sharp distinctions,
my controversy is itself too keen. I myself held with conviction for many
years the theories which I now attack, and I am not, I think, ignorant of
their strong points.
The matters at issue are of an importance which cannot be
exaggerated. But, if my explanations are right, it is my fellow economists,
not the general public, whom I must first convince. At this stage of the
argument the general public, though welcome at the debate, are only
eavesdroppers at an attempt by an economist to bring to an issue the deep
divergences of opinion between fellow economists which have for the time
being almost destroyed the practical influence of economic theory, and
will, until they are resolved, continue to do so.
The relation between this book and my Treatise on Money [JMK vols.
v and vi], which I published five years ago, is probably clearer to myself
than it will be to others; and what in my own mind is a natural evolution in
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a line of thought which I have been pursuing for several years, may
sometimes strike the reader as a confusing change of view. This difficulty
is not made less by certain changes in terminology which I have felt
compelled to make. These changes of language I have pointed out in the
course of the following pages; but the general relationship between the two
books can be expressed briefly as follows. When I began to write my
Treatise on Money I was still moving along the traditional lines of
regarding the influence of money as something so to speak separate from
the general theory of supply and demand. When I finished it, I had made
some progress towards pushing monetary theory back to becoming a
theory of output as a whole. But my lack of emancipation from
preconceived ideas showed itself in what now seems to me to be the
outstanding fault of the theoretical parts of that work (namely, Books III
and IV), that I failed to deal thoroughly with the effects of changes in the
level of output. My so-called fundamental equations were an
instantaneous picture taken on the assumption of a given output. They
attempted to show how, assuming the given output, forces could develop
which involved a profit-disequilibrium, and thus required a change in the
level of output. But the dynamic development, as distinct from the
instantaneous picture, was left incomplete and extremely confused. This
book, on the other hand, has evolved into what is primarily a study of the
forces which determine changes in the scale of output and employment as
a whole; and, whilst it is found that money enters into the economic
scheme in an essential and peculiar manner, technical monetary detail
falls into the background. A monetary economy, we shall find, is
essentially one in which changing views about the future are capable of
influencing the quantity of employment and not merely its direction. But
our method of analysing the economic behaviour of the present under the
influence of changing ideas about the future is one which depends on the
interaction of supply and demand, and is in this way linked up with our
fundamental theory of value. We are thus led to a more general theory,
which includes the classical theory with which we are familiar, as a special
case.
The writer of a book such as this, treading along unfamiliar paths, is
extremely dependent on criticism and conversation if he is to avoid an
undue proportion of mistakes. It is astonishing what foolish things one can
temporarily believe if one thinks too long alone, particularly in economics
(along with the other moral sciences), where it is often impossible to bring
ones ideas to a conclusive test either formal or experimental. In this book,
even more perhaps than in writing my Treatise on Money, I have
depended on the constant advice and constructive criticism of Mr R.F.

Kahn. There is a great deal in this book which would not have taken the
shape it has except at his suggestion. I have also had much help from Mrs
Joan Robinson, Mr R.G. Hawtrey and Mr R.F. Harrod, who have read the
whole of the proof-sheets. The index has been compiled by Mr D. M.
Bensusan-Butt of Kings College, Cambridge.
The composition of this book has been for the author a long struggle
of escape, and so must the reading of it be for most readers if the authors
assault upon them is to be successful a struggle of escape from habitual
modes of thought and expression. The ideas which are here expressed so
laboriously are extremely simple and should be obvious. The difficulty lies,
not in the new ideas, but in escaping from the old ones, which ramify, for
those brought up as most of us have been, into every corner of our minds.
J. M. KEYNES
13 December 1935
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8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : PREFACE TO THE GERMAN EDITION

P G E
Alfred Marshall, on whose Principles of Economics all contemporary

English economists have been brought up, was at particular pains to
emphasise the continuity of his thought with Ricardos. His work largely
consisted in grafting the marginal principle and the principle of
substitution on to the Ricardian tradition; and his theory of output and
consumption as a whole, as distinct from his theory of the production and
distribution of a given output, was never separately expounded. Whether
he himself felt the need of such a theory, I am not sure. But his immediate
successors and followers have certainly dispensed with it and have not,
apparently, felt the lack of it. It was in this atmosphere that I was brought
up. I taught these doctrines myself and it is only within the last decade that
I have been conscious of their insufficiency. In my own thought and
development, therefore, this book represents a reaction, a transition away
from the English classical (or orthodox) tradition. My emphasis upon this
in the following pages and upon the points of my divergence from received
doctrine has been regarded in some quarters in England as unduly
controversial. But how can one brought up a Catholic in English
economics, indeed a priest of that faith, avoid some controversial
emphasis, when he first becomes a Protestant?
But I fancy that all this may impress German readers somewhat
differently. The orthodox tradition, which ruled in nineteenth century
England, never took so firm a hold of German thought. There have always
existed important schools of economists in Germany who have strongly
disputed the adequacy of the classical theory for the analysis of
contemporary events. The Manchester School and Marxism both derive
ultimately from Ricardo a conclusion which is only superficially
surprising. But in Germany there has always existed a large section of
opinion which has adhered neither to the one nor to the other.
It can scarcely be claimed, however, that this school of thought has
erected a rival theoretical construction; or has even attempted to do so. It
has been sceptical, realistic, content with historical and empirical methods
and results, which discard formal analysis. The most important

unorthodox discussion on theoretical lines was that of Wicksell. His books
were available in German (as they were not, until lately, in English);
indeed one of the most important of them was written in German. But his
followers were chiefly Swedes and Austrians, the latter of.whom combined
his ideas with specifically Austrian theory so as to bring them in effect,
back again towards the classical tradition. Thus Germany, quite contrary
to her habit in most of the sciences, has been content for a whole century
to do without any formal theory of economics which was predominant and
generally accepted.
Perhaps, therefore, I may expect less resistance from German, than
from English, readers in offering a theory of employment and output as a
whole, which departs in important respects from the orthodox tradition.
But can I hope to overcome Germanys economic agnosticism? Can I
persuade German economists that methods of formal analysis have
something important to contribute to the interpretation of contemporary
events and to the moulding of contemporary policy? After all, it is German
to like a theory. How hungry and thirsty German economists must feel
after having lived all these years without one! Certainly, it is worth while
for me to make the attempt. And if I can contribute some stray morsels
towards the preparation by German economists of a full repast of theory
designed to meet specifically German conditions, I shall be content. For I
confess that much of the following book is illustrated and expounded
mainly with reference to the conditions existing in the Anglo-Saxon
countries.
Nevertheless the theory of output as a whole, which is what the
following book purports to provide, is much more easily adapted to the
conditions of a totalitarian state, than is the theory of the production and
distribution of a given output produced under conditions of free
competition and a large measure of laissez-faire. The theory of the
psychologi-cal laws relating consumption and saving, the influence of loan
expenditure on prices and real wages, the part played by the rate of
interest these remain as necessary ingredients in our scheme of thought.
I take this opportunity to acknowledge my indebtedness to the
excellent work of my translator Herr Waeger (I hope his vocabulary at the
end of this volume may prove useful beyond its immediate purpose) and to
my publishers, Messrs Duncker and Humblot, whose enterprise, from the
days now sixteen years ago when they published my Economic
Consequences of the Peace, has enabled me to maintain contact with
German readers.
J. M. KEYNES
7 September 1936
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : PREFACE TO THE JAPANESE EDITION

P J E
Alfred Marshall, on whose Principles of Economics all contemporary

English economists have been brought up, was at particular pains to
emphasise the continuity of his thought with Ricardos. His work largely
consisted in grafting the marginal principle and the principle of
substitution on to the Ricardian tradition; and his theory of output and
consumption as a whole, as distinct from his theory of the production and
distribution of a given output, was never separately expounded. Whether
he himself felt the need of such a theory, I am not sure. But his immediate
successors and followers have certainly dispensed with it and have not,
apparently, felt the lack of it. It was in this atmosphere that I was brought
up. I taught these doctrines myself and it is only within the last decade that
I have been conscious of their insufficiency. In my own thought and
development, therefore, this book represents a reaction, a transition away
from the English classical (or orthodox) tradition. My emphasis upon this
in the following pages and upon the points of my divergence from received
doctrine has been regarded in some quarters in England as unduly
controversial. But how can one brought up in English economic orthodoxy,
indeed a priest of that faith at one time, avoid some controversial
emphasis, when he first becomes a Protestant?
Perhaps Japanese readers, however, will neither require nor resist my
assaults against the English tradition. We are well aware of the large scale
on which English economic writings are read in Japan, but we are not so
well informed as to how Japanese opinions regard them. The recent
praiseworthy enterprise on the part of the International Economic Circle
of Tokyo in reprinting Malthuss Principles of Political Economy as the
first volume in the Tokyo Series of Reprints encourages me to think that a
book which traces its descent from Malthus rather than Ricardo may be
received with sympathy in some quarters at least.
At any rate I am grateful to the Oriental Economist for making it
possible for me to approach Japanese readers without the extra handicap
of a foreign language.
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : PREFACE TO THE JAPANESE EDITION
J. M. KEYNES
4 December 1936
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : PREFACE TO THE FRENCH EDITION

P F E
For a hundred years or longer, English Political Economy has been

dominated by an orthodoxy. That is not to say that an unchanging doctrine
has prevailed. On the contrary. There has been a progressive evolution of
the doctrine. But its presuppositions, its atmosphere, its method have
remained surprisingly the same, and a remarkable continuity has been
observable through all the changes. In that orthodoxy, in that continuous
transition, I was brought up. I learnt it, I taught it, I wrote it. To those
looking from outside I probably still belong to it. Subsequent historians of
doctrine will regard this book as in essentially the same tradition. But I
myself in writing it, and in other recent work which has led up to it, have
felt myself to be breaking away from this orthodoxy, to be in strong
reaction against it, to be escaping from something, to be gaining an
emancipation. And this state of mind on my part is the explanation of
certain faults in the book, in particular its controversial note in some
passages, and its air of being addressed too much to the holders of a
particular point of view and too little ad urbem et orbem. I was wanting to
convince my own environment and did not address myself with sufficient
directness to outside opinion. Now three years later, having grown
accustomed to my new skin and having almost forgotten the smell of my
old one, I should, if I were writing afresh, endeavour to free myself from
this fault and state my own position in a more clear-cut manner.
I say all this, partly to explain and partly to excuse, myself to French
readers. For in France there has been no orthodox tradition with the same
authority over contemporary opinion as in my own country. In the United
States the position has been much the same as in England. But in France,
as in the rest of Europe, there has been no such dominant school since the
expiry of the school of French Liberal economists who were in their prime
twenty years ago (though they lived to so great an age, long after their
influence had passed away, that it fell to my duty, when I first became a
youthful editor of the Economic Journal to write the obituaries of many of
them Levasseur, Molinari, Leroy-Beaulieu). If Charles Gide had attained
to the same influence and authority as Alfred Marshall, your position

would have borne more resemblance to ours. As it is, your economists are
eclectic, too much (we sometimes think) without deep roots in systematic
thought. Perhaps this may make them more easily accessible to what I
have to say. But it may also have the result that my readers will sometimes
wonder what I am talking about when I speak, with what some of my
English critics consider a misuse of language, of the classical school of
thought and classical economists. It may, therefore, be helpful to my
French readers if I attempt to indicate very briefly what I regard as the
main differentiae of my approach.
I have called my theory a general theory. I mean by this that I am
chiefly concerned with the behaviour of the economic system as a whole
with aggregate incomes, aggregate profits, aggregate output, aggregate
employment, aggregate investment, aggregate saving rather than with the
incomes, profits, output, employment, investment and saving of particular
industries, firms or individuals. And I argue that important mistakes have
been made through extending to the system as a whole conclusions which
have been correctly arrived at in respect of a part of it taken in isolation.
Let me give examples of what I mean. My contention that for the
system as a whole the amount of income which is saved, in the sense that it
is not spent on current consumption, is and must necessarily be exactly
equal to the amount of net new investment has been considered a paradox
and has been the occasion of widespread controversy. The explanation of
this is undoubtedly to be found in the fact that this relationship of equality
between saving and investment, which necessarily holds good for the
system as a whole, does not hold good at all for a particular individual.
There is no reason whatever why the new investment for which I am
responsible should bear any relation whatever to the amount of my own
savings. Qute legitimately we regard an individuals income as
independent of what he himself consumes and invests. But this, I have to
point out, should not have led us to overlook the fact that the demand
arising out of the consumption and investment of one individual is the
source of the incomes of other individuals, so that incomes in general are
not independent, quite the contrary, of the disposition of individuals to
spend and invest; and since in turn the readiness of individuals to spend
and invest depends on their incomes, a relationship is set up between
aggregate savings and aggregate investment which can be very easily
shown, beyond any possibility of reasonable dispute, to be one of exact and
necessary equality. Rightly regarded this is a banale conclusion. But it sets
in motion a train of thought from which more substantial matters follow.
It is shown that, generally speaking, the actual level of output and

employment depends, not on the capacity to produce or on the pre-
existing level of incomes, but on the current decisions to produce which
depend in turn on current decisions to invest and on present expectations
of current and prospective consumption. Moreover, as soon as we know
the propensity to consume and to save (as I call it), that is to say the result
for the community as a whole of the individual psychological inclinations
as to how to dispose of given incomes, we can calculate what level of
incomes, and therefore what level of output and employment, is in profit-
equilibrium with a given level of new investment; out of which develops
the doctrine of the Multiplier. Or again, it becomes evident that an
increased propensity to save will ceteris paribus contract incomes and
output; whilst an increased inducement to invest will expand them. We are
thus able to analyse the factors which determine the income and output of
the system as a whole; we have, in the most exact sense, a theory of
employment. Conclusions emerge from this reasoning which are
particularly relevant to the problems of public finance and public policy
generally and of the trade cycle.
Another feature, specially characteristic of this book, is the theory of
the rate of interest. In recent times it has been held by many economists
that the rate of current saving determined the supply of free capital, that
the rate of current investment governed the demand for it, and that the
rate of interest was, so to speak, the equilibrating price-factor determined
by the point of intersection of the supply curve of savings and the demand
curve of investment. But if aggregate saving is necessarily and in all
circumstances exactly equal to aggregate investment, it is evident that this
explanation collapses. We have to search elsewhere for the solution. I find
it in the idea that it is the function of the rate of interest to preserve
equilibrium, not between the demand and the supply of new capital goods,
but between the demand and the supply of money, that is to say between
the demand for liquidity and the means of satisfying this demand. I am
here returning to the doctrine of the older, pre-nineteenth century
economists. Montesquieu, for example, saw this truth with considerable
clarity Montesquieu who was the real French equivalent of Adam Smith,
the greatest of your economists, head and shoulders above the physiocrats
in penetration, clear-headedness and good sense (which are the qualities
an economist should have). But I must leave it to the text of this book to
show how in detail all this works out.
I have called this book the General Theory of Employment, Interest
and Money; and the third feature to which I may call attention is the
treatment of money and prices. The following analysis registers my final

escape from the confusions of the Quantity Theory, which once entangled
me. I regard the price level as a whole as being determined in precisely the
same way as individual prices; that is to say, under the influence of supply
and demand. Technical conditions, the level of wages, the extent of unused
capacity of plant and labour, and the state of markets and competition
determine the supply conditions of individual products and of products as
a whole. The decisions of entrepreneurs, which provide the incomes of
individual producers and the decisions of those individuals as to the
disposition of such incomes determine the demand conditions. And prices
both individual prices and the price-level emerge as the resultant of
these two factors. Money, and the quantity of money, are not direct
influences at this stage of the proceedings. They have done their work at
an earlier stage of the analysis. The quantity of money determines the
supply of liquid resources, and hence the rate of interest, and in
conjunction with other factors (particularly that of confidence) the
inducement to invest, which in turn fixes the equilibrium level of incomes,
output and employment and (at each stage in conjunction with other
factors) the price-level as a whole through the influences of supply and
demand thus established.
I believe that economics everywhere up to recent times has been
dominated, much more than has been understood, by the doctrines
associated with the name of J.-B. Say. It is true that his law of markets
has been long abandoned by most economists; but they have not
extricated themselves from his basic assumptions and particularly from
his fallacy that demand is created by supply. Say was implicitly assuming
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. Nearly all subsequent economic theory has depended
on, in the sense that it has required, this same assumption. Yet a theory so
based is clearly incompetent to tackle the problems of unemployment and
of the trade cycle. Perhaps I can best express to French readers what I
claim for this book by saying that in the theory of production it is a final
break-away from the doctrines of J.-B. Say and that in the theory of
interest it is a return to the doctrines of Montesquieu.
J. M. KEYNES
20 February 1939
Kings College
Cambridge
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : Chapter 1

C 1
T G T
I have called this book the General Theory of Employment, Interest and
Money, placing the emphasis on the prefix general. The object of such a
title is to contrast the character of my arguments and conclusions with
those of the classical theory of the subject, upon which I was brought up
and which dominates the economic thought, both practical and
theoretical, of the governing and academic classes of this generation, as it
has for a hundred years past. 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.
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C 2
T P C
E
Most treatises on the theory of value and production are primarily

concerned with the distribution of a given volume of employed resources
between different uses and with the conditions which, assuming the
employment of this quantity of resources, determine their relative rewards
and the relative values of their products.
The question, also, of the volume of the available resources, in the
sense of the size of the employable population, the extent of natural wealth
and the accumulated capital equipment, has often been treated
descriptively. But the pure theory of what determines the actual
employment of the available resources has seldom been examined in great
detail. To say that it has not been examined at all would, of course, be
absurd. For every discussion concerning fluctuations of employment, of
which there have been many, has been concerned with it. I mean, not that
the topic has been overlooked, but that the fundamental theory underlying
it has been deemed so simple and obvious that it has received, at the most,
a bare mention.
The classical theory of employment supposedly simple and obvious
has been based, I think, on two fundamental postulates, though
practically without discussion, namely:
I. The wage is equal to the marginal product of labour
That is to say, the wage of an employed person is equal to the value
which would be lost if employment were to be reduced by one unit (after
deducting any other costs which this reduction of output would avoid);
subject, however, to the qualification that the equality may be disturbed, in
accordance with certain principles, if competition and markets are
imperfect.
II. The utility of the wage when a given volume of labour is employed
is equal to the marginal disutility of that amount of employment.
That is to say, the real wage of an employed person is that which is
just sufficient (in the estimation of the employed persons themselves) to
induce the volume of labour actually employed to be forthcoming; subject
to the qualification that the equality for each individual unit of labour may
be disturbed by combination between employable units analogous to the
imperfections of competition which qualify the first postulate. Disutility
must be here understood to cover every kind of reason which might lead a
man, or a body of men, to withhold their labour rather than accept a wage
which had to them a utility below a certain minimum.
This postulate is compatible with what may be called frictional
unemployment. For a realistic interpretation of it legitimately allows for
various inexactnesses of adjustment which stand in the way of continuous
full employment: for example, unemployment due to a temporary want of
balance between the relative quantities of specialised resources as a result
of miscalculation or intermittent demand; or to time-lags consequent on
unforeseen changes; or to the fact that the change-over from one
employment to another cannot be effected without a certain delay, so that
there will always exist in a non-static society a proportion of resources
unemployed between jobs. In addition to frictional unemployment, the
postulate is also compatible with voluntary unemployment due to the
refusal or inability of a unit of labour, as a result of legislation or social
practices or of combination for collective bargaining or of slow response to
change or of mere human obstinacy, to accept a reward corresponding to
the value of the product attributable to its marginal productivity. But these
two categories of frictional unemployment and voluntary unemployment
are comprehensive. The classical postulates do not admit of the possibility
of the third category, which I shall define below as involuntary
unemployment.
Subject to these qualifications, the volume of employed resources is
duly determined, according to the classical theory, by the two postulates.
The first gives us the demand schedule for employment, the second gives
us the supply schedule; and the amount of employment is fixed at the
point where the utility of the marginal product balances the disutility of
the marginal employment. It would follow from this that there are only
four possible means of increasing employment:
(a) An improvement in organisation or in foresight which diminishes
frictional unemployment;
(b) a decrease in the marginal disutility of labour, as expressed by the

real wage for which additional labour is available, so as to diminish
voluntary unemployment;
(c) an increase in the marginal physical productivity of labour in the
wage-goods industries (to use Professor Pigous convenient term for goods
upon the price of which the utility of the money-wage depends);
or (d) an increase in the price of non-wage-goods compared with the
price of wage-goods, associated with a shift in the expenditure of non-
wage-earners from wage-goods to non-wage-goods.
This, to the best of my understanding, is the substance of Professor
Pigous Theory of Unemployment the only detailed account of the
classical theory of employment which exists.
Is it true that the above categories are comprehensive in view of the fact
that the population generally is seldom doing as much work as it would
like to do on the basis of the current wage? For, admittedly, more labour
would, as a rule, be forthcoming at the existing money-wage if it were
demanded. The classical school reconcile this phenomenon with their
second postulate by arguing that, while the demand for labour at the
existing money-wage may be satisfied before everyone willing to work at
this wage is employed, this situation is due to an open or tacit agreement
amongst workers not to work for less, and that if labour as a whole would
agree to a reduction of money-wages more employment would be
forthcoming. If this is the case, such unemployment, though apparently
involuntary, is not strictly so, and ought to be included under the above
category of voluntary unemployment due to the effects of collective
bargaining, etc.
This calls for two observations, the first of which relates to the actual
attitude of workers towards real wages and money-wages respectively and
is not theoretically fundamental, but the second of which is fundamental.
Let us assume, for the moment, that labour is not prepared to work
for a lower money-wage and that a reduction in the existing level of
money-wages would lead, through strikes or otherwise, to a withdrawal
from the labour market of labour which is now employed. Does it follow
from this that the existing level of real wages accurately measures the
marginal disutility of labour? Not necessarily. For, although a reduction in
the existing money-wage would lead to a withdrawal of labour, it does not
follow that a fall in the value of the existing money-wage in terms of wage-
goods would do so, if it were due to a rise in the price of the latter. In other
words, it may be the case that within a certain range the demand of labour
is for a minimum money-wage and not for a minimum real wage. The
classical school have tacitly assumed that this would involve no significant
change in their theory. But this is not so. For if the supply of labour is not a
function of real wages as its sole variable, their argument breaks down
entirely and leaves the question of what the actual employment will be
quite indeterminate. They do not seem to have realised that, unless the
supply of labour is a function of real wages alone, their supply curve for
labour will shift bodily with every movement of prices. Thus their method
is tied up with their very special assumptions, and cannot be adapted to
deal with the more general case.
Now ordinary experience tells us, beyond doubt, that a situation
where labour stipulates (within limits) for a money-wage rather than a real
wage, so far from being a mere possibility, is the normal case. Whilst
workers will usually resist a reduction of money-wages, it is not their
practice to withdraw their labour whenever there is a rise in the price of
wage-goods. It is sometimes said that it would be illogical for labour to
resist a reduction of money-wages but not to resist a reduction of real
wages. For reasons given below (p. 14), this might not be so illogical as it
appears at first; and, as we shall see later, fortunately so. But, whether
logical or illogical, experience shows that this is how labour in fact
behaves.
Moreover, the contention that the unemployment which characterises
a depression is due to a refusal by labour to accept a reduction of money-
wages is not clearly supported by the facts. It is not very plausible to assert
that unemployment in the United States in 1932 was due either to labour
obstinately refusing to accept a reduction of money-wages or to its
obstinately demanding a real wage beyond what the productivity of the
economic machine was capable of furnishing. Wide variations are
experienced in the volume of employment without any apparent change
either in the minimum real demands of labour or in its productivity.
Labour is not more truculent in the depression than in the boom far
from it. Nor is its physical productivity less. These facts from experience
are a prima facie ground for questioning the adequacy of the classical
analysis.
It would be interesting to see the results of a statistical enquiry into
the actual relationship between changes in money-wages and changes in
real wages. In the case of a change peculiar to a particular industry one
would expect the change in real wages to be in the same direction as the
change in money-wages. But in the case of changes in the general level of
wages, it will be found, I think, that the change in real wages associated
with a change in money-wages, so far from being usually in the same
direction, is almost always in the opposite direction. When money-wages
are rising, that is to say, it will be found that real wages are falling; and
when money-wages are falling, real wages are rising. This is because, in
the short period, falling money-wages and rising real wages are each, for
independent reasons, likely to accompany decreasing employment; labour
being readier to accept wage-cuts when employment is falling off, yet real
wages inevitably rising in the same circumstances on account of the
increasing marginal return to a given capital equipment when output is
diminished.
If, indeed, it were true that the existing real wage is a minimum below
which more labour than is now employed will not be forthcoming in any
circumstances, involuntary unemployment, apart from frictional
unemployment, would be non-existent. But to suppose that this is
invariably the case would be absurd. For more labour than is at present
employed is usually available at the existing money-wage, even though the
price of wage-goods is rising and, consequently, the real wage falling. If
this is true, the wage-goods equivalent of the existing money-wage is not
an accurate indication of the marginal disutility of labour, and the second
postulate does not hold good.
But there is a more fundamental objection. The second postulate
flows from the idea that the real wages of labour depend on the wage
bargains which labour makes with the entrepreneurs. It is admitted, of
course, that the bargains are actually made in terms of money, and even
that the real wages acceptable to labour are not altogether independent of
what the corresponding money-wage happens to be. Nevertheless it is the
money-wage thus arrived at which is held to determine the real wage. Thus
the classical theory assumes that it is always open to labour to reduce its
real wage by accepting a reduction in its money-wage. The postulate that
there is a tendency for the real wage to come to equality with the marginal
disutility of labour clearly presumes that labour itself is in a position to
decide the real wage for which it works, though not the quantity of
employment forthcoming at this wage.
The traditional theory maintains, in short, that the wage bargains
between the entrepreneurs and the workers determine the real wage; so
that, assuming free competition amongst employers and no restrictive
combination amongst workers, the latter can, if they wish, bring their real
wages into conformity with the marginal disutility of the amount of

employment offered by the employers at that wage. If this is not true, then
there is no longer any reason to expect a tendency towards equality
between the real wage and the marginal disutility of labour.
The classical conclusions are intended, it must be remembered, to
apply to the whole body of labour and do not mean merely that a single
individual can get employment by accepting a cut in money-wages which
his fellows refuse. They are supposed to be equally applicable to a closed
system as to an open system, and are not dependent on the characteristics
of an open system or on the effects of a reduction of money-wages in a
single country on its foreign trade, which lie, of course, entirely outside the
field of this discussion. Nor are they based on indirect effects due to a
lower wages-bill in terms of money having certain reactions on the
banking system and the state of credit, effects which we shall examine in
detail in chapter 19. They are based on the belief that in a closed system a
reduction in the general level of money-wages will be accompanied, at any
rate in the short period and subject only to minor qualifications, by some,
though not always a proportionate, reduction in real wages.
Now the assumption that the general level of real wages depends on
the money-wage bargains between the employers and the workers is not
obviously true. Indeed it is strange that so little attempt should have been
made to prove or to refute it. For it is far from being consistent with the
general tenor of the classical theory, which has taught us to believe that
prices are governed by marginal prime cost in terms of money and that
money-wages largely govern marginal prime cost. Thus if money-wages
change, one would have expected the classical school to argue that prices
would change in almost the same proportion, leaving the real wage and the
level of unemployment practically the same as before, any small gain or
loss to labour being at the expense or profit of other elements of marginal
cost which have been left unaltered. They seem, however, to have been
diverted from this line of thought, partly by the settled conviction that
labour is in a position to determine its own real wage and partly, perhaps,
by preoccupation with the idea that prices depend on the quantity of
money. And the belief in the proposition that labour is always in a position
to determine its own real wage, once adopted, has been ina~ntained by its
being confused with the proposition that labour is always in a position to
determine what real wage shall correspond to full employment, i.e. the
maximum quantity of employment which is compatible with a given real
wage.
To sum up: there are two objections to the second postulate of the
classical theory. The first relates to the actual behaviour of labour. A fall in
real wages due to a rise in prices, with money-wages unaltered, does not,
as a rule, cause the supply of available labour on offer at the current wage
to fall below the amount actually employed prior to the rise of prices. To
sthat it does is to suppose that all those who are now unemployed though
willing to work at the current wage will withdraw the offer of their labour
in the event of even a small rise in the cost of living. Yet this strange
supposition apparently underlies Professor Pigous Theory of
Unemployment, and it is what all members of the orthodox school are
tacitly assuming.
But the other, more fundamental, objection, which we shall develop in
the ensuing chapters, flows from our disputing the assumption that the
general level of real wages is directly determined by the character of the
wage bargain. In assuming that the wage bargain determines the real wage
the classical school have slipt in an illicit assumption. For there may be no
method available to labour as a whole whereby it can bring the wage-goods
equivalent of the general level of money wages into conformity with the
marginal disutility of the current volume of employment. There may exist
no expedient by which labour as a whole can reduce its real wage to a given
figure by making revised money bargains with the entrepreneurs. This will
be our contention. We shall endeavour to show that primarily it is certain
other forces which determine the general level of real wages. The attempt
to elucidate this problem will be one of our main themes. We shall argue
that there has been a fundamental misunderstanding of how in this
respect the economy in which we live actually works.
Though the struggle over money-wages between individuals and groups is

often believed to determine the general level of real-wages, it is, in fact,
concerned with a different object. Since there is imperfect mobility of
labour, and wages do not tend to an exact equality of net advantage in
different occupations, any individual or group of individuals, who consent
to a reduction of money-wages relatively to others, will suffer a relative
reduction in real wages, which is a sufficient justification for them to resist
it. On the other hand it would be impracticable to resist every reduction of
real wages, due to a change in the purchasing-power of money which
affects all workers alike; and in fact reductions of real wages arising in this
way are not, as a rule, resisted unless they proceed to an extreme degree.
Moreover, a resistance to reductions in money-wages applying to
particular industries does not raise the same insuperable bar to an
increase in aggregate employment which would result from a similar
resistance to every reduction in real wages.
In other words, the struggle about money-wages primarily affects the
distribution of the aggregate real wage between different labour-groups,
and not its average amount per unit of employment, which depends, as we
shall see, on a different set of forces. The effect of combination on the part
of a group of workers is to protect their relative real wage. The general
level of real wages depends on the other forces of the economic system.
Thus it is fortunate that the workers, though unconsciously, are
instinctively more reasonable economists than the classical school,
inasmuch as they resist reductions of money-wages, which are seldom or
never of an all-round character, even though the existing real equivalent of
these wages exceeds the marginal disutility of the existing employment;
whereas they do not resist reductions of real wages, which are associated
with increases in aggregate employment and leave relative money-wages
unchanged, unless the reduction proceeds so far as to threaten a reduction
of the real wage below the marginal disutility of the existing volume of
employment. Every trade union will put up some resistance to a cut in
money-wages, however small. But since no trade union would dream of
striking on every occasion of a rise in the cost of living, they do not raise
the obstacle to any increase in aggregate employment which is attributed
to them by the classical school.
We must now define the third category of unemployment, namely

involuntary unemployment in the strict sense, the possibility of which the
classical theory does not admit.
Clearly we do not mean by involuntary unemployment the mere
existence of an unexhausted capacity to work. An eight-hour day does not
constitute unemployment because it is not beyond human capacity to work
ten hours. Nor should we regard as involuntary unemployment the
withdrawal of their labour by a body of workers because they do not
choose to work for less than a certain real reward. Furthermore, it will be
convenient to exclude frictional unemployment from our definition of
involuntary unemployment. My definition is, therefore, as follows: Men
are involuntarily unemployed If, in the event of a small rise in the price of
wage-goods relatively to the money-wage, both the aggregate supply of
labour 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. An alternative definition, which amounts, however, to the
same thing, will be given in the next chapter (Chapter 3).
It follows from this definition that the equality of the real wage to the
marginal disutility of employment presupposed by the second postulate,
realistically interpreted, corresponds to the absence of involuntary
unemployment. This state of affairs we shall describe as full employment,
both frictional and voluntary unemployment being consistent with full
employment thus defined. This fits in, we shall find, with other
characteristics of the classical theory, which is best regarded as a theory of
distribution in conditions of full employment. So long as the classical
postulates hold good, unemployment, which is in the above sense
involuntary, cannot occur. Apparent unemployment must, therefore, be
the result either of temporary loss of work of the between jobs type or of
intermittent demand for highly specialised resources or of the effect of a
trade union closed shop on the employment of free labour. Thus writers
in the classical tradition, overlooking the special assumption underlying
their theory, have been driven inevitably to the conclusion, perfectly
logical on their assumption, that apparent unemployment (apart from the
admitted exceptions) must be due at bottom to a refusal by the
unemployed factors to accept a reward which corresponds to their
marginal productivity. A classical economist may sympathise with labour
in refusing to accept a cut in its money-wage, and he will admit that it may
not be wise to make it to meet conditions which are temporary; but
scientific integrity forces him to declare that this refusal is, nevertheless, at
the bottom of the trouble.
Obviously, however, if the classical theory is only applicable to the
case of full employment, it is fallacious to apply it to the problems of
involuntary unemployment if there be such a thing (and who will deny
it?). The classical theorists resemble Euclidean geometers in a non-
Euclidean world who, discovering that in experience straight lines
apparently parallel often meet, rebuke the lines for not keeping straight
as the only remedy for the unfortunate collisions which are occurring. Yet,
in truth, there is no remedy except to throw over the axiom of parallels and
to work out a non-Euclidean geometry. Something similar is required to-
day in economics. We need to throw over the second postulate of the
classical doctrine and to work out the behaviour of a system in which

involuntary unemployment in the strict sense is possible.
In emphasising our point of departure from the classical system, we must

not overlook an important point of agreement. For we shall maintain the
first postulate as heretofore, subject only to the same qualifications as in
the classical theory; and we must pause, for a moment, to consider what
this involves.
It means that, with a given organisation, equipment and technique,
real wages and the volume of output (and hence of employment) are
uniquely correlated, so that, in general, an increase in employment can
only occur to the accompaniment of a decline in the rate of real wages.
Thus I am not disputing this vital fact which the classical economists have
(rightly) asserted as indefeasible. In a given state of organisation,
equipment and technique, the real wage earned by a unit of labour has a
unique (inverse) correlation with the volume of employment. Thus if
employment increases, then, in the short period, the reward per unit of
labour in terms of wage-goods must, in general, decline and profits
increase. This is simply the obverse of the familiar proposition that
industry is normally working subject to decreasing returns in the short
period during which equipment etc. is assumed to be constant; so that the
marginal product in the wage-good industries (which governs real wages)
necessarily diminishes as employment is increased. So long, indeed, as this
proposition holds, any means of increasing employment must lead at the
same time to a diminution of the marginal product and hence of the rate of
wages measured in terms of this product.
But when we have thrown over the second postulate, a decline in
employment, although necessarily associated with labours receiving a
wage equal in value to a larger quantity of wage-goods, is not necessarily
due to labours demanding a larger quantity of wage-goods; and a
willingness on the part of labour to accept lower money-wages is not
necessarily a remedy for unemployment. The theory of wages in relation to
employment, to which we are here leading up, cannot be fully elucidated,
however, until chapter 19 and its Appendix have been reached.
From the time of Say and Ricardo the classical economists have taught
that supply creates its own demand; meaning by this in some
significant, but not clearly defined, sense that the whole of the costs of
production must necessarily be spent in the aggregate, directly or
indirectly, on purchasing the product.
In J.S. Mills Principles of Political Economy the doctrine is expressly
set forth:
What constitutes the means of payment for commodities is simply

commodities. Each persons means of paying for the productions of other
people consist of those which he himself possesses. All sellers are
inevitably, and by the meaning of the word, buyers. Could we suddenly
double the productive powers of the country, we should double the supply
of commodities in every market; but we should, by the same stroke, double
the purchasing power. Everybody would bring a double demand as well as
supply; everybody would be able to buy twice as much, because every one
would have twice as much to offer in exchange.
As a corollary of the same doctrine, it has been supposed that any

individual act of abstaining from consumption necessarily leads to, and
amounts to the same thing as, causing the labour and commodities thus
released from supplying consumption to be invested in the production of
capital wealth. The following passage from Marshalls Pure Theory of
Domestic Values illustrates the traditional approach:
The whole of a mans income is expended in the purchase of services and

of commodities. It is indeed commonly said that a man spends some
portion of his income and saves another. But it is a familiar economic
axiom that a man purchases labour and commodities with that portion of
his income which he saves just as much as he does with that he is said to
spend. He is said to spend when he seeks to obtain present enjoyment
from the services and commodities which he purchases. He is said to save
when he causes the labour and the commodities which he purchases to be
devoted to the production of wealth from which he expects to derive the
means of enjoyment in the future.
It is true that it would not be easy to quote comparable passages from

Marshalls later work or from Edgeworth or Professor Pigou. The doctrine
is never stated to-day in this crude form. Nevertheless it still underlies the
whole classical theory, which would collapse without it. Contemporary
economists, who might hesitate to agree with Mill, do not hesitate to
accept conclusions which require Mills doctrine as their premiss. The
conviction, which runs, for example, through almost all Professor Pigous
work, that money makes no real difference except frictionally and that the
theory of production and employment can be worked out (like Mills) as

being based on real exchanges with money introduced perfunctorily in a
later chapter, is the modern version of the classical tradition.
Contemporary thought is still deeply steeped in the notion that if people
do not spend their money in one way they will spend it in another. Post-
war economists seldom, indeed, succeed in maintaining this standpoint
consistently; for their thought to-day is too much permeated with the
contrary tendency and with facts of experience too obviously inconsistent
with their former view. But they have not drawn sufficiently far-reaching
consequences; and have not revised their fundamental theory.
In the first instance, these conclusions may have been applied to the
kind of economy in which we actually live by false analogy from some kind
of non-exchange Robinson Crusoe economy, in which the income which
individuals consume or retain as a result of their productive activity is,
actually and exclusively, the output in specie of that activity. But, apart
from this, the conclusion that the costs of output are always covered in the
aggregate by the sale-proceeds resulting from demand, has great
plausibility, because it is difficult to distinguish it from another, similar-
looking proposition which is indubitable, namely that the income derived
in the aggregate by all the elements in the community concerned in a
productive activity necessarily has a value exactly equal to the value of the
output.
Similarly it is natural to suppose that the act of an individual, by
which he enriches himself without apparently taking anything from
anyone else, must also enrich the community as a whole; so that (as in the
passage just quoted from Marshall) an act of individual saving inevitably
leads to a parallel act of investment. For, once more, it is indubitable that
the sum of the net increments of the wealth of individuals must be exactly
equal to the aggregate net increment of the wealth of the community.
Those who think in this way are deceived, nevertheless, by an optical
illusion, which makes two essentially different activities appear to be the
same. They are fallaciously supposing that there is a nexus which unites
decisions to abstain from present consumption with decisions to provide
for future consumption; whereas the motives which determine the latter
are not linked in any simple way with the motives which determine the
former.
It is, then, the assumption of equality between the demand price of
output as a whole and its supply price which is to be regarded as the
classical theorys axiom of parallels. Granted this, all the rest follows
the social advantages of private and national thrift, the traditional attitude
towards the rate of interest, the classical theory of unemployment, the

quantity theory of money, the unqualified advantages of laissez-faire in
respect of foreign trade and much else which we shall have to question.
At different points in this chapter we have made the classical theory to

depend in succession on the assumptions:
1. that the real wage is equal to the marginal disutility of the existing
employment;
2. that there is no such thing as involuntary unemployment in the strict
sense;
3. that supply creates its own demand in the sense that the aggregate
demand price is equal to the aggregate supply price for all levels of
output and employment.
These three assumptions, however, all amount to the same thing in the
sense that they all stand and fall together, any one of them logically
involving the other two.

C 3
T P E D
We need, to start with, a few terms which will be defined precisely later. In
a given state of technique, resources and costs, the employment of a given
volume of labour by an entrepreneur involves him in two kinds of expense:
first of all, the amounts which he pays out to the factors of production
(exclusive of other entrepreneurs) for their current services, which we
shall call the factor cost of the employment in question; and secondly, the
amounts which he pays out to other entrepreneurs for what he has to
purchase from them together with the sacrifice which he incurs by
employing the equipment instead of leaving it idle, which we shall call the
user cost of the employment in question. The excess of the value of the
resulting output over the sum of its factor cost and its user cost is the
profit or, as we shall call it, the income of the entrepreneur. The factor cost
is, of course, the same thing, looked at from the point of view of the
entrepreneur, as what the factors of production regard as their income.
Thus the factor cost and the entrepreneurs profit make up, between them,
what we shall define as the total income resulting from the employment
given by the entrepreneur. The entrepreneurs profit thus defined is, as it
should be, the quantity which he endeavours to maximise when he is
deciding what amount of employment to offer. It is sometimes convenient,
when we are looking at it from the entrepreneurs standpoint, to call the
aggregate income (i.e. factor cost plus profit) resulting from a given
amount of employment the proceeds of that employment. On the other
hand, the aggregate supply price of the output of a given amount of
employment is the expectation of proceeds which will just make it worth
the while of the entrepreneurs to give that employment.
It follows that in a given situation of technique, resources and factor
cost per unit of employment, the amount of employment, both in each
individual firm and industry and in the aggregate, depends on the amount
of the proceeds which the entrepreneurs expect to receive from the
corresponding output. For entrepreneurs will endeavour to fix the amount
of employment at the level which they expect to maximise the excess of the
proceeds over the factor cost.
Let Z be the aggregate supply price of the output from employing N
men, the relationship between Z and N being written Z = (N), which can
be called the aggregate supply function. Similarly, let D be the proceeds
which entrepreneurs expect to receive from the employment of N men, the
relationship between D and N being written D = f(N), which can be called
the aggregate demand function.
Now if for a given value of N the expected proceeds are greater than
the aggregate supply price, i.e. if D is greater than Z, there will be an
incentive to entrepreneurs to increase employment beyond N and, if
necessary, to raise costs by competing with one another for the factors of
production, up to the value of N for which Z has become equal to D. Thus
the 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 profits will be
maximised. The value of D at the point of the aggregate demand function,
where it is intersected by the aggregate supply function, will be called the
effective demand. Since this is the substance of the General Theory of
Employment, which it will be our object to expound, the succeeding
chapters will be largely occupied with examining the various factors upon
which these two functions depend.
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 (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 ( = (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 Says 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.
A brief summary of the theory of employment to be worked out in the

course of the following chapters may, perhaps, help the reader at this
stage, even though it may not be fully intelligible. The terms involved will
be more carefully defined in due course. In this summary we shall assume
that the money-wage and other factor costs are constant per unit of labour
employed. But this simplification, with which we shall dispense later, is
introduced solely to facilitate the exposition. The essential character of the
argument is precisely the same whether or not money-wages, etc., are
liable to change.
The outline of our theory can be expressed as follows. When
employment increases, aggregate real income is increased. The psychology
of the community is such that when aggregate real income is increased
aggregate consumption is increased, but not by so much as income. Hence
employers would make a loss if the whole of the increased employment
were to be devoted to satisfying the increased demand for immediate
consumption. Thus, to justify any given amount of employment there must
be an amount of current investment sufficient to absorb the excess of total
output over what the community chooses to consume when employment is

at the given level. For unless there is this amount of investment, the
receipts of the entrepreneurs will be less than is required to induce them to
offer the given amount of employment. It follows, therefore, that, given
what we shall call the communitys propensity to consume, the equilibrium
level of employment, i.e. the level at which there is no inducement to
employers as a whole either to expand or to contract employment, will
depend on the amount of current investment. The amount of current
investment will depend, in turn, on what we shall call the inducement to
invest; and the inducement to invest will be found to depend on the
relation between the schedule of the marginal efficiency of capital and the
complex of rates of interest on loans of various maturities and risks.
Thus, given the propensity to consume and the rate of new
investment, there will be only one level of employment consistent with
equilibrium; since any other level will lead to inequality between the
aggregate supply price of output as a whole and its aggregate demand
price. This level cannot be greater than full employment, i.e. the real wage
cannot be less than the marginal disutility of labour. But there is no reason
in general for expecting it to be equal to full employment. The effective
demand associated with full employment is a special case, only realised
when the propensity to consume and the inducement to invest stand in a
particular relationship to one another. This particular relationship, which
corresponds to the assumptions of the classical theory, is in a sense an
optimum relationship. But it can only exist when, by accident or design,
current investment provides an amount of demand just equal to the excess
of the aggregate supply price of the output resulting from full employment
over what the community will choose to spend on consurnption when it is
fully employed.
This theory can be summed up in the following propositions:
(1) In a given situation of technique, resources and costs, income
(both money-income and real income) depends on the volume of
employment N.
(2) The relationship between the communitys income and what it can
be expected to spend on consumption, designated by D1, will depend on
the psychological characteristic of the community, which we shall call its
propensity to consume. That is to say, consumption will depend on the
level of aggregate income and, therefore, on the level of employment N,
except when there is some change in the propensity to consume.
(3) The amount of labour N which the entrepreneurs decide to employ

depends on the sum (D) of two quantities, namely D1, the amount which
the community is expected to spend on consumption, and D2, the amount
which it is expected to devote to new investment. D is what we have called
above the effective demand.
(4) Since D1 + D2 = D = (N), where is the aggregate supply
function, and since, as we have seen in (2) above, D1 is a function of N,
which we may write (N), depending on the propensity to consume, it
follows that (N) (N) = D2.
(5) Hence the volume of employment in equilibrium depends on (i)
the aggregate supply function, (ii) the propensity to consume, and (iii) the
volume of investment, D2. This is the essence of the General Theory of
Employment.
(6) For every value of N there is a corresponding marginal
productivity of labour in the wage-goods industries; and it is this which
determines the real wage. (5) is, therefore, subject to the condition that N
cannot exceed the value which reduces the real wage to equality with the
marginal disutility of labour. This means that not all changes in D are
compatible with our temporary assumption that money-wages are
constant. Thus it will be essential to a full statement of our theory to
dispense with this assumption.
(7) On the classical theory, according to which D = (N) for all values
of N, the volume of employment is in neutral equilibrium for all values of
N less than its maximum value; so that the forces of competition between
entrepreneurs may be expected to push it to this maximum value. Only at
this point, on the classical theory, can there be stable equilibrium.
(8) When employment increases, D1will increase, but not by so much
as D; since when our income increases our consumption increases also,
but not by so much. The key to our practical problem is to be found in this
psychological law. For it follows from this that the greater the volume of
employment the greater will be the gap between the aggregate supply price
(Z) of the corresponding output and the sum (D1) which the entrepreneurs
can expect to get back out of the expenditure of consumers. Hence, if there
is no change in the propensity to consume, employment cannot increase,
unless at the same time D2 is increasing so as to fill the increasing gap
between Z and D1. Thus except on the special assumptions of the
classical theory according to which there is some force in operation which,
when employment increases, always causes D2 to increase sufficiently to
fill the widening gap between Z and D1 the economic system may find
itself in stable equilibrium with N at a level below full employment,
namely at the level given by the intersection of the aggregate demand
function with the aggregate supply function.
Thus the volume of employment is not determined by the marginal
disutility of labour measured in terms of real wages, except in so far as the
supply of labour available at a given real wage sets a maximum level to
employment. The propensity to consume and the rate of new investment
determine between them the volume of employment, and the volume of
employment is uniquely related to a given level of real wages not the
other way round. If the propensity to consume and the rate of new
investment result in a deficient effective demand, the actual level of
employment will fall short of the supply of labour potentially available at
the existing real wage, and the equilibrium real wage will be greater than
the marginal disutility of the equilibrium level of employment.
This analysis supplies us with an explanation of the paradox of
poverty in the midst of plenty. For the mere existence of an insufficiency of
effective demand may, and often will, bring the increase of employment to
a standstill before a level of full employment has been reached. The
insufficiency of effective demand will inhibit the process of production in
spite of the fact that the marginal product of labour still exceeds in value
the marginal disutility of employment.
Moreover the richer the community, the wider will tend to be the gap
between its actual and its potential production; and therefore the more
obvious and outrageous the defects of the economic system. For a poor
community will be prone to consume by far the greater part of its output,
so that a very modest measure of investment will be sufficient to provide
full employment; whereas 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. If in a potentially wealthy community the inducement to invest
is weak, then, in spite of its potential wealth, the working of the principle
of effective demand will compel it to reduce its actual output, until, in spite
of its potential wealth, it has become so poor that its surplus over its
consumption is sufficiently diminished to correspond to the weakness of
the inducement to invest.
But worse still. Not only is the marginal propensity to consume
weaker in a wealthy community, but, owing to its accumulation of capital
being already larger, the opportunities for further investment are less
attractive unless the rate of interest falls at a sufficiently rapid rate; which
brings us to the theory of the rate of interest and to the reasons why it
does not automatically fall to the appropriate level, which will occupy Book
IV.
Thus the analysis of the propensity to consume, the definition of the
marginal efficiency of capital and the theory of the rate of interest are the
three main gaps in our existing knowledge which it will be necessary to fill.
When this has been accomplished, we shall find that the theory of prices
falls into its proper place as a matter which is subsidiary to our general
theory. We shall discover, however, that money plays an essential part in
our theory of the rate of interest; and we shall attempt to disentangle the
peculiar characteristics of money which distinguish it from other things.
The idea that we can safely neglect the aggregate demand function is
fundamental to the Ricardian economics, which underlie what we have
been taught for more than a century. Malthus, indeed, had vehemently
opposed Ricardos doctrine that it was impossible for effective demand to
be deficient; but vainly. For, since Malthus was unable to explain clearly
(apart from an appeal to the facts of common observation) how and why
effective demand could be deficient or excessive, he failed to furnish an
alternative construction; and Ricardo conquered England as completely as
the Holy Inquisition conquered Spain. Not only was his theory accepted by
the city, by statesmen and by the academic world. But controversy ceased;
the other point of view completely disappeared; it ceased to be discussed.
The great puzzle of effective demand with which Malthus had wrestled
vanished from economic literature. You will not find it mentioned even
once in the whole works of Marshall, Edgeworth and Professor Pigou, from
whose hands the classical theory has received its most mature
embodiment. It could only live on furtively, below the surface, in the
underworlds of Karl Marx, Silvio Gesell or Major Douglas.
The completeness of the Ricardian victory is something of a curiosity
and a mystery. It must have been due to a complex of suitabilities in the
doctrine to the environment into which it was projected. That it reached
conclusions quite different from what the ordinary uninstructed person
would expect, added, I suppose, to its intellectual prestige. That its
teaching, translated into practice, was austere and often unpalatable, lent
it virtue. That it was adapted to carry a vast and consistent logical
superstructure, gave it beauty. That it could explain much social injustice
and apparent cruelty as an inevitable incident in the scheme of progress,

and the attempt to change such things as likely on the whole to do more
harm than good, commended it to authority. That it afforded a measure of
justification to the free activities of the individual capitalist, attracted to it
the support of the dominant social force behind authority.
But although the doctrine itself has remained unquestioned by
orthodox economists up to a late date, its signal failure for purposes of
scientific prediction has greatly impaired, in the course of time, the
prestige of its practitioners. For professional economists, after Malthus,
were apparently unmoved by the lack of correspondence between the
results of their theory and the facts of observation; a discrepancy which
the ordinary man has not failed to observe, with the result of his growing
unwillingness to accord to economists that measure of respect which he
gives to other groups of scientists whose theoretical results are confirmed
by observation when they are applied to the facts.
The celebrated optimism of traditional economic theory, which has
led to economists being looked upon as Candides, who, having left this
world for the cultivation of their gardens, teach that all is for the best in
the best of all possible worlds provided we will let well alone, is also to be
traced, I think, to their having neglected to take account of the drag on
prosperity which can be exercised by an insufficiency of effective demand.
For there would obviously be a natural tendency towards the optimum
employment of resources in a society which was functioning after the
manner of the classical postulates. It may well be that the classical theory
represents the way in which we should like our economy to behave. But to
assume that it actually does so is to assume our difficulties away.

C 4
T C U
In this and the next three chapters we shall be occupied with an attempt to
clear up certain perplexities which have no peculiar or exclusive relevance
to the problems which it is our special purpose to examine. Thus these
chapters are in the nature of a digression, which will prevent us for a time
from pursulng our main theme. Their subject-matter is only discussed
here because it does not happen to have been already treated elsewhere in
a way which I find adequate to the needs of my own particular enquiry.
The three perplexities which most impeded my progress in writing
this book, so that I could not express myself conveniently until I had found
some solution for them, are: firstly, the choice of the units of quantity
appropriate to the problems of the economic system as a whole; secondly,
the part played by expectation in economic analysis; and, thirdly, the
definition of income.
That the units, in terms of which economists commonly work, are

unsatisfactory can be illustrated by the concepts of the national dividend,
the stock of real capital and the general price-level:
(i) The national dividend, as defined by Marshall and Professor Pigou,
measures the volume of current output or real income and not the value of
output or money-income. Furthermore, it depends, in some sense, on net
output; on the net addition, that is to say, to the resources of the
community available for consumption or for retention as capital stock, due
to the economic activities and sacrifices of the current period, after
allowing for the wastage of the stock of real capital existing at the
commencement of the period. On this basis an attempt is made to erect a

quantitative science. But it is a grave objection to this definition for such a
purpose that the communitys output of goods and services is a non-
homogeneous complex which cannot be measured, strictly speaking,
except in certain special cases, as for example when all the items of one
output are included in the same proportions in another output.
(ii) The difficulty is even greater when, in order to calculate net
output, we try to measure the net addition to capital equipment; for we
have to find some basis for a quantitative comparison between the new
items of equipment produced during the period and the old items which
have perished by wastage. In order to arrive at the net national dividend,
Professor Pigou deducts such obsolescence, etc., as may fairly be called
normal; and the practical test of normality is that the depletion is
sufficiently regular to be foreseen, if not in detail, at least in the large. But,
since this deduction is not a deduction in terms of money, he is involved in
assuming that there can be a change in physical quantity, although there
has been no physical change; i.e. he is covertly introducing changes in
value.
Moreover, he is unable to devise any satisfactory formula to evaluate
new equipment against old when, owing to changes in technique, the two
are not identical. I believe that the concept at which Professor Pigou is
aiming is the right and appropriate concept for economic analysis. But,
until a satisfactory system of units has been adopted, its precise definition
is an impossible task. The problem of comparing one real output with
another and of then calculating net output by setting off new items of
equipment against the wastage of old items presents conundrums which
permit, one can confidently say, of no solution.
(iii) Thirdly, the well-known, but unavoidable, element of vagueness
which admittedly attends the concept of the general price-level makes this
term very unsatisfactory for the purposes of a causal analysis, which ought
to be exact.
Nevertheless these difficulties are rightly regarded as conundrums.
They are purely theoretical in the sense that they never perplex, or indeed
enter in any way into, business decisions and have no relevance to the
causal sequence of economic events, which are clear-cut and determinate
in spite of the quantitative indeterminacy of these concepts. It is natural,
therefore, to conclude that they not only lack precision but are
unnecessary. Obviously our quantitative analysis must be expressed
without using any quantitatively vague expressions. And, indeed, as soon
as one makes the attempt, it becomes clear, as I hope to show, that one can
get on much better without them.
The fact that two incommensurable collections of miscellaneous
objects cannot in themselves provide the material for a quantitative
analysis need not, of course, prevent us from making approximate
statistical comparisons, depending on some broad element of judgment
rather than of strict calculation, which may possess significance and
validity within certain limits.
But the proper place for such things as net real output and the general
level of prices lies within the field of historical and statistical description,
and their purpose should be to satisfy historical or social curiosity, a
purpose for which perfect precision such as our causal analysis requires,
whether or not our knowledge of the actual values of the relevant
quantities is complete or exact is neither usual nor necessary. To say
that net output to-day is greater, but the price-level lower, than ten years
ago or one year ago, is a proposition of a similar character to the statement
that Queen Victoria was a better queen but not a happier woman than
Queen Elizabeth a proposition not without meaning and not without
interest, but unsuitable as material for the differential calculus. Our
precision will be a mock precision if we try to use such partly vague and
non-quantitative concepts as the basis of a quantitative analysis.
On every particular occasion, let it be remembered, an entrepreneur is

concerned with decisions as to the scale on which to work a given capital
equipment; and when we say that the expectation of an increased demand,
i.e. a raising of the aggregate demand function, will lead to an increase in
aggregate output, we really mean that the firms, which own the capital
equipment, will be induced to associate with it a greater aggregate
employment of labour. In the case of an individual firm or industry
producing a homogeneous product we can speak legitimately, if we wish,
of increases or decreases of output. But when we are aggregating the
activities of all firms, we cannot speak accurately except in terms of
quantities of employment applied to a given equipment. The concepts of
output as a whole and its price-level are not required in this context, since
we have no need of an absolute measure of current aggregate output, such
as would enable us to compare its amount with the amount which would
result from the association of a different capital equipment with a different
quantity of employment. When, for purposes of description or rough

comparison, we wish to speak of an increase of output, we must rely on the
general presumption that the amount of employment associated with a
given capital equipment will be a satisfactory index of the amount of
resultant output; the two being presumed to increase and decrease
together, though not in a definite numerical proportion.
In dealing with the theory of employment I propose, therefore, to
make use of only two fundamental units of quantity, namely, quantities of
money-value and quantities of employment. The first of these is strictly
homogeneous, and the second can be made so. For, in so far as different
grades and kinds of labour and salaried assistance enjoy a more or less
fixed relative remuneration, the quantity of employment can be
sufficiently defined for our purpose by taking an hours employment of
ordinary labour as our unit and weighting an hours employment of special
labour in proportion to its remuneration; i.e. an hour of special labour
remunerated at double ordinary rates will count as two units. We shall call
the unit in which the quantity of employment is measured the labour-unit;
and the money-wage of a labour-unit we shall call the wage-unit. Thus, if E
is the wages (and salaries) bill, W the wage-unit, and N the quantity of
employment, E = N W.
This assumption of homogeneity in the supply of labour is not upset
by the obvious fact of great differences in the specialised skill of individual
workers and in their suitability for different occupations. For, if the
remuneration of the workers is proportional to their efficiency, the
differences are dealt with by our having regarded individuals as
contributing to the supply of labour in proportion to their remuneration;
whilst if, as output increases, a given firm has to bring in labour which is
less and less efficient for its special purposes per wage-unit paid to it, this
is merely one factor among others leading to a diminishing return from the
capital equipment in terms of output as more labour is employed on it. We
subsume, so to speak, the non-homogeneity of equally remunerated labour
units in the equipment, which we regard as less and less adapted to
employ the available labour units as output increases, instead of regarding
the available labour units as less and less adapted to use a homogeneous
capital equipment. Thus if there is no surplus of specialised or practised
labour and the use of less suitable labour involves a higher labour cost per
unit of output, this means that the rate at which the return from the
equipment diminishes as employment increases is more rapid than it
would be if there were such a surplus. Even in the limiting case where
different labour units were so highly specialised as to be altogether
incapable of being substituted for one another, there is no awkwardness;

for this merely means that the elasticity of supply of output from a
particular type of capital equipment falls suddenly to zero when all the
available labour specialised to its use is already employed. Thus our
assumption of a homogeneous unit of labour involves no difficulties unless
there is great instability in the relative remuneration of different labour-
units; and even this difficulty can be dealt with, if it arises, by supposing a
rapid liability to change in the supply of labour and the shape of the
aggregate supply function.
It is my belief that much unnecessary perplexity can be avoided if we
limit ourselves strictly to the two units, money and labour, when we are
dealing with the behaviour of the economic system as a whole; reserving
the use of units of particular outputs and equipments to the occasions
when we are analysing the output of individual firms or industries in
isolation; and the use of vague concepts, such as the quantity of output as
a whole, the quantity of capital equipment as a whole and the general level
of prices, to the occasions when we are attempting some historical
comparison which is within certain (perhaps fairly wide) limits avowedly
unprecise and approximate.
It follows that we shall measure changes in current output by
reference to the number of hours of labour paid for (whether to satisfy
consumers or to produce fresh capital equipment) on the existing capital
equipment, hours of skilled labour being weighted in proportion to their
remuneration. We have no need of a quantitative comparison between this
output and the output which would result from associating a different set
of workers with a different capital equipment. To predict how
entrepreneurs possessing a given equipment will respond to a shift in the
aggregate demand function it is not necessary to know how the quantity of
the resulting output, the standard of life and the general level of prices
would compare with what they were at a different date or in another
country.
It is easily shown that the conditions of supply, such as are usually

expressed in terms of the supply curve, and the elasticity of supply relating
output to price, can be handled in terms of our two chosen units by means
of the aggregate supply function, without reference to quantities of output,
whether we are concerned with a particular firm or industry or with
economic activity as a whole. For the aggregate supply function for a given
firm (and similarly for a given industry or for industry as a whole) is given
by
Zr = r(Nr),
where Zr is the proceeds (net of user cost) the expectation of which will
induce a level of employment Nr. If, therefore, the relation between
employment and output is such that an employment Nr results in an
output Or, where Or = r(Nr), it follows that
Zr + Ur(Nr) r(Nr) + Ur(Nr)
p= =
Or r(Nr)
is the ordinary supply curve, where Ur(Nr) is the (expected) user cost
corresponding to a level of employment Nr.
Thus in the case of each homogeneous commodity, for which

Or = r(Nr) has a definite meaning, we can evaluate Zr = r(Nr) in the
ordinary way; but we can then aggregate the Nrs in a way in which we
cannot aggregate the Ors, since Or is not a numerical quantity. Moreover,
if we can assume that, in a given environment, a given aggregate
employment will be distributed in a unique way between different
industries, so that Nr is a function of N, further simplifications are
possible.

C 5
E D O
E
All production is for the purpose of ultimately satisfying a consumer. Time

usually elapses, however and sometimes much time between the
incurring of costs by the producer (with the consumer in view) and the
purchase of the output by the ultimate consumer. Meanwhile the
entrepreneur (including both the producer and the investor in this
description) has to form the best expectations he can as to what the
consumers will be prepared to pay when he is ready to supply them
(directly or indirectly) after the elapse of what may be a lengthy period;
and he has no choice but to be guided by these expectations, if he is to
produce at all by processes which occupy time.
These expectations, upon which business decisions depend, fall into
two groups, certain individuals or firms being specialised in the business
of framing the first type of expectation and others in the business of
framing the second. The first type is concerned with the price which a
manufacturer can expect to get for his finished output at the time when
he commits himself to starting the process which will produce it; output
being finished (from the point of view of the manufacturer) when it is
ready to be used or to be sold to a second party. The second type is
concerned with what the entrepreneur can hope to earn in the shape of
future returns if he purchases (or, perhaps, manufactures) finished
output as an addition to his capital equipment. We may call the former
short-term expectation and the latter long-term expectation.
Thus the behaviour of each individual firm in deciding its daily output
will be determined by its short-term expectations expectations as to the
cost of output on various possible scales and expectations as to the sale-
proceeds of this output; though, in the case of additions to capital

equipment and even of sales to distributors, these short-term expectations
will largely depend on the long-term (or medium-term) expectations of
other parties. It is upon these various expectations that the amount of
employment which the firms offer will depend. The actually realised
results of the production and sale of output will only be relevant to
employment in so far as they cause a modification of subsequent
expectations. Nor, on the other hand, are the original expectations
relevant, which led the firm to acquire the capital equipment and the stock
of intermediate products and half-finished materials with which it finds
itself at the time when it has to decide the next days output. Thus, on each
and every occasion of such a decision, the decision will be made, with
reference indeed to this equipment and stock, but in the light of the
current expectations of prospective costs and sale-proceeds.
Now, in general, a change in expectations (whether short-term or
long-term) will only produce its full effect on employment over a
considerable period. The change in employment due to a change in
expectations will not be the same on the second day after the change as on
the first, or the same on the third day as on the second, and so on, even
though there be no further change in expectations. In the case of short-
term expectations this is because changes in expectation are not, as a rule,
sufficiently violent or rapid, when they are for the worse, to cause the
abandonment of work on all the productive processes which, in the light of
the revised expectation, it was a mistake to have begun; whilst, when they
are for the better, some time for preparation must needs elapse before
employment can reach the level at which it would have stood if the state of
expectation had been revised sooner. In the case of long-term
expectations, equipment which will not be replaced will continue to give
employment until it is worn out; whilst when the change in long-term
expectations is for the better, employment may be at a higher level at first,
than it will be after there has been time to adjust the equipment to the new
situation.
If we suppose a state of expectation to continue for a sufficient length
of time for the effect on employment to have worked itself out so
completely that there is, broadly speaking, no piece of employment going
on which would not have taken place if the new state of expectation had
always existed, the steady level of employment thus attained may be called
the long-period employment corresponding to that state of expectation. It
follows that, although expectation may change so frequently that the
actual level of employment has never had time to reach the long-period
employment corresponding to the existing state of expectation,

nevertheless every state of expectation has its definite corresponding level
of long-period employment.
Let us consider, first of all, the process of transition to a long-period
position due to a change in expectation, which is not confused or
interrupted by any further change in expectation. We will first suppose
that the change is of such a character that the new long-period
employment will be greater than the old. Now, as a rule, it will only be the
rate of input which will be much affected at the beginning, that is to say,
the volume of work on the earlier stages of new processes of production,
whilst the output of consumption-goods and the amount of employment
on the later stages of processes which were started before the change will
remain much the same as before. In so far as there were stocks of partly
finished goods, this conclusion may be modified; though it is likely to
remain true that the initial increase in employment will be modest. As,
however, the days pass by, employment will gradually increase. Moreover,
it is easy to conceive of conditions which will cause it to increase at some
stage to a higher level than the new long-period employment. For the
process of building up capital to satisfy the new state of expectation may
lead to more employment and also to more current consumption than will
occur when the long-period position has been reached. Thus the change in
expectation may lead to a gradual crescendo in the level of employment,
rising to a peak and then declining to the new long-period level. The same
thing may occur even if the new long-period level is the same as the old, if
the change represents a change in the direction of consumption which
renders certain existing processes and their equipment obsolete. Or again,
if the new long-period employment is less than the old, the level of
employment during the transition may fall for a time below what the new
long-period level is going to be. Thus a mere change in expectation is
capable of producing an oscillation of the same kind of shape as a cyclical
movement, in the course of working itself out. It was movements of this
kind which I discussed in my Treatise on Money in connection with the
building up or the depletion of stocks of working and liquid capital
consequent on change.
An uninterrupted process of transition, such as the above, to a new
long-period position can be complicated in detail. But the actual course of
events is more complicated still. For the state of expectation is liable to
constant change, a new expectation being superimposed long before the
previous change has fully worked itself out; so that the economic machine
is occupied at any given time with a number of overlapping activities, the

existence of which is due to various past states of expectation.
This leads us to the relevance of this discussion for our present purpose. It
is evident from the above that the level of employment at any time
depends, in a sense, not merely on the existing state of expectation but on
the states of expectation which have existed over a certain past period.
Nevertheless past expectations, which have not yet worked themselves out,
are embodied in the to-days capital equipment with reference to which the
entrepreneur has to make to-days decisions, and only influence his
decisions in so far as they are so embodied. It follows, therefore, that, in
spite of the above, to-days employment can be correctly described as
being governed by to-days expectations taken in conjunction with to-days
capital equipment.
Express reference to current long-term expectations can seldom be
avoided. But it will often be safe to omit express reference to short-term
expectation, in view of the fact that in practice the process of revision of
short-term expectation is a gradual and continuous one, carried on largely
in the light of realised results; so that expected and realised results run
into and overlap one another in their influence. For, although output and
employment are determined by the producers short-term expectations
and not by past results, the most recent results usually play a predominant
part in determining what these expectations are. It would be too
complicated to work out the expectations de novo whenever a productive
process was being started; and it would, moreover, be a waste of time since
a large part of the circumstances usually continue substantially unchanged
from one day to the next. Accordingly it is sensible for producers to base
their expectations on the assumption that the most recently realised
results will continue, except in so far as there are definite reasons for
expecting a change. Thus in practice there is a large overlap between the
effects on employment of the realised sale-proceeds of recent output and
those of the sale-proceeds expected from current input; and producers
forecasts are more often gradually modified in the light of results than in
anticipation of prospective changes.
Nevertheless, we must not forget that, in the case of durable goods,
the producers short-term expectations are based on the current long-term
expectations of the investor; and it is of the nature of long-term
expectations that they cannot be checked at short intervals in the light of

realised results. Moreover, as we shall see in chapter 12, where we shall
consider long-term expectations in more detail, they are liable to sudden
revision. Thus the factor of current long-term expectations cannot be even
approximately eliminated or replaced by realised results.

C 6
T D I ,S
I
I. Income
During any period of time an entrepreneur will have sold finished
output to consumers or to other entrepreneurs for a certain sum which we
will designate as A. He will also have spent a certain sum, designated by
A1, on purchasing finished output from other entrepreneurs. And he will
end up with a capital equipment, which term includes both his stocks of
unfinished goods or working capital and his stocks of finished goods,
having a value G.
Some part, however, of A + G A1 will be attributable, not to the
activities of the period in question, but to the capital equipment which he
had at the beginning of the period. We must, therefore, in order to arrive
at what we mean by the income of the current period, deduct from
A + G A1 a certain sum, to represent that part of its value which has been
(in some sense) contributed by the equipment inherited from the previous
period. The problem of defining income is solved as soon as we have found
a satisfactory method for calculating this deduction.
There are two possible principles for calculating it, each of which has
a certain significance; one of them in connection with production, and
the other in connection with consumption. Let us consider them in turn.
(i) The actual value G of the capital equipment at the end of the period
is the net result of the entrepreneur, on the one hand, having maintained
and improved it during the period, both by purchases from other
entrepreneurs and by work done upon it by himself, and, on the other
hand, having exhausted or depreciated it through using it to produce
output. If he had decided not to use it to produce output, there is,
nevertheless, a certain optimum sum which it would have paid him to
spend on maintaining and improving it. Let us suppose that, in this event,
he would have spent B on its maintenance and improvement, and that,
having had this spent on it, it would have been worth G at the end of the
period. That is to say, G B is the maximum net value which might have
been conserved from the previous period, if it had not been used to
produce A. The excess of this potential value of the equipment over G A1
is the measure of what has been sacrificed (one way or another) to produce
A. Let us call this quantity, namely
(G B) (G A1),
which measures the sacrifice of value involved in the production of A, the

user cost of A. User cost will be written U. The amount paid out by the
entrepreneur to the other factors of production in return for their services,
which from their point of view is their income, we will call the factor cost
of A. The sum of the factor cost F and the user cost U we shall call the
prime cost of the output A.
We can then define the income of the entrepreneur as being the excess
of the value of his finished output sold during the period over his prime
cost. The entrepreneurs income, that is to say, is taken as being equal to
the quantity, depending on his scale of production, which he endeavours
to maximise, i.e. to his gross profit in the ordinary sense of this term;
which agrees with common sense. Hence, since the income of the rest of
the community is equal to the entrepreneurs factor cost, aggregate income
is equal to A U.
Income, thus defined, is a completely unambiguous quantity.
Moreover, since it is the entrepreneurs expectation of the excess of this
quantity over his outgoings to the other factors of production which he
endeavours to maximise when he decides how much employment to give
to the other factors of production, it is the quantity which is causally
significant for employment.
It is conceivable, of course, that G A1 may exceed G B, so that
user cost will be negative. For example, this may well be the case if we
happen to choose our period in such a way that input has been increasing
during the period but without there having been time for the increased
output to reach the stage of being finished and sold. It will also be the case,
whenever there is positive investment, if we imagine industry to be so
much integrated that entrepreneurs make most of their equipment for
themselves. Since, however, user cost is only negative when the
entrepreneur has been increasing his capital equipment by his own labour,
we can, in an economy where capital equipment is largely manufactured

by different firms from those which use it, normally think of user cost as
being positive. Moreover, it is difficult to conceive of a case where
marginal user cost associated with an increase in A, i.e. dU/dA, will be
other than positive.
It may be convenient to mention here, in anticipation of the latter part
of this chapter, that, for the community as a whole, the aggregate
consumption (C) of the period is equal to (A A1), and the aggregate
investment (I) is equal to (A1 U). Moreover, U is the individual
entrepreneurs disinvestment (and U his investment) in respect of his
own equipment exclusive of what he buys from other entrepreneurs. Thus
in a completely integrated system (where A1 = 0) consumption is equal to
A and investment to U, i.e. to G (G B). The slight complication of
the above, through the introduction of A1, is simply due to the desirability
of providing in a generalised way for the case of a non-integrated system of
production.
Furthermore, the effective demand is simply the aggregate income (or
proceeds) which the entrepreneurs expect to receive, inclusive of the
incomes which they will hand on to the other factors of production, from
the amount of current employment which they decide to give. The
aggregate demand function relates various hypothetical quantities of
employment to the proceeds which their outputs are expected to yield; and
the effective demand is the point on the aggregate demand function which
becomes effective because, taken in conjunction with the conditions of
supply, it corresponds to the level of employment which maximises the
entrepreneurs expectation of profit.
This set of definitions also has the advantage that we can equate the
marginal proceeds (or income) to the marginal factor cost; and thus arrive
at the same sort of propositions relating marginal proceeds thus defined to
marginal factor costs as have been stated by those economists who, by
ignoring user cost or assuming it to be zero, have equated supply price to
marginal factor cost.
(ii) We turn, next, to the second of the principles referred to above.
We have dealt so far with that part of the change in the value of the capital
equipment at the end of the period as compared with its value at the
beginning which is due to the voluntary decisions of the entrepreneur in
seeking to maximise his profit. But there may, in addition, be an
involuntary loss (or gain) in the value of his capital equipment, occurring
for reasons beyond his control and irrespective of his current decisions, on
account of (e.g.) a change in market values, wastage by obsolescence or the

mere passage of time, or destruction by catastrophe such as war or
earthquake. Now some part of these involuntary losses, whilst they are
unavoidable, are broadly speaking not unexpected; such as losses
through the lapse of time irrespective of use, and also normal
obsolescence which, as Professor Pigou expresses it, is sufficiently regular
to be foreseen, if not in detail, at least in the large, including, we may add,
those losses to the community as a whole which are sufficiently regular to
be commonly regarded as insurable risks. Let us ignore for the moment
the fact that the amount of the expected loss depends on when the
expectation is assumed to be framed, and let us call the depreciation of the
equipment, which is involuntary but not unexpected, i.e. the excess of the
expected depreciation over the user cost, the supplementary cost, which
will be written V. It is, perhaps, hardly necessary to point out that this
definition is not the same as Marshalls definition of supplementary cost,
though the underlying idea, namely, of dealing with that part of the
expected depreciation which does not enter into prime cost, is similar.
In reckoning, therefore, the net income and the net profit of the
entrepreneur it is usual to deduct the estimated amount of the
supplementary cost from his income and gross profit as defined above. For
the psychological effect on the entrepreneur, when he is considering what
he is free to spend and to save, of the supplementary cost is virtually the
same as though it came off his gross profit. In his capacity as a producer
deciding whether or not to use the equipment, prime cost and gross profit,
as defined above, are the significant concepts. But in his capacity as a
consumer the amount of the supplementary cost works on his mind in the
same way as if it were a part of the prime cost. Hence we shall not only
come nearest to common usage but will also arrive at a concept which is
relevant to the amount of consumption, if, in defining aggregate net
income, we deduct the supplementary cost as well as the user cost, so that
aggregate net income is equal to A U V.
There remains the change in the value of the equipment, due to
unforeseen changes in market values, exceptional obsolescence or
destruction by catastrophe, which is both involuntary and in a broad
sense unforeseen. The actual loss under this head, which we disregard
even in reckoning net income and charge to capital account, may be called
the windfall loss.
The causal significance of net income lies in the psychological
influence of the magnitude of V on the amount of current consumption,
since net income is what we suppose the ordinary man to reckon his
available income to be when he is deciding how much to spend on current

consumption. This is not, of course, the only factor of which he takes
account when he is deciding how much to spend. It makes a considerable
difference, for example, how much windfall gain or loss he is making on
capital account. But there is a difference between the supplementary cost
and a windfall loss in that changes in the former are apt to affect him in
just the same way as changes in his gross profit. It is the excess of the
proceeds of the current output over the sum of the prime cost and the
supplementary cost which is relevant to the entrepreneurs consumption;
whereas, although the windfall loss (or gain) enters into his decisions, it
does not enter into them on the same scale a given windfall loss does
not have the same effect as an equal supplementary cost.
We must now recur, however, to the point that the line between
supplementary costs and windfall losses, i.e. between those unavoidable
losses which we think it proper to debit to income account and those
which it is reasonable to reckon as a windfall loss (or gain) on capital
account, is partly a conventional or psychological one, depending on what
are the commonly accepted criteria for estimating the former. For no
unique principle can be established for the estimation of supplementary
cost, and its amount will depend on our choice of an accounting method.
The expected value of the supplementary cost, when the equipment was
originally produced, is a definite quantity. But if it is re-estimated
subsequently, its amount over the remainder of the life of the equipment
may have changed as a result of a change in the meantime in our
expectations; the windfall capital loss being the discounted value of the
difference between the former and the revised expectation of the
prospective series of U + V. It is a widely approved principle of business
accounting, endorsed by the Inland Revenue authorities, to establish a
figure for the sum of the supplementary cost and the user cost when the
equipment is acquired and to maintain this unaltered during the life of the
equipment, irrespective of subsequent changes in expectation. In this case
the supplementary cost over any period must be taken as the excess of this
predetermined figure over the actual user cost. This has the advantage of
ensuring that the windfall gain or loss shall be zero over the life of the
equipment taken as a whole. But it is also reasonable in certain
circumstances to recalculate the allowance for supplementary cost on the
basis of current values and expectations at an arbitrary accounting
interval, e.g. annually. Business men in fact differ as to which course they
adopt. It may be convenient to call the initial expectation of
supplementary cost when the equipment is first acquired the basic
supplementary cost, and the same quantity recalculated up to date on the

basis of current values and expectations the current supplementary cost.
Thus we cannot get closer to a quantitative definition of
supplementary cost than that it comprises those deductions from his
income which a typical entrepreneur makes before reckoning what he
considers his net income for the purpose of declaring a dividend (in the
case of a corporation) or of deciding the scale of his current consumption
(in the case of an individual). Since windfall charges on capital account are
not going to be ruled out of the picture, it is clearly better, in case of doubt,
to assign an item to capital account, and to include in supplementary cost
only what rather obviously belongs there. For any overloading of the
former can be corrected by allowing it more influence on the rate of
current consumption than it would otherwise have had.
It will be seen that our definition of net income comes very close to
Marshalls definition of income, when he decided to take refuge in the
practices of the Income Tax Commissioners and broadly speaking to
regard as income whatever they, with their experience, choose to treat as
such. For the fabric of their decisions can be regarded as the result of the
most careful and extensive investigation which is available, to interpret
what, in practice, it is usual to treat as net income. It also corresponds to
the money value of Professor Pigous most recent definition of the national
dividend.
It remains true, however, that net income, being based on an
equivocal criterion which different authorities might interpret differently,
is not perfectly clear-cut. Professor Hayek, for example, has suggested that
an individual owner of capital goods might aim at keeping the income he
derives from his possessions constant, so that he would not feel himself
free to spend his income on consumption until he had set aside sufficient
to offset any tendency of his investment-income to decline for whatever
reason. I doubt if such an individual exists; but, obviously, no theoretical
objection can be raised against this deduction as providing a possible
psychological criterion of net income. But when Professor Hayek infers
that the concepts of saving and investment suffer from a corresponding
vagueness, he is only right if he means net saving and net investment. The
saving and the investment, which are relevant to the theory of
employment, are clear of this defect, and are capable of objective
definition, as we have shown above.
Thus it is a mistake to put all the emphasis on net income, which is
only relevant to decisions concerning consumption, and is, moreover, only
separated from various other factors affecting consumption by a narrow
line; and to overlook (as has been usual) the concept of income proper,
which is the concept relevant to decisions concerning current production
and is quite unambiguous.
The above definitions of income and of net income are intended to
conform as closely as possible to common usage. It is necessary, therefore,
that I should at once remind the reader that in my Treatise on Money I
defined income in a special sense. The peculiarity in my former definition
related to that part of aggregate income which accrues to the
entrepreneurs, since I took neither the profit (whether gross or net)
actually realised from their current operations nor the profit which they
expected when they decided to undertake their current operations, but in
some sense (not, as I now think, sufficiently defined if we allow for the
possibility of changes in the scale of output) a normal or equilibrium
profit; with the result that on this definition saving exceeded investment
by the amount of the excess of normal profit over the actual profit. I am
afraid that this use of terms has caused considerable confusion, especially
in the case of the correlative use of saving; since conclusions (relating, in
particular, to the excess of saving over investment), which were only valid
if the terms employed were interpreted in my special sense, have been
frequently adopted in popular discussion as though the terms were being
employed in their more familiar sense. For this reason, and also because I
no longer require my former terms to express my ideas accurately, I have
decided to discard them with much regret for the confusion which they
have caused.
II. Saving and Investment

Amidst the welter of divergent usages of terms, it is agreeable to
discover one fixed point. So far as I know, everyone is agreed that saving
means the excess of income over expenditure on consumption. Thus any
doubts about the meaning of saving must arise from doubts about the
meaning either of income or of consumption. Income we have defined
above. Expenditure on consumption during any period must mean the
value of goods sold to consumers during that period, which throws us back
to the question of what is meant by a consumer-purchaser. Any reasonable
definition of the line between consumer-purchasers and investor-
purchasers will serve us equally well, provided that it is consistently
applied. Such problem as there is, e.g. whether it is right to regard the
purchase of a motor-car as a consumer-purchase and the purchase of a
house as an investor-purchase, has been frequently discussed and I have

nothing material to add to the discussion.
The criterion must obviously correspond to where we draw the line
between the consumer and the entrepreneur. Thus when we have defined
A1 as the value of what one entrepreneur has purchased from another, we
have implicitly settled the question. It follows that expenditure on
consumption can be unambiguously defined as (A A1), where A is the
total sales made during the period and A1 is the total sales made by one
entrepreneur to another. In what follows it will be convenient, as a rule, to
omit and write A for the aggregate sales of all kinds, A1 for the aggregate
sales from one entrepreneur to another and U for the aggregate user costs
of the entrepreneurs.
Having now defined both income and consumption, the definition of
saving, which is the excess of income over consumption, naturally follows.
Since income is equal to A U and consumption is equal to A A1, it
follows that saving is equal to A1 U. Similarly, we have net saving for the
excess of net income over consumption, equal to A1 U V.
Our definition of income also leads at once to the definition of current

investment. For we must mean by this the current addition to the value of
the capital equipment which has resulted from the productive activity of
the period. This is, clearly, equal to what we have just defined as saving.
For it is that part of the income of the period which has not passed into
consumption. We have seen above that as the result of the production of
any period entrepreneurs end up with having sold finished output having a
value A and with a capital equipment which has suffered a deterioration
measured by U (or an improvement measured by U where U is negative)
as a result of having produced and parted with A, after allowing for
purchases A1 from other entrepreneurs. During the same period finished
output having a value A A1 will have passed into consumption. The
excess of A U over A A1, namely A1 U, is the addition to capital
equipment as a result of the productive activities of the period and is,
therefore, the investment of the period. Similarly A1 U V; which is the
net addition to capital equipment, after allowing for normal impairment in
the value of capital apart from its being used and apart from windfall
changes in the value of the equipment chargeable to capital account, is the
net investment of the period.
Whilst, therefore, the amount of saving is an outcome of the collective

behaviour of individual consumers and the amount of investment of the
collective behaviour of individual entrepreneurs, these two amounts are
necessarily equal, since each of them is equal to the excess of income over
consumption. Moreover, this conclusion in no way depends on any
subtleties or peculiarities in the definition of income given above. Provided
it is agreed that income is equal to the value of current output, that current
investment is equal to the value of that part of current output which is not
consumed, and that saving is equal to the excess of income over
consumption all of which is conformable both to common sense and to
the traditional usage of the great majority of economists the equality of
saving and investment necessarily follows. In short-
Income = value of output = consumption + investment.
Saving = income consumption.
Therefore saving = investment.
Thus any set of definitions which satisfy the above conditions leads to the
same conclusion. It is only by denying the validity of one or other of them
that the conclusion can be avoided.
The equivalence between the quantity of saving and the quantity of
investment emerges from the bilateral character of the transactions
between the producer on the one hand and, on the other hand, the
consumer or the purchaser of capital equipment.
Income is created by the value in excess of user cost which the
producer obtains for the output he has sold; but the whole of this output
must obviously have been sold either to a consumer or to another
entrepreneur; and each entrepreneurs current investment is equal to the
excess of the equipment which he has purchased from other entrepreneurs
over his own user cost. Hence, in the aggregate the excess of income over
consumption, which we call saving, cannot differ from the addition to
capital equipment which we call investment. And similarly with net saving
and net investment. Saving, in fact, is a mere residual. The decisions to
consume and the decisions to invest between them determine incomes.
Assuming that the decisions to invest become effective, they must in doing
so either curtail consumption or expand income. Thus the act of
investment in itself cannot help causing the residual or margin, which we
call saving, to increase by a corresponding amount.
It might be, of course, that individuals were so tte monte in their
decisions as to how much they themselves would save and invest
respectively, that there would be no point of price equilibrium at which

transactions could take place. In this case our terms would cease to be
applicable, since output would no longer have a definite market value,
prices would find no resting-place between zero and infinity. Experience
shows, however, that this, in fact, is not so; and that there are habits of
psychological response which allow of an equilibrium being reached at
which the readiness to buy is equal to the readiness to sell. That there
should be such a thing as a market value for output is, at the same time, a
necessary condition for money-income to possess a definite value and a
sufficient condition for the aggregate amount which saving individuals
decide to save to be equal to the aggregate amount which investing
individuals decide to invest.
Clearness of mind on this matter is best reached, perhaps, by thinking
in terms of decisions to consume (or to refrain from consuming) rather
than of decisions to save. A decision to consume or not to consume truly
lies within the power of the individual; so does a decision to invest or not
to invest. The amounts of aggregate income and of aggregate saving are
the results of the free choices of individuals whether or not to consume
and whether or not to invest; but they are neither of them capable of
assuming an independent value resulting from a separate set of decisions
taken irrespective of the decisions concerning consumption and
investment. In accordance with this principle, the conception of the
propensity to consume will, in what follows, take the place of the
propensity or disposition to save.
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : Chapter 6a: Appendix on User Cost

C 6 :A U C
User cost has, I think, an importance for the classical theory of value which
has been overlooked. There is more to be said about it than would be
relevant or appropriate in this place. But, as a digression, we will examine
it somewhat further in this appendix.
An entrepreneurs user cost is by definition equal to
A1 + (G B) G,
where A1 is the amount of our entrepreneurs purchases from other

entrepreneurs, G the actual value of his capital equipment at the end of the
period, and G the value it might have had at the end of the period if he had
refrained from using it and had spent the optimum sum B on its
maintenance and improvement. Now G (G B), namely the increment
in the value of the entrepreneurs equipment beyond the net value which
he has inherited from the previous period, represents the entrepreneurs
current investment in his equipment and can be written I. Thus U, the user
cost of his sales-turnover A, is equal to A1 I where A1 is what he has
bought from other entrepreneurs and I is what he has currently invested in
his own equipment. A little reflection will show that all this is no more
than common sense. Some part of his outgoings to other entrepreneurs is
balanced by the value of his current investment in his own equipment, and
the rest represents the sacrifice which the output he has sold must have
cost him over and above the total sum which he has paid out to the factors
of production. If the reader tries to express the substance of this otherwise,
he will find that its advantage lies in its avoidance of insoluble (and
unnecessary) accounting problems. There is, I think, no other way of
analysing the current proceeds of production unambiguously. If industry is
completely integrated or if the entrepreneur has bought nothing from
outside, so that A1 = 0, the user cost is simply the equivalent of the
current disinvestment involved in using the equipment; but we are still left
file:///D:/keyness/chapter6a.html 1/7
with the advantage that we do not require at any stage of the analysis to
allocate the factor cost between the goods which are sold and the
equipment which is retained. Thus we can regard the employment given
by a firm, whether integrated or individual, as depending on a single
consolidated decision a procedure which corresponds to the actual
interlocking character of the production of what is currently sold with total
production.
The concept of user cost enables us, moreover, to give a clearer
definition than that usually adopted of the short-period supply price of a
unit of a firms saleable output. For the short-period supply price is the
sum of the marginal factor cost and the marginal user cost.
Now in the modern theory of value it has been a usual practice to
equate the short-period supply price to the marginal factor cost alone. It is
obvious, however, that this is only legitimate if marginal user cost is zero
or if supply price is specially defined so as to be net of marginal user cost,
just as I have defined (p. 24 above) proceeds and aggregate supply price
as being net of aggregate user cost. But, whereas it may be occasionally
convenient in dealing with output as a whole to deduct user cost, this
procedure deprives our analysis of all reality if it is habitually (and tacitly)
applied to the output of a single industry or firm, since it divorces the
supply price of an article from any ordinary sense of its price; and some
confusion may have resulted from the practice of doing so. It seems to
have been assumed that supply price has an obvious meaning as applied
to a unit of the saleable output of an individual firm, and the matter has
not been deemed to require discussion. Yet the treatment both of what is
purchased from other firms and of the wastage of the firms own
equipment as a consequence of producing the marginal output involves
the whole pack of perplexities which attend the definition of income. For,
even if we assume that the marginal cost of purchases from other firms
involved in selling an additional unit of output has to be deducted from the
sale-proceeds per unit in order to give us what we mean by our firms
supply price, we still have to allow for the marginal disinvestment in the
firms own equipment involved in producing the marginal output. Even if
all production is carried on by a completely integrated firm, it is still
illegitimate to suppose that the marginal user cost is zero, i.e. that the
marginal disinvestment in equipment due to the production of the
marginal output can generally be neglected.
The concepts of user cost and of supplementary cost also enable us to
establish a clearer relationship between long-period supply price and
short-period supply price. Long-period cost must obviously include an
amount to cover the basic supplementary cost as well as the expected

prime cost appropriately averaged over the life of the equipment. That is to
say, the long-period cost of the output is equal to the expected sum of the
prime cost and the supplementary cost; and, furthermore, in order to yield
a normal profit, the long-period supply price must exceed the long-period
cost thus calculated by an amount determined by the current rate of
interest on loans of comparable term and risk, reckoned as a percentage of
the cost of the equipment. Or if we prefer to take a standard pure rate of
interest, we must include in the long-period cost a third term which we
might call the risk-cost to cover the unknown possibilities of the actual
yield differing from the expected yield. Thus the long-period supply price
is equal to the sum of the prime cost, the supplementary cost, the risk cost
and the interest cost, into which several components it can be analysed.
The short-period supply price, on the other hand, is equal to the marginal
prime cost. The entrepreneur must, therefore, expect, when he buys or
constructs his equipment, to cover his supplementary cost, his risk cost
and his interest cost out of the excess of the marginal value of the prime
cost over its average value; so that in long-period equilibrium the excess of
the marginal prime cost over the average prime cost is equal to the sum of
the supplementary, risk and interest costs.
The level of output, at which marginal prime cost is exactly equal to
the sum of the average prime and supplementary costs, has a special
importance, because it is the point at which the entrepreneurs trading
account breaks even. It corresponds, that is to say, to the point of zero net
profit; whilst with a smaller output than this he is trading at a net loss.
The extent to which the supplementary cost has to be provided for
apart from the prime cost varies very much from one type of equipment to
another. Two extreme cases are the following:
(i) Some part of the maintenance of the equipment must necessarily
take place pari passu with the act of using it (e.g. oiling the machine). The
expense of this (apart from outside purchases) is included in the factor
cost. If, for physical reasons, the exact amount of the whole of the current
depreciation has necessarily to be made good in this way, the amount of
the user cost (apart from outside purchases) would be equal and opposite
to that of the supplementary cost; and in long-period equilibrium the
marginal factor cost would exceed the average factor cost by an amount
equal to the risk and interest cost.
(ii) Some part of the deterioration in the value of the equipment only
occurs if it is used. The cost of this is charged in user cost, in so far as it is
not made good pari passu with the act of using it. If loss in the value of the
equipment could only occur in this way, supplementary cost would be

zero.
It may be worth pointing out that an entrepreneur does not use his
oldest and worst equipment first, merely because its user cost is low; since
its low user cost may be outweighed by its relative inefficiency, i.e. by its
high factor cost. Thus an entrepreneur uses by preference that part of his
equipment for which the user cost plus factor cost is least per unit of
output. It follows that for any given volume of output of the product in
question there is a corresponding user cost, but that this total user cost
does not bear a uniform relation to the marginal user cost, i.e. to the
increment of user cost due to an increment in the rate of output.
User cost constitutes one of the links between the present and the future.
For in deciding his scale of production an entrepreneur has to exercise a
choice between using up his equipment now and preserving it to be used
later on. It is the expected sacrifice of future benefit involved in present
use which determines the amount of the user cost, and it is the marginal
amount of this sacrifice which, together with the marginal factor cost and
the expectation of the marginal proceeds, determines his scale of
production. How, then, is the user cost of an act of production calculated
by the entrepreneur?
We have defined the user cost as the reduction in the value of the
equipment due to using it as compared with not using it, after allowing for
the cost of the maintenance and improvements which it would be worth
while to undertake and for purchases from other entrepreneurs. It must be
arrived at, therefore, by calculating the discounted value of the additional
prospective yield which would be obtained at some later date if it were not
used now. Now this must be at least equal to the present value of the
opportunity to postpone replacement which will result from laying up the
equipment; and it may be more.
If there is no surplus or redundant stock, so that more units of similar
equipment are being newly produced every year either as an addition or in
replacement, it is evident that marginal user cost will be calculable by
reference to the amount by which the life or efficiency of the equipment
will be shortened if it is used, and the current replacement cost. If,
however, there is redundant equipment, then the user cost will also
depend on the rate of interest and the current (i.e. re-estimated)
supplementary cost over the period of time before the redundancy is

expected to be absorbed through wastage, etc. In this way interest cost and
current supplementary cost enter indirectly into the calculation of user
cost.
The calculation is exhibited in its simplest and most intelligible form
when the factor cost is zero, e.g. in the case of a redundant stock of a raw
material such as copper, on the lines which I have worked out in my
Treatise on Money, vol. ii. chap. 29. Let us take the prospective values of
copper at various future dates, a series which will be governed by the rate
at which redundancy is being absorbed and gradually approaches the
estimated normal cost. The present value or user cost of a ton of surplus
copper will then be equal to the greatest of the values obtainable by
subtracting from the estimated future value at any given date of a ton of
copper the interest cost and the current supplementary cost on a ton of
copper between that date and the present.
In the same way the user cost of a ship or factory or machine, when
these equipments are in redundant supply, is its estimated replacement
cost discounted at the percentage rate of its interest and current
supplementary costs to the prospective date of absorption of the
redundancy.
We have assumed above that the equipment will be replaced in due
course by an identical article. If the equipment in question will not be
renewed identically when it is worn out, then its user cost has to be
calculated by taking a proportion of the user cost of the new equipment,
which will be erected to do its work when it is discarded, given by its
comparative efficiency.
The reader should notice that, where the equipment is not obsolescent but
merely redundant for the time being, the difference between the actual
user cost and its normal value (i.e. the value when there is no redundant
equipment) varies with the interval of time which is expected to elapse
before the redundancy is absorbed. Thus if the type of equipment in
question is of all ages and not bunched, so that a fair proportion is
reaching the end of its life annually, the marginal user cost will not decline
greatly unless the redundancy is exceptionally excessive. In the case of a
general slump, marginal user cost will depend on how long entrepreneurs
expect the slump to last. Thus the rise in the supply price when affairs
begin to mend may be partly due to a sharp increase in marginal user cost
due to a revision of their expectations.
It has sometimes been argued, contrary to the opinion of business
men, that organised schemes for scrapping redundant plant cannot have
the desired effect of raising prices unless they apply to the whole of the
redundant plant. But the concept of user cost shows how the scrapping of
(say) half the redundant plant may have the effect of raising prices
immediately. For by bringing the date of the absorption of the redundancy
nearer, this policy raises marginal user cost and consequently increases
the current supply price. Thus business men would seem to have the
notion of user cost implicitly in mind, though they do not formulate it
distinctly. If the supplementary cost is heavy, it follows that the marginal
user cost will be low when there is surplus equipment. Moreover, when
there is surplus equipment, the marginal factor and user costs are unlikely
to be much in excess of their average value. If both these conditions are
fulfilled, the existence of surplus equipment is likely to lead to the
entrepreneurs working at a net loss, and perhaps at a heavy net loss.
There will not be a sudden transition from this state of affairs to a normal
profit, taking place at the moment when the redundancy is absorbed. As
the redundancy becomes less, the user cost will gradually increase; and the
excess of marginal over average factor and user cost may also gradually
increase.
In Marshalls Principles of Economics (6th ed. p.360) a part of user cost is

included in prime cost under the heading of extra wear-and-tear of plant.
But no guidance is given as to how this item is to be calculated or as to its
importance. In his Theory of Unemployment (p.42) Professor Pigou
expressly assumes that the marginal disinvestment in equipment due to
the marginal output can, in general, be neglected: The differences in the
quantity of wear-and-tear suffered by equipment and in the costs of non-
manual labour employed, that are associated with differences in output,
are ignored, as being, in general, of secondary importance. Indeed, the
notion that the disinvestment in equipment is zero at the margin of
production runs through a good deal of recent economic theory. But the
whole problem is brought to an obvious head as soon as it is thought
necessary to explain exactly what is meant by the supply price of an
individual firm.
It is true that the cost of maintenance of idle plant may often, for the
reasons given above, reduce the magnitude of marginal user cost,
especially in a slump which is expected to last a long time. Nevertheless a
very low user cost at the margin is not a characteristic of the short period
as such, but of particular situations and types of equipment where the cost
of maintaining idle plant happens to be heavy, and of those disequilibria
which are characterised by very rapid obsolescence or great redundancy,
especially if it is coupled with a large proportion of comparatively new
plant.
In the case of raw materials the necessity of allowing for user cost is
obvious; if a ton of copper is used up to-day it cannot be used to-
morrow, and the value which the copper would have for the purposes of
to-morrow must clearly he reckoned as a part of the marginal cost. But the
fact has been overlooked that copper is only an extreme case of what
occurs whenever capital equipment is used to produce. The assumption
that there is a sharp division between raw materials where we must allow
for the disinvestment due to using them and fixed capital where we can
safely neglect it does not correspond to the facts; especially in normal
conditions where equipment is falling due for replacement every year and
the use of equipment brings nearer the date at which replacement is
necessary.
It is an advantage of the concepts of user cost and supplementary cost
that they are as applicable to working and liquid capital as to fixed capital.
The essential difference between raw materials and fixed capital lies not in
their liability to user and supplementary costs, but in the fact that the
return to liquid capital consists of a single term; whereas in the case of
fixed capital, which is durable and used up gradually, the return consists of
a series of user costs and profits earned in successive periods.
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C 7
T M S
I F C
In the previous chapter saving and investment have been so defined that
they are necessarily equal in amount, being, for the community as a whole,
merely different aspects of the same thing. Several contemporary writers
(including myself in my Treatise on Money) have, however, given special
definitions of these terms on which they are not necessarily equal. Others
have written on the assumption that they may be unequal without
prefacing their discussion with any definitions at all. It will be useful,
therefore, with a view to relating the foregoing to other discussions of
these terms, to classify some of the various uses of them which appear to
be current.
So far as I know, everyone agrees in meaning by saving the excess of
income over what is spent on consumption. It would certainly be very
inconvenient and misleading not to mean this. Nor is there any important
difference of opinion as to what is meant by expenditure on consumption.
Thus the differences of usage arise either out of the definition of
investment or out of that of income.
Let us take investment first. In popular usage it is common to mean by this

the purchase of an asset, old or new, by an individual or a corporation.
Occasionally, the term might be restricted to the purchase of an asset on
the Stock Exchange. But we speak just as readily of investing, for example,
in a house, or in a machine, or in a stock of finished or unfinished goods;
and, broadly speaking, new investment, as distinguished from
reinvestment, means the purchase of a capital asset of any kind out of

income. If we reckon the sale of an investment as being negative
investment, i.e. disinvestment, my own definition is in accordance with
popular usage; since exchanges of old investments necessarily cancel out.
We have, indeed, to adjust for the creation and discharge of debts
(including changes in the quantity of credit or money); but since for the
community as a whole the increase or decrease of the aggregate creditor
position is always exactly equal to the increase or decrease of the aggregate
debtor position, this complication also cancels out when we are dealing
with aggregate investment. Thus, assuming that income in the popular
sense corresponds to my net income, aggregate investment in the popular
sense coincides with my definition of net investment, namely the net
addition to all kinds of capital equipment, after allowing for those changes
in the value of the old capital equipment which are taken into account in
reckoning net income.
Investment, thus defined, includes, therefore, the increment of capital
equipment, whether it consists of fixed capital, working capital or liquid
capital; and the significant differences of definition (apart from the
distinction between investment and net investment) are due to the
exclusion from investment of one or more of these categories.
Mr Hawtrey, for example, who attaches great importance to changes
in liquid capital, i.e. to undesigned increments (or decrements) in the
stock of unsold goods, has suggested a possible definition of investment
from which such changes are excluded. In this case an excess of saving
over investment would be the same thing as an undesigned increment in
the stock of unsold goods, i.e. as an increase of liquid capital. Mr Hawtrey
has not convinced me that this is the factor to stress; for it lays all the
emphasis on the correction of changes which were in the first instance
unforeseen, as compared with those which are, rightly or wrongly,
anticipated. Mr Hawtrey regards the daily decisions of entrepreneurs
concerning their scale of output as being varied from the scale of the
previous day by reference to the changes in their stock of unsold goods.
Certainly, in the case of consumption goods, this plays an important part
in their decisions. But I see no object in excluding the play of other factors
on their decisions; and I prefer, therefore, to emphasise the total change of
effective demand and not merely that part of the change in effective
demand which reflects the increase or decrease of unsold stocks in the
previous period. Moreover, in the case of fixed capital, the increase or
decrease of unused capacity corresponds to the increase or decrease in
unsold stocks in its effect on decisions to produce; and I do not see how Mr
Hawtreys method can handle this at least equally important factor.
It seems probable that capital formation and capital consumption, as
used by the Austrian school of economists, are not identical either with
investment and disinvestment as defined above or with net investment
and disinvestment. In particular, capital consumption is said to occur in
circumstances where there is quite clearly no net decrease in capital
equipment as defined above. I have, however, been unable to discover a
reference to any passage where the meaning of these terms is clearly
explained. The statement, for example, that capital formation occurs when
there is a lengthening of the period of production does not much advance
matters.
We come next to the divergences between saving and investment which

are due to a special definition of income and hence of the excess of income
over consumption. My own use of terms in my Treatise on Money is an
example of this. For, as I have explained on p. 60 above, the definition of
income, which I there employed, differed from my present definition by
reckoning as the income of entrepreneurs not their actually realised profits
but (in some sense) their normal profit. Thus by an excess of saving over
investment I meant that the scale of output was such that entrepreneurs
were earning a less than normal profit from their ownership of the capital
equipment; and by an increased excess of saving over investment I meant
that a decline was taking place in the actual profits, so that they would be
under a motive to contract output.
As I now think, the volume of employment (and consequently of
output and real income) is fixed by the entrepreneur under the motive of
seeking to maximise his present and prospective profits (the allowance for
user cost being determined by his view as to the use of equipment which
will maximise his return from it over its whole life); whilst the volume of
employment which will maximise his profit depends on the aggregate
demand function given by his expectations of the sum of the proceeds
resulting from consumption and investment respectively on various
hypotheses. In my Treatise on Money the concept of changes in the excess
of investment over saving, as there defined, was a way of handling changes
in profit, though I did not in that book distinguish clearly between
expected and realised results. I there argued that change in the excess of
investment over saving was the motive force governing changes in the
volume of output. Thus the new argument, though (as I now think) much
more accurate and instructive, is essentially a development of the old.
Expressed in the language of my Treatise on Money, it would run: the
expectation of an increased excess of investment over saving, given the
former volume of employment and output, will induce entrepreneurs to
increase the volume of employment and output. The significance of both
my present and my former arguments lies in their attempt to show that the
volume of employment is determined by the estimates of effective demand
made by the entrepreneurs, an expected increase of investment relatively
to saving as defined in my Treatise on Money being a criterion of an
increase in effective demand. But the exposition in my Treatise on Money
is, of course, very confusing and incomplete in the light of the further
developments here set forth.
Mr D. H. Robertson has defined to-days income as being equal to
yesterdays consumption plus investment, so that to-days saving, in his
sense, is equal to yesterdays investment plus the excess of yesterdays
consumption over to-days consumption. On this definition saving can
exceed investment, namely, by the excess of yesterdays income (in my
sense) over to-days income. Thus when Mr Robertson says that there is an
excess of saving over investment, he means literally the same thing as I
mean when I say that income is falling, and the excess of saving in his
sense is exactly equal to the decline of income in my sense. If it were true
that current expectations were always determined by yesterdays realised
results, to-days effective demand would be equal to yesterdays income.
Thus Mr Robertsons method might be regarded as an alternative. attempt
to mine (being, perhaps, a first approximation to it) to make the same
distinction, so vital for causal analysis, that I have tried to make by the
contrast between effective demand and income.
We come next to the much vaguer ideas associated with the phrase forced
saving. Is any clear significance discoverable in these? In my Treatise on
Money (vol.1, p. 171, footnote [JMK, vol. V, p.154] I gave some references
to earlier uses of this phrase and suggested that they bore some affinity to
the difference between investment and saving in the sense in which I
there used the latter term. I am no longer confident that there was in fact
so much affinity as I then supposed. In any case, I feel sure that forced
saving and analogous phrases employed more recently (e.g. by Professor

Hayek or Professor Robbins) have no definite relation to the difference
between investment and saving in the sense intended in my Treatise on
Money. For whilst these authors have not explained exactly what they
mean by this term, it is clear that forced saving, in their sense, is a
phenomenon which results directly from, and is measured by, changes in
the quantity of money or bank-credit.
It is evident that a change in the volume of output and employment
will, indeed, cause a change in income measured in wage-units; that a
change in the wage-unit will cause both a redistribution of income between
borrowers and lenders and a change in aggregate income measured in
money; and that in either event there will (or may) be a change in the
amount saved. Since, therefore, changes in the quantity of money may
result, through their effect on the rate of interest, in a change in the
volume and distribution of income (as we shall show later), such changes
may involve, indirectly, a change in the amount saved. But such changes in
the amounts saved are no more forced savings than any other changes in
the amounts saved due to a change in circumstances; and there is no
means of distinguishing between one case and another, unless we specify
the amount saved in certain given conditions as our norm or standard.
Moreover, as we shall see, the amount of the change in aggregate saving
which results from a given change in the quantity of money is highly
variable and depends on many other factors.
Thus forced saving has no meaning until we have specified some
standard rate of saving. If we select (as might be reasonable) the rate of
saving which corresponds to an established state of full employment, the
above definition would become: Forced saving is the excess of actual
saving over what would be saved if there were full employment in a
position of long-period equilibrium. This definition would make good
sense, but a sense in which a forced excess of saving would be a very rare
and a very unstable phenomenon, and a forced deficiency of saving the
usual state of affairs.
Professor Hayeks interesting Note on the Development of the
Doctrine of Forced Saving shows that this was in fact the original
meaning of the term. Forced saving or forced frugality was, in the first
instance, a conception of Benthams; and Bentham expressly stated that he
had in mind the consequences of an increase in the quantity of money
(relatively to the quantity of things vendible for money) in circumstances
of all hands being employed and employed in the most advantageous
manner. In such circumstances, Bentham points out, real income cannot
be increased, and, consequently, additional investment, taking place as a

result of the transition, involves forced frugality at the expense of national
comfort and national justice. All the nineteenth-century writers who dealt
with this matter had virtually the same idea in mind. But an attempt to
extend this perfectly clear notion to conditions of less than full
employment involves difficulties. It is true, of course (owing to the fact of
diminishing returns to an increase in the employment applied to a given
capital equipment), that any increase in employment involves some
sacrifice of real income to those who were already employed, but an
attempt to relate this loss to the increase in investment which may
accompany the increase in employment is not likely to be fruitful. At any
rate I am not aware of any attempt having been made by the modern
writers who are interested in forced saving to extend the idea to
conditions where employment is increasing; and they seem, as a rule, to
overlook the fact that the extension of the Benthamite concept of forced
frugality to conditions of less than full employment requires some
explanation or qualification.
The prevalence of the idea that saving and investment, taken in their
straightforward sense, can differ from one another, is to be explained, I
think, by an optical illusion due to regarding an individual depositors
relation to his bank as being a one-sided transaction, instead of seeing it as
the two-sided transaction which it actually is. It is supposed that a
depositor and his bank can somehow contrive between them to perform an
operation by which savings can disappear into the banking system so that
they are lost to investment, or, contrariwise, that the banking system can
make it possible for investment to occur, to which no saving corresponds.
But no one can save without acquiring an asset, whether it be cash or a
debt or capital-goods; and no one can acquire an asset which he did not
previously possess, unless either an asset of equal value is newly produced
or someone else parts with an asset of that value which he previously had.
In the first alternative there is a corresponding new investment: in the
second alternative someone else must be dis-saving an equal sum. For his
loss of wealth must be due to his consumption exceeding his income, and
not to a loss on capital account through a change in the value of a capital-
asset, since it is not a case of his suffering a loss of value which his asset
formerly had; he is duly receiving the current value of his asset and yet is
not retaining this value in wealth of any form, i.e. he must be spending it
on current consumption in excess of current income. Moreover, if it is the

banking system which parts with an asset, someone must be parting with
cash. It follows that the aggregate saving of the first individual and of
others taken together must necessarily be equal to the amount of current
new investment.
The notion that the creation of credit by the banking system allows
investment to take place to which no genuine saving corresponds can
only be the result of isolating one of the consequences of the increased
bank-credit to the exclusion of the others. If the grant of a bank credit to
an entrepreneur additional to the credits already existing allows him to
make an addition to current investment which would not have occurred
otherwise, incomes will necessarily be increased and at a rate which will
normally exceed the rate of increased investment. Moreover, except in
conditions of full employment, there will be an increase of real income as
well as of money-income. The public will exercise a free choice as to the
proportion in which they divide their increase of income between saving
and spending; and it is impossible that the intention of the entrepreneur
who has borrowed in order to increase investment can become effective
(except in substitution for investment by other entrepreneurs which would
have occurred otherwise) at a faster rate than the public decide to increase
their savings. Moreover, the savings which result from this decision are
just as genuine as any other savings. No one can be compelled to own the
additional money corresponding to the new bank-credit, unless he
deliberately prefers to hold more money rather than some other form of
wealth. Yet employment, incomes and prices cannot help moving in such a
way that in the new situation someone does choose to hold the additional
money. It is true that an unexpected increase of investment in a particular
direction may cause an irregularity in the rate of aggregate saving and
investment which would not have occurred if it had been sufficiently
foreseen. It is also true that the grant of the bank-credit will set up three
tendencies (1) for output to increase, (2) for the marginal product to rise
in value in terms of the wage-unit (which in conditions of decreasing
return must necessarily accompany an increase of output), and (3) for the
wage-unit to rise in terms of money (since this is a frequent concomitant
of better employment); and these tendencies may affect the distribution of
real income between different groups. But these tendencies are
characteristic of a state of increasing output as such, and will occur just as
much if the increase in output has been initiated otherwise than by an
increase in bank-credit. They can only be avoided by avoiding any course
of action capable of improving employment. Much of the above, however,

is anticipating the result of discussions which have not yet been reached.
Thus the old-fashioned view that saving always involves investment,
though incomplete and misleading, is formally sounder than the new-
fangled view that there can be saving without investment or investment
without genuine saving. The error lies in proceeding to the plausible
inference that, when an individual saves, he will increase aggregate
investment by an equal amount. It is true, that, when an individual saves
he increases his own wealth. But the conclusion that he also increases
aggregate wealth fails to allow for the possibility that an act of individual
saving may react on someone elses savings and hence on someone elses
wealth.
The reconciliation of the identity between saving and investment with
the apparent free-will of the individual to save what he chooses
irrespective of what he or others may be investing, essentially depends on
saving being, like spending, a two-sided affair. For although the amount of
his own saving is unlikely to have any significant influence on his own
income, the reactions of the amount of his consumption on the incomes of
others makes it impossible for all individuals simultaneously to save any
given sums. Every such attempt to save more by reducing consumption
will so affect incomes that the attempt necessarily defeats itself. It is, of
course, just as impossible for the community as a whole to save less than
the amount of current investment, since the attempt to do so will
necessarily raise incomes to a level at which the sums which individuals
choose to save add up to a figure exactly equal to the amount of
investment.
The above is closely analogous with the proposition which harmonises
the liberty, which every individual possesses, to change, whenever he
chooses, the amount of money he holds, with the necessity for the total
amount of money, which individual balances add up to, to be exactly equal
to the amount of cash which the banking system has created. In this latter
case the equality is brought about by the fact that the amount of money
which people choose to hold is not independent of their incomes or of the
prices of the things (primarily securities), the purchase of which is the
natural alternative to holding money. Thus incomes and such prices
necessarily change until the aggregate of the amounts of money which
individuals choose to hold at the new level of incomes and prices thus
brought about has come to equality with the amount of money created by
the banking system. This, indeed, is the fundamental proposition of
monetary theory.
Both these propositions follow merely from the fact that there cannot
be a buyer without a seller or a seller without a buyer. Though an
individual whose transactions are small in relation to the market can safely
neglect the fact that demand is not a one-sided transaction, it makes
nonsense to neglect it when we come to aggregate demand. This is the vital
difference between the theory of the economic behaviour of the aggregate
and the theory of the behaviour of the individual unit, in which we assume
that changes in the individuals own demand do not affect his income.

C 8
T P C :
I. T O F
We are now in a position to return to our main theme, from which we

broke off at the end of Book I in order to deal with certain general
problems of method and definition. The ultimate object of our analysis is
to discover what determines the volume of employment. So far we have
established the preliminary conclusion that the volume of employment is
determined by the point of intersection of the aggregate supply function
with the aggregate demand function. The aggregate supply function,
however, which depends in the main on the physical conditions of supply,
involves few considerations which are not already familiar. The form may
be unfamiliar but the underlying factors are not new. We shall return to
the aggregate supply function in chapter 20, where we discuss its inverse
under the name of the employment function. But, in the main, it is the
part played by the aggregate demand function which has been overlooked;
and it is to the aggregate demand function that we shall devote Books III
and IV.
The aggregate demand function relates any given level of employment
to the proceeds which that level of employment is expected to realise. The
proceeds are made up of the sum of two quantities the sum which will
be spent on consumption when employment is at the given level, and the
sum which will be devoted to investment. The factors which govern these
two quantities are largely distinct. In this book we shall consider the
former, namely what factors determine the sum which will be spent on
consumption when employment is at a given level; and in Book IV we shall
proceed to the factors which determine the sum which will be devoted to
investment.
Since we are here concerned in determining what sum will be spent
on consumption when employment is at a given level, we should, strictly
speaking, consider the function which relates the former quantity (C) to
the latter (N). It is more convenient, however, to work in terms of a slightly
different function, namely, the function which relates the consumption in
terms of wage-units (Cw) to the income in terms of wage-units (Yw)

corresponding to a level of employment N. This suffers from the objection
that Yw is not a unique function of N, which is the same in all
circumstances. For the relationship between Yw and N may depend
(though probably in a very minor degree) on the precise nature of the
employment. That is to say, two different distributions of a given aggregate
employment N between different employments might (owing to the
different shapes of the individual employment functions a matter to be
discussed in Chapter 20 below) lead to different values of Yw. In
conceivable circumstances a special allowance might have to be made for
this factor. But in general it is a good approximation to regard Yw as
uniquely determined by N. We will therefore define what we shall call the
propensity to consume as the functional relationship between Yw a given
level of income in terms of wage-units, and Cw the expenditure on
consumption out of that level of income, so that
Cw = (Yw) or C = W (Yw).
The amount that the community spends on consumption obviously

depends (i) partly on the amount of its income, (ii) partly on the other
objective attendant circumstances, and (iii) partly on the subjective needs
and the psychological propensities and habits of the individuals
composing it and the principles on which the income is divided between
them (which may suffer modification as output is increased). The motives
to spending interact and the attempt to classify them runs the danger of
false division. Nevertheless it will clear our minds to consider them
separately under two broad heads which we shall call the subjective factors
and the objective factors. The subjective factors, which we shall consider in
more detail in the next chapter, include those psychological characteristics
of human nature and those social practices and institutions which, though
not unalterable, are unlikely to undergo a material change over a short
period of time except in abnormal or revolutionary circumstances. In an
historical enquiry or in comparing one social system with another of a
different type, it is necessary to take account of the manner in which
changes in the subjective factors may affect the propensity to consume.
But, in general, we shall in what follows take the subjective factors as
given; and we shall assume that the propensity to consume depends only
on changes in the objective factors.
The principal objective factors which influence the propensity to consume

appear to be the following:
(1) A change in the wage-unit. Consumption (C) is obviously much

more a function of (in some sense) real income than of money-income. In
a given state of technique and tastes and of social conditions determining
the distribution of income, a mans real income will rise and fall with the
amount of his command over labour-units, i.e. with the amount of his
income measured in wage-units; though when the aggregate volume of
output changes, his real income will (owing to the operation of decreasing
returns) rise less than in proportion to his income measured in wage-
units. As a first approximation, therefore, we can reasonably assume that,
if the wage-unit changes, the expenditure on consumption corresponding
to a given level of employment will, like prices, change in the same
proportion; though in some circumstances we may have to make an
allowance for the possible reactions on aggregate consumption of the
change in the distribution of a given real income between entrepreneurs
and rentiers resulting from a change in the wage-unit. Apart from this, we
have already allowed for changes in the wage-unit by defining the
propensity to consume in terms of income measured in terms of wage-
units.
(2) A change in the difference between income and net income. We
have shown above that the amount of consumption depends on net income
rather than on income, since it is, by definition, his net income that a man
has primarily in mind when he is deciding his scale of consumption. In a
given situation there may be a somewhat stable relationship between the
two, in the sense that there will be a function uniquely relating different
levels of income to the corresponding levels of net income. If, however,
this should not be the case, such part of any change in income as is not
reflected in net income must be neglected since it will have no effect on
consumption; and, similarly, a change in net income, not reflected in
income, must be allowed for. Save in exceptional circumstances, however,
I doubt the practical importance of this factor. We will return to a fuller
discussion of the effect on consumption of the difference between income
and net income in the fourth section of this chapter.
(3) Windfall changes in capital-values not allowed for in calculating
net income. These are of much more importance in modifying the
propensity to consume, since they will bear no stable or regular
relationship to the amount of income. The consumption of the wealth-
owning class may be extremely susceptible to unforeseen changes in the
money-value of its wealth. This should be classified amongst the major
factors capable of causing short-period changes in the propensity to
consume.
(4) Changes in the rate of time-discounting, i.e. in the ratio of
exchange between present goods and future goods. This is not quite the
same thing as the rate of interest, since it allows for future changes in the
purchasing power of money in so far as these are foreseen. Account has
also to be taken of all kinds of risks, such as the prospect of not living to
enjoy the future goods or of confiscatory taxation. As an approximation,
however, we can identify this with the rate of interest.
The influence of this factor on the rate of spending out of a given
income is open to a good deal of doubt. For the classical theory of the rate
of interest, which was based on the idea that the rate of interest was the
factor which brought the supply and demand for savings into equilibrium,
it was convenient to suppose that expenditure on consumption is cet. par.
negatively sensitive to changes in the rate of interest, so that any rise in the
rate of interest would appreciably diminish consumption. It has long been
recognised, however, that the total effect of changes in the rate ofinterest
on the readiness to spend on present consumption is complex and
uncertain, being dependent on conflicting tendencies, since some of the
subjective motives towards saving will be more easily satisfied if the rate of
interest rises, whilst others will be weakened. Over a long period
substantial changes in the rate of interest probably tend to modify social
habits considerably, thus affecting the subjective propensity to spend
though in which direction it would be hard to say, except in the light of
actual experience. The usual type of short-period fluctuation in the rate of
interest is not likely, however, to have much direct influence on spending
either way.
There are not many people who will alter their way of living because
the rate of interest has fallen from 5 to 4 per cent, if their aggregate income
is the same as before. Indirectly there may be more effects, though not all
in the same direction. Perhaps the most important influence, operating
through changes in the rate of interest, on the readiness to spend out of a
given income, depends on the effect of these changes on the appreciation
or depreciation in the price of securities and other assets. For if a man is
enjoying a windfall increment in the value of his capital, it is natural that
his motives towards current spending should be strengthened, even
though in terms of income his capital is worth no more than before; and
weakened if he is suffering capital losses. But this indirect influence we
have allowed for already under (3) above. Apart from this, the main
conclusion suggested by experience is, I think, that the short-period
influence of the rate of interest on individual spending out of a given
income is secondary and relatively unimportant, except, perhaps, where
unusually large changes are in question. When the rate of interest falls
very low indeed, the increase in the ratio between an annuity purchasable
for a given sum and the annual interest on that sum may, however, provide
an important source of negative saving by encouraging the practice of
providing for old age by the purchase of an annuity.
The abnormal situation, where the propensity to consume may be
sharply affected by the development of extreme uncertainty concerning
the future and what it may bring forth, should also, perhaps, be classified
under this heading.
(5) Changes in fiscal policy. In so far as the inducement to the
individual to save depends on the future return which he expects, it clearly
depends not only on the rate of interest but on the fiscal policy of the
government. Income taxes, especially when they discriminate against
unearned income, taxes on capital-profits, death-duties and the like are
as relevant as the rate of interest; whilst the range of possible changes in
fiscal policy may be greater, in expectation at least, than for the rate of
interest itself. If fiscal policy is used as a deliberate instrument for the
more equal distribution of incomes, its effect in increasing the propensity
to consume is, of course, all the greater.
We must also take account of the effect on the aggregate propensity to
consume of government sinking funds for the discharge of debt paid for
out of ordinary taxation. For these represent a species of corporate saving,
so that a policy of substantial sinking funds must be regarded in given
circumstances as reducing the propensity to consume. It is for this reason
that a change-over from a policy of government borrowing to the opposite
policy of providing sinking funds (or vice versa) is capable of causing a
severe contraction (or marked expansion) of effective demand.
(6) Changes in expectations of the relation between the present and
the future level of income. We must catalogue this factor for the sake of
formal completeness. But, whilst it may affect considerably a particular
individuals propensity to consume, it is likely to average out for the
community as a whole. Moreover, it is a matter about which there is, as a
rule, too much uncertainty for it to exert much influence.
We are left therefore, with the conclusion that in a given situation the
propensity to consume may be considered a fairly stable function,
provided that we have eliminated changes in the wage-unit in terms of
money. Windfall changes in capital-values will be capable of changing the
propensity to consume, and substantial changes in the rate of interest and
in fiscal policy may make some difference; but the other objective factors
which might affect it, whilst they must not be overlooked, are not likely to
be important in ordinary circumstances.
The fact that, given the general economic situation, the expenditure
on consumption in terms of the wage-unit depends in the main, on the
volume of output and employment is the justification for summing up the
other factors in the portmanteau function propensity to consume. For
whilst the other factors are capable of varying {and this must not be
forgotten), the aggregate income measured in terms of the wage-unit is, as
a rule, the principal variable upon which the consumption-constituent of
the aggregate demand function will depend.
Granted, then, that the propensity to consume is a fairly stable function so

that, as a rule, the amount of aggregate consumption mainly depends on
the amount of aggregate income (both measured in terms of wage-units),
changes in the propensity itself being treated as a secondary influence,
what is the normal shape of this function?
The fundamental psychological law, upon which we are entitled to
depend with great confidence both a priori from our knowledge of human
nature and from the detailed facts of experience, is that men are disposed,
as a rule and on the average, to increase their consumption as their income
increases, but not by as much as the increase in their income. That is to
say, if Cw is the amount of consumption and Yw is income (both measured
in wage-units) Cw has the same sign as Yw but is smaller in amount, i.e.
dCw/dYw is positive and less than unity.
This is especially the case where we have short periods in view, as in

the case of the so-called cyclical fluctuations of employment during which
habits, as distinct from more permanent psychological propensities, are
not given time enough to adapt themselves to changed objective
circumstances. For a mans habitual standard of life usually has the first
claim on his income, and he is apt to save the difference which discovers
itself between his actual income and the expense of his habitual standard;
or, if he does adjust his expenditure to changes in his income, he will over
short periods do so imperfectly. Thus a rising income will often be
accompanied by increased saving, and a falling income by decreased
saving, on a greater scale at first than subsequently.
But, apart from short-period changes in the level of income, it is also
obvious that a higher absolute level of income will tend, as a rule, to widen
the gap between income and consumption. For the satisfaction of the
immediate primary needs of a man and his family is usually a stronger
motive than the motives towards accumulation, which only acquire
effective sway when a margin of comfort has been attained. These reasons
will lead, as a rule, to a greater proportion of income being saved as real
income increases. But whether or not a greater proportion is saved, we
take it as a fundamental psychological rule of any modern community that,
when its real income is increased, it will not increase its consumption by
an equal absolute amount, so that a greater absolute amount must be
saved, unless a large and unusual change is occurring at the same time in
other factors. As we shall show subsequently, the stability of the economic
system essentially depends on this rule prevailing in practice. This means
that, if employment and hence aggregate income increase, not all the
additional employment will be required to satisfy the needs of additional
consumption.
On the other hand, a decline in income due to a decline in the level of

employment, if it goes far, may even cause consumption to exceed income
not only by some individuals and institutions using up the financial
reserves which they have accumulated in better times, but also by the
government, which will be liable, willingly or unwillingly, to run into a
budgetary deficit or will provide unemployment relief; for example, out of
borrowed money. Thus, when employment falls to a low level, aggregate
consumption will decline by a smaller amount than that by which real
income has declined, by reason both of the habitual behaviour of
individuals and also of the probable policy of governments; which is the
explanation why a new position of equilibrium can usually be reached
within a modest range of fluctuation. Otherwise a fall in employment and
income, once started, might proceed to extreme lengths.
This simple principle leads, it will be seen, to the same conclusion as
before, namely, that employment can only increase pari passu with an
increase in investment; unless, indeed, there is a change in the propensity
to consume. For since consumers will spend less than the increase in
aggregate supply price when employment is increased, the increased
employment will prove unprofitable unless there is an increase in
investment to fill the gap.
We must not underestimate the importance of the fact already mentioned

above that, whereas employment is a function of the expected
consumption and the expected investment, consumption is, cet. par., a
function of net income, i.e. of net investment (net income being equal to
consumption plus net investment). In other words, the larger the financial
provision which it is thought necessary to make before reckoning net
income, the less favourable to consumption, and therefore to employment,
will a given level of investment prove to be.
When the whole of this financial provision (or supplementary cost) is
in fact currently expended in the upkeep of the already existing capital
equipment, this point is not likely to be overlooked. But when the financial
provision exceeds the actual expenditure on current upkeep, the practical
results of this in its effect on employment are not always appreciated. For
the amount of this excess neither directly gives rise to current investment
nor is available to pay for consumption. It has, therefore, to be balanced by
new investment, the demand for which has arisen quite independently of
the current wastage of old equipment against which the financial provision
is being made; with the result that the new investment available to provide
current income is correspondingly diminished and a more intense demand
for new investment is necessary to make possible a given level of
employment. Moreover, much the same considerations apply to the

allowance for wastage included in user cost, in so far as the wastage is not
actually made good.
Take a house which continues to be habitable until it is demolished or
abandoned. If a certain sum is written off its value out of the annual rent
paid by the tenants, which the landlord neither spends on upkeep nor
regards as net income available for consumption, this provision, whether it
is a part of U or of V; constitutes a drag on employment all through the life
of the house, suddenly made good in a lump when the house has to be
rebuilt.
In a stationary economy all this might not be worth mentioning, since
in each year the depreciation allowances in respect of old houses would be
exactly offset by the new houses built in replacement of those reaching the
end of their lives in that year. But such factors may be serious in a non-
static economy, especially during a period which immediately succeeds a
lively burst of investment in long-lived capital. For in such circumstances a
very large proportion of the new items of investment may be absorbed by
the larger financial provisions made by entrepreneurs in respect of
existing capital equipment, upon the repairs and renewal of which, though
it is wearing out with time, the date has not yet arrived for spending
anything approaching the full financial provision which is being set aside;
with the result that incomes cannot rise above a level which is low enough
to correspond with a low aggregate of net investment. Thus sinking funds,
etc., are apt to withdraw spending power from the consumer long before
the demand for expenditure on replacements (which such provisions are
anticipating) comes into play; i.e. they diminish the current effective
demand and only increase it in the year in which the replacement is
actually made. If the effect of this is aggravated by financial prudence, i.e.
by its being thought advisable to write off the initial cost more rapidly
than the equipment actually wears out, the cumulative result may be very
serious indeed.
In the United States, for example, by 1929 the rapid capital expansion
of the previous five years had led cumulatively to the setting up of sinking
funds and depreciation allowances, in respect of plant which did not need
replacement, on so huge a scale that an enormous volume of entirely new
investment was required merely to absorb these financial provisions; and
it became almost hopeless to find still more new investment on a sufficient
scale to provide for such new saving as a wealthy community in full
employment would be disposed to set aside. This factor alone was
probably sufficient to cause a slump. And, furthermore, since financial
prudence of this kind continued to be exercised through the slump by
those great corporations which were still in a position to afford it, it
offered a serious obstacle to early recovery.
Or again, in Great Britain at the present time (1935) the substantial

amount of house-building and of other new investments since the war has
led to an amount of sinking funds being set up much in excess of any
present requirements for expenditure on repairs and renewals, a tendency
which has been accentuated, where the investment has been made by local
authorities and public boards, by the principles of sound finance which
often require sinking funds sufficient to write off the initial cost some time
before replacement will actually fall due; with the result that even if
private individuals were ready to spend the whole of their net incomes it
would be a severe task to restore full employment in the face of this heavy
volume of statutory provision by public and semi-public authorities,
entirely dissociated from any corresponding new investment. The sinking
funds of local authorities now stand, I think, at an annual figure of more
than half the amount which these authorities are spending on the whole of
their new developments. Yet it is not certain that the Ministry of Health
are aware, when they insist on stiff sinking funds by local authorities, how
much they may be aggravating the problem of unemployment. In the case
of advances by building societies to help an individual to build his own
house, the desire to be clear of debt more rapidly than the house actually
deteriorates may stimulate the house-owner to save more than he
otherwise would; though this factor should be classified, perhaps, as
diminishing the propensity to consume directly rather than through its
effect on net income. In actual figures, repayments of mortgages advanced
by building societies, which amounted to 24,000,000 in 1925, had risen
to 68,000,000 by 1933, as compared with new advances of
103,000,000; and to-day the repayments are probably still higher.
That it is investment, rather than net investment, which emerges from
the statistics of output, is brought out forcibly and naturally in Mr Colin
Clarks National Income, 19241931. He also shows what a large
proportion depreciation, etc., normally bears to the value of investment.
For example, he estimates that in Great Britain, over the years 19281931,
the investment and the net investment were as follows, though his gross
investment is probably somewhat greater than my investment, inasmuch
as it may include a part of user cost, and it is not clear how closely his net
investment corresponds to my definition of this term:
( million)
1928 1929 1930 1931
Gross Investment-Output 791 731 620 482
Value of physical wasting of old capital 433 435 437 439
Net Investment 358 296 183 43
Mr Kuznets has arrived at much the same conclusion in compiling the

statistics of the Gross Capital Formation (as he calls what I call
investment) in the United States, 19191933. The physical fact, to which
the statistics of output correspond, is inevitably the gross, and not the net,
investment. Mr Kuznets has also discovered the difficulties in passing
from gross investment to net investment. The difficulty, he writes, of
passing from gross to net capital formation, that is, the difficulty of
correcting for the consumption of existing durable commodities, is not
only in the lack of data. The very concept of annual consumption of
commodities that last over a number of years suffers from ambiguity. He
falls back, therefore, on the assumption that the allowance for
depreciation and depletion on the books of business firms describes
correctly the volume of consumption of already existing, finished durable
goods used by business firms On the other hand, he attempts no
deduction at all in respect of houses and other durable commodities in the
hands of individuals. His very interesting results for the United States can
be summarised as follows:
(Millions of dollars)
1925 1926 1927 1928 1929 1930 1931 1932 1933
Gross capital
formation
(after allowing
30,706 33,571 31,157 33,934 34,491 27,538 18,721 7,780 14,879
for net change
in business
inventories)
Entrepreneurs
servicing,
repairs,
7,685 8,288 8,223 8,481 9,010 8,502 7,623 6,543 8,204
maintenance,
depreciation
and depletion
Net capital
formation (on
23,021 25,283 22,934 25,453 25,481 19,036 11,098 1,237 6,675
Mr Kuznets
definition)
Several facts emerge with prominence from this table. Net capital
formation was very steady over the quinquennium 19251929, with only a
10 percent increase in the latter part of the upward movement. The
deduction for entrepreneurs repairs, maintenance, depreciation and
depletion remained at a high figure even at the bottom of the slump. But
Mr Kuznets method must surely lead to too low an estimate of the annual
increase in depreciation, etc.; for he puts the latter at less than 1 per cent
per annum of the new net capital formation. Above all, net capital
formation suffered an appalling collapse after 1929, falling in 1932 to a

figure no less than 95 per cent below the average of the quinquennium
19251929.
The above is, to some extent, a digression. But it is important to
emphasise the magnitude of the deduction which has to be made from the
income of a society, which already possesses a large stock of capital, before
we arrive at the net income which is ordinarily available for consumption.
For if we overlook this, we may underestimate the heavy drag on the
propensity to consume which exists even in conditions where the public is
ready to consume a very large proportion of its net income.
Consumption to repeat the obvious is the sole end and object of
all economic activity. Opportunities for employment are necessarily
limited by the extent of aggregate demand. Aggregate demand can be
derived only from present consumption or from present provision for
future consumption. The consumption for which we can profitably provide
in advance cannot be pushed indefinitely into the future. We cannot, as a
community, provide for future consumption by financial expedients but
only by current physical output. In so far as our social and business
organisation separates financial provision for the future from physical
provision for the future so that efforts to secure the former do not
necessarily carry the latter with them, financial prudence will be liable to
diminish aggregate demand and thus impair well-being, as there are many
examples to testify. The grcater, moreover, the consumption for which we
have provided in advance, the more difficult it is to find something further
to provide for in advance, and the greater our dependence on present
consumption as a source of demand. Yet the larger our incomes, the
greater, unfortunately, is the margin between our incomes and our
consumption. So, failing some novel expedient, there is, as we shall see, no
answer to the riddle, except that there must be sufficient unemployment to
keep us so poor that our consumption falls short of our income by no more
than the equivalent of the physical provision for future consumption which
it pays to produce to-day.
Or look at the matter thus. Consumption is satisfied partly by objects
produced currently and partly by objects produced previously, i.e. by
disinvestment. To the extent that consumption is satisfied by the latter,
there is a contraction of current demand, since to that extent a part of
current expenditure fails to find its way back as a part of net income.
Contrariwise whenever an object is produced within the period with a view
to satisfying consumption subsequently, an expansion of current demand
is set up. Now all capital-investment is destined to result, sooner or later,
in capital-disinvestment. Thus the problem of providing that new capital-
investment shall always outrun capital-disinvestment sufficiently to fill the
gap between net income and consumption, presents a problem which is
increasingly difficult as capital increases. New capital-investment can only
take place in excess of current capital-disinvestment if future expenditure

on consumption is expected to increase. Each time we secure to-days
equilibrium by increased investment we are aggravating the difficulty of
securing equilibrium to-morrow. A diminished propensity to consume to-
day can only be accommodated to the public advantage if an increased
propensity to consume is expected to exist some day. We are reminded of
The Fable of the Bees the gay of tomorrow are absolutely indispensable
to provide a raison dtre for the grave of to-day. It is a curious thing,
worthy of mention, that the popular mind seems only to be aware of this
ultimate perplexity where public investment is concerned, as in the case of
road-building and house-building and the like. It is commonly urged as an
objection to schemes for raising employment by investment under the
auspices of public authority that it is laying up trouble for the future.
What will you do, it is asked, when you have built all the houses and
roads and town halls and electric grids and water supplies and so forth
which the stationary population of the future can be expected to require?
But it is not so easily understood that the same difficulty applies to private
investment and to industrial expansion; particularly to the latter, since it is
much easier to see an early satiation of the demand for new factories and
plant which absorb individually but little money, than of the demand for
dwelling-houses.
The obstacle to a clear understanding is, in these examples, much the
same as in many academic discussions of capital, namely, an inadequate
appreciation of the fact that capital is not a self-subsistent entity existing
apart from consumption. On the contrary, every weakening in the
propensity to consume regarded as a permanent habit must weaken the
demand for capital as well as the demand for consumption.

C 9
T P C :
II. T S F
There remains the second category of factors which affect the amount of
consumption out of a given income namely, those subjective and social
incentives which determine how much is spent, given the aggregate of
income in terms of wage-units and given the relevant objective factors
which we have already discussed. Since, however, the analysis of these
factors raises no point of novelty, it may be sufficient if we give a catalogue
of the more important, without enlarging on them at any length.
There are, in general, eight main motives or objects of a subjective
character which lead individuals to refrain from spending out of their
incomes:
i. To build up a reserve against unforeseen contingencies;

ii. To provide for an anticipated future relation between the income and
the needs of the individual or his family different from that which
exists in the present, as, for example, in relation to old age, family
education, or the maintenance of dependents;
iii. To enjoy interest and appreciation, i.e. because a larger real
consumption at a later date is preferred to a smaller immediate
consumption;
iv. To enjoy a gradually increasing expenditure, since it gratifies a
common instinct to look forward to a gradually improving standard
of life rather than the contrary, even though the capacity for
enjoyment may be diminishing;
v. To enjoy a sense of independence and the power to do things, though
without a clear idea or definite intention of specific action;
vi. To secure a masse de manoeuvre to carry out speculative or business
projects;
vii. To bequeath a fortune;

viii. To satisfy pure miserliness, i.e. unreasonable but insistent
inhibitions against acts of expenditure as such.
These eight motives might be called the motives of Precaution, Foresight,

Calculation, Improvement, Independence, Enterprise, Pride and Avarice;
and we could also draw up a corresponding list of motives to consumption
such as Enjoyment, Shortsightedness, Generosity, Miscalculation,
Ostentation and Extravagance.
Apart from the savings accumulated by individuals, there is also the
large amount of income, varying perhaps from one-third to two-thirds of
the total accumulation in a modern industrial community such as Great
Britain or the United States, which is withheld by central and local
government, by institutions and by business corporations for motives
largely analogous to, but not identical with, those actuating individuals,
and mainly the four following:
i. The motive of enterprise to secure resources to carry out further

capital investment without incurring debt or raising further capital
on the market;
ii. The motive of liquidity to secure liquid resources to meet
emergencies, difficulties and depressions;
iii. The motive of improvement to secure a gradually increasing
income, which, incidentally, will protect the management from
criticism, since increasing income due to accumulation is seldom
distinguished from increasing income due to efficiency;
iv. The motive of financial prudence and the anxiety to be on the right
side by making a financial provision in excess of user and
supplementary cost, so as to discharge debt and write off the cost of
assets ahead of; rather than behind, the actual rate of wastage and
obsolescence, the strength of this motive mainly depending on the
quantity and character of the capital equipment and the rate of
technical change.
Corresponding to these motives which favour the withholding of a part of

income from consumption, there are also operative at times motives which
lead to an excess of consumption over income. Several of the motives
towards positive saving catalogued above as affecting individuals have
their intended counterpart in negative saving at a later date, as, for
example, with saving to provide for family needs or old age.
Unemployment relief financed by borrowing is best regarded as negative
saving.
Now the strength of all these motives will vary enormously according
to the institutions and organisation of the economic society which we
presume, according to habits formed by race, education, convention,

religion and current morals, according to present hopes and past
experience, according to the scale and technique of capital equipment, and
according to the prevailing distribution of wealth and the established
standards of life. In the argument of this book, however, we shall not
concern ourselves, except in occasional digressions, with the results of far-
reaching social changes or with the slow effects of secular progress. We
shall, that is to say, take as given the main background of subjective
motives to saving and to consumption respectively. In so far as the
distribution of wealth is determined by the more or less permanent social
structure of the community, this also can be reckoned a factor, subject only
to slow change and over a long period, which we can take as given in our
present context.
Since, therefore, the main background of subjective and social incentives

changes slowly, whilst the short-period influence of changes in the rate of
interest and the other objective factors is often of secondary importance,
we are left with the conclusion that short-period changes in consumption
largely depend on changes in the rate at which income (measured in wage-
units) is being earned and not on changes in the propensity to consume
out of a given income.
We must, however, guard against a misunderstanding. The above
means that the influence of moderate changes in the rate of interest on the
propensity to consume is usually small. It does not mean that changes in
the rate of interest have only a small influence on the amounts actually
saved and consumed. Quite the contrary. The influence of changes in the
rate of interest on the amount actually saved is of paramount importance,
but is in the opposite direction to that usually supposed. For even if the
attraction of the larger future income to be earned from a higher rate of
interest has the effect of diminishing the propensity to consume,
nevertheless we can be certain that a rise in the rate of interest will have
the effect of reducing the amount actually saved. For aggregate saving is
governed by aggregate investment; a rise in the rate of interest (unless it is
offset by a corresponding change in the demand-schedule for investment)
will diminish investment; hence a rise in the rate of interest must have the
effect of reducing incomes to a level at which saving is decreased in the
same measure as investment. Since incomes will decrease by a greater
absolute amount than investment, it is, indeed, true that, when the rate of
interest rises, the rate of consumption will decrease. But this does not
mean that there will be a wider margin for saving. On the contrary, saving
and spending will both decrease.
Thus, even if it is the case that a rise in the rate of interest would cause
the community to save more out of a given income, we can be quite sure
that a rise in the rate of interest (assuming no favourable change in the
demand-schedule for investment) will decrease the actual aggregate of
savings. The same line of argument can even tell us by how much a rise in
the rate of interest will, cet. par., decrease incomes. For incomes will have
to fall (or be redistributed) by just that amount which is required, with the
existing propensity to consume to decrease savings by the same amount by
which the rise in the rate of interest will, with the existing marginal
efficiency of capital, decrease investment. A detailed examination of this
aspect will occupy our next chapter.
The rise in the rate of interest might induce us to save more, if our
incomes were unchanged. But if the higher rate of interest retards
investment, our incomes will not, and cannot, be unchanged. They must
necessarily fall, until the declining capacity to save has sufficiently offset
the stimulus to save given by the higher rate of interest. The more virtuous
we are, the more determinedly thrifty, the more obstinately orthodox in
our national and personal finance, the more our incomes will have to fall
when interest rises relatively to the marginal efficiency of capital.
Obstinacy can bring only a penalty and no reward. For the result is
inevitable.
Thus, after all, the actual rates of aggregate saving and spending do
not depend on Precaution, Foresight, Calculation, Improvement,
Independence, Enterprise, Pride or Avarice. Virtue and vice play no part.
It all depends on how far the rate of interest is favourable to investment,
after taking account of the marginal efficiency of capital. No, this is an
overstatement. If the rate of interest were so governed as to maintain
continuous full employment, virtue would resume her sway; the rate of
capital accumulation would depend on the weakness of the propensity to
consume. Thus, once again, the tribute that classical economists pay to her
is due to their concealed assumption that the rate of interest always is so
governed.


C 10
T M P C
M
We established in chapter 8 that employment can only increase pari passu

with investment unless there is a change in the propensity to consume. We
can now carry this line of thought a stage further. For in given
circumstances a definite ratio, to be called the multiplier, can be
established between income and investment and, subject to certain
simplifications, between the total employment and the employment
directly employed on investment (which we shall call the primary
employment). This further step is an integral part of our theory of
employment, since it establishes a precise relationship, given the
propensity to consume, between aggregate employment and income and
the rate of investment. The conception of the multiplier was first
introduced into economic theory by Mr R. F. Kahn in his article on The
Relation of Home Investment to Unemployment (Economic Journal,
June 1931). His argument in this article depended on the fundamental
notion that, if the propensity to consume in various hypothetical
circumstances is (together with certain other conditions) taken as given
and we conceive the monetary or other public authority to take steps to
stimulate or to retard investment, the change in the amount of
employment will be a function of the net change in the amount of
investment; and it aimed at laying down general principles by which to
estimate the actual quantitative relationship between an increment of net
investment and the increment of aggregate employment which will be
associated with it. Before coming to the multiplier, however, it will be
convenient to introduce the conception of the marginal propensity to
consume.
The fluctuations in real income under consideration in this book are those
which result from applying different quantities of employment (i.e. of
labour-units) to a given capital equipment, so that real income increases
and decreases with the number of labour-units employed. If, as we assume
in general, there is a decreasing return at the margin as the number of
labour-units employed on the given capital equipment is increased,
income measured in terms of wage-units will increase more than in
proportion to the amount of employment, which, in turn, will increase
more than in proportion to the amount of real income measured (if that is
possible) in terms of product. Real income measured in terms of product
and income measured in terms of wage-units will, however, increase and
decrease together (in the short period when capital equipment is virtually
unchanged). Since, therefore, real income, in terms of product, may be
incapable of precise numerical measurement, it is often convenient to
regard income in terms of wage-units (Yw) as an adequate working index
of changes in real income. In certain contexts we must not overlook the
fact that, in general, Yw increases and decreases in a greater proportion
than real income; but in other contexts the fact that they always increase
and decrease together renders them virtually interchangeable.
Our normal psychological law that, when the real income of the
community increases or decreases, its consumption will increase or
decrease but not so fast, can, therefore, be translated not, indeed, with
absolute accuracy but subject to qualifications which are obvious and can
easily be stated in a formally complete fashion into the propositions that
Cw and Yw have the same sign, but Yw > Cw, where Cw is the
consumption in terms of wage-units. This is merely a repetition of the
proposition already established in Chapter 3 above. Let us define, then,
dCw/dYw as the marginal propensity to consume.
This quantity is of considerable importance, because it tells us how

the next increment of output will have to be divided between consumption
and investment. For Yw = Cw + Iw, where Cw and Iw are the
increments of consumption and investment; so that we can write Yw =
kIw, where 1 1/k is equal to the marginal propensity to consume.
Let us call k the investment multiplier. It tells us that, when there is

an increment of aggregate investment, income will increase by an amount
which is k times the increment of investment.
Mr Kahns multiplier is a little different from this, being what we may call
the employment multiplier designated by k, since it measures the ratio of
the increment of total employment which is associated with a given
increment of primary employment in the investment industries. That is to
say, if the increment of investment Iw leads to an increment of primary
employment N2 in the investment industries, the increment of total
employment N = kN2.
There is no reason in general to suppose that k = k. For there is no

necessary presumption that the shapes of the relevant portions of the
aggregate supply functions for different types of industry are such that the
ratio of the increment of employment in the one set of industries to the
increment of demand which has stimulated it will be the same as in the
other set of industries. It is easy, indeed, to conceive of cases, as, for
example, where the marginal propensity to consume is widely different
from the average propensity, in which there would be a presumption in
favour of some inequality between Yw/N and Iw/N2, since there
would be very divergent proportionate changes in the demands for
consumption-goods and investment-goods respectively. If we wish to take
account of such possible differences in the shapes of the relevant portions
of the aggregate supply functions for the two groups of industries
respectively, there is no difficulty in rewriting the following argument in
the more generalised form. But to elucidate the ideas involved, it will be
convenient to deal with the simplified case where k = k.
It follows, therefore, that, if the consumption psychology of the
community is such that they will choose to consume, e.g. nine-tenths of an
increment of income, then the multiplier k is 10; and the total employment
caused by (e.g.) increased public works will be ten times the primary
employment provided by the public works themselves, assuming no
reduction of investment in other directions. Only in the event of the
community maintaining their consumption unchanged in spite of the
increase in employment and hence in real income, will the increase of
employment be restricted to the primary employment provided by the
public works. If, on the other hand, they seek to consume the whole of any
increment of income, there will be no point of stability and prices will rise
without limit. With normal psychological suppositions, an increase in
employment will only be associated with a decline in consumption if there
is at the same time a change in the propensity to consume as the result,
for instance, of propaganda in time of war in favour of restricting

individual consumption; and it is only in this event that the increased
employment in investment will be associated with an unfavourable
repercussion on employment in the industries producing for consumption.
This only sums up in a formula what should by now be obvious to the
reader on general grounds. An increment of investment in terms of wage-
units cannot occur unless the public are prepared to increase their savings
in terms of wage-units. Ordinarily speaking, the public will not do this
unless their aggregate income in terms of wage-units is increasing. Thus
their effort to consume a part of their increased incomes will stimulate
output until the new level (and distribution) of incomes provides a margin
of saving sufficient to correspond to the increased investment. The
multiplier tells us by how much their employment has to be increased to
yield an increase in real income sufficient to induce them to do the
necessary extra saving, and is a function of their psychological
propensities. If saving is the pill and consumption is the jam, the extra jam
has to be proportioned to the size of the additional pill. Unless the
psychological propensities of the public are different from what we are
supposing, we have here established the law that increased employment
for investment must necessarily stimulate the industries producing for
consumption and thus lead to a total increase of employment which is a
multiple of the primary employment required by the investment itself.
It follows from the above that, if the marginal propensity to consume
is not far short of unity, small fluctuations in investment will lead to wide
fluctuations in employment; but, at the same time, a comparatively small
increment of investment will lead to full employment. If, on the other
hand, the marginal propensity to consume is not much above zero, small
fluctuations in investment will lead to correspondingly small fluctuations
in employment; but, at the same time, it may require a large increment of
investment to produce full employment. In the former case involuntary
unemployment would be an easily remedied malady, though liable to be
troublesome if it is allowed to develop. In the latter case, employment may
be less variable but liable to settle down at a low level and to prove
recalcitrant to any but the most drastic remedies. In actual fact the
marginal propensity to consume seems to lie somewhere between these
two extremes, though much nearer to unity than to zero; with the result
that we have, in a sense, the worst of both worlds, fluctuations in
employment being considerable and, at the same time, the increment in
investment required to produce full employment being too great to be
easily handled. Unfortunately the fluctuations have been sufficient to
prevent the nature of the malady from being obvious, whilst its severity is
such that it cannot be remedied unless its nature is understood.
When full employment is reached, any attempt to increase investment
still further will set up a tendency in money-prices to rise without limit,
irrespective of the marginal propensity to consume; i.e. we shall have
reached a state of true inflation. Up to this point, however, rising prices
will be associated with an increasing aggregate real income.
We have been dealing so far with a net increment of investment. If,

therefore, we wish to apply the above without qualification to the effect of
(e.g.) increased public works, we have to assume that there is no offset
through decreased investment in other directions and also, of course, no
associated change in the propensity of the community to consume. Mr
Kahn was mainly concerned in the article referred to above in considering
what offsets we ought to take into account as likely to be important, and in
suggesting quantitative estimates. For in an actual case there are several
factors besides some specific increase of investment of a given kind which
enter into the final result. If, for example, a government employs 100,000
additional men on public works, and if the multiplier (as defined above) is
4, it is not safe to assume that aggregate employment will increase by
400,000. For the new policy may have adverse reactions on investment in
other directions.
It would seem (following Mr Kahn) that the following are likely in a
modern community to be the factors which it is most important not to
overlook (though the first two will not be fully intelligible until after Book
IV has been reached):
(i) The method of financing the policy and the increased working
cash, required by the increased employment and the associated rise of
prices, may have the effect of increasing the rate of interest and so
retarding investment in other directions, unless the monetary authority
takes steps to the contrary; whilst, at the same time, the increased cost of
capital goods will reduce their marginal efficiency to the private investor,
and this will require an actual fall in the rate of interest to offset it.
(ii) With the confused psychology which often prevails, the
government programme may, through its effect on confidence, increase
liquidity-preference or diminish the marginal efficiency of capital, which,
again, may retard other investment unless measures are taken to offset it.
(iii) In an open system with foreign-trade relations, some part of the

multiplier of the increased investment will accrue to the benefit of
employment in foreign countries, since a proportion of the increased
consumption will diminish our own countrys favourable foreign balance;
so that, if we consider only the effect on domestic employment as distinct
from world employment, we must diminish the full figure of the
multiplier. On the other hand our own country may recover a portion of
this leakage through favourable repercussions due to the action of the
multiplier in the foreign country in increasing its economic activity.
Furthermore, if we are considering changes of a substantial amount,
we have to allow for a progressive change in the marginal propensity to
consume, as the position of the margin is gradually shifted; and hence in
the multiplier. The marginal propensity to consume is not constant for all
levels of employment, and it is probable that there will be, as a rule, a
tendency for it to diminish as employment increases; when real income
increases, that is to say, the community will wish to consume a gradually
diminishing proportion of it.
There are also other factors, over and above the operation of the
general rule Just mentioned, which may operate to modify the marginal
propensity to consume, and hence the multiplier; and these other factors
seem likely, as a rule, to accentuate the tendency of the general rule rather
than to offset jt. For, in the first place, the increase of employment will
tend, owing to the effect of diminishing returns in the short period, to
increase the proportion of aggregate income which accrues to the
entrepreneurs, whose individual marginal propensity to consume is
probably less than the average for the community as a whole. In the
second place, unemployment is likely to be associated with negative saving
in certain quarters, private or public, because the unemployed may be
living either on the savings of themselves and their friends or on public
relief which is partly financed out of loans; with the result that re-
employment will gradually diminish these particular acts of negative
saving and reduce, therefore, the marginal propensity to consume more
rapidly than would have occurred from an equal increase in the
communitys real income accruing in different circumstances.
In any case, the multiplier is likely to be greater for a small net
increment of investment than for a large increment; so that, where
substantial changes are in view, we must be guided by the average value of
the multiplier based on the average marginal propensity to consume over
the range in question.
Mr Kahn has examined the probable quantitative result of such

factors as these in certain hypothetical special cases. But, clearly, it is not
possible to carry any generalisation very far. One can only say, for
example, that a typical modern community would probably tend to
consume not much less than 80 per cent of any increment of real income,
if it were a closed system with the consumption of the unemployed paid for
by transfers from the consumption of other consumers, so that the
multiplier after allowing for offsets would not be much less than 5. In a
country, however, where foreign trade accounts for, say, 20 per cent of
consumption and where the unemployed receive out of loans or their
equivalent up to, say, 50 per cent of their normal consumption when in
work, the multiplier may fall as low as 2 or 3 times the employment
provided by a specific new investment. Thus a given fluctuation of
investment will be associated with a much less violent fluctuation of
employment in a country in which foreign trade plays a large part and
unemployment relief is financed on a larger scale out of borrowing (as was
the case, e.g. in Great Britain in 1931), than in a country in which these
factors are less important (as in the United States in 1932).
It is, however, to the general principle of the multiplier to which we
have to look for an explanation of how fluctuations in the amount of
investment, which are a comparatively small proportion of the national
income, are capable of generating fluctuations in aggregate employment
and income so much greater in amplitude than themselves.
The discussion has been carried on, so far, on the basis of a change in
aggregate investment which has been foreseen sufficiently in advance for
the consumption industries to advance pari passu with the capital-goods
industries without more disturbance to the price of consumption-goods
than is consequential, in conditions of decreasing returns, on an increase
in the quantity which is produced.
In general, however, we have to take account of the case where the
initiative comes from an increase in the output of the capital-goods
industries which was not fully foreseen. It is obvious that an initiative of
this description only produces its full effect on employment over a period
of time. I have found, however, in discussion that this obvious fact often
gives rise to some confusion between the logical theory of the multiplier,
which holds good continuously, without time-lag, at all moments of time,
and the consequences of an expansion in the capital-goods industries

which take gradual effect, subject to time-lag and only after an interval.
The relationship between these two things can be cleared up by
pointing out, firstly that an unforeseen, or imperfectly foreseen, expansion
in the capital-goods industries does not have an instantaneous effect of
equal amount on the aggregate of investment but causes a gradual increase
of the latter; and, secondly, that it may cause a temporary departure of the
marginal propensity to consume away from its normal value, followed,
however, by a gradual return to it.
Thus an expansion in the capital-goods industries causes a series of
increments in aggregate investment occurring in successive periods over
an interval of time, and a series of values of the marginal propensity to
consume in these successive periods which differ both from what the
values would have been if the expansion had been foreseen and from what
they will be when the community has settled down to a new steady level of
aggregate investment. But in every interval of time the theory of the
multiplier holds good in the sense that the increment of aggregate demand
is equal to the product of the increment of aggregate investment and the
multiplier as determined by the marginal propensity to consume.
The explanation of these two sets of facts can be seen most clearly by
taking the extreme case where the expansion of employment in the capital-
goods industries is so entirely unforeseen that in the first instance there is
no increase whatever in the output of consumption-goods. In this event
the efforts of those newly employed in the capital-goods industries to
consume a proportion of their increased incomes will raise the prices of
consumption-goods until a temporary equilibrium between demand and
supply has been brought about partly by the high prices causing a
postponement of consumption, partly by a redistribution of income in
favour of the saving classes as an effect of the increased profits resulting
from the higher prices, and partly by the higher prices causing a depletion
of stocks. So far as the balance is restored by a postponement of
consumption there is a temporary reduction of the marginal propensity to
consume, i.e. of the multiplier itself, and in so far as there is a depletion of
stocks, aggregate investment increases for the time being by less than the
increment of investment in the capital-goods industries i.e. the thing to
be multiplied does not increase by the full increment of investment in the
capital-goods industries. As time goes on, however, the consumption-
goods industries adjust themselves to the new demand, so that when the
deferred consumption is enjoyed, the marginal propensity to consume
rises temporarily above its normal level, to compensate for the extent to
which it previously fell below it, and eventually returns to its normal level;
whilst the restoration of stocks to their previous figure causes the
increment of aggregate investment to be temporarily greater than the
increment of investment in the capital-goods industries (the increment of
working capital corresponding to the greater output also having
temporarily the same effect).
The fact that an unforeseen change only exercises its full effect on
employment over a period of time is important in certain contexts; in
particular it plays a part in the analysis of the trade cycle (on lines such as
I followed in my Treatise on Money). But it does not in any way affect the
significance of the theory of the multiplier as set forth in this chapter; nor
render it inapplicable as an indicator of the total benefit to employment to
be expected from an expansion in the capital. goods industries. Moreover,
except in conditions where the consumption industries are already
working almost at capacity so that an expansion of output requires an
expansion of plant and not merely the more intensive employment of the
existing plant, there is no reason to suppose that more than a brief interval
of time nced elapse before employment in the consumption industries is
advancing pari passu with employment in the capital-goods industries
with the multiplier operating near its normal figure.
We have seen above that the greater the marginal propensity to consume,
the greater the multiplier, and hence the greater the disturbance to
employment corresponding to a given change in investment. This might
seem to lead to the paradoxical conclusion that a poor community in
which saving is a very small proportion of income will be more subject to
violent fluctuations than a wealthy community where saving is a larger
proportion of income and the multiplier consequently smaller.
This conclusion, however, would overlook the distinction between the
effects of the marginal propensity to consume and those of the average
propensity to consume. For whilst a high marginal propensity to consume
involves a larger proportionate effect from a given percentage change in
investment, the absolute effect will, nevertheless, be small if the average
propensity to consume is also high. This may be illustrated as follows by a
numerical example.
Let us suppose that a communitys propensity to consume is such
that, so long as its real income does not exceed the output from employing
5,000,000 men on its existing capital equipment, it consumes the whole of

its income; that of the output of the next 100,000 additional men
employed it consumes 99 per cent, of the next 100,000 after that 98 per
cent, of the third 100,000 97 per cent and so on; and that 10,000,000 men
employed represents full employment. It follows from this that, when
5,000,000 + n 100,000 men are employed, the multiplier at the margin is
100/n, and [n(n + i)]/[2(50 + n)] per cent of the national income is
invested.
Thus when 5,200,000 men are employed the multiplier is very large,
namely 50, but investment is only a trifling proportion of current income,
namely, 0.06 per cent; with the result that if investment falls off by a large
proportion, say about two-thirds, employment will only decline to
5,100,000, i.e. by about 2 per cent. On the other hand, when 9,000,000
men are employed, the marginal multiplier is comparatively small, namely
2, but investment is now a substantial proportion of current income,
namely, 9 per cent; with the result that if investment falls by two-thirds,
employment will decline to 6,900,000, namely, by 19 per cent. In the limit
where investment falls off to zero, employment will decline by about 4 per
cent in the former case, whereas in the latter case it will decline by 44 per
cent.
In the above example, the poorer of the two communities under
comparison is poorer by reason of under-employment. But the same
reasoning applies by easy adaptation if the poverty is due to inferior skill,
technique or equipment. Thus whilst the multiplier is larger in a poor
community, the effect on employment of fluctuations in investment will be
much greater in a wealthy community, assuming that in the latter current
investment represents a much larger proportion of current output.
It is also obvious from the above that the employment of a given
number of men on public works will (on the assumptions made) have a
much larger effect on aggregate employment at a time when there is severe
unemployment, than it will have later on when full employment is
approached. In the above example, if, at a time when employment has
fallen to 5,200,000, an additional 100,000 men are employed on public
works, total employment will rise to 6,400,000. But if employment is
already 9,000,000 when the additional 100,000 men are taken on for
public works, total employment will only rise to 9,200,000. Thus public
works even of doubtful utility may pay for themselves over and over again
at a time of severe unemployment, if only from the diminished cost of
relief expenditure, provided that we can assume that a smaller proportion
of income is saved when unemployment is greater; but they may become a
more doubtful proposition as a state of full employment is approached.

Furthermore, if our assumption is correct that the marginal propensity to
consume falls off steadily as we approach full employment, it follows that
it will become more and more troublesome to secure a further given
increase of employment by further increasing investment. It should not be
difficult to compile a chart of the marginal propensity to consume at each
stage of a trade cycle from the statistics (if they were available) of
aggregate incorne and aggregate investment at successive dates. At
present, however, our statistics are not accurate enough (or compiled
sufficiently with this specific object in view) to allow us to infer more than
highly approximate estimates. The best for the purpose, of which I am
aware, are Mr Kuznets figures for the United States (already referred to,
p.103 above), though they are, nevertheless, very precarious. Taken in
conjunction with estimates of national income these suggest, for what they
are worth, both a lower figure and a more stable figure for the investment
multiplier than I should have expected. If single years are taken in
isolation, the results look rather wild. But if they are grouped in pairs, the
multiplier seems to have been less than 3 and probably fairly stable in the
neighbourhood of 2.5. This suggests a marginal propensity to consume not
exceeding 6o to 70 per cent a figure quite plausible for the boom, but
surprisingly, and, in my judgment, improbably low for the slump. It is
possible, however, that the extreme financial conservatism of corporate
finance in the United States, even during the slump, may account for it. In
other words, if, when investment is falling heavily through a failure to
undertake repairs and replacements, financial provision is made,
nevertheless, in respect of such wastage, the effect is to prevent the rise in
the marginal propensity to consume which would have occurred
otherwise. I suspect that this factor may have played a significant part in
aggravating the degree of the recent slump in the United States. On the
other hand, it is possible that the statistics somewhat overstate the decline
in investment, which is alleged to have fallen off by more than 75 per cent
in 1932 compared with 1929, whilst net capital formation declined by
more than 95 per cent; a moderate change in these estimates being
capable of making a substantial difference to the multiplier.
When involuntary unemployment exists, the marginal disutility of labour

is necessarily less than the utility of the marginal product. Indeed it may
be much less. For a man who has been long unemployed some measure of
labour, instead of involving disutility, may have a positive utility. If this is

accepted, the above reasoning shows how wasteful loan expenditure may
nevertheless enrich the community on balance. Pyramid-building,
earthquakes, even wars may serve to increase wealth, if the education of
our statesmen on the principles of the classical economics stands in the
way of anything better.
It is curious how common sense, wriggling for an escape from absurd
conclusions, has been apt to reach a preference for wholly wasteful forms
of loan expenditure rather than for partly wasteful forms, which, because
they are not wholly wasteful, tend to be judged on strict business
principles. For example, unemployment relief financed by loans is more
readily accepted than the financing of improvements at a charge below the
current rate of interest; whilst the form of digging holes in the ground
known as gold-mining, which not only adds nothing whatever to the real
wealth of the world but involves the disutility of labour, is the most
acceptable of all solutions.
If the Treasury were to fill old bottles with banknotes, bury them at
suitable depths in disused coalmines which are then filled up to the surface
with town rubbish, and leave it to private enterprise on well-tried
principles of laissez-faire to dig the notes up again (the right to do so
being obtained, of course, by tendering for leases of the note-bearing
territory), there need be no more unemployment and, with the help of the
repercussions, the real income of the community, and its capital wealth
also, would probably become a good deal greater than it actually is. It
would, indeed, be more sensible to build houses and the like; but if there
are political and practical difficulties in the way of this, the above would be
better than nothing.
The analogy between this expedient and the goldmines of the real
world is complete. At periods when gold is available at suitable depths
experience shows that the real wealth of the world increases rapidly; and
when but little of it is so available our wealth suffers stagnation or decline.
Thus gold-mines are of the greatest value and importance to civilisation.
Just as wars have been the only form of large-scale loan expenditure which
statesmen have thought justifiable, so gold-mining is the only pretext for
digging holes in the ground which has recommended itself to bankers as
sound finance; and each of these activities has played its part in progress
failing something better. To mention a detail, the tendency in slumps
for the price of gold to rise in terms of labour and materials aids eventual
recovery, because it increases the depth at which gold-digging pays and
lowers the minimum grade of ore which is payable.
In addition to the probable effect of increased supplies of gold on the

rate of interest, gold-mining is for two reasons a highly practical form of
investment, if we are precluded from increasing employment by means
which at the same time increase our stock of useful wealth. In the first
place, owing to the gambling attractions which it offers it is carried on
without too close a regard to the ruling rate of interest. In the second place
the result, namely, the increased stock of gold, does not, as in other cases,
have the effect of diminishing its marginal utility. Since the value of a
house depends on its utility, every house which is built serves to diminish
the prospective rents obtainable from further house-building and
therefore lessens the attraction of further similar investment unless the
rate of interest is falling pari passu. But the fruits of gold-mining do not
suffer from this disadvantage, and a check can only come through a rise of
the wage-unit in terms of gold, which is not likely to occur unless and until
employment is substantially better. Moreover, there is no subsequent
reverse effect on account of provision for user and supplementary costs, as
in the case of less durable forms of wealth.
Ancient Egypt was doubly fortunate, and doubtless owed to this its
fabled wealth, in that it possessed two activities, namely, pyramid-building
as well as the search for the precious metals, the fruits of which, since they
could not serve the needs of man by being consumed, did not stale with
abundance. The Middle Ages built cathedrals and sang dirges. Two
pyramids, two masses for the dead, are twice as good as one; but not so
two railways from London to York. Thus we are so sensible, have schooled
ourselves to so close a semblance of prudent financiers, taking careful
thought before we add to the financial burdens of posterity by building
them houses to live in, that we have no such easy escape from the
sufferings of unemployment. We have to accept them as an inevitable
result of applying to the conduct of the State the maxims which are best
calculated to enrich an individual by enabling him to pile up claims to
enjoyment which he does not intend to exercise at any definite time.

C 11
T M E C
When a man buys an investment or capital-asset, he purchases the right to

the series of prospective returns, which he expects to obtain from selling
its output, after deducting the running expenses of obtaining that output,
during the life of the asset. This series of annuities Q1, Q2, . . . Q n it is
convenient to call the prospective yield of the investment.
Over against the prospective yield of the investment we have the
supply price of the capital-asset, meaning by this, not the market-price at
which an asset of the type in question can actually be purchased in the
market, but the price which would just induce a manufacturer newly to
produce an additional unit of such assets, i.e. what is sometimes called its
replacement cost . The relation between the prospective yield of a capital-
asset and its supply price or replacement cost, i.e. the relation between the
prospective yield of one more unit of that type of capital and the cost of
producing that unit, furnishes us with the marginal efficiency of capital of
that type. More precisely, I define the marginal efficiency of capital as
being equal to that rate of discount which would make the present value of
the series of annuities given by the returns expected from the capital-asset
during its life just equal to its supply price. This gives us the marginal
efficiencies of particular types of capital-assets. The greatest of these
marginal efficiencies can then be regarded as the marginal efficiency of
capital in general.
The reader should note that the marginal efficiency of capital is here
defined in terms of the expectation of yield and of the current supply price
of the capital-asset. It depends on the rate of return expected to be
obtainable on money if it were invested in a newly produced asset; not on
the historical result of what an investment has yielded on its original cost
if we look back on its record after its life is over.
If there is an increased investment in any given type of capital during

any period of time, the marginal efficiency of that type of capital will
diminish as the investment in it is increased, partly because the
prospective yield will fall as the supply of that type of capital is increased,
and partly because, as a rule, pressure on the facilities for producing that
type of capital will cause its supply price to increase; the second of these
factors being usually the more important in producing equilibrium in the
short run, but the longer the period in view the more does the first factor
take its place. Thus for each type of capital we can build up a schedule,
showing by how much investment in it will have to increase within the
period, in order that its marginal efficiency should fall to any given figure.
We can then aggregate these schedules for all the different types of capital,
so as to provide a schedule relating the rate of aggregate investment to the
corresponding marginal efficiency of capital in general which that rate of
investment will establish. We shall call this the investment demand-
schedule; or, alternatively, the schedule of the marginal efficiency of
capital.
Now it is obvious that the actual rate of current investment will be
pushed to the point where there is no longer any class of capital-asset of
which the marginal efficiency exceeds the current rate of interest. In other
words, the rate of investment will be pushed to the point on the
investment demand-schedule where the marginal efficiency of capital in
general is equal to the market rate of interest.
The same thing can also be expressed as follows. If Qr is the
prospective yield from an asset at time r, and dr is the present value of 1
deferred r years at the current rate of interest, Qrdr is the demand price
of the investment; and investment will be carried to the point where Qrdr
becomes equal to the supply price of the investment as defined above. If,
on the other hand, Qrdr falls short of the supply price, there will be no
current investment in the asset in question.
It follows that the inducement to invest depends partly on the
investment demand-schedule and partly on the rate of interest. Only at the
conclusion of Book IV will it be possible to take a comprehensive view of
the factors determining the rate of investment in their actual complexity. I
would, however, ask the reader to note at once that neither the knowledge
of an assets prospective yield nor the knowledge of the marginal efficiency
of the asset enables us to deduce either the rate of interest or the present
value of the asset. We must ascertain the rate of interest from some other
source, and only then can we value the asset by capitalising its
prospective yield.
How is the above definition of the marginal efficiency of capital related to

common usage? The Marginal Productivity or Yield or Efficiency or
Utility of Capital are familiar terms which we have all frequently used. But
it is not easy by searching the literature of economics to find a clear
statement of what economists have usually intended by these terms.
There are at least three ambiguities to clear up. There is, to begin
with, the ambiguity whether we are concerned with the increment of
physical product per unit of time due to the employment of one more
physical unit of capital, or with the increment of value due to the
employment of one more value unit of capital. The former involves
difficulties as to the definition of the physical unit of capital, which I
believe to be both insoluble and unnecessary. It is, of course, possible to
say that ten labourers will raise more wheat from a given area when they
are in a position to make use of certain additional machines; but I know no
means of reducing this to an intelligible arithmetical ratio which does not
bring in values. Nevertheless many discussions of this subject seem to be
mainly concerned with the physical productivity of capital in some sense,
though the writers fail to make themselves clear.
Secondly, there is the question whether the marginal efficiency of
capital is some absolute quantity or a ratio. The contexts in which it is used
and the practice of treating it as being of the same dimension as the rate of
interest seem to require that it should be a ratio. Yet it is not usually made
clear what the two terms of the ratio are supposed to be.
Finally, there is the distinction, the neglect of which has been the
main cause of confusion and misunderstanding, between the increment of
value obtainable by using an additional quantity of capital in the existing
situation, and the series of increments which it is expected to obtain over
the whole life of the additional capital asset; i.e. the distinction between
Q1 and the complete series Q1, Q2, . . . Qr, . . . .This involves the whole
question of the place of expectation in economic theory. Most discussions
of the marginal efficiency of capital seem to pay no attention to any
member of the series except Q1 . Yet this cannot be legitimate except in a
Static theory, for which all the Q s are equal. The ordinary theory of
distribution, where it is assumed that capital is getting now its marginal
productivity (in some sense or other), is only valid in a stationary state.

The aggregate current return to capital has no direct relationship to its
marginal efficiency; whilst its current return at the margin of production
(i.e. the return to capital which enters into the supply price of output) is its
marginal user cost, which also has no close connection with its marginal
efficiency.
There is, as I have said above, a remarkable lack of any clear account
of the matter. At the same time I believe that the definition which I have
given above is fairly close to what Marshall intended to mean by the term.
The phrase which Marshall himself uses is marginal net efficiency of a
factor of production; or, alternatively, the marginal utility of capital. The
following is a summary of the most relevant passage which I can find in his
Principles (6th ed. pp. 519-520). I have run together some non-
consecutive sentences to convey the gist of what he says:
In a certain factory an extra 100 worth of machinery can be applied
so as not to involve any other extra expense, and so as to add annually 3
worth to the net output of the factory after allowing for its own wear and
tear. If the investors of capital push it into every occupation in which it
seems likely to gain a high reward; and if, after this has been done and
equilibrium has been found, it still pays and only just pays to employ this
machinery, we can infer from this fact that the yearly rate of interest is 3
per cent. But illustrations of this kind merely indicate part of the action of
the great causes which govern value. They cannot be made into a theory of
interest, any more than into a theory of wages, without reasoning in a
circle . . . Suppose that the rate of interest is 3 per cent. per annum on
perfectly good security; and that the hat-making trade absorbs a capital of
one million pounds. This implies that the hat-making trade can turn the
whole million pounds worth of capital to so good account that they would
pay 3 per cent. per annum net for the use of it rather than go without any
of it. There may be machinery which the trade would have refused to
dispense with if the rate of interest had been 20 per cent. per annum. If
the rate had been 10 per cent., more would have been used; if it had been 6
per cent., still more; if 4 per cent. still more; and finally, the rate being 3
per cent., they use more still. When they have this amount, the marginal
utility of the machinery, i.e. the utility of that machinery which it is only
just worth their while to employ, is measured by 3 per cent.
It is evident from the above that Marshall was well aware that we are
involved in a circular argument if we try to determine along these lines
what the rate of interest actually is. In this passage he appears to accept
the view set forth above, that the rate of interest determines the point to
which new investment will be pushed, given the schedule of the marginal
efficiency of capital. If the rate of interest is 3 per cent, this means that no
one will pay 100 for a machine unless he hopes thereby to add 3 to his
annual net output after allowing for costs and depreciation. But we shall
see in chapter 14 that in other passages Marshall was less cautious
though still drawing back when his argument was leading him on to
dubious ground.
Although he does not call it the marginal efficiency of capital,
Professor Irving Fisher has given in his Theory of Interest (1930) a
definition of what he calls the rate of return over cost which is identical
with my definition. The rate of return over cost, he writes, is that rate
which, employed in computing the present worth of all the costs and the
present worth of all the returns, will make these two equal. Professor
Fisher explains that the extent of investment in any direction will depend
on a comparison between the rate of return over cost and the rate of
interest. To induce new investment the rate of return over cost must
exceed the rate of interest. This new magnitude (or factor) in our study
plays the central rle on the investment opportunity side of interest
theory. Thus Professor Fisher uses his rate of return over cost in the same
sense and for precisely the same purpose as I employ the marginal
efficiency of capital.
The most important confusion concerning the meaning and significance of

the marginal efficiency of capital has ensued on the failure to see that it
depends on the prospective yield of capital, and not merely on its current
yield. This can be best illustrated by pointing out the effect on the marginal
efficiency of capital of an expectation of changes in the prospective cost of
production, whether these changes are expected to come from changes in
labour cost, i.e. in the wage-unit, or from inventions and new technique.
The output from equipment produced to-day will have to compete, in the
course of its life, with the output from equipment produced subsequently,
perhaps at a lower labour cost, perhaps by an improved technique, which
is content with a lower price for its output and will be increased in
quantity until the price of its output has fallen to the lower figure with
which it is content. Moreover, the entrepreneurs profit (in terms of
money) from equipment, old or new, will be reduced, if all output comes to
be produced more cheaply. In so far as such developments are foreseen as
probable, or even as possible, the marginal efficiency of capital produced

to-day is appropriately diminished.
This is the factor through which the expectation of changes in the
value of money influences the volume of current output. The expectation
of a fall in the value of money stimulates investment, and hence
employment generally, because it raises the schedule of the marginal
efficiency of capital, i.e. the investment demand-schedule; and the
expectation of a rise in the value of money is depressing, because it lowers
the schedule of the marginal efficiency of capital.
This is the truth which lies behind Professor Irving Fishers theory of
what he originally called Appreciation and Interest the distinction
between the money rate of interest and the real rate of interest where the
latter is equal to the former after correction for changes in the value of
money. It is difficult to make sense of this theory as stated, because it is
not clear whether the change in the value of money is or is not assumed to
be foreseen. There is no escape from the dilemma that, if it is not foreseen,
there will be no effect on current affairs; whilst, if it is foreseen, the prices
of existing goods will be forthwith so adjusted that the advantages of
holding money and of holding goods are again equalised, and it will be too
late for holders of money to gain or to suffer a change in the rate of interest
which will offset the prospective change during the period of the loan in
the value of the money lent. For the dilemma is not successfully escaped by
Professor Pigous expedient of supposing that the prospective change in
the value of money is foreseen by one set of people but not foreseen by
another.
The mistake lies in supposing that it is the rate of interest on which
prospective changes in the value of money will directly react, instead of the
marginal efficiency of a given stock of capital. The prices of existing assets
will always adjust themselves to changes in expectation concerning the
prospective value of money. The significance of such changes in
expectation lies in their effect on the readiness to produce new assets
through their reaction on the marginal efficiency of capital. The
stimulating effect of the expectation of higher prices is due, not to its
raising the rate of interest (that would be a paradoxical way of stimulating
output in so far as the rate of interest rises, the stimulating effect is to
that extent offset), but to its raising the marginal efficiency of a given stock
of capital. If the rate of interest were to rise pari passu with the marginal
efficiency of capital, there would be no stimulating effect from the
expectation of rising prices. For the stimulus to output depends on the
marginal efficiency of a given stock of capital rising relatively to the rate of
interest. Indeed Professor Fishers theory could be best re-written in terms

of a real rate of interest defined as being the rate of interest which would
have to rule, consequently on a change in the state of expectation as to the
future value of money, in order that this change should have no effect on
current output. It is worth noting that an expectation of a future fall in the
rate of interest will have the effect of lowering the schedule of the
marginal efficiency of capital; since it means that the output from
equipment produced to-day will have to compete during part of its life
with the output from equipment which is content with a lower return. This
expectation will have no great depressing effect, since the expectations,
which are held concerning the complex of rates of interest for various
terms which will rule in the future, will be partially reflected in the
complex of rates of interest which rule to-day. Nevertheless there may be
some depressing effect, since the output from equipment produced to-day,
which will emerge towards the end of the life of this equipment, may have
to compete with the output of much younger equipment which is content
with a lower return because of the lower rate of interest which rules for
periods subsequent to the end of the life of equipment produced to-day.
It is important to understand the dependence of the marginal
efficiency of a given stock of capital on changes in expectation, because it
is chiefly this dependence which renders the marginal efficiency of capital
subject to the somewhat violent fluctuations which are the explanation of
the trade cycle. In chapter 22 below we shall show that the succession of
boom and slump can be described and analysed in terms of the
fluctuations of the marginal efficiency of capital relatively to the rate of
interest.
Two types of risk affect the volume of investment which have not
commonly been distinguished, but which it is important to distinguish.
The first is the entrepreneurs or borrowers risk and arises out of doubts
in his own mind as to the probability of his actually earning the
prospective yield for which he hopes. If a man is venturing his own money,
this is the only risk which is relevant.
But where a system of borrowing and lending exists, by which I mean
the ranting of loans with a margin of real or personal security, a second
type of risk is relevant which we may call the lenders risk. This may be due
either to moral hazard, i.e. voluntary default or other means of escape,
possibly lawful, from the fulfilment of the obligation, or to the possible

insufficiency of the margin of security, i.e. involuntary default due to the
disappointment of expectation. A third source of risk might be added,
namely, a possible adverse change in the value of the monetary standard
which renders a money-loan to this extent less secure than a real asset;
though all or most of this should be already reflected, and therefore
absorbed, in the price of durable real assets.
Now the first type of risk is, in a sense, a real social cost, though
susceptible to diminution by averaging as well as by an increased accuracy
of foresight. The second, however, is a pure addition to the cost of
investment which would not exist if the borrower and lender were the
same person. Moreover, it involves in part a duplication of a proportion of
the entrepreneurs risk, which is added twice to the pure rate of interest to
give the minimum prospective yield which will induce the investment. For
if a venture is a risky one, the borrower will require a wider margin
between his expectation of yield and the rate of interest at which he will
think it worth his while to borrow; whilst the very same reason will lead
the lender to require a wider margin between what he charges and the
pure rate of interest in order to induce him to lend (except where the
borrower is so strong and wealthy that he is in a position to offer an
exceptional margin of security). The hope of a very favourable outcome,
which may balance the risk in the mind of the borrower, is not available to
solace the lender.
This duplication of allowance for a portion of the risk has not hitherto
been emphasised, so far as I am aware; but it may be important in certain
circumstances. During a boom the popular estimation of the magnitude of
both these risks, both borrowers risk and lenders risk, is apt to become
unusually and imprudently low.
The schedule of the marginal efficiency of capital is of fundamental

importance because it is mainly through this factor (much more than
through the rate of interest) that the expectation of the future influences
the present. The mistake of regarding the marginal efficiency of capital
primarily in terms of the current yield of capital equipment, which would
be correct only in the static state where there is no changing future to
influence the present, has had the result of breaking the theoretical link
between to-day and to-morrow. Even the rate of interest is, virtually, a
current phenomenon; and if we reduce the marginal efficiency of capital to

the same status, we cut ourselves off from taking any direct account of the
influence of the future in our analysis of the existing equilibrium.
The fact that the assumptions of the static state often underlie
present-day economic theory, imports into it a large element of unreality.
But the introduction of the concepts of user cost and of the marginal
efficiency of capital, as defined above, will have the effect, I think, of
bringing it back to reality, whilst reducing to a minimum the necessary
degree of adaptation.
It is by reason of the existence of durable equipment that the
economic future is linked to the present. It is, therefore, consonant with,
and agreeable to, our broad principles of thought, that the expectation of
the future should affect the present through the demand price for durable
equipment.

C 12
T S L -T E
We have seen in the previous chapter that the scale of investment depends
on the relation between the rate of interest and the schedule of the
marginal efficiency of capital corresponding to different scales of current
investment, whilst the marginal efficiency of capital depends on the
relation between the supply price of a capital-asset and its prospective
yield. In this chapter we shall consider in more detail some of the factors
which determine the prospective yield of an asset.
The considerations upon which expectations of prospective yields are
based are partly existing facts which we can assume to be known more or
less for certain, and partly future events which can only be forecasted with
more or less confidence. Amongst the first may be mentioned the existing
stock of various types of capital-assets and of capital-assets in general and
the strength of the existing consumers demand for goods which require
for their efficient production a relatively larger assistance from capital.
Amongst the latter are future changes in the type and quantity of the stock
of capital-assets and in the tastes of the consumer, the strength of effective
demand from time to time during the life of the investment under
consideration, and the changes in the wage-unit in terms of money which
may occur during its life. We may sum up the state of psychological
expectation which covers the latter as being the state of long-term
expectation; as distinguished from the short-term expectation upon the
basis of which a producer estimates what he will get for a product when it
is finished if he decides to begin producing it to-day with the existing
plant, which we examined in chapter 5.
It would be foolish, in forming our expectations, to attach great weight to

matters which are very uncertain. It is reasonable, therefore, to be guided
to a considerable degree by the facts about which we feel somewhat
confident, even though they may be less decisively relevant to the issue
than other facts about which our knowledge is vague and scanty. For this
reason the facts of the existing situation enter, in a sense
disproportionately, into the formation of our long-term expectations; our
usual practice being to take the existing situation and to project it into the
future, modified only to the extent that we have more or less definite
reasons for expecting a change.
The state of long-term expectation, upon which our decisions are
based, does not solely depend, therefore, on the most probable forecast we
can make. It also depends on the confidence with which we make this
forecast on how highly we rate the likelihood of our best forecast
turning out quite wrong. If we expect large changes but are very uncertain
as to what precise form these changes will take, then our confidence will be
weak.
The state of confidence, as they term it, is a matter to which practical
men always pay the closest and most anxious attention. But economists
have not analysed it carefully and have been content, as a rule, to discuss it
in general terms. In particular it has not been made clear that its relevance
to economic problems comes in through its important influence on the
schedule of the marginal efficiency of capital. There are not two separate
factors affecting the rate of investment, namely, the schedule of the
marginal efficiency of capital and the state of confidence. The state of
confidence is relevant because it is one of the major factors determining
the former, which is the same thing as the investment demand-schedule.
There is, however, not much to be said about the state of confidence a
priori. Our conclusions must mainly depend upon the actual observation
of markets and business psychology. This is the reason why the ensuing
digression is on a different level of abstraction from most of this book.
For convenience of exposition we shall assume in the following
discussion of the state of confidence that there are no changes in the rate
of interest; and we shall write, throughout the following sections, as if
changes in the values of investments were solely due to changes in the
expectation of their prospective yields and not at all to changes in the rate
of interest at which these prospective yields are capitalised. The effect of
changes in the rate of interest is, however, easily superimposed on the
effect of changes in the state of confidence.
The outstanding fact is the extreme precariousness of the basis of

knowledge on which our estimates of prospective yield have to be made.
Our knowledge of the factors which will govern the yield of an investment
some years hence is usually very slight and often negligible. If we speak
frankly, we have to admit that our basis of knowledge for estimating the
yield ten years hence of a railway, a copper mine, a textile factory, the
goodwill of a patent medicine, an Atlantic liner, a building in the City of
London amounts to little and sometimes to nothing; or even five years
hence. In fact, those who seriously attempt to make any such estimate are
often so much in the minority that their behaviour does not govern the
market.
In former times, when enterprises were mainly owned by those who
undertook them or by their friends and associates, investment depended
on a sufficient supply of individuals of sanguine temperament and
constructive impulses who embarked on business as a way of life, not
really relying on a precise calculation of prospective profit. The affair was
partly a lottery, though with the ultimate result largely governed by
whether the abilities and character of the managers were above or below
the average. Some would fail and some would succeed. But even after the
event no one would know whether the average results in terms of the sums
invested had exceeded, equalled or fallen short of the prevailing rate of
interest; though, if we exclude the exploitation of natural resources and
monopolies, it is probable that the actual average results of investments,
even during periods of progress and prosperity, have disappointed the
hopes which prompted them. Business men play a mixed game of skill and
chance, the average results of which to the players are not known by those
who take a hand. If human nature felt no temptation to take a chance, no
satisfaction (profit apart) in constructing a factory, a railway, a mine or a
farm, there might not be much investment merely as a result of cold
calculation.
Decisions to invest in private business of the old-fashioned type were,
however, decisions largely irrevocable, not only for the community as a
whole, but also for the individual. With the separation between ownership
and management which prevails to-day and with the development of
organised investment markets, a new factor of great importance has
entered in, which sometimes facilitates investment but sometimes adds
greatly to the instability of the system. In the absence of security markets,
there is no object in frequently attempting to revalue an investment to
which we are committed. But the Stock Exchange revalues many

investments every day and the revaluations give a frequent opportunity to
the individual (though not to the community as a whole) to revise his
commitments. It is as though a farmer, having tapped his barometer after
breakfast, could decide to remove his capital from the farming business
between 10 and II in the morning and reconsider whether he should
return to it later in the week. But the daily revaluations of the Stock
Exchange, though they are primarily made to facilitate transfers of old
investments between one individual and another, inevitably exert a
decisive influence on the rate of current investment. For there is no sense
in building up a new enterprise at a cost greater than that at which a
similar existing enterprise can be purchased; whilst there is an
inducement to spend on a new project what may seem an extravagant
sum, if it can be floated off on the Stock Exchange at an immediate profit.
Thus certain classes of investment are governed by the average expectation
of those who deal on the Stock Exchange as revealed in the price of shares,
rather than by the genuine expectations of the professional entrepreneur.
How then are these highly significant daily, even hourly, revaluations of
existing investments carried out in practice?
In practice we have tacitly agreed, as a rule, to fall back on what is, in

truth, a convention. The essence of this convention though it does not,
of course, work out quite so simply lies in assuming that the existing
state of affairs will continue indefinitely, except in so far as we have
specific reasons to expect a change. This does not mean that we really
believe that the existing state of affairs will continue indefinitely. We know
from extensive experience that this is most unlikely. The actual results of
an investment over a long term of years very seldom agree with the initial
expectation. Nor can we rationalise our behaviour by arguing that to a man
in a state of ignorance errors in either direction are equally probable, so
that there remains a mean actuarial expectation based on equi-
probabilities. For it can easily be shown that the assumption of
arithmetically equal probabilities based on a state of ignorance leads to
absurdities. We are assuming, in effect, that the existing market valuation,
however arrived at, is uniquely correct in relation to our existing
knowledge of the facts which will influence the yield of the investment, and
that it will only change in proportion to changes in this knowledge;
though, philosophically speaking, it cannot be uniquely correct, since our
existing knowledge does not provide a sufficient basis for a calculated

mathematical expectation. In point of fact, all sorts of considerations enter
into the market valuation which are in no way relevant to the prospective
yield.
Nevertheless the above conventional method of calculation will be
compatible with a considerable measure of continuity and stability in our
affairs, so long as we can rely on the maintenance of the convention.
For if there exist organised investment markets and if we can rely on
the maintenance of the convention, an investor can legitimately encourage
himself with the idea that the only risk he runs is that of a genuine change
in the news over the near future, as to the likelihood of which he can
attempt to form his own judgment, and which is unlikely to be very large.
For, assuming that the convention holds good, it is only these changes
which can affect the value of his investment, and he need not lose hiS sleep
merely because he has not any notion what his investment will be worth
ten years hence. Thus investment becomes reasonably safe for the
individual investor over short periods, and hence over a succession of
short periods however many, if he can fairly rely on there being no
breakdown in the convention and on his therefore having an opportunity
to revise his judgment and change his investment, before there has been
time for much to happen. Investments which are fixed for the community
are thus made liquid for the individual.
It has been, I am sure, on the basis of some such procedure as this
that our leading investment markets have been developed. But it is not
surprising that a convention, in an absolute view of things so arbitrary,
should have its weak points. It is its precariousness which creates no small
part of our contemporary problem of securing sufficient investment.
Some of the factors which accentuate this precariousness may be briefly

mentioned.
(1) As a result of the gradual increase in the proportion of the equity in
the communitys aggregate capital investment which is owned by persons
who do not manage and have no special knowledge of the circumstances,
either actual or prospective, of the business in question, the element of
real knowledge in the valuation of investments by whose who own them or
contemplate purchasing them has seriously declined.
(2) Day-to-day fluctuations in the profits of existing investments,

which are obviously of an ephemeral and non-significant character, tend to
have an altogether excessive, and even an absurd, influence on the market.
It is said, for example, that the shares of American companies which
manufacture ice tend to sell at a higher price in summer when their profits
are seasonally high than in winter when no one wants ice. The recurrence
of a bank-holiday may raise the market valuation of the British railway
system by several million pounds.
(3) A conventional valuation which is established as the outcome of
the mass psychology of a large number of ignorant individuals is liable to
change violently as the result ofa sudden fluctuation of opinion due to
factors which do not really make much difference to the prospective yield;
since there will be no strong roots of conviction to hold it steady. In
abnormal times in particular, when the hypothesis of an indefinite
continuance of the existing state of affairs is less plausible than usual even
though there are no express grounds to anticipate a definite change, the
market will be subject to waves of optimistic and pessimistic sentiment,
which are unreasoning and yet in a sense legitimate where no solid basis
exists for a reasonable calculation.
(4) But there is one feature in particular which deserves our attention.
It might have been supposed that competition between expert
professionals, possessing judgment and knowledge beyond that of the
average private investor, would correct the vagaries of the ignorant
individual left to himself. It happens, however, that the energies and skill
of the professional investor and speculator are mainly occupied otherwise.
For most of these persons are, in fact, largely concerned, not with making
superior long-term forecasts of the probable yield of an investment over its
whole life, but with foreseeing changes in the conventional basis of
valuation a short time ahead of the general public. They are concerned, not
with what an investment is really worth to a man who buys it for keeps,
but with what the market will value it at, under the influence of mass
psychology, three months or a year hence. Moreover, this behaviour is not
the outcome of a wrong-headed propensity. It is an inevitable result of an
investment market organised along the lines described. For it is not
sensible to pay 25 for an investment of which you believe the prospective
yield to justify a value of 30, if you also believe that the market will value it
at 20 three months hence.
Thus the professional investor is forced to concern himself with the
anticipation of impending changes, in the news or in the atmosphere, of
the kind by which experience shows that the mass psychology of the
market is most influenced. This is the inevitable result of investment

markets organised with a view to so-called liquidity. Of the maxims of
orthodox finance none, surely, is more anti-social than the fetish of
liquidity, the doctrine that it is a positive virtue on the part of investment
institutions to concentrate their resources upon the holding of liquid
securities. It forgets that there is no such thing as liquidity of investment
for the community as a whole. The social object of skilled investment
should be to defeat the dark forces of time and ignorance which envelop
our future. The actual, private object of the most skilled investment to-day
is to beat the gun, as the Americans so well express it, to outwit the
crowd, and to pass the bad, or depreciating, half-crown to the other fellow.
This battle of wits to anticipate the basis of conventional valuation a
few months hence, rather than the prospective yield of an investment over
a long term of years, does not even require gulls amongst the public to feed
the maws of the professional; it can be played by professionals amongst
themselves. Nor is it necessary that anyone should keep his simple faith in
the conventional basis of valuation having any genuine long-term validity.
For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs a
pastime in which he is victor who says Snap neither too soon nor too late,
who passed the Old Maid to his neighbour before the game is over, who
secures a chair for himself when the music stops. These games can be
played with zest and enjoyment, though all the players know that it is the
Old Maid which is circulating, or that when the music stops some of the
players will find themselves unseated.
Or, to change the metaphor slightly, professional investment may be
likened to those newspaper competitions in which the competitors have to
pick out the six prettiest faces from a hundred photographs, the prize
being awarded to the competitor whose choice most nearly corresponds to
the average preferences of the competitors as a whole; so that each
competitor has to pick, not those faces which he himself finds prettiest,
but those which he thinks likeliest to catch the fancy of the other
competitors, all of whom are looking at the problem from the same point
of view. It is not a case of choosing those which, to the best of ones
judgment, are really the prettiest, nor even those which average opinion
genuinely thinks the prettiest. We have reached the third degree where we
devote our intelligences to anticipating what average opinion expects the
average opinion to be. And there are some, I believe, who practise the
fourth, fifth and higher degrees.
If the reader interjects that there must surely be large profits to be
gained from the other players in the long run by a skilled individual who,
unperturbed by the prevailing pastime, continues to purchase investments

on the best genuine long-term expectations he can frame, he must be
answered, first of all, that there are, indeed, such serious-minded
individuals and that it makes a vast difference to an investment market
whether or not they predominate in their influence over the game-players.
But we must also add that there are several factors which jeopardise the
predominance of such individuals in modern investment markets.
Investment based on genuine long-term expectation is so difficult to-day
as to be scarcely practicable. He who attempts it must surely lead much
more laborious days and run greater risks than he who tries to guess better
than the crowd how thc crowd will behave; and, given equal intelligence,
he may make more disastrous mistakes. There is no clear evidence from
experience that the investment policy which is socially advantageous
coincides with that which is most profitable. It needs more intelligence to
defeat the forces of time and our ignorance of the future than to beat the
gun. Moreover, life is not long enough; human nature desires quick
results, there is a peculiar zest in making money quickly, and remoter
gains are discounted by the average man at a very high rate. The game of
professional investment is intolerably boring and over-exacting to anyone
who is entirely exempt from the gambling instinct; whilst he who has it
must pay to this propensity the appropriate toll. Furthermore, an investor
who proposes to ignore near-term market fluctuations needs greater
resources for safety and must not operate on so large a scale, if at all, with
borrowed money a further reason for the higher return from the
pastime to a given stock of intelligence and resources. Finally it is the long-
term investor, he who most promotes the public interest, who will in
practice come in for most criticism, wherever investment funds are
managed by committees or boards or banks. For it is in the essence of his
behaviour that he should be eccentric, unconventional and rash in the eyes
of average opinion. If he is successful, that will only confirm the general
belief in his rashness; and if in the short run he is unsuccessful, which is
very likely, he will not receive much mercy. Worldly wisdom teaches that it
is better for reputation to fail conventionally than to succeed
unconventionally.
(5) So far we have had chiefly in mind the state of confidence of the
speculator or speculative investor himself and may have seemed to be
tacitly assuming that, if he himself is satisfied with the prospects, he has
unlimited command over money at the market rate of interest. This is, of
course, not the case. Thus we must also take account of the other facet of
the state of confidence, namely, the confidence of the lending institutions
towards those who seek to borrow from them, sometimes described as the
state of credit. A collapse in the price of equities, which has had disastrous
reactions on the marginal efficiency of capital, may have been due to the
weakening either of speculative confidence or of the state of credit. But
whereas the weakening of either is enough to cause a collapse, recovery
requires the revival of both. For whilst the weakening of credit is sufficient
to bring about a collapse, its strengthening, though a necessary condition
of recovery, is not a sufficient condition.
These considerations should not lie beyond the purview of the economist.
But they must be relegated to their right perspective. If I may be allowed to
appropriate the term speculation for the activity of forecasting the
psychology of the market, and the term enterprise for the activity of
forecasting the prospective yield of assets over their whole life, it is by no
means always the case that speculation predominates over enterprise. As
the organisation of investment markets improves, the risk of the
predominance of speculation does, however, increase. In one of the
greatest investment markets in the world, namely, New York, the influence
of speculation (in the above sense) is enormous. Even outside the field of
finance, Americans are apt to be unduly interested in discovering what
average opinion believes average opinion to be; and this national weakness
finds its nemesis in the stock market. It is rare, one is told, for an
American to invest, as many Englishmen still do, for income; and he will
not readily purchase an investment except in the hope of capital
appreciation. This is only another way of saying that, when he purchases
an investment, the American is attaching his hopes, not so much to its
prospective yield, as to a favourable change in the conventional basis of
valuation, i.e. that he is, in the above sense, a speculator. Speculators may
do no harm as bubbles on a steady stream of enterprise. But the position is
serious when enterprise becomes the bubble on a whirlpool of speculation.
When the capital development of a country becomes a by-product of the
activities of a casino, the job is likely to be ill-done. The measure of success
attained by Wall Street, regarded as an institution of which the proper
social purpose is to direct new investment into the most profitable
channels in terms of future yield, cannot be claimed as one of the
outstanding triumphs of laissez-faire capitalism which is not surprising,
if I am right in thinking that the best brains of Wall Street have been in
fact directed towards a different object.
These tendencies are a scarcely avoidable outcome of our having

successfully organised liquid investment markets. It is usually agreed that
casinos should, in the public interest, be inaccessible and expensive. And
perhaps the same is true of stock exchanges. That the sins of the London
Stock Exchange are less than those of Wall Street may be due, not so much
to differences in national character, as to the fact that to the average
Englishman Throgmorton Street is, compared with Wall Street to the
average American, inaccessible and very expensive. The jobbers turn, the
high brokerage charges and the heavy transfer tax payable to the
Exchequer, which attend dealings on the London Stock Exchange,
sufficiently diminish the liquidity of the market (although the practice of
fortnightly accounts operates the other way) to rule out a large proportion
of the trinsaction characteristic of Wall Street. The introduction of a
substantial government transfer tax on all transactions might prove the
most serviceable reform available, with a view to mitigating the
predominance of speculation over enterprise in the United States.
The spectacle of modern investment markets has sometimes moved
me towards the conclusion that to make the purchase of an investment
permanent and indissoluble, like marriage, except by reason of death or
other grave cause, might be a useful remedy for our contemporary evils.
For this would force the investor to direct his mind to the long-term
prospects and to those only. But a little consideration of this expedient
brings us up against a dilemma, and shows us how the liquidity of
investment markets often facilitates, though it sometimes impedes, the
course of new investment. For the fact that each individual investor
flatters himself that his commitment is liquid (though this cannot be true
for all investors collectively) calms his nerves and makes him much more
willing to run a risk. If individual purchases of investments were rendered
illiquid, this might seriously impede new investment, so long as
alternative ways in which to hold his savings are available to the
individual. This is the dilemma. So long as it is open to the individual to
employ his wealth in hoarding or lending money, the alternative of
purchasing actual capital assets cannot be rendered sufficiently attractive
(especially to the man who does not manage the capital assets and knows
very little about them), except by organising markets wherein these assets
can be easily realised for money.
The only radical cure for the crises of confidence which afflict the
economic life of the modern world would be to allow the individual no
choice between consuming his income and ordering the production of the
specific capital-asset which, even though it be on precarious evidence,
impresses him as the most promising investment available to him. It

might be that, at times when he was more than usually assailed by doubts
concerning the future, he would turn in his perplexity towards more
consumption and less new investment. But that would avoid the
disastrous, cumulative and far-reaching repercussions of its being open to
him, when thus assailed by doubts, to spend his income neither on the one
nor on the other.
Those who have emphasised the social dangers of the hoarding of
money have, of course, had something similar to the above in mind. But
they have overlooked the possibility that the phenomenon can occur
without any change, or at least any commensurate change, in the hoarding
of money.
Even apart from the instability due to speculation, there is the instability
due to the characteristic of human nature that a large proportion of our
positive activities depend on spontaneous optimism rather than on a
mathematical expectation, whether moral or hedonistic or economic.
Most, probably, of our decisions to do something positive, the full
consequences of which will be drawn out over many days to come, can
only be taken as a result of animal spirits of a spontaneous urge to
action rather than inaction, and not as the outcome of a weighted average
of quantitative benefits multiplied by quantitative probabilities. Enterprise
only pretends to itself to be mainly actuated by the statements in its own
prospectus, however candid and sincere. Only a little more than an
expedition to the South Pole, is it based on an exact calculation of benefits
to come. Thus if the animal spirits are dimmed and the spontaneous
optimism falters, leaving us to depend on nothing but a mathematical
expectation, enterprise will fade and die; though fears of loss may have a
basis no more reasonable than hopes of profit had before.
It is safe to say that enterprise which depends on hopes stretching into
the future benefits the community as a whole. But individual initiative will
only be adequate when reasonable calculation is supplemented and
supported by animal spirits, so that the thought of ultimate loss which
often overtakes pioneers, as experience undoubtedly tells us and them, is
put aside as a healthy man puts aside the expectation of death.
This means, unfortunately, not only that slumps and depressions are
exaggerated in degree, but that economic prosperity is excessively
dependent on a political and social atmosphere which is congenial to the

average business man. If the fear of a Labour Government or a New Deal
depresses enterprise, this need not be the result either of a reasonable
calculation or of a plot with political intent; it is the mere consequence
of upsetting the delicate balance of spontaneous optimism. In estimating
the prospects of investment, we must have regard, therefore, to the nerves
and hysteria and even the digestions and reactions to the weather of those
upon whose spontaneous activity it largely depends.
We should not conclude from this that everything depends on waves
of irrational psychology. On the contrary, the state of long-term
expectation is often steady, and, even when it is not, the other factors exert
their compensating effects. We are merely reminding ourselves that
human decisions affecting the future, whether personal or political or
economic, cannot depend on strict mathematical expectation, since the
basis for making such calculations does not exist; and that it is our innate
urge to activity which makes the wheels go round, our rational selves
choosing between the alternatives as best we are able, calculating where
we can, but often falling back for our motive on whim or sentiment or
chance.
There are, moreover, certain important factors which somewhat mitigate

in practice the effects of our ignorance of the future. Owing to the
operation of compound interest combined with the likelihood of
obsolescence with the passage of time, there are many individual
investments of which the prospective yield is legitimately dominated by
the returns of the comparatively near future. In the case of the most
important class of very long-term investments, namely buildings, the risk
can be frequently transferred from the investor to the occupier, or at least
shared between them, by means of long-term contracts, the risk being
outweighed in the mind of the occupier by the advantages of continuity
and security of tenure. In the case of another important class of long-term
investments, namely public utilities, a substantial proportion of the
prospective yield is practically guaranteed by monopoly privileges coupled
with the right to charge such rates as will provide a certain stipulated
margin. Finally there is a growing class of investments entered upon by, or
at the risk of; public authorities, which are frankly influenced in making
the investment by a general presumption of there being prospective social
advantages from the investment, whatever its commercial yield may prove
to be within a wide range, and without seeking to be satisfied that the
mathematical expectation of the yield is at least equal to the current rate of
interest though the rate which the public authority has to pay may still
play a decisive part in determining the scale of investment operations
which it can afford.
Thus after giving full weight to the importance of the influence of
short-period changes in the state of long-term expectation as distinct from
changes in the rate of interest, we are still entitled to return to the latter as
exercising, at any rate, in normal circumstances, a great, though not a
decisive, influence on the rate of investment. Only experience, however,
can show how far management of the rate of interest is capable of
continuously stimulating the appropriate volume of investment.
For my own part I am now somewhat sceptical of the success of a
merely monetary policy directed towards influencing the rate of interest. I
expect to see the State, which is in a position to calculate the marginal
efficiency of capital-goods on long views and on the basis of the general
social advantage, taking an ever greater responsibility for directly
organising investment; since it seems likely that the fluctuations in the
market estimation of the marginal efficiency of different types of capital,
calculated on the principles I have described above, will be too great to be
offset by any practicable changes in the rate of interest.

C 13
T G T R
I
We have shown in chapter 11 that, whilst there are forces causing the rate
of investment to rise or fall so as to keep the marginal efficiency of capital
equal to the rate of interest, yet the marginal efficiency of capital is, in
itself; a different thing from the ruling rate of interest. The schedule of the
marginal efficiency of capital may be said to govern the terms on which
loanable funds are demanded for the purpose of new investment; whilst
the rate of interest governs the terms on which funds are being currently
supplied. To complete our theory, therefore, we need to know what
determines the rate of interest.
In chapter 14 and its Appendix we shall consider the answers to this
question which have been given hitherto. Broadly speaking, we shall find
that they make the rate of interest to depend on the interaction of the
schedule of the marginal efficiency of capital with the psychological
propensity to save. But the notion that the rate of interest is the balancing
factor which brings the demand for saving in the shape of new investment
forthcoming at a iven rate of interest into equality with the supply of
saving which results at that rate of interest from the communitys
psychological propensity to save, breaks down as soon as we perceive that
it is impossible to deduce the rate of interest merely from a knowledge of
these two factors. What, then, is our own answer to this question?
The psychological time-preferences of an individual require two distinct

sets of decisions to carry them out completely. The first is concerned with
that aspect of time-preference which I have called the propensity to

consume, which, operating under the influence of the various motives set
forth in Book III, determines for each individual how much of his income
he will consume and how much he will reserve in some form of command
over future consumption.
But this decision having been made, there is a further decision which
awaits him, namely, in what form he will hold the command over future
consumption which he has reserved, whether out of his current income or
from previous savings. Does he want to hold it in the form of immediate,
liquid command (i.e. in money or its equivalent)? Or is he prepared to part
with immediate command for a specified or indefinite period, leaving it to
future market conditions to determine on what terms he can, if necessary,
convert deferred command over specific goods into immediate command
over goods in general? In other words, what is the degree of his liquidity-
preference where an individuals liquidity-preference is given by a
schedule of the amounts of his resources, valued in terms of money or of
wage-units, which he will wish to retain in the form of money in different
sets of circumstances?
We shall find that the mistake in the accepted theories of the rate of
interest lies in their attempting to derive the rate of interest from the first
of these two constituents of psychological time-preference to the neglect of
the second; and it is this neglect which we must endeavour to repair.
It should be obvious that the rate of interest cannot be a return to
saving or waiting as such. For if a man hoards his savings in cash, he earns
no interest, though he saves just as much as before. On the contrary, the
mere definition of the rate of interest tells us in so many words that the
rate of interest is the reward for parting with liquidity for a specified
period. For the rate of interest is, in itself; nothing more than the inverse
proportion between a sum of money and what can be obtained for parting
with control over the money in exchange for a debt for a stated period of
time.
Thus the rate of interest at any time, being the reward for parting with
liquidity, is a measure of the unwillingness of those who possess money to
part with their liquid control over it. The rate of interest is not the price
which brings into equilibrium the demand for resources to invest with the
readiness to abstain from present consumption. It is the price which
equilibrates the desire to hold wealth in the form of cash with the available
quantity of cash; which implies that if the rate of interest were lower, i.e.
if the reward for parting with cash were diminished, the aggregate amount
of cash which the public would wish to hold would exceed the available
supply, and that if the rate of interest were raised, there would be a surplus
of cash which no one would be willing to hold. If this explanation is
correct, the quantity of money is the other factor, which, in conjunction
with liquidity-preference, determines the actual rate of interest in given
circumstances. Liquidity-preference is a potentiality or functional
tendency, which fixes the quantity of money which the public will hold
when the rate of interest is given; so that if r is the rate of interest, M the
quantity of money and L the function of liquidity-preference, we have
M = L(r). This is where, and how, the quantity of money enters into the
economic scheme.
At this point, however, let us turn back and consider why such a thing
as liquidity-preference exists. In this connection we can usefully employ
the ancient distinction between the use of money for the transaction of
current business and its use as a store of wealth. As regards the first of
these two uses, it is obvious that up to a point it is worth while to sacrifice
a certain amount of interest for the convenience of liquidity. But, given
that the rate of interest is never negative, why should anyone prefer to
hold his wealth in a form which yields little or no interest to holding it in a
form which yields interest (assuming, of course, at this stage, that the risk
of default is the same in respect of a bank balance as of a bond)? A full
explanation is complex and must wait for chapter 15. There is, however, a
necessary condition failing which the existence of a liquidity-preference
for money as a means of holding wealth could not exist.
This necessary condition is the existence of uncertainty as to the
future of the rate of interest, i.e. as to the complex of rates of interest for
varying maturities which will rule at future dates. For if the rates of
interest ruling at all future times could be foreseen with certainty, all
future rates of interest could be inferred from the present rates of interest
for debts of different maturities, which would be adjusted to the
knowledge of the future rates. For example, if 1dr is the value ln the present
year 1 of 1 deferred r years and it is known that ndr will be the value in the
year n of 1 deferred r years from that date, we have
1dn + r
ndr = ;
1dn
whence it follows that the rate at which any debt can be turned into cash n
years hence is given by two out of the complex of current rates of interest.
If the current rate of interest is positive for debts of every maturity, it must
always be more advantageous to purchase a debt than to hold cash as a
store of wealth.
If, on the contrary, the future rate of interest is uncertain we cannot

safely infer that ndr will prove to be equal to 1dn + r / 1dn when the time
comes. Thus if a need for liquid cash may conceivably arise before the
expiry of n years, there is a risk of a loss being incurred in purchasing a
long-term debt and subsequently turning it into cash, as compared with
holding cash. The actuarial profit or mathematical expectation of gain
calculated in accordance with the existing probabilities if it can be so
calculated, which is doubtful must be sufficient to compensate for the
risk of disappointment.
There is, moreover, a further ground for liquidity-preference which
results from the existence of uncertainty as to the future of the rate of
interest, provided that there is an organlsed market for dealing in debts.
For different people will estimate the prospects differently and anyone
who differs from the predominant opinion as expressed in market
quotations may have a good reason for keeping liquid resources in order to
profit, if he is right, from its turning out in due course that the 1drs were in
a mistaken relationship to one another.
This is closely analogous to what we have already discussed at some
length in connection with the marginal efficiency of capital. Just as we
found that the marginal efficiency of capital is fixed, not by the best
opinion, but by the market valuation as determined by mass psychology,
so also expectations as to the future of the rate of interest as fixed by mass
psychology have their reactions on liquidity-preference; but with this
addition that the individual, who believes that future rates of interest will
be above the rates assumed by the market, has a reason for keeping actual
liquid cash, whilst the individual who differs from the market in the other
direction will have a motive for borrowing money for short periods in
order to purchase debts of longer term. The market price will be fixed at
the point at which the sales of the bears and the purchases of the bulls
are balanced.
The three divisions of liquidity-preference which we have
distinguished above may be defined as depending on (i) the transactions-
motive, i.e. the need of cash for the current transaction of personal and
business exchanges; (ii) the precautionary-motive, i.e. the desire for
security as to the future cash equivalent of a certain proportion of total
resources; and (iii) the speculative-motive, i.e. the object of securing profit
from knowing better than the market what the future will bring forth. As
when we were discussing the marginal efficiency of capital, the question of
the desirability of having a highly organised market for dealing with debts
presents us with a dilemma. For, in the absence of an organised market,

liquidity-preference due to the precautionary-motive would be greatly
increased; whereas the existence of an organised market gives an
opportunity for wide fluctuations in liquidity-preference due to the
speculative-motive.
It may illustrate the argument to point out that, if the liquidity-
preferences due to the transactions-motive and the precautionary-motive
are assumed to absorb a quantity of cash which is not very sensitive to
changes in the rate of interest as such and apart from its reactions on the
level of income, so that the total quantity of money, less this quantity, is
available for satisfying liquidity-preferences due to the speculative-motive,
the rate of interest and the price of bonds have to be fixed at the level at
which the desire on the part of certain individuals to hold cash (because at
that level they feel bearish of the future of bonds) is exactly equal to the
amount of cash available for the speculative-motive. Thus each increase in
the quantity of money must raise the price of bonds sufficiently to exceed
the expectations of some bull and so influence him to sell his bond for
cash and join the bear brigade. If, however, there is a negligible demand
for cash from the speculative-motive except for a short transitional
interval, an increase in the quantity of money will have to lower the rate of
interest almost forthwith, in whatever degree is necessary to raise
employment and the wage-unit sufficiently to cause the additional cash to
be absorbed by the transactions-motive and the precautionary-motive.
As a rule, we can suppose that the schedule of liquidity-preference
relating the quantity of money to the rate of interest is given by a smooth
curve which shows the rate of interest falling as the quantity of money is
increased. For there are several different causes all leading towards this
result.
In the first place, as the rate of interest falls, it is likely, cet. par., that
more money will be absorbed by liquidity-preferences due to the
transactions-motive. For if the fall in the rate of interest increases the
national income, the amount of money which it is convenient to keep for
transactions will be increased more or less proportionately to the increase
in income; whilst, at the same time, the cost of the convenience of plenty
of ready cash in terms of loss of interest will be diminished. Unless we
measure liquidity-preference in terms of wage-units rather than of money
(which is convenient in some contexts), similar results follow if the
increased employment ensuing on a fall in the rate of interest leads to an
increase of wages, i.e. to an increase in the money value of the wage-unit.
In the second place, every fall in the rate of interest may, as we have just
seen, increase the quantity of cash which certain individuals will wish to
hold because their views as to the future of the rate of interest differ from
the market views.
Nevertheless, circumstances can develop in which even a large
increase in the quantity of money may exert a comparatively small
influence on the rate of interest. For a large increase in the quantity of
money may cause so much uncertainty about the future that liquidity-
preferences due to the precautionary-motive may be strengthened; whilst
opinion about the future of the rate of interest may be so unanimous that a
small change in present rates may cause a mass movement into cash. It is
interesting that the stability of the system and its sensitiveness to changes
in the quantity of money should be so dependent on the existence of a
variety of opinion about what is uncertain. Best of all that we should know
the future. But if not, then, if we are to control the activity of the economic
system by changing the quantity of money, it is important that opinions
should differ Thus this method of control is more precarious in the United
States, where everyone tends to hold the same opinion at the same time,
than in England where differences of opinion are more usual.
We have now introduced money into our causal nexus for the first time,
and we are able to catch a first glimpse of the way in which changes in the
quantity of money work their way into the economic system. If, however,
we are tempted to assert that money is the drink which stimulates the
system to activity, we must remind ourselves that there may be several
slips between the cup and the lip. For whilst an increase in the quantity of
money may be expected, cet. par., to reduce the rate of interest, this will
not happen if the liquidity-preferences of the public are increasing more
than the quantity of money; and whilst a decline in the rate of interest may
be expected, cet. par., to increase the volume of investment, this will not
happen if the schedule of the marginal efficiency of capital is falling more
rapidly than the rate of intere~t; and whilst an increase in the volume of
investment may be expected, cet. par., to increase employment, this may
not happen if the propensity to consume is falling off. Finally, if
employment increases, prices will rise in a degree partly governed by the
shapes of the physical supply functions, and partly by the liability of the
wage-unit to rise in terms of money. And when output has increased and
prices have risen, the effect of this on liquidity-preference will be to
increase the quantity of money necessary to maintain a given rate of

interest.
Whilst liquidity-preference due to the speculative-motive corresponds to

what in my Treatise on Money I called the state of bearishness, it is by no
means the same thing. For bearishness is there defined as the functional
relationship, not between the rate of interest (or price of debts) and the
quantity of money, but between the price of assets and debts, taken
together, and the quantity of money. This treatment, however, involved a
confusion between results due to a change in the rate of interest and those
due to a change in the schedule of the marginal efficiency of capital, which
I hope I have here avoided.
The concept of hoarding may be regarded as a first approximation to the

concept of liquidity-preference. Indeed if we were to substitute propensity
to hoard for hoarding, it would come to substantially the same thing. But
if we mean by hoarding an actual increase in cash-holding, it is an
incomplete idea and seriously misleading if it causes us to think of
hoarding and not-hoarding as simple alternatives. For the decision to
hoard is not taken absolutely or without regard to the advantages offered
for parting with liquidity; it results from a balancing of advantages, and
we have, therefore, to know what lies in the other scale. Moreover it is
impossible for the actual amount of hoarding to change as a result of
decisions on the part of the public, so long as we mean by hoarding the
actual holding of cash. For the amount of hoarding must be equal to the
quantity of money (or on some definitions to the quantity of money
minus what is required to satisfy the transactions-motive); and the
quantity of money is not determined by the public. All that the propensity
of the public towards hoarding can achieve is to determine the rate of
interest at which the aggregate desire to hoard becomes equal to the
available cash. The habit of overlooking the relation of the rate of interest
to hoarding may be a part of the explanation why interest has been usually
regarded as the reward of not-spending, whereas in fact it is the reward of
not-hoarding.

C 14
T C T R
I
What is the classical theory of the rate of interest? It is something upon

which we have all been brought up and which we have accepted without
much reserve until recently. Yet I find it difficult to state it precisely or to
discover an explicit account of it in the leading treatises of the modern
classical school.
It is fairly clear, however, that this tradition has regarded the rate of
interest as the factor which brings the demand for investment and the
willingness to save into equilibrium with one another. Investment
represents the demand for investible resources and saving represents the
supply, whilst the rate of interest is the price of investible resources at
which the two are equated. Just as the price of a commodity is necessarily
fixed at that point where the demand for it is equal to the supply, so the
rate of interest necessarily comes to rest under the play of market forces at
the point where the amount of investment at that rate of interest is equal
to the amount of saving at that rate.
The above is not to be found in Marshalls Principles in so many
words. Yet his theory seems to be this, and it is what I myself was brought
up on and what I taught for many years to others. Take, for example, the
following passage from his Principles: Interest, being the price paid for
the use of capital in any market, tends towards an equilibrium level such
that the aggregate demand for capital in that market, at that rate of
interest, is equal to the aggregate stock forthcoming at that rate. Or again
in Professor Cassels Nature and Necessity of Interest it is explained that
investment constitutes the demand for waiting and saving the supply of
waiting, whilst interest is a price which serves, it is implied, to equate the
two, though here again I have not found actual words to quote. Chapter vi
of Professor Carvers Distribution of Wealth clearly envisages interest as
the factor which brings into equilibrium the marginal disutility of waiting
with the marginal productivity of capital. Sir Alfred Flux (Economic
Principles, p. 95) writes: If there is justice in the contentions of our
general discussion, it must be admitted that an automatic adjustment
takes place between saving and the opportunities for employing capital
profitably . . . Saving will not have exceeded its possibilities of usefulness
. . . so long as the rate of net interest is in excess of zero. Professor Taussig
(Principles, vol. ii. p. 29) draws a supply curve of saving and a demand
curve representing the diminishing productiveness of the several
instalments of capital, having previously stated (p.20) that the rate of
interest settles at a point where the marginal productivity of capital
suffices to bring out the marginal instalment of saving. Walras, in
Appendix I (III) of his lments dconomie pure, where he deals with
lchange dpargnes contre capitaux neufs, argues expressly that,
corresponding to each possible rate of interest, there is a sum which
individuals will save and also a sum which they will invest in new capital
assets, that these two aggregates tend to equality with one another, and
that the rate of interest is the variable which brings them to equality; so
that the rate of interest is fixed at the point where saving, which represents
the supply of new capital, is equal to the demand for it. Thus he is strictly
in the classical tradition.
Certainly the ordinary man banker, civil servant or politician
brought up on the traditional theory, and the trained economist also, has
carried away with him the idea that whenever an individual performs an
act of saving he has done something which automatically brings down the
rate of interest, that this automatically stimulates the output of capital,
and that the fall in the rate of interest is just so much as is necessary to
stimulate the output of capital to an extent which is equal to the increment
of saving; and, further, that this is a self-regulatory process of adjustment
which takes place without the necessity for any special intervention or
grandmotherly care on the part of the monetary authority. Similarly and
this is an even more general belief, even to-day each additional act of
investment will necessarily raise the rate of interest, if it is not offset by a
change in the readiness to save.
Now the analysis of the previous chapters will have made it plain that
this account of the matter must be erroneous. In tracing to its source the
reason for the difference of opinion, let us, however, begin with the
matters which are agreed.
Unlike the neo-classical school, who believe that saving and

investment can be actually unequal, the classical school proper has
accepted the view that they are equal. Marshall, for example, surely
believed, although he did not expressly say so, that aggregate saving and
aggregate investment are necessarily equal. Indeed, most members of the
classical school carried this belief much too far; since they held that every
act of increased saving by an individual necessarily brings into existence a
corresponding act of increased investment. Nor is there any material
difference, relevant in this context, between my schedule of the marginal
efficiency of capital or investment demand-schedule and the demand
curve for capital contemplated by some of the classical writers who have
been quoted above. When we come to the propensity to consume and its
corollary the propensity to save, we are nearer to a difference of opinion,
owing to the emphasis which they have placed on the influence of the rate
of interest on the propensity to save. But they would, presumably, not wish
to deny that the level of income also has an important influence on the
amount saved; whilst I, for my part, would not deny that the rate of
interest may perhaps have an influence (though perhaps not of the kind
which they suppose) on the amount saved out of a given income. All these
points of agreement can be summed up in a proposition which the classical
school would accept and I should not dispute; namely, that, if the level of
income is assumed to be given, we can infer that the current rate of
interest must lie at the point where the demand curve for capital
corresponding to different rates of interest cuts the curve of the amounts
saved out of the given income corresponding to different rates of interest.
But this is the point at which definite error creeps into the classical
theory. If the classical school merely inferred from the above proposition
that, given the demand curve for capital and the influence of changes in
the rate of interest on the readiness to save out of given incomes, the level
of income and the rate of interest must be uniquely correlated, there would
be nothing to quarrel with. Moreover, this proposition would lead
naturally to another proposition which embodies an important truth;
namely, that, if the rate of interest is given as well as the demand curve for
capital and the influence of the rate of interest on the readiness to save out
of given levels of income, the level of income must be the factor which
brings the amount saved to equality with the amount invested. But, in fact,
the classical theory not merely neglects the influence of changes in the
level of income, but involves formal error.
For the classical theory, as can be seen from the above quotations,
assumes that it can then proceed to consider the effect on the rate of
interest of (e.g.) a shift in the demand curve for capital, without abating or
modifying its assumption as to the amount of the given income out of
which the savings are to be made. The independent variables of the
classical theory of the rate of interest are the demand curve for capital and
the influence of the rate of interest on the amount saved out of a given
income; and when (e.g.) the demand curve for capital shifts, the new rate
of interest, according to this theory, is given by the point of intersection
between the new demand curve for capital and the curve relating the rate
of interest to the amounts which will be saved out of the given income. The
classical theory of the rate of interest seems to suppose that, if the demand
curve for capital shifts or if the curve relating the rate of interest to the
amounts saved out of a given income shifts or if both these curves shift,
the new rate of interest will be given by the point of intersection of the new
positions of the two curves. But this is a nonsense theory. For the
assumption that income is constant is inconsistent with the assumption
that these two curves can shift independently of one another. If either of
them shift, then, in general, income will change; with the result that the
whole schematism based on the assumption of a given income breaks
down. The position could only be saved by some complicated assumption
providing for an automatic change in the wage-unit of an amount just
sufficient in its effect on liquidity-preference to establish a rate of interest
which would just offset the supposed shift, so as to leave output at the
same level as before. In fact, there is no hint to be found in the above
writers as to the necessity for any such assumption; at the best it would be
plausible only in relation to long-period equilibrium and could not form
the basis of a short-period theory; and there is no ground for supposing it
to hold even in the long-period. In truth, the classical theory has not been
alive to the relevance of changes in the level of income or to the possibility
of the level of income being actually a function of the rate of the
investment.
The above can be illustrated by a diagram as follows:
In this diagram the amount of investment (or saving) I is measured

vertically, and the rate of interest r horizontally. X1X1 is the first position
of the investment demand-schedule, and X2X2 is a second position of this
curve. The curve Y1 relates the amounts saved out of an income Y1 to
various levels of the rate of interest, the curves Y2, Y3, etc., being the
corresponding curves for levels of income Y2, Y3, etc. Let us suppose that
the curve Y1 is the Y-curve consistent with an investment demand-
schedule X1X1 and a rate of interest r1. Now if the investment demand-
schedule shifts from X1X1 to X2X2, income will, in general, shift also. But
the above diagram does not contain enough data to tell us what its new
value will be; and, therefore, not knowing which is the appropriate Y-
curve, we do not know at what point the new investment demand-schedule
will cut it. If, however, we introduce the state of liquidity-preference and
the quantity of money and these between them tell us that the rate of
interest is r2, then the whole position becomes determinate. For the Y-
curve which intersects X2X2 at the point vertically above r2, namely, the
curve Y2, will be the appropriate curve. Thus the X-curve and the Y-curves
tell us nothing about the rate of interest. They only tell us what income will
be, if from some other source we can say what the rate of interest is. If
nothing has happened to the state of liquidity-preference and the quantity
of money, so that the rate of interest is unchanged, then the curve Y2
which intersects the new investment demand-schedule vertically below the
point where the curve Y1 intersected the old investment demand-schedule
will be the appropriate Y-curve, and Y2 will be the new level of income.
Thus the functions used by the classical theory, namely, the response
of investment and the response of the amount saved out of a given income
to change in the rate of interest, do not furnish material for a theory of the
rate of interest; but they could be used to tell us what the level of income
will be, given (from some other source) the rate of interest; and,
alternatively, what the rate of interest will have to be, if the level of income
is to be maintained at a given figure (e.g. the level corresponding to full
employment).
The mistake originates from regarding interest as the reward for
waiting as such, instead of as the reward for not-hoarding; just as the rates
of return on loans or investments involving different degrees of risk, are
quite properly regarded as the reward, not of waiting as such, but of
running the risk. There is, in truth, no sharp line between these and the so-
called pure rate of interest, all of them being the reward for running the
risk of uncertainty of one kind or another. Only ln the event of money
being used solely for transactions and never as a store of value, would a
different theory become appropriate.
There are, however, two familiar points which might, perhaps, have
warned the classical school that something was wrong. In the first place, it
has been agreed, at any rate since the publication of Professor Cassels
Nature and Necessity of Interest, that it is not certain that the sum saved
out of a given income necessarily increases when the rate of interest is
increased; whereas no one doubts that the investment demand-schedule
falls with a rising rate of interest. But if the Y-curves and the X-curves both
fall as the rate of interest rises, there is no guarantee that a given Y-curve
will intersect a given X-curve anywhere at all. This suggests that it cannot
be the Y-curve and the X-curve alone which determine the rate of interest.
In the second place, it has been usual to suppose that an increase in
the quantity of money has a tendency to reduce the rate of interest, at any
rate in the first instance and in the short period. Yet no reason has been
given why a change in the quantity of money should affect either the
investment demand-schedule or the readiness to save out of a given
income. Thus the classical school have had quite a different theory of the
rate of interest in volume I dealing with the theory of value from what they
have had in volume II dealing with the theory of money. They have seemed
undisturbed by the conflict and have made no attempt, so far as I know, to
build a bridge between the two theories. The classical school proper, that is
to say; since it is the attempt to build a bridge on the part of the neo-
classical school which has led to the worst muddles of all. For the latter
have inferred that there must be two sources of supply to meet the
investment demand-schedule; namely, savings proper, which are the
savings dealt with by the classical school, plus the sum made available by
any increase in the quantity of money (this being balanced by some species
of levy on the public, called forced saving or the like). This leads on to the
idea that there is a natural or neutral or equilibrium rate of interest,
namely, that rate of interest which equates investment to classical savings
proper without any addition from forced savings; and finally to what,
assuming they are on the right track at the start, is the most obvious
solution of all, namely, that, if the quantity of money could only be kept
constant in all circumstances, none of these complications would arise,
since the evils supposed to result from the supposed excess of investment
over savings proper would cease to be possible. But at this point we are in
deep water. The wild duck has dived down to the bottom as deep as she
can get and bitten fast hold of the weed and tangle and all the rubbish
that is down there, and it would need an extraordinarily clever dog to dive
after and fish her up again.
Thus the traditional analysis is faulty because it has failed to isolate
correctly the independent variables of the system. Saving and investment
are the determinates of the system, not the determinants. They are the
twin results of the systems determinants, namely, the propensity to
consume, the schedule of the marginal efficiency of capital and the rate of
interest. These determinants are, indeed, themselves complex and each is
capable of being affected by prospective changes in the others. But they
remain independent in the sense that their values cannot be inferred from
one another. The traditional analysis has been aware that saving depends
on income but it has overlooked the fact that income depends on
investment, in such fashion that, when investment changes, income must
necessarily change in just that degree which is necessary to make the
change in saving equal to the change in investment.
Nor are those theories more successful which attempt to make the
rate of interest depend on the marginal efficiency of capital. It is true that
in equilibrium the rate of interest will be equal to the marginal efficiency
of capital, since it will be profitable to increase (or decrease) the current
scale of investment until the point of equality has been reached. But to
make this into a theory of the rate of interest or to derive the rate of
interest from it involves a circular argument, as Marshall discovered after
he had got half-way into giving an account of the rate of interest along
these lines. For the marginal efficiency of capital partly depends on the
scale of current investment, and we must already know the rate of interest
before we can calculate what this scale will be. The significant conclusion
is that the output of new investment will be pushed to the point at which
the marginal efficiency of capital becomes equal to the rate of interest; and
what the schedule of the marginal efficiency of capital tells us, is, not what
the rate of interest is, but the point to which the output of new investment
will be pushed, given the rate of interest.
The reader will readily appreciate that the problem here under
discussion is a matter of the most fundamental theoretical significance and
of overwhelming practical importance. For the economic principle, on
which the practical advice of economists has been almost invariably based,
has assumed, in effect, that, cet. par., a decrease in spending will tend to
lower the rate of interest and an increase in investment to raise it. But if
what these two quantities determine is, not the rate of interest, but the
aggregate volume of employment, then our outlook on the mechanism of
the economic system will be profoundly changed. A decreased readiness to
spend will be looked on in quite a different light If, instead of being
regarded as a factor which will, cet. par., increase investment, it is seen as
a factor which will, cet. par., diminish employment.
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : Appendix to Chapter 14

A C 14
A R I
M P E ,
R P P
E ,A E
There is no consecutive discussion of the rate of interest in the works of

Marshall, Edgeworth or Professor Pigou nothing more than a few obiter
dicta. Apart from the passage already quoted above (p. 139) the only
important clues to Marshalls position on the rate of interest are to be
found in his Principles of Economics (6th edn.), Book VI. p. 534 and
p. 593, the gist of which is given by the following quotations:
Interest, being the price paid for the use of capital in any market,
tends towards an equilibrium level such that the aggregate demand for
capital in that market, at that rate of interest, is equal to the aggregate
stock forthcoming there at that rate. If the market, which we are
considering, is a small one say a single town, or a single trade in a
progressive country an increased demand for capital in it will be
promptly met by an increased supply drawn from surrounding districts or
trades. But if we are considering the whole world, or even the whole of a
large country, as one market for capital, we cannot regard the aggregate
supply of it as altered quickly and to a considerable extent by a change in
the rate of interest. For the general fund of capital is the product of labour
and waiting; and the extra work, and the extra waiting, to which a rise in
the rate of interest would act as an incentive, would not quickly amount to
much, as compared with the work and waiting, of which the total existing
stock of capital is the result. An extensive increase in the demand for
capital in general will therefore be met for a time not so much by an
increase of supply, as by a rise in the rate of interest; which will cause
capital to withdraw itself partially from those uses in which its marginal
utility is lowest. It is only slowly and gradually that the rise in the rate of
interest will increase the total stock of capital (p.534).
It cannot be repeated too often that the phrase the rate of interest is
applicable to old investments of capital only in a very limited sense. For
instance, we may perhaps estimate that a trade capital of some seven
thousand millions is invested in the different trades of this country at
about 3 per cent net interest. But such a method of speaking, though
convenient and justifiable for many purposes, is not accurate. What ought
to be said is that, taking the rate of net interest on the investments of new
capital in each of those trades [i.e. on marginal investments] to be about 3
per cent; then the aggregate net income rendered by the whole of the
trade-capital invested in the various trades is such that, if capitalised at 33
years purchase (that is, on the basis of interest at 3 per cent), it would
amount to some seven thousand million pounds. For the value of the
capital already invested in improving land or erecting a building, in
making a railway or a machine, is the aggregate discounted value of its
estimated future net incomes [or quasi-rents]; and if its prospective
income-yielding power should diminish, its value would fall accordingly
and would be the capitalised value of that smaller income after allowing
for depreciation (p.593).
In his Economics of Welfare (3rd edn.), p. 163, Professor Pigou
writes: The nature of the service of waiting has been much
misunderstood. Sometimes it has been supposed to consist in the
provision of money, sometimes in the provision of time, and, on both
suppositions, it has been argued that no contribution whatever is made by
it to the dividend. Neither supposition is correct. Waiting simply means
postponing consumption which a person has power to enjoy immediately,
thus allowing resources, which might have been destroyed, to assume the
form of production instruments. The unit of waiting is, therefore, the use
of a given quantity of resources for example, labour or machinery for
a given time . . . In more general terms we may say that the unit of waiting
is a year-value-unit, or, in the simpler, if less accurate, language of Dr
Cassel, a year-pound . . . A caution may be added against the common view
that the amount of capital accumulated in any year is necessarily equal to
the amount of savings made in it. This is not so, even when savings are
interpreted to mean net savings, thus eliminating the savings of one man
that are lent to increase the consumption of another, and when temporary
accumulations of unused claims upon services in the form of bank-money
are ignored; for many savings which are meant to become capital in fact
fail of their purpose through misdirection into wasteful uses.
Professor Pigous only significant reference to what determines the
rate of interest is, I think, to be found in his Industrial Fluctuations (1st
edn.), pp. 2513, where he controverts the view that the rate of interest,
being determined by the general conditions of demand and supply of real
capital, lies outside the central or any other banks control. Against this
view he argues that: When bankers create more credit for business men,
they make, in their interest, subject to the explanations given in chapter
xiii. of part i., a forced levy of real things from the public, thus increasing
the stream of real capital available for them, and causing a fall in the real
rate of interest on long and short loans alike. It is true, in short, that the
bankers rate for money is bound by a mechanical tie to the real rate of
interest on long loans; but it is not true that this real rate is determined by
conditions wholly outside bankers control.
My running comments on the above have been made in the footnotes.
The perplexity which I find in Marshalls account of the matter is
fundamentally due, I think, to the incursion of the concept interest, which
belongs to a monetary economy, into a treatise which takes no account of
money. Interest has really no business to turn up at all in Marshalls
Principles of Economics it belongs to another branch of the subject.
Professor Pigou, conformably with his other tacit assumptions, leads
us (in his Economics of Welfare) to infer that the unit of waiting is the
same as the unit of current investment and that the reward of waiting is
quasi-rent, and practically never mentions interest, which is as it should
be. Nevertheless these writers are not dealing with a non-monetary
economy (if there is such a thing). They quite clearly presume that money
is used and that there is a banking system. Moreover, the rate of interest
scarcely plays a larger part in Professor Pigous Industrial Fluctuations
(which is mainly a study of fluctuations in the marginal efficiency of
capital) or in his Theory of Unemployment (which is mainly a study of
what determines changes in the volume of employment, assuming that
there is no involuntary unemployment) than in his Economics of Welfare.
The following from his Principles of Political Economy (p. 511) puts the
substance of Ricardos theory of the rate of interest:
The interest of money is not regulated by the rate at which the Bank
will lend, whether it be 5, 3 or 2 per cent., but by the rate of profit which
can be made by the employment of capital, and which is totally
independent of the quantity or of the value of money. Whether the Bank
lent one million, ten millions, or a hundred millions, they would not
permanently alter the market rate of interest; they would alter only the
value of the money which they thus issued. In one case, ten or twenty
times more money might be required to carry on the same business than
what might be required in the other. The applications to the Bank for
money, then, depend on the comparison between the rate of profits that
may be made by the employment of it, and the rate at which they are
willing to lend it. If they charge less than the market rate of interest, there
is no amount of money which they might not lend; if they charge more
than that rate, none but spendthrifts and prodigals would be found to
borrow of them.
This is so clear-cut that it affords a better starting-point for a
discussion than the phrases of later writers who, without really departing
from the essence of the Ricardian doctrine, are nevertheless sufficiently
uncomfortable about it to seek refuge in haziness. The above is, of course,
as always with Ricardo, to be interpreted as a long-period doctrine, with
the emphasis on the word permanently half-way through the passage;
and it is interesting to consider the assumptions required to validate it.
Once again the assumption required is the usual classical assumption,
that there is always full employment; so that, assuming no change in the
supply curve of labour in terms of product, there is only one possible level
of employment in long-period equilibrium. On this assumption with the
usual ceteris paribus, i.e. no change in psychological propensities and
expectations other than those arising out of a change in the quantity of
money, the Ricardian theory is valid, in the sense that on these
suppositions there is only one rate of interest which will be compatible
with full employment in the long period. Ricardo and his successors
overlook the fact that even in the long period the volume of employment is
not necessarily full but is capable of varying, and that to every banking
policy there corresponds a different long-period level of employment; so
that there are a number of positions of long-period equilibrium
corresponding to different conceivable interest policies on the part of the
monetary authority.
If Ricardo had been content to present his argument solely as
applying to any given quantity of money created by the monetary
authority, it would still have been correct on the assumption of flexible
money-wages. If, that is to say, Ricardo had argued that it would make no
permanent alteration to the rate of interest whether the quantity of money
was fixed by the monetary authority at ten millions or at a hundred
millions, his conclusion would hold. But if by the policy of the monetary
authority we mean the terms on which it will increase or decrease the
quantity of money, i.e. the rate of interest at which it will, either by a
change in the volume of discounts or by open-market operations, increase
or decrease its assets which is what Ricardo expressly does mean in the
above quotation then it is not the case either that the policy of the
monetary authority is nugatory or that only one policy is compatible with
long-period equilibrium; though in the extreme case where money-wages
are assumed to fall without limit in face of involuntary unemployment
through a futile competition for employment between the unemployed
labourers, there will, it is true, be only two possible long-period positions
full employment and the level of employment corresponding to the rate
of interest at which liquidity-preference becomes absolute (in the event of
this being less than full employment). Assuming flexible money-wages, the
quantity of money as such is, indeed, nugatory in the long period; but the
terms on which the monetary authority will change the quantity of money
enters as a real determinant into the economic scheme.
It is worth adding that the concluding sentences of the quotation
suggest that Ricardo was overlooking the possible changes in the marginal
efficiency of capital according to the amount invested. But this again can
be interpreted as another example of his greater internal consistency
compared with his successors. For if the quantity of employment and the
psychological propensities of the community are taken as given, there is in
fact only one possible rate of accumulation of capital and, consequently,
only one possible value for the marginal efficiency of capital. Ricardo
offers us the supreme intellectual achievement, unattainable by weaker
spirits, of adopting a hypothetical world remote from experience as though
it were the world of experience and then living in it consistently. With
most of his successors common sense cannot help breaking in with
injury to their logical consistency.
A peculiar theory of the rate of interest has been propounded by Professor

von Mises and adopted from him by Professor Hayek and also, I think, by
Professor Robbins; namely, that changes in the rate of interest can be
identified with changes in the relative price levels of consumption-goods

and capital-goods It is not clear how this conclusion is reached. But the
argument seems to run as follows. By a somewhat drastic simplification
the marginal efficiency of capital is taken as measured by the ratio of the
supply price of new consumers goods to the supply price of new
producers goods. This is then identified with the rate of interest. The fact
is called to notice that a fall in the rate of interest is favourable to
investment. Ergo, a fall in the ratio of the price of consumers goods to the
price of producers goods is favourable to investment.
By this means a link is established between tncreased saving by an
individual and increased aggregate investment. For it is common gound
that increased individual saving will cause a fall in the price of consumers
goods, and, quite possibly, a greater fall than in the price of producers
goods; hence, according to the above reasoning, it means a reduction in
the rate of interest which will stimulate investment. But, of course, a
lowering of the marginal efficiency of particular capital assets, and hence a
lowering of the schedule of the marginal efficiency of capital in general,
has exactly the opposite effect to what the above argument assumes. For
investment is stimulated either by a raising of the schedule of the
marginal efficiency or by a lowering of the rate of interest. As a result of
confusing the marginal efficiency of capital with the rate of interest,
Professor von Mises and his disciples have got their conclusions exactly
the wrong way round. A good example of a confusion along these lines is
given by the following passage by Professor Alvin Hansen: It has been
suggested by some economists that the net effect of reduced spending will
be a lower price level of consumers goods than would otherwise have been
the case, and that, in consequence, the stimulus to investment in fixed
capital would thereby tend to be minimised. This view is, however,
incorrect and is based on a confusion of the effect on capital formation of
(i) higher or lower prices of consumers goods, and (2) a change in the rate
of interest. It is true that in consequence of the decreased spending and
increased saving, consumers prices would be low relative to the prices of
producers goods. But this, in effect, means a lower rate of interest, and a
lower rate of interest stimulates an expansion of capital investment in
fields which at higher rates would be unprofitable.

C 15
T P B
I L
We must now develop in more detail the analysis of the motives to

liquidity-preference which were introduced in a preliminary way in
chapter 13. The subject is substantially the same as that which has been
sometimes discussed under the heading of the demand for money. It is
also closely connected with what is called the income-velocity of money;
for the income-velocity of money merely measures what proportion of
their incomes the public chooses to hold in cash, so that an increased
income-velocity of money may be a symptom of a decreased liquidity-
preference. It is not the same thing, however, since it is in respect of his
stock of accumulated savings, rather than of his income, that the
individual can exercise his choice between liquidity and illiquidity. And,
anyhow, the term income-velocity of money carries with it the misleading
suggestion of a presumption in favour of the demand for money as a whole
being proportional, or having some determinate relation, to income,
whereas this presumption should apply, as we shall see, only to a portion
of the publics cash holdings; with the result that it overlooks the part
played by the rate of interest.
In my Treatise on Money I studied the total demand for money under
the headings of income-deposits, business-deposits, and savings-deposits,
and I need not repeat here the analysis which I gave in chapter 3 of that
book. Money held for each of the three purposes forms, nevertheless, a
single pool, which the holder is under no necessity to segregate into three
water-tight compartments; for they need not be sharply divided even in his
own mind, and the same sum can be held primarily for one purpose and
secondarily for another. Thus we can equally well, and, perhaps, better
consider the individuals aggregate demand for money in given
circumstances as a single decision, though the composite result of a

number of different motives.
In analysing the motives, however, it is still convenient to classify
them under certain headings, the first of which broadly corresponds to the
former classification of income-deposits and business-deposits, and the
two latter to that of savings-deposits. These I have briefly introduced in
chapter 13 under the headings of the transactions-motive, which can be
further classified as the income-motive and the business-motive, the
precautionary-motive and the speculative-motive.
(i) The Income-motive. One reason for holding cash is to bridge the
interval between the receipt of income and its disbursement. The strength
of this motive in inducing a decision to hold a given aggregate of cash will
chiefly depend on the amount of income and the normal length of the
interval between its receipt and its disbursement. It is in this connection
that the concept of the income-velocity of money is strictly appropriate.
(ii) The Business-motive. Similarly, cash is held to bridge the interval
between the time of incurring business costs and that of the receipt of the
sale-proceeds; cash held by dealers to bridge the interval between
purchase and realisation being included under this heading. The strength
of this demand will chiefly depend on the value of current output (and
hence on current income), and on the number of hands through which
output passes.
(iii) The Precautionary-motive. To provide for contingencies
requiring sudden expenditure and for unforeseen opportunities of
advantageous purchases, and also to hold an asset of which the value is
fixed in terms of money to meet a subsequent liability fixed in terms of
money, are further motives for holding cash.
The strength of all these three types of motive will partly depend on
the cheapness and the reliability of methods of obtaining cash, when it is
required, by some form of temporary borrowing, in particular by overdraft
or its equivalent. For there is no necessity to hold idle cash to bridge over
intervals if it can be obtained without difficulty at the moment when it is
actually required. Their strength will also depend on what we may term
the relative cost of holding cash. If the cash can only be retained by
forgoing the purchase of a profitable asset, this increases the cost and thus
weakens the motive towards holding a given amount of cash. If deposit
interest is earned or if bank charges are avoided by holding cash, this
decreases the cost and strengthens the motive. It may be, however, that
this is likely to be a minor factor except where large changes in the cost of
holding cash are in question.
(iv) There remains the Speculative-motive. This needs a more

detailed examination than the others, both because it is less well
understood and because it is particularly important in transmitting the
effects of a change in the quantity of money.
In normal circumstances the amount of money required to satisfy the
transactions-motive and the precautionary-motive is mainly a resultant of
the general activity of the economic system and of the level of money-
income. But it is by playing on the speculative-motive that monetary
management (or, in the absence of management, chance changes in the
quantity of money) is brought to bear on the economic system. For the
demand for money to satisfy the former motives is generally irresponsive
to any influence except the actual occurrence of a change in the general
economic activity and the level of incomes; whereas experience indicates
that the aggregate demand for money to satisfy the speculative-motive
usually shows a continuous response to gradual changes in the rate of
interest, i.e. there is a continuous curve relating changes in the demand for
money to satisfy the speculative motive and changes in the rate of interest
as given by changes in the prices of bonds and debts of various maturities.
Indeed, if this were not so, open market operations would be
impracticable. I have said that experience indicates the continuous
relationship stated above, because in normal circumstances the banking
system is in fact always able to purchase (or sell) bonds in exchange for
cash by bidding the price of bonds up (or down) in the market by a modest
amount; and the larger the quantity of cash which they seek to create (or
cancel) by purchasing (or selling) bonds and debts, the greater must be the
fall (or rise) in the rate of interest. Where, however, (as in the United
States, 19331934) open-market operations have been limited to the
purchase of very short-dated securities, the effect may, of course, be
mainly confined to the very short-term rate of interest and have but little
reaction on the much more important long-term rates of interest.
In dealing with the speculative-motive it is, however, important to
distinguish between the changes in the rate of interest which are due to
changes in the supply of money available to satisfy the speculative-motive,
without there having been any change in the liquidity function, and those
which are primarily due to changes in expectation affecting the liquidity
function itself. Open-market Operations may, indeed, influence the rate of
interest through both channels; since they may not only change the
volume of money, but may also give rise to changed expectations
concerning the future policy of the central bank or of the government.
Changes in the liquidity function itself; due to a change in the news which
causes revision of expectations, will often be discontinuous, and will,

therefore, give rise to a corresponding discontinuity of change in the rate
of interest. Only, indeed, in so far as the change in the news is differently
interpreted by different individuals or affects individual lnterests
differently will there be room for any increased activity of dealing in the
bond market. If the change in the news affects the judgment and the
requirements of everyone in precisely the same way, the rate of interest (as
indicated by the prices of bonds and debts) will be adjusted forthwith to
the new situation without any market transactions being necessary.
Thus, in the simplest case, where everyone is similar and similarly
placed, a change in circumstances or expectations will not be capable of
causing any displacement of money whatever; it will simply change the
rate of interest in whatever degree is necessary to offset the desire of each
individual, felt at the previous rate, to change his holding of cash in
response to the new circumstances or expectations; and, since everyone
will change his ideas as to the rate which would induce him to alter his
holdings of cash in the same degree, no transactions will result. To each
set of circumstances and expectations there will correspond an
appropriate rate of interest, and there will never be any question of anyone
changing his usual holdings of cash.
In general, however, a change in circumstances or expectations will
cause some realignment in individual holdings of money; since, in fact,
a change will influence the ideas of different individuals differently by
reasons partly of differences in environment and the reason for which
money is held and partly of differences in knowledge and interpretation of
the new situation. Thus the new equilibrium rate of interest will be
associated with a redistribution of money-holdings. Nevertheless it is the
change in the rate of interest, rather than the redistribution of cash, which
deserves our main attention. The latter is incidental to individual
differences, whereas the essential phenomenon is that which occurs in the
simplest case. Moreover, even in the general case, the shift in the rate of
interest is usually the most prominent part of the reaction to a change in
the news. The movement in bond-prices is, as the newspapers are
accustomed to say, out of all proportion to the activity of dealing;
which is as it should be, in view of individuals being much more similar
than they are dissimilar in their reaction to news.
Whilst the amount of cash which an individual decides to hold to satisfy

the transactions-motive and the precautionary-motive is not entirely
independent of what he is holding to satisfy the speculative-motive, it is a
safe first approximation to regard the amounts of these two sets of cash-
holdings as being largely independent of one another. Let us, therefore, for
the purposes of our further analysis, break up our problem in this way. Let
the amount of cash held to satisfy the transactions- and precautionary-
motives be M1, and the amount held to satisfy the speculative-motive be
M2. Corresponding to these two compartments of cash, we then have two
liquidity functions L1 and L2. L1 mainly depends on the level of income,
whilst L2 mainly depends on the relation between the current rate of
interest and the state of expectation. Thus
M = M1 + M2 = L1(Y) + L2(r),
where L1 is the liquidity function corresponding to an income Y, which

determines M1, and L2 is the liquidity function of the rate of interest r,
which determines M2. It follows that there are three matters to investigate:
(i) the relation of changes in M to Y and r, (ii) what determines the shape
of L1, (iii) what determines the shape of L2.
(i) The relation of changes in M to Y and r depends, in the first

instance, on the way in which changes in M come about. Suppose that M
consists of gold coins and that changes in M can only result from increased
returns to the activities of gold-miners who belong to the economic system
under examination. In this case changes in M are, in the first instance,
directly associated with changes in Y, since the new gold accrues as
someones income. Exactly the same conditions hold if changes in M are
due to the government printing money wherewith to meet its current
expenditure; in this case also the new money accrues as someones
income. The new level of income, however, will not continue sufficiently
high for the requirements of M1 to absorb the whole of the increase in M;
and some portion of the money will seek an outlet in buying securities or
other assets until r has fallen so as to bring about an increase in the
magnitude of M2 and at the same time to stimulate a rise in Y to such an
extent that the new money is absorbed either in M2 or in the M1 which
corresponds to the rise in Y caused by the fall in r. Thus at one remove this
case comes to the same thing as the alternative case, where the new money
can only be issued in the first instance by a relaxation of the conditions of
credit by the banking system, so as to induce someone to sell the banks a

debt or a bond in exchange for the new cash.
It will, therefore, be safe for us to take the latter case as typical. A
change in M can be assumed to operate by changing r, and a change in r
will lead to a new equilibrium partly by changing M2 and partly by
changing Y and therefore M1. The division of the increment of cash
between M1 and M2 in the new position of equilibrium will depend on the
responses of investment to a reduction in the rate of interest and of
income to an increase in investment. Since Y partly depends on r, it
follows that a given change in M has to cause a sufficient change in r for
the resultant changes in M1 and M2 respectively to add up to the given
change in M.
(ii) It is not always made clear whether the income-velocity of money
is defined as the ratio of Y to M or as the ratio of Y to M1. I propose,
however, to take it in the latter sense. Thus if V is the income-velocity of
money,
L1(Y) = Y = M1.
V
There is, of course, no reason for supposing that V is constant. Its value
will depend on the character of banking and industrial organisation, on
social habits, on the distribution of income between different classes and
on the effective cost of holding idle cash. Nevertheless, if we have a short
period of time in view and can safely assume no material change in any of
these factors, we can treat V as nearly enough constant.
(iii) Finally there is the question of the relation between M2 and r. We
have seen in chapter 13 that uncertainty as to the future course of the rate
of interest is the sole intelligible explanation of the type of liquidity-
preference L2 which leads to the holding of cash M2. It follows that a given
M2 will not have a definite quantitative relation to a given rate of interest
of r; what matters is not the absolute level of r but the degree of its
divergence from what is considered a fairly safe level of r, having regard to
those calculations of probability which are being relied on. Nevertheless,
there are two reasons for expecting that, in any given state of expectation,
a fall in r will be associated with an increase in M2. In the first place, if the
general view as to what is a safe level of r is unchanged, every fall in r
reduces the market rate relatively to the safe rate and therefore increases
the risk of illiquidity; and, in the second place, every fall in r reduces the
current earnings from illiquidity, which are available as a sort of insurance
premium to offset the risk of loss on capital account, by an amount equal

to the difference between the squares of the old rate of interest and the
new. For example, if the rate of interest on a long-term debt is 4 per cent,
it is preferable to sacrifice liquidity unless on a balance of probabilities it is
feared that the long-term rate of interest may rise faster than by 4 per cent
of itself per annum, i.e. by an amount greater than 0.16 per cent per
annum. If, however, the rate of interest is already as low as 2 per cent, the
running yield will only offset a rise in it of as little as 0.04 per cent per
annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of
interest to a very low level. Unless reasons are believed to exist why future
experience will be very different from past experience, a long-term rate of
interest of (say) 2 per cent leaves more to fear than to hope, and offers, at
the same time, a running yield which is only sufficient to offset a very
small measure of fear.
It is evident, then, that the rate of interest is a highly psychological
phenomenon. We shall find, indeed, in Book V that it cannot be in
equilibrium at a level below the rate which corresponds to full
employment; because at such a level a state of true inflation will be
produced, with the result that M1 will absorb ever-increasing quantities of
cash. But at a level above the rate which corresponds to full employment,
the long-term market-rate of interest will depend, not only on the current
policy of the monetary authority, but also on market expectations
concerning its future policy. The short-term rate of interest is easily
controlled by the monetary authority, both because it is not difficult to
produce a conviction that its policy will not greatly change in the very near
future, and also because the possible loss is small compared with the
running yield (unless it is approaching vanishing point). But the long-term
rate may be more recalcitrant when once it has fallen to a level which, on
the basis of past experience and present expectations of future monetary
policy, is considered unsafe by representative opinion. For example, in a
country linked to an international gold standard, a rate of interest lower
than prevails elsewhere will be viewed with a justifiable lack of confidence;
yet a domestic rate of interest dragged up to a parity with the highest rate
(highest after allowing for risk) prevailing in any country belonging to the
international system may be much higher than is consistent with domestic
full employment.
Thus a monetary policy which strikes public opinion as being
experimental in character or easily liable to change may fail in its objective
of greatly reducing the long-term rate of interest, because M2 may tend to
increase almost without limit in response to a reduction of r below a
certain figure. The same policy, on the other hand, may prove easily
successful if it appeals to public opinion as being reasonable and
practicable and in the public interest, rooted in strong conviction, and
promoted by an authority unlikely to be superseded.
It might be more accurate, perhaps, to say that the rate of interest is a
highly conventional, rather than a highly psychological, phenomenon. For
its actual value is largely governed by the prevailing view as to what its
value is expected to be. Any level of interest which is accepted with
sufficient conviction as likely to be durable will be durable; subject, of
course, in a changing society to fluctuations for all kinds of reasons round
the expected normal. In particular, when M1 is increasing faster than M,
the rate of interest will rise, and vice versa. But it may fluctuate for
decades about a level which is chronically too high for full employment;
particularly if it is the prevailing opinion that the rate of interest is self-
adjusting, so that the level established by convention is thought to be
rooted in objective grounds much stronger than convention, the failure of
employment to attain an optimum level being in no way associated, in the
minds either of the public or of authority, with the prevalence of an
inappropriate range of rates of interest.
The difficulties in the way of maintaining effective demand at a level
high enough to provide full employment, which ensue from the association
of a conventional and fairly stable long-term rate of interest with a fickle
and highly unstable marginal efficiency of capital, should be, by now,
obvious to the reader.
Such comfort as we can fairly take from more encouraging reflections
must be drawn from the hope that, precisely because the convention is not
rooted in secure knowledge, it will not be always unduly resistant to a
modest measure of persistence and consistency of purpose by the
monetary authority. Public opinion can be fairly rapidly accustomed to a
modest fall in the rate of interest and the conventional expectation of the
future may be modified accordingly; thus preparing the way for a further
movement up to a point. The fall in the long-term rate of interest in
Great Britain after her departure from the gold standard provides an
interesting example of this; the major movements were effected by a
series of discontinuous jumps, as the liquidity function of the public,
having become accustomed to each successive reduction, became ready to
respond to some new incentive in the news or in the policy of the
authorities.
We can sum up the above in the proposition that in any given state of
expectation there is in the minds of the public a certain potentiality
towards holding cash beyond what is required by the transactions-motive
or the precautionary-motive, which will realise itself in actual cash-
holdings in a degree which depends on the terms on which the monetary
authority is willing to create cash. It is this potentiality which is summed
up in the liquidity function L2. Corresponding to the quantity of money
created by the monetary authority, there will, therefore, be cet. par. a
determlnate rate of interest or, more strictly, a determinate complex of
rates of interest for debts of different maturities. The same thing, however,
would be true of any other factor in the economic system taken separately.
Thus this particular analysis will only be useful and significant in so far as
there is some specially direct or purposive connection between changes in
the quantity of money and changes in the rate of interest. Our reason for
supposing that there is such a special connection arises from the fact that,
broadly speaking, the banking system and the monetary authority are
dealers in money and debts and not in assets or consumables.
If the monetary authority were prepared to deal both ways on
specified terms in debts of all maturities, and even more so if it were
prepared to deal in debts of varying degrees of risk, the relationship
between the complex of rates of interest and the quantity of money would
be direct. The complex of rates of interest would simply be an expression
of the terms on which the banking system is prepared to acquire or part
with debts; and the quantity of money would be the amount which can
find a home in the possession of individuals who after taking account of
all relevant circumstances prefer the control of liquid cash to parting
with it in exchange for a debt on the terms indicated by the market rate of
interest. Perhaps a complex offer by the central bank to buy and sell at
stated prices gilt-edged bonds of all maturities, in place of the single bank
rate for short-term bills, is the most important practical improvement
which can be made in the technique of monetary management.
To-day, however, in actual practice, the extent to which the price of
debts as fixed by the banking system is effective in the market, in the
sense that it governs the actual market-price, varies in different systems.
Sometimes the price is more effective in one direction than in the other;
that is to say, the banking system may undertake to purchase debts at a
certain price but not necessarily to sell them at a figure near enough to its
buying-price to represent no more than a dealers turn, though there is no
reason why the price should not be made effective both ways with the aid
of open-market operations. There is also the more important qualification
which arises out of the monetary authority not being, as a rule, an equally
willing dealer in debts of all maturities. The monetary authority often
tends in practice to concentrate upon short-term debts and to leave the
price of long-term debts to be influenced by belated and imperfect
reactions from the price of short-term debts; though here again there is
no reason why they need do so. Where these qualifications operate, the
directness of the relation between the rate of interest and the quantity of
money is correspondingly modified. In Great Britain the field of deliberate
control appears to be widening. But in applying this theory in any
particular case allowance must be made for the special characteristics of
the method actually employed by the monetary authority. If the monetary
authority deals only in short-term debts, we have to consider what
influence the price, actual and prospective, of short-term debts exercises
on debts of longer maturity.
Thus there are certain limitations on the ability of the monetary
authority to establish any given complex of rates of interest for debts of
different terms and risks, which can be summed up as follows:
(1) There are those limitations which arise out of the monetary
authoritys own practices in limiting its willingness to deal to debts of a
particular type.
(2) There is the possibility, for the reasons discussed above, that, after
the rate of interest has fallen to a certain level, liquidity-preference may
become virtually absolute in the sense that almost everyone prefers cash to
holding a debt which yields so low a rate of interest. In this event the
monetary authority would have lost effective control over the rate of
interest. But whilst this limiting case might become practically important
in future, I know of no example of it hitherto. Indeed, owing to the
unwillingness of most monetary authorities to deal boldly in debts of long
term, there has not been much opportunity for a test. Moreover, if such a
situation were to arise, it would mean that the public authority itself could
borrow through the banking system on an unlimited scale at a nominal
rate of interest.
(3) The most striking examples of a complete breakdown of stability
in the rate of interest, due to the liquidity function flattening out in one
direction or the other, have occurred in very abnormal circumstances. In
Russia and Central Europe after the war a currency crisis or flight from the
currency was experienced, when no one could be induced to retain
holdings either of money or of debts on any terms whatever, and even a
high and rising rate of interest was unable to keep pace with the marginal
efficiency of capital (especially of stocks of liquid goods) under the
influence of the expectation of an ever greater fall in the value of money;
whilst in the United States at certain dates in 1932 there was a crisis of the
opposite kind a financial crisis or crisis of liquidation, when scarcely
anyone could be induced to part with holdings of money on any reasonable
terms.
(4) There is, finally, the difficulty discussed in section IV of chapter 11,
p. 144, in the way of bringing the effective rate of interest below a certain
figure, which may prove important in an era of low interest-rates; namely
the intermediate costs of bringing the borrower and the ultimate lender
together, and the allowance for risk, especially for moral risk, which the
lender requires over and above the pure rate of interest. As the pure rate of
interest declines it does not follow that the allowances for expense and risk
decline pari passu. Thus the rate of interest which the typical borrower
has to pay may decline more slowly than the pure rate of interest, and may
be incapable of being brought, by the methods of the existing banking and
financial organisation, below a certain minimum figure. This is
particularly important if the estimation of moral risk is appreciable. For
where the risk is due to doubt in the mind of the lender concerning the
honesty of the borrower, there is nothing in the mind of a borrower who
does not intend to be dishonest to offset the resultant higher charge. It is
also important in the case of short-term loans (e.g. bank loans) where the
expenses are heavy; a bank may have to charge its customers 1 to 2
per cent., even if the pure rate of interest to the lender is nil.
At the cost of anticipating what is more properly the subject of chapter 21

below it may be interesting briefly at this stage to indicate the relationship
of the above to the quantity theory of money.
In a static society or in a society in which for any other reason no one
feels any uncertainty about the future rates of interest, the liquidity
function L2, or the propensity to hoard (as we might term it), will always
be zero in equilibrium. Hence in equilibrium M2 = 0 and M = M1; so that
any change in M will cause the rate of interest to fluctuate until income
reaches a level at which the change in M1 is equal to the supposed change
in M. Now M1 V = Y, where V is the income-velocity of money as defined
above and Y is the aggregate income. Thus if it is practicable to measure

the quantity, O, and the price, P, of current output, we have Y = OP, and,
therefore, MV = OP; which is much the same as the quantity theory of
money in its traditional form.
For the purposes of the real world it is a great fault in the quantity
theory that it does not distinguish between changes in prices which are a
function of changes in output, and those which are a function of changes in
the wage-unit. The explanation of this omission is, perhaps, to be found in
the assumptions that there is no propensity to hoard and that there is
always full employment. For in this case, O being constant and M2 being
zero, it follows, if we can take V also as constant, that both the wage-unit
and the price-level will be directly proportional to the quantity of money.

C 16
S O N
C
An act of individual saving means so to speak a decision not to have

dinner to-day. But it does not necessitate a decision to have dinner or to
buy a pair of boots a week hence or a year hence or to consume any
specified thing at any specified date. Thus it depresses the business of
preparing to-days dinner without stimulating the business of making
ready for some future act of consumption. It is not a substitution of future
consumption-demand for present consumption-demand it is a net
diminution of such demand. Moreover, the expectation of future
consumption is so largely based on current experience of present
consumption that a reduction in the latter is likely to depress the former,
with the result that the act of saving will not merely depress the price of
consumption-goods and leave the marginal efficiency of existing capital
unaffected, but may actually tend to depress the latter also. In this event it
may reduce present investment-demand as well as present consumption-
demand.
If saving consisted not merely in abstaining from present
consumption but in placing simultaneously a specific order for future
consumption, the effect might indeed be different. For in that case the
expectation of some future yield from investment would be improved, and
the resources released from preparing for present consumption could be
turned over to preparing for the future consumption. Not that they
necessarily would be, even in this case, on a scale equal to the amount of
resources released; since the desired interval of delay might require a
method of production so inconveniently roundabout as to have an
efficiency well below the current rate of interest, with the result that the
favourable effect on employment of the forward order for consumption
would eventuate not at once but at some subsequent date, so that the
immediate effect of the saving would still be adverse to employment. In
any case, however, an individual decision to save does not, in actual fact,
involve the placing of any specific forward order for consumption, but
merely the cancellation of a present order. Thus, since the expectation of
consumption is the only raison dtre of employment, there should be
nothing paradoxical in the conclusion that a diminished propensity to
consume has cet. par. a depressing effect on employment.
The trouble arises, therefore, because the act of saving implies, not a
substitution for present consumption of some specific additional
consumption which requires for its preparation just as much immediate
economic activity as would have been required by present consumption
equal in value to the sum saved, but a desire for wealth as such, that is for
a potentiality of consuming an unspecified article at an unspecified time.
The absurd, though almost universal, idea that an act of individual saving
is just as good for effective demand as an act of individual consumption,
has been fostered by the fallacy, much more specious than the conclusion
derived from it, that an increased desire to hold wealth, being much the
same thing as an increased desire to hold investments, must, by increasing
the demand for investments, provide a stimulus to their production; so
that current investment is promoted by individual saving to the same
extent as present consumption is diminished.
It is of this fallacy that it is most difficult to disabuse mens minds. It
comes from believing that the owner of wealth desires a capital-asset as
such, whereas what he really desires is its prospective yield. Now,
prospective yield wholly depends on the expectation of future effective
demand in relation to future conditions of supply. If, therefore, an act of
saving does nothing to improve prospective yield, it does nothing to
stimulate investment. Moreover, in order that an individual saver may
attain his desired goal of the ownership of wealth, it is not necessary that a
new capital-asset should be produced wherewith to satisfy him. The mere
act of saving by one individual, being two-sided as we have shown above,
forces some other individual to transfer to him some article of wealth old
or new. Every act of saving involves a forced inevitable transfer of wealth
to him who saves, though he in his turn may suffer from the saving of
others. These transfers of wealth do not require the creation of new wealth
indeed, as we have seen, they may be actively inimical to it. The creation
of new wealth wholly depends on the prospective yield of the new wealth
reaching the standard set by the current rate of interest. The prospective
yield of the marginal new investment is not increased by the fact that
someone wishes to increase his wealth, since the prospective yield of the
marginal new investment depends on the expectation of a demand for a
specific article at a specific date.
Nor do we avoid this conclusion by arguing that what the owner of
wealth desires is not a given prospective yield but the best available
prospective yield, so that an increased desire to own wealth reduces the
prospective yield with which the producers of new investment have to be
content. For this overlooks the fact that there is always an alternative to
the ownership of real capital-assets, namely the ownership of money and
debts; so that the prospective yield with which the producers of new
investment have to be content cannot fall below the standard set by the
current rate of interest. And the current rate of interest depends, as we
have seen, not on the strength of the desire to hold wealth, but on the
strengths of the desires to hold it in liquid and in illiquid forms
respectively, coupled with the amount of the supply of wealth in the one
form relatively to the supply of it in the other. If the reader still finds
himself perplexed, let him ask himself why, the quantity of money bcing
unchanged, a fresh act of saving should diminish the sum which it is
desired to keep in liquid form at the existing rate of interest.
Certain deeper perplexities, which may arise when we try to probe still
further into the whys and wherefores, will be considered in the next
chapter.
It is much preferable to speak of capital as having a yield over the course of

its life in excess of its original cost, than as being productive. For the only
reason why an asset offers a prospect of yielding during its life services
having an aggregate value greater than its initial supply price is because it
is scarce; and it is kept scarce because of the competition of the rate of
interest on money. If capital becomes less scarce, the excess yield will
diminish, without its having become less productive at least in the
physical sense.
I sympathise, therefore, with the pre-classical doctrine that everything
is produced by labour, aided by what used to be called art and is now
called technique, by natural resources which are free or cost a rent
according to their scarcity or abundance, and by the results of past labour,
embodied in assets, which also command a price according to their
scarcity or abundance. It is preferable to regard labour, including, of
course, the personal services of the entrepreneur and his assistants, as the
sole factor of production, operating in a given environment of technique,
natural resources, capital equipment and effective demand. This partly
explains why we have been able to take the unit of labour as the sole
physical unit which we require in our economic system, apart from units of
money and of time.
It is true that some lengthy or roundabout processes are physically
efficient. But so are some short processes. Lengthy processes are not
physically efficient because they are long. Some, probably most, lengthy
processes would be physically very inefficient, for there are such things as
spoiling or wasting with time. With a given labour force there is a definite
limit to the quantity of labour embodied in roundabout processes which
can be used to advantage. Apart from other considerations, there must be
a due proportion between the amount of labour employed in making
machines and the amount which will be employed in using them. The
ultimate quantity of value will not increase indefinitely, relatively to the
quantity of labour employed, as the processes adopted become more and
more roundabout, even if their physical efficiency is still increasing. Only if
the desire to postpone consumption were strong enough to produce a
situation in which full employment required a volume of investment so
great as to involve a negative marginal efficiency of capital, would a
process become advantageous merely because it was lengthy; in which
event we should employ physically inefficient processes, provided they
were sufficiently lengthy for the gain from postponement to outweigh their
inefficiency. We should in fact have a situation in which short processes
would have to be kept sufficiently scarce for their physical efficiency to
outweigh the disadvantage of the early delivery of their product. A correct
theory, therefore, must be reversible so as to be able to cover the eases of
the marginal efficiency of capital corresponding either to a positive or to a
negative rate of interest; and it is, I think, only the scarcity theory outlined
above which is capable of this.
Moreover there are all sorts of reasons why various kinds of services
and facilities are scarce and therefore expensive refatively to the quantity
of labour involved. For example, smelly processes command a higher
reward, because people will not undertake them otherwise. So do risky
processes. But we do not devise a productivity theory of smelly or risky
processes as such. In short, not all labour is accomplished in equally
agreeable attendant circumstances; and conditions of equilibrium require
that articles produced in less agreeable attendant circumstances
(characterised by smelliness, risk or the lapse of time) must be kept
sufficiently scarce to command a higher price. But if the lapse of time

becomes an agreeable attendant circumstance, which is a quite possible
case and already holds for many individuals, then, as I have said above, it
is the short processes which must be kept sufficiently scarce.
Given the optimum amount of roundaboutness, we shall, of course,
select the most efficient roundabout processes which we can find up to the
required aggregate. But the optimum amount itself should be such as to
provide at the appropriate dates for that part of consumers demand which
it is desired to defer. In optimum conditions, that is to say, production
should be so organised as to produce in the most efficient manner
compatible with delivery at the dates at which consumers demand is
expected to become effective. It is no use to produce for delivery at a
different date from this, even though the physical output could be
increased by changing the date of delivery; except in so far as the
prospect of a larger meal, so to speak, induces the consumer to anticipate
or postpone the hour of dinner. If, after hearing full particulars of the
meals he can get by fixing dinner at different hours, the consumer is
expected to decide in favour of 8 oclock, it is the business of the cook to
provide the best dinner he can for service at that hour, irrespective of
whether 7.30, 8 oclock or 8.30 is the hour which would suit him best if
time counted for nothing, one way or the other, and his only task was to
produce the absolutely best dinner. In some phases of society it may be
that we could get physically better dinners by dining later than we do; but
it is equally conceivable in other phases that we could get better dinners by
dining earlier. Our theory must, as I have said above, be applicable to both
contingencies.
If the rate of interest were zero, there would be an optimum interval
for any given article between the average date of input and the date of
consumption, for which labour cost would be a minimum; a shorter
process of production would be less efficient technically, whilst a longer
process would also be less efficient by reason of storage costs and
deterioration. If, however, the rate of interest exceeds zero, a new element
of cost is introduced which increases with the length of the process, so that
the optimum interval will be shortened, and the current input to provide
for the eventual delivery of the article will have to be curtailed until the
prospective price has increased sufficiently to cover the increased cost a
cost which will be increased both by the interest charges and also by the
diminished efficiency of the shorter method of production. Whilst if the
rate of interest falls below zero (assuming this to be technically possible),
the opposite is the case. Given the prospective consumers demand,
current input to-day has to compete, so to speak, with the alternative of

starting input at a later date; and, consequently, current input will only be
worth while when the greater cheapness, by reason of greater technical
efficiency or prospective price changes, of producing later on rather than
now, is insufficient to offset the smaller return from negative interest. In
the case of the great majority of articles it would involve great technical
inefficiency to start up their input more than a very modest length of time
ahead of their prospective consumption. Thus even if the rate of interest is
zero, there is a strict limit to the proportion of prospective consumers
demand which it is profitable to begin providing for in advance; and, as
the rate of interest rises, the proportion of the prospective consumers
demand for which it pays to produce to-day shrinks pari passu.
We have seen that capital has to be kept scarce enough in the long-period
to have a marginal efficiency which is at least equal to the rate of interest
for a period equal to the life of the capital, as determined by psychological
and institutional conditions. What would this involve for a society which
finds itself so well equipped with capital that its marginal efficiency is zero
and would be negative with any additional investment; yet possessing a
monetary system, such that money will keep and involves negligible costs
of storage and safe custody, with the result that in practice interest cannot
be negative; and, in conditions of full employment, disposed to save?
If, in such circumstances, we start from a position of full employment,
entrepreneurs will necessarily make losses if they continue to offer
employment on a scale which will utilise the whole of the existing stock of
capital. Hence the stock of capital and the level of employment will have to
shrink until the community becomes so impoverished that the aggregate of
saving has become zero, the positive saving of some individuals or groups
being offset by the negative saving of others. Thus for a society such as we
have supposed, the position of equilibrium, under conditions of laissez-
faire, will be one in which employment is low enough and the standard of
life sufficiently miserable to bring savings to zero. More probably there will
be a cyclical movement round this equilibrium position. For if there is still
room for uncertainty about the future, the marginal efficiency of capital
will occasionally rise above zero leading to a boom, and in the succeeding
slump the stock of capital may fall for a time below the level which will
yield a marginal efficiency of zero in the long run. Assuming correct
foresight, the equilibrium stock of capital which will have a marginal

efficiency of precisely zero will, of course, be a smaller stock than would
correspond to full employment of the available labour; for it will be the
equipment which corresponds to that proportion of unemployment which
ensures zero saving.
The only alternative position of equilibrium would be given by a
situation in which a stock of capital sufficiently great to have a marginal
efficiency of zero also represents an amount of wealth sufficiently great to
satiate to the full the aggregate desire on the part of the public to make
provision for the future, even with full employment, in circumstances
where no bonus is obtainable in the form of interest. It would, however, be
an unlikely coincidence that the propensity to save in conditions of full
employment should become satisfied just at the point where the stock of
capital reaches the level where its marginal efficiency is zero. If, therefore,
this more favourable possibility comes to the rescue, it will probably take
effect, not just at the point where the rate of interest is vanishing, but at
some previous point during the gradual decline of the rate of interest.
We have assumed so far an institutional factor which prevents the rate
of interest from being negative, in the shape of money which has negligible
carrying costs. In fact, however, institutional and psychological factors are
present which set a limit much above zero to the practicable decline in the
rate of interest. In particular the costs of bringing borrowers and lenders
together and uncertainty as to the future of the rate of interest, which we
have examined above, set a lower limit, which in present circumstances
may perhaps be as high as 2 or 2 per cent on long term. If this should
prove correct, the awkward possibilities of an increasing stock of wealth, in
conditions where the rate of interest can fall no further under laissez-faire,
may soon be realised in actual experience Moreover if the minimum level
to which it is practicable to bring the rate of interest is appreciably above
zero, there is less likelihood of the aggregate desire to accumulate wealth
being satiated before the rate of interest has reached its minimum level.
The post-war experiences of Great Britain and the United States are,
indeed, actual examples of how an accumulation of wealth, so large that its
marginal efficiency has fallen more rapidly than the rate of interest can fall
in the face of the prevailing institutional and psychological factors, can
interfere, in conditions mainly of laissez-faire, with a reasonable level of
employment and with the standard of life which the technical conditions of
production are capable of furnishing.
It follows that of two equal communities, having the same technique
but different stocks of capital, the community with the smaller stocks of
capital may be able for the time being to enjoy a higher standard of life
than the community with the larger stock; though when the poorer
community has caught up the rich as, presumably, it eventually will
then both alike will suffer the fate of Midas. This disturbing conclusion
depends, of course, on the assumption that the propensity to consume and
the rate of investment are not deliberately controlled in the social interest
but are mainly left to the influences of laissez-faire.
If for whatever reason the rate of interest cannot fall as fast as
the marginal efficiency of capital would fall with a rate of accumulation
corresponding to what the community would choose to save at a rate of
interest equal to the marginal efficiency of capital in conditions of full
employment, then even a diversion of the desire to hold wealth towards
assets, which will in fact yield no economic fruits whatever, will increase
economic well-being. In so far as millionaires find their satisfaction in
building mighty mansions to contain their bodies when alive and pyramids
to shelter them after death, or, repenting of their sins, erect cathedrals and
endow monasteries or foreign missions, the day when abundance of
capital will interfere with abundance of output may be postponed. To dig
holes in the ground, paid for out of savings, will increase, not only
employment, but the real national dividend of useful goods and services. It
is not reasonable, however, that a sensible community should be content
to remain dependent on such fortuitous and often wasteful mitigations
when once we understand the influences upon which effective demand
depends.
Let us assume that steps are taken to ensure that the rate of interest is
consistent with the rate of investment which corresponds to full
employment. Let us assume, further, that State action enters in as a
balancing factor to provide that the growth of capital equipment shall be
such as to approach saturation-point at a rate which does not put a
disproportionate burden on the standard of life of the present generation.
On such assumptions I should guess that a properly run community
equipped with modern technical resources, of which the population is not
increasing rapidJy, ought to be able to bring down the marginal efficiency
of capital in equilibrium approximately to zero within a single generation;
so that we should attain the conditions of a quasi-stationary community
where change and progress would result only from changes in technique,
taste, population and institutions, with the products of capital selling at a

price proportioned to the labour, etc., embodied in them on just the same
principles as govern the prices of consumption-goods into which capital-
charges enter in an insignificant degree.
If I am right in supposing it to be comparatively easy to make capital-
goods so abundant that the marginal efficiency of capital is zero, this may
be the most sensible way of gradually getting rid of many of the
objectionable features of capitalism. For a little reflection will show what
enormous social changes would result from a gradual disappearance of a
rate of return on accumulated wealth. A man would still be free to
accumulate his earned income with a view to spending it at a later date.
But his accumulation would not grow. He would simply be in the position
of Popes father, who, when he retired from business, carried a chest of
guineas with him to his villa at Twickenham and met his household
expenses from it as required.
Though the rentier would disappear, there would still be room,
nevertheless, for enterprise and skill in the estimation of prospective yields
about which opinions could differ. For the above relates primarily to the
pure rate of interest apart from any allowance for risk and the like, and not
to the gross yield of assets including the return in respect of risk. Thus
unless the pure rate of interest were to be held at a negative figure, there
would still be a positive yield to skilled investment in individual assets
having a doubtful prospective yield. Provided there was some measurable
unwillingness to undertake risk, there would also be a positive net yield
from the aggregate of such assets over a period of time. But it is not
unlikely that, in such circumstances, the eagerness to obtain a yield from
doubtful investments might be such that they would show in the aggregate
a negative net yield.

C 17
T E P I
M
It seems, then, that the rate of interest on money plays a peculiar part in
setting a limit to the level of employment, since it sets a standard to which
the marginal efficiency of a capital-asset must attain if it is to be newly
produced. That this should be so, is, at first sight, most perplexing. It is
natural to enquire wherein the peculiarity of money lies as distinct from
other assets, whether it is only money which has a rate of interest, and
what would happen in a non-monetary economy. Until we have answered
these questions, the full significance of our theory will not be clear.
The money-rate of interest we may remind the reader is nothing
more than the percentage excess of a sum of money contracted for forward
delivery, e.g. a year hence, over what we may call the spot or cash price of
the sum thus contracted for forward delivery. It would seem, therefore,
that for every kind of capital-asset there must be an analogue of the rate of
interest on money. For there is a definite quantity of (e.g.) wheat to be
delivered a year hence which has the same exchange value to-day as 100
quarters of wheat for spot delivery. If the former quantity is 105 quarters,
we may say that the wheat-rate of interest is 5 per cent per annum; and if
jt is 95 quarters, that it is minus 5 per cent per annum. Thus for every
durable commodity we have a rate of interest in terms of itself; a wheat-
rate of interest, a copper-rate of interest, a house-rate of interest, even a
steel-plant-rate of interest.
The difference between the future and spot contracts for a
commodity, such as wheat, which are quoted in the market, bears a
definite relation to the wheat-rate of interest, but, since the future contract
is quoted in terms of money for forward delivery and not in terms of wheat
for spot delivery, it also brings in the money-rate of interest. The exact
relationship is as follows:
Let us suppose that the spot price of wheat is 100 per 100 quarters,
that the price of the future contract for wheat for delivery a year hence is
107 per 100 quarters, and that the money-rate of interest is 5 per cent;
what is the wheat-rate of interest? 100 spot will buy 105 for forward
delivery, and 105 for forward delivery will buy 105/107 100 ( = 98)
quarters for forward delivery. Alternatively 100 spot will buy 100
quarters of wheat for spot delivery. Thus 100 quarters of wheat for spot
delivery will buy 98 quarters for forward delivery. It follows that the
wheat-rate of interest is minus 2 per cent per annum.
It follows from this that there is no reason why their rates of interest
should be the same for different commodities why the wheat-rate of
interest should be equal to the copper-rate of interest. For the relation
between the spot and future contracts, as quoted in the market, is
notoriously different for different commodities. This, we shall find, will
lead us to the clue we are seeking. For it may be that it is the greatest of
the own-rates of interest (as we may call them) which rules the roost
(because it is the greatest of these rates that the marginal efficiency of a
capital-asset must attain if it is to be newly produced); and that there are
reasons why it is the money-rate of interest which is often the greatest
(because, as we shall find, certain forces, which operate to reduce the own-
rates of interest of other assets, do not operate in the case of money).
It may be added that, just as there are differing commodity-rates of
interest at any time, so also exchange dealers are familiar with the fact that
the rate of interest is not even the same in terms of two different moneys,
e.g. sterling and dollars. For here also the difference between the spot and
future contracts for a foreign money in terms of sterling are not, as a rule,
the same for different foreign moneys.
Now each of these commodity standards offers us the same facility as
money for measuring the marginal efficiency of capital. For we can take
any commodity we choose, e.g. wheat; calculate the wheat-value of the
prospective yields of any capital asset; and the rate of discount which
makes the present value of this series of wheat annuities equal to the
present supply price of the asset in terms of wheat gives us the marginal
efficiency of the asset in terms of wheat. If no change is expected in the
relative value of two alternative standards, then the marginal efficiency of
a capital-asset will be the same in whichever of the two standards it is
measured, since the numerator and denominator of the fraction which
leads up to the marginal efficiency will be changed in the same proportion.
If, however, one of the alternative standards is expected to change in value

in terms of the other, the marginal efficiencies of capital-assets will be
changed by the same percentage, according to which standard they are
measured in. To illustrate this let us take the simplest case where wheat,
one of the alternative standards, is expected to appreciate at a steady rate
of a per cent per annum in terms of money; the marginal efficiency of an
asset, which is x per cent in terms of money, will then be x a per cent in
terms of wheat. Since the marginal efficiencies of all capital-assets will be
altered by the same amount, it follows that their order of magnitude will
be the same irrespective of the standard which is selected.
If there were some composite commodity which could be regarded
strictly speaking as representative, we could regard the rate of interest and
the marginal efficiency of capital in terms of this commodity as being, in a
sense, uniquely the rate of interest and the marginal efficiency of capital.
But there are, of course, the same obstacles in the way of this as there are
to setting up a unique standard of value.
So far, therefore, the money-rate of interest has no uniqueness
compared with other rates of interest, but is on precisely the same footing.
Wherein, then, lies the peculiarity of the money-rate of interest which
gives it the predominating practical importance attributed to it in the
preceding chapters? Why should the volume of output and employment be
more intimately bound up with the money-rate of interest than with the
wheat-rate of interest or the house-rate of interest?
Let us consider what the various commodity-rates of interest over a period

of (say) a year are likely to be for different types of assets. Since we are
taking each commodity in turn as the standard, the returns on each
commodity must be reckoned in this context as being measured in terms
of itself.
There are three attributes which different types of assets possess in
different degrees; namely, as follows:
(i) Some assets produce a yield or output q, measured in terms of
themselves, by assisting some process of production or supplying services
to a consumer.
(ii) Most assets, except money, suffer some wastage or involve some
cost through the mere passage of time (apart from any change in their
relative value), irrespective of their being used to produce a yield; i.e. they
involve a carrying cost c measured in terms of themselves. It does not

matter for our present purpose exactly where we draw the line between the
costs which we deduct before calculating q and those which we include in
c, since in what follows we shall be exclusively concerned with q c.
(iii) Finally, the power of disposal over an asset during a period may
offer a potential convenience or security, which is not equal for assets of
different kinds, though the assets themselves are of equal initial value.
There is, so to speak, nothing to show for this at the end of the period in
the shape of output; yet it is something for which people are ready to pay
something. The amount (measured in terms of itself) which they are
willing to pay for the potential convenience or security given by this power
of disposal (exclusive of yield or carrying cost attaching to the asset), we
shall call its liquidity-premium l.
It follows that the total return expected from the ownership of an
asset over a period is equal to its yield minus its carrying cost plus its
liquidity-premium, i.e. to q c + l. That is to say, q c + l is the own-rate
of interest of any commodity, where q, c and l are measured in terms of
itself as the standard.
It is characteristic of instrumental capital (e.g. a machine) or of
consumption capital (e.g. a house) which is in use, that its yield should
normally exceed its carrying cost, whilst its liquidity-premium is probably
negligible; of a stock of liquid goods or of surplus laid-up instrumental or
consumption capital that it should incur a carrying cost in terms of itself
without any yield to set off against it, the liquidity-premium in this case
also being usually negligible as soon as stocks exceed a moderate level,
though capable of being significant in special circumstances; and of money
that its yield is nil and its carrying cost negligible, but its liquidity-
premium substantial. Different commodities may, indeed, have differing
degrees of liquidity-premium amongst themselves, and money may incur
some degree of carrying costs, e.g. for safe custody. But it is an essential
difference between money and all (or most) other assets that in the case of
money its liquidity-premium much exceeds its carrying cost, whereas in
the case of other assets their carrying cost much exceeds their liquidity-
premium. Let us, for purposes of illustration, assume that on houses the
yield is q1 and the carrying cost and liquidity-premium negligible; that on
wheat the carrying cost is c2 and the yield and liquidity-premium
negligible; and that on money the liquidity-premium is l3 and the yield and
carrying cost negligible. That is to say, q1 is the house-rate of interest, c2
the wheat-rate of interest, and l3 the money-rate of interest.
To determine the relationships between the expected returns on

different types of assets which are consistent with equilibrium, we must
also know what the changes in relative values during the year are expected
to be. Taking money (which need only be a money of account for this
purpose, and we could equally well take wheat) as our standard of
measurement, let the expected percentage appreciation (or depreciation)
of houses be a1 and of wheat a2. q1, c2 and l3 we have called the own-
rates of interest of houses, wheat and money in terms of themselves as the
standard of value; i.e. q1 is the house-rate of interest in terms of houses,
c2 is the wheat-rate of interest in terms of wheat, and l3 is the money-
rate of interest in terms of money. It will also be useful to call a1 + q1,
a2 c2 and l3, which stand for the same quantities reduced to money as the
standard of value, the house-rate of money-interest, the wheat-rate of
money-interest and the money-rate of money-interest respectively. With
this notation it is easy to see that the demand of wealth-owners will be
directed to houses, to wheat or to money, according as a1 + q1 or a2 c2 or
l3 is greatest. Thus in equilibrium the demand-prices of houses and wheat
in terms of money will be such that there is nothing to choose in the way of
advantage between the alternatives; i.e. a1 + q1, a2 c2 and l3 will be
equal. The choice of the standard of value will make no difference to this
result because a shift from one standard to another will change all the
terms equally, i.e. by an amount equal to the expected rate of appreciation
(or depreciation) of the new standard in terms of the old.
Now those assets of which the normal supply-price is less than the
demand-price will be newly produced; and these will be those assets of
which the marginal efficiency would be greater (on the basis of their
normal supply-price) than the rate of interest (both being measured in the
same standard of value whatever it is). As the stock of the assets, which
begin by having a marginal efficiency at least equal to the rate of interest,
is increased, their marginal efficiency (for reasons, sufficiently obvious,
already given) tends to fall. Thus a point will come at which it no longer
pays to produce them, unless the rate of interest falls pari passu. When
there is no asset of which the marginal efficiency reaches the rate of
interest, the further production of capital-assets will come to a standstill.
Let us suppose (as a mere hypothesis at this stage of the argument)
that there is some asset (e.g. money) of which the rate of interest is fixed
(or declines more slowly as output increases than does any other
commoditys rate of interest); how is the position adjusted? Since a1 + q1,
a2 c2 and l3 are necessarily equal, and since l3 by hypothesis is either

fixed or falling more slowly than q1 or c2, it follows that a1 and a2 must
be rising. In other words, the present money-price of every commodity
other than money tends to fall relatively to its expected future price.
Hence, if q1 and c2 continue to fall, a point comes at which it is not
profitable to produce any of the commodities, unless the cost of
production at some future date is expected to rise above the present cost
by an amount which will cover the cost of carrying a stock produced now
to the date of the prospective higher price.
It is now apparent that our previous statement to the effect that it is
the money-rate of interest which sets a limit to the rate of output, is not
strictly correct. We should have said that it is that assets rate of interest
which declines most slowly as the stock of assets in general increases,
which eventually knocks out the profitable production of each of the others
except in the contingency, just mentioned, of a special relationship
between the present and prospective costs of production. As output
increases, own-rates of interest decline to levels at which one asset after
another falls below the standard of profitable production; until, finally,
one or more own-rates of interest remain at a level which is above that of
the marginal efficiency of any asset whatever.
If by money we mean the standard of value, it is clear that it is not
necessarily the money-rate of interest which makes the trouble. We could
not get out of our difficulties (as some have supposed) merely by decreeing
that wheat or houses shall be the standard of value instead of gold or
sterling. For, it now appears that the same difficulties will ensue if there
continues to exist any asset of which the own-rate of interest is reluctant
to decline as output increases. It may be, for example, that gold will
continue to fill this r6le in a country which has gone over to an
inconvertible paper standard.
In attributing, therefore, a peculiar significance to the money-rate of

interest, we have been tacitly assuming that the kind of money to which we
are accustomed has some special characteristics which lead to its own-rate
of interest in terms of itself as standard being more reluctant to fall as the
stock of assets in general increases than the own-rates of interest of any
other assets in terms of themselves. Is this assumption justified?
Reflection shows, I think, that the following peculiarities, which commonly
characterise money as we know it, are capable of justifying it. To the extent
that the established standard of value has these peculiarities, the summary
statement, that it is the money-rate of interest which is the significant rate
of interest, will hold good.
(i) The first characteristic which tends towards the above conclusion is
the fact that money has, both in the long and in the short period, a zero, or
at any rate a very small, elasticity of production, so far as the power of
private enterprise is concerned, as distinct from the monetary authority;
elasticity of production meaning, in this context, the response of the
quantity of labour applied to producing it to a rise in the quantity of labour
which a unit of it will command. Money, that is to say, cannot be readily
produced; labour cannot be turned on at will by entrepreneurs to
produce money in increasing quantities as its price rises in terms of the
wage-unit. In the case of an inconvertible managed currency this condition
is strictly satisfied. But in the case of a gold-standard currency it is also
approximately so, in the sense that the maximum proportional addition to
the quantity of labour which can be thus employed is very small, except
indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the
reason why we assumed their own-rate of interest to decline was because
we assumed the stock of them to increase as the result of a higher rate of
output. In the case of money, however postponing, for the moment, our
consideration of the effects of reducing the wage-unit or of a deliberate
increase in its supply by the monetary authority the supply is fixed.
Thus the characteristic that money cannot be readily produced by labour
gives at once some prima facie presumption for the view that its own-rate
of interest will be relatively reluctant to fall; whereas if money could be
grown like a crop or manufactured like a motor-car, depressions would be
avoided or mitigated because, if the price of other assets was tending to fall
in terms of money, more labour would be diverted into the production of
money; as we see to be the case in gold-mining countries, though for the
world as a whole the maximum diversion in this way is almost negligible.
(ii) Obviously, however, the above condition is satisfied, not only by
money, but by all pure rent-factors, the production of which is completely
inelastic. A second condition, therefore, is required to distinguish money
from other rent elements.
The second differentia of money is that it has an elasticity of
substitution equal, or nearly equal, to zero which means that as the
exchange value of money rises there is no tendency to substitute some
other factor for it; except, perhaps, to some trifling extent, where the
money-commodity is also used in manufacture or the arts. This follows

from the peculiarity of money that irs utility is solely derived from its
exchange-value, so that the two rise and fall pari passu, with the result
that as the exchange value of money rises there is no motive or tendency,
as in the case of rent-factors, to substitute some other factor for it.
Thus, not only is it impossible to turn more labour on to producing
money when its labour-price rises, but money is a bottomless sink for
purchasing power, when the demand for it increases, since there is no
value for it at which demand is diverted as in the case of other rent-
factors so as to slop over into a demand for other things.
The only qualification to this arises when the rise in the value of
money leads to uncertainty as to the future maintenance of this rise; in
which event, a1 and a2 are increased, which is tantamount to an increase in
the commodity-rates of money-interest and is, therefore, stimulating to
the output of other assets.
(iii) Thirdly, we must consider whether these conclusions are upset by
the fact that, even though the quantity of money cannot be increased by
diverting labour into pro4ucing it, nevertheless an assumption that its
effective supply is rigidly fixed would be inaccurate. In particular, a
reduction of the wage-unit will release cash from its other uses for the
satisfaction of the liquidity-motive; whilst, in addition to this, as money-
values fall, the stock of money will bear a higher proportion to the total
wealth of the community.
It is not possible to dispute on purely theoretical grounds that this
reaction might be capable of allowing an adequate decline in the money-
rate of interest. There are, however, several reasons, which taken in
combination are of compelling force, why in an economy of the type to
which we are accustomed it is very probable that the money-rate of
interest will often prove reluctant to decline adequately:
(a) We have to allow, first of all, for the reactions of a fall in the wage-
unit on the marginal efficiencies of other assets in terms of money; for it
is the difference between these and the money-rate of interest with which
we are concerned. If the effect of the fall in the wage-unit is to produce an
expectation that it will subsequently rise again, the result will be wholly
favourable. If, on the contrary, the effect is to produce an expectation of a
further fall, the reaction on the marginal efficiency of capital may offset the
decline in the rate of interest.
(b) The fact that wages tend to be sticky in terms of money, the
money-wage being more stable than the real wage, tends to limit the
readiness of the wage-unit to fall in terms of money. Moreover, if this were

not so, the position might be worse rather than better; because, if money-
wages were to fall easily, this might often tend to create an expectation of a
further fall with unfavourable reactions on the marginal efficiency of
capital.
Furthermore, if wages were to be fixed in terms of some other
commodity, e.g. wheat, it is improbable that they would continue to be
sticky. It is because of moneys other characteristics those, especially,
which make it liquid that wages, when fixed in terms of it, tend to be
sticky.
(c) Thirdly, we come to what is the most fundamental consideration in
this context, namely, the characteristics of money which satisfy liquidity-
preference. For, in certain circumstances such as will often occur, these
will cause the rate of interest to be insensitive, particularly below a certain
figure, even to a substantial increase in the quantity of money in
proportion to other forms of wealth. In other words, beyond a certain
point moneys yield from liquidity does not fall in response to an increase
in its quantity to anything approaching the extent to which the yield from
other types of assets falls when their quantity is comparably increased.
In this connection the low (or negligible) carrying-costs of money play
an essential part. For if its carrying costs were material, they would offset
the effect of expectations as to the prospective value of money at future
dates. The readiness of the public to increase their stock of money in
response to a comparatively small stimulus is due to the advantages of
liquidity (real or supposed) having no offset to contend with in the shape
of carrying-costs mounting steeply with the lapse of time. In the case of a
commodity other than money a modest stock of it may offer some
convenience to users of the commodity. But even though a larger stock
might have some attractions as representing a store of wealth of stable
value, this would be offset by its carrying-costs in the shape of storage,
wastage, etc.
Hence, after a certain point is reached, there is necessarily a loss in
holding a greater stock.
In the case of money, however, this, as we have seen, is not so and
for a variety of reasons, namely, those which constitute money as being, in
the estimation of the public, par excellence liquid. Thus those reformers,
who look for a remedy by creating artificial carrying-costs for money
through the device of requiring legal-tender currency to be periodically
stamped at a prescribed cost in order to retain its quality as money, or in
analogous ways, have been on the right track; and the practical value of
their proposals deserves consideration.
The significance of the money-rate of interest arises, therefore, out of
the combination of the characteristics that, through the working of the
liquidity-motive, this rate of interest may be somewhat unresponsive to a
change in the proportion which the quantity of money bears to other forms
of wealth measured in money, and that money has (or may have) zero (or
negligible) elasticities both of production and of substitution. The first
condition means that demand may be predominantly directed to money,
the second that when this occurs labour cannot be employed in producing
more money, and the third that there is no mitigation at any point through
some other factor being capable, if it is sufficiently cheap, of doing moneys
duty equally well. The only relief apart from changes in the marginal
efficiency of capital can come (so long as the propensity towards
liquidity is unchanged) from an increase in the quantity of money, or
which is formally the same thing a rise in the value of money which
enables a given quantity to provide increased money-services.
Thus a rise in the money-rate of interest retards the output of all the
objects of which the production is elastic without being capable of
stimulating the output of money (the production of which is, by
hypothesis, perfectly inelastic). The money-rate of interest, by setting the
pace for all the other commodity-rates of interest, holds back investment
in the production of these other commodities without being capable of
stimulating investment for the production of money, which by hypothesis
cannot be produced. Moreover, owing to the elasticity of demand for liquid
cash in terms of debts, a small change in the conditions governing this
demand may not much alter the money-rate of interest, whilst (apart from
official action) it is also impracticable, owing to the inelasticity of the
production of money, for natural forces to bring the money-rate of interest
down by affecting the supply side. In the case of an ordinary commodity,
the inelasticity of the demand for liquid stocks of it would enable small
changes on the demand side to bring its rate of interest up or down with a
rush, whilst the elasticity of its supply would also tend to prevent a high
premium on spot over forward delivery. Thus with other commodities left
to themselves, natural forces, i.e. the ordinary forces of the market, would
tend to bring their rate of interest down until the emergence of full
employment had brought about for commodities generally the inelasticity
of supply which we have postulated as a normal characteristic of money.
Thus in the absence of money and in the absence we must, of course,
also suppose of any other commodity with the assumed characteristics
of money, the rates of interest would only reach equilibrium when there is
full employment. Unemployment develops, that is to say, because people
want the moon; men cannot be employed when the object of desire (i.e.
money) is something which cannot be produced and the demand for which
cannot be readily choked off. There is no remedy but to persuade the
public that green cheese is practically the same thing and to have a green
cheese factory (i.e. a central bank) under public control.
It is interesting to notice that the characteristic which has been
traditionally supposed to render gold especially suitable for use as the
standard of value, namely, its inelasticity of supply, turns out to be
precisely the characteristic which is at the bottom of the trouble.
Our conclusion can be stated in the most general form (taking the
propensity to consume as given) as follows. No further increase in the rate
of investment is possible when the greatest amongst the own-rates of own-
interest of all available assets is equal to the greatest amongst the marginal
efficiencies of all assets, measured in terms of the asset whose own-rate of
own-interest is greatest.
In a position of full employment this condition is necessarily satisfied.
But it may also be satisfied before full employment is reached, if there
exists some asset, having zero (or relatively small) elasticities of
production and substitution, whose rate of interest declines more closely,
as output increases, than the marginal efficiencies of capital-assets
measured in terms of it.
We have shown above that for a commodity to be the standard of value is

not a sufficient condition for that commoditys rate of interest to be the
significant rate of interest. It is, however, interesting to consider how far
those characteristics of money as we know it, which make the money-rate
of interest the significant rate, are bound up with money being the
standard in which debts and wages are usually fixed. The matter requires
consideration under two aspects.
In the first place, the fact that contracts are fixed, and wages are
usually somewhat stable, in terms of money unquestionably plays a large
part in attracting to money so high a liquidity-premium. The convenience
of holding assets in the same standard as that in which future liabilities
may fall due and in a standard in terms of which the future cost of living is
expected to be relatively stable, is obvious. At the same time the
expectation of relative stability in the future money-cost of output might

not be entertained with much confidence if the standard of value were a
commodity with a high elasticity of production. Moreover, the low
carrying-costs of money as we know it play quite as large a part as a high
liquidity-premium in making the money-rate of interest the significant
rate. For what matters is the difference between the liquidity-premium
and the carrying-costs; and in the case of most commodities, other than
such assets as gold and silver and bank-notes, the carrying-costs are at
least as high as the liquidity-premium ordinarily attaching to the standard
in which contracts and wages are fixed, so that, even if the liquidity-
premium now attaching to (e.g.) sterling-money were to be transferred
to(e.g.) wheat, the wheat-rate of interest would still be unlikely to rise
above zero. It remains the case, therefore, that, whilst the fact of contracts
and wages being fixed in terms of money considerably enhances the
significance of the money-rate of interest, this circumstance is,
nevertheless, probably insufficient by itself to produce the observed
characteristics of the money-rate of interest.
The second point to be considered is more subtle. The normal
expectation that the value of output will be more stable in terms of money
than in terms of any other commodity, depends of course, not on wages
being arranged in terms of money, but on wages being relatively sticky in
terms of money. What, then, would the position be if wages were expected
to be more sticky (i.e. more stable) in terms of some one or more
commodities other than money, than in terms of money itself? Such an
expectation requires, not only that the costs of the commodity in question
are expected to be relatively constant in terms of the wage-unit for a
greater or smaller scale of output both in the short and in the long period,
but also that any surplus over the current demand at cost-price can be
taken into stock without cost, i.e. that its liquidity-premium exceeds its
carrying-costs (for, otherwise, since there is no hope of profit from a
higher price, the carrying of a stock must necessarily involve a loss). If a
commodity can be found to satisfy these conditions, then, assuredly, it
might be set up as a rival to money. Thus it is not logically impossible that
there should be a commodity in terms of which the value of output is
expected to be more stable than in terms of money. But it does not seem
probable that any such commodity exists.
I conclude, therefore, that the commodity, in terms of which wages
are expected to be most sticky, cannot be one whose elasticity of
production is not least, and for which the excess of carrying-costs over
liquidity-premium is not least. In other words, the expectation of a relative
stickiness of wages in terms of money is a corollary of the excess of

liquidity-premium over carrying-costs being greater for money than for
any other asset.
Thus we see that the various characteristics, which combine to make
the money-rate of interest significant, interact with one another in a
cumulative fashion. The fact that money has low elasticities of production
and substitution and low carrying-costs tends to raise the expectation that
money-wages will be relatively stable; and this expectation enhances
moneys liquidity-premium and prevents the exceptional correlation
between the money-rate of interest and the marginal efficiencies of other
assets which might, if it could exist, rob the money-rate of interest of its
sting.
Professor Pigou (with others) has been accustomed to assume that
there is a presumption in favour of real wages being more stable than
money-wages. But this could only be the case if there were a presumption
in favour of stability of employment. Moreover, there is also the difficulty
that wage-goods have a high carrying-cost. If, indeed, some attempt were
made to stabilise real wages by fixing wages in terms of wage-goods, the
effect could only be to cause a violent oscillation of money-prices. For
every small fluctuation in the propensity to consume and the inducement
to invest would cause money-prices to rush violently between zero and
infinity. That money-wages should be more stable than real wages is a
condition of the system possessing inherent stability. Thus the attribution
of relative stability to real wages is not merely a mistake in fact and
experience. It is also a mistake in logic, if we are supposing that the system
in view is stable, in the sense that small changes in the propensity to
consume and the inducement to invest do not produce violent effects on
prices.
As a footnote to the above, it may be worth emphasising what has been

already stated above, namely, that liquidity and carrying-costs are both a
matter of degree; and that it is only in having the former high relatively to
the latter that the peculiarity of money consists.
Consider, for example, an economy in which there is no asset for
which the liquidity-premium is always in excess of the carrying-costs;
which is the best definition I can give of a so-called non-monetary
economy. There exists nothing, that is to say, but particular consumables
and particular capital equipments more or less differentiated according to

the character of the consumables which they can yield up, or assist to yield
up, over a greater or a shorter period of time; all of which, unlike cash,
deteriorate or involve expense, if they are kept in stock, to a value in excess
of any liquidity-premium which may attach to them.
In such an economy capital equipments will differ from one another
(a) in the variety of the consumables in the production of which they are
capable of assisting, (b) in the stability of value of their output (in the
sense in which the value of bread is more stable through time than the
value of fashionable novelties), and (c) in the rapidity with which the
wealth embodied in them can become liquid, in the sense of producing
output, the proceeds of which can be re-embodied if desired in quite a
different form.
The owners of wealth will then weigh the lack of liquidity of different
capital equipments in the above sense as a medium in which to hold
wealth against the best available actuarial estimate of their prospective
yields after allowing for risk. The liquidity-premium, it will be observed, is
partly similar to the risk-premium, but partly different; the difference
corresponding to the difference between the best estimates we can make of
probabilities and the confidence with which we make them. When we were
dealing, in earlier chapters, with the estimation of prospective yield, we
did not enter into detail as to how the estimation is made: and to avoid
complicating the argument, we did not distinguish differences in liquidity
from differences in risk proper. It is evident, however, that in calculating
the own-rate of interest we must allow for both.
There is, clearly, no absolute standard of liquidity but merely a scale
of liquidity a varying premium of which account has to be taken, in
addition to the yield of use and the carrying-costs, in estimating the
comparative attractions of holding different forms of wealth. The
conception of what contributes to liquidity is a partly vague one, changing
from time to time and depending on social practices and institutions. The
order of preference in the minds of owners of wealth in which at any given
time they express their feelings about liquidity is, however, definite and is
all we require for our analysis of the behaviour of the economic system.
It may be that in certain historic environments the possession of land
has been characterised by a high liquidity-premium in the minds of
owners of wealth; and since land resembles money in that its elasticities of
production and substitution may be very low, it is conceivable that there
have been occasions in history in which the desire to hold land has played
the same rle in keeping up the rate of interest at too high a level which
money has played in recent times. It is difficult to trace this influence

quantitatively owing to the absence of a forward price for land in terms of
itself which is strictly comparable with the rate of interest on a money
debt. We have, however, something which has, at times, been closely
analogous, in the shape of high rates of interest on mortgages. The high
rates of interest from mortgages on land, often exceeding the probable net
yield from cultivating the land, have been a familiar feature of many
agricultural economies. Usury laws have been directed primarily against
encumbrances of this character. And rightly so. For in earlier social
organisation where long-term bonds in the modern sense were non-
existent, the competition of a high interest-rate on mortgages may well
have had the same effect in retarding the growth of wealth from current
investment in newly produced capital-assets, as high interest rates on
long-term debts have had in more recent times.
That the world after several millennia of steady individual saving, is so
poor as it is in accumulated capital-assets, is to be explained, in my
opinion, neither by the improvident propensities of mankind, nor even by
the destruction of war, but by the high liquidity-premiums formerly
attaching to the ownership of land and now attaching to money. I differ in
this from the older view as expressed by Marshall with an unusual
dogmatic force in his Principles of Economics, p. 581:
Everyone is aware that the accumulation of wealth is held in check, and

the rate of interest so far sustained, by the preference which the great mass
of humanity have for present over deferred gratifications, or, in other
words, by their unwillingness to wait.
In my Treatise on Money I defined what purported to be a unique rate of

interest, which I called the natural rate of interest namely, the rate of
interest which, in the terminology of my Treatise, preserved equality
between the rate of saving (as there defined) and the rate of investment. I
believed this to be a development and clarification of Wicksells natural
rate of interest, which was, according to him, the rate which would
preserve the stability of some, not quite clearly specified, price-level.
I had, however, overlooked the fact that in any given society there is,
on this definition, a different natural rate of interest for each hypothetical
level of employment. And, similarly, for every rate of interest there is a
level of employment for which that rate is the natural rate, in the sense
that the system will be in equilibrium with that rate of interest and that
level of employment. Thus it was a mistake to speak of the natural rate of
interest or to suggest that the above definition would yield a unique value
for the rate of interest irrespective of the level of employment. I had not
then understood that, in certain conditions, the system could be in
equilibrium with less than full employment.
I am now no longer of the opinion that the concept of a natural rate
of interest, which previously seemed to me a most promising idea, has
anything very useful or significant to contribute to our analysis. It is
merely the rate of interest which will preserve the status quo; and, in
general, we have no predominant interest in the status quo as such.
If there is any such rate of interest, which is unique and significant, it
must be the rate which we might term the neutral rate of interest, namely,
the natural rate in the above sense which is consistent with full
employment, given the other parameters of the system; though this rate
might be better described, perhaps, as the optimum rate.
The neutral rate of interest can be more strictly defined as the rate of
interest which prevails in equilibrium when output and employment are
such that the elasticity of employment as a whole is zero.
The above gives us, once again, the answer to the question as to what
tacit assumption is required to make sense of the classical theory of the
rate of interest. This theory assumes either that the actual rate of interest
is always equal to the neutral rate of interest in the sense in which we have
just defined the latter, or alternatively that the actual rate of interest is
always equal to the rate of interest which will maintain employment at
some specified constant level. If the traditional theory is thus interpreted,
there is little or nothing in its practical conclusions to which we need take
exception. The classical theory assumes that the banking authority or
natural forces cause the market-rate of interest to satisfy one or other of
the above conditions; and it investigates what laws will govern the
application and rewards of the communitys productive resources subject
to this assumption. With this limitation in force, the volume of output
depends solely on the assumed constant level of employment in
conjunction with the current equipment and technique; and we are safely
ensconced in a Ricardian world.


C 18
T G T E
R -S
We have now reached a point where we can gather together the threads of
our argument. To begin with, it may be useful to make clear which
elements in the economic system we usually take as given, which are the
independent variables of our system and which are the dependent
variables.
We take as given the existing skill and quantity of available labour, the
existing quality and quantity of available equipment, the existing
technique, the degree of competition, the tastes and habits of the
consumer, the disutility of different intensities of labour and of the
activities of supervision and organisation, as well as the social structure
including the forces, other than our variables set forth below, which
determine the distribution of the national income. This does not mean that
we assume these factors to be constant; but merely that, in this place and
context, we are not considering or taking into account the effects and
consequences of changes in them.
Our independent variables are, in the first instance, the propensity to
consume, the schedule of the marginal efficiency of capital and the rate of
interest, though, as we have already seen, these are capable of further
analysis.
Our dependent variables are the volume of employment and the
national income (or national dividend) measured in wage-units.
The factors, which we have taken as given, influence our independent
variables, but do not completely determine them. For example, the
schedule of the marginal efficiency of capital depends partly on the
existing quantity of equipment which is one of the given factors, but partly
on the state of long-term expectation which cannot be inferred from the

given factors. But there are certain other elements which the given factors
determine so completely that we can treat these derivatives as being
themselves given. For example, the given factors allow us to infer what
level of national income measured in terms of the wage-unit will
correspond to any given level of employment; so that, within the economic
framework which we take as given, the national income depends on the
volume of employment, i.e. on the quantity of effort currently devoted to
production, in the sense that there is a unique correlation between the two.
Furthermore, they allow us to infer the shape of the aggregate supply
functions, which embody the physical conditions of supply, for different
types of products; that is to say, the quantity of employment which will
be devoted to production corresponding to any given level of effective
demand measured in terms of wage-units. Finally, they furnish us with the
supply function of labour (or effort); so that they tell us inter alia at what
point the employment function for labour as a whole will cease to be
elastic.
The schedule of the marginal efficiency of capital depends, however,
partly on the given factors and partly on the prospective yield of capital-
assets of different kinds; whilst the rate of interest depends partly on the
state of liquidity-preference (i.e. on the liquidity function) and partly on
the quantity of money measured in terms of wage-units. Thus we can
sometimes regard our ultimate independent variables as consisting of (i)
the three fundamental psychological factors, namely, the psychological
propensity to consume, the psychological attitude to liquidity and the
psychological expectation of future yield from capital-assets, (2) the wage-
unit as determined by the bargains reached between employers and
employed, and (3) the quantity of money as determined by the action of
the central bank; so that, if we take as given the factors specified above,
these variables determine the national income (or dividend) and the
quantity of employment. But these again would be capable of being
subjected to further analysis, and are not, so to speak, our ultimate atomic
independent elements.
The division of the determinants of the economic system into the two
groups of given factors and independent variables is, of course, quite
arbitrary from any absolute standpoint. The division must be made
entirely on the basis of experience, so as to correspond on the one hand to
the factors in which the changes seem to be so slow or so little relevant as
to have only a small and comparatively negligible short-term influence on
our quaesitum; and on the other hand to those factors in which the
changes are found in practice to exercise a dominant influence on our

quaesitum. Our present object is to discover what determines at any time
the national income of a given economic system and (which is almost the
same thing) the amount of its employment; which means in a study so
complex as economics, in which we cannot hope to make completely
accurate generalisations, the factors whose changes mainly determine our
quaesitum. Our final task might be to select those variables which can be
deliberately controlled or managed by central authority in the kind of
system in which we actually live.
Let us now attempt to summarise the argument of the previous chapters;

taking the factors in the reverse order to that in which we have introduced
them.
There will be an inducement to push the rate of new investment to the
point which forces the supply-price of each type of capital-asset to a figure
which, taken in conjunction with its prospective yield, brings the marginal
efficiency of capital in general to approximate equality with the rate of
interest. That is to say, the physical conditions of supply in the capital-
goods industries, the state of confidence concerning the prospective yield,
the psychological attitude to liquidity and the quantity of money
(preferably calculated in terms of wage-units) determine, between them,
the rate of new investment.
But an increase (or decrease) in the rate of investment will have to
carry with it an increase (or decrease) in the rate of consumption; because
the behaviour of the public is, in general, of such a character that they are
only willing to widen (or narrow) the gap between their income and their
consumption if their income is being increased (or diminished). That is to
say, changes in the rate of consumption are, in general, in the same
direction (though smaller in amount) as changes in the rate of income. The
relation between the increment of consumption which has to accompany a
given increment of saving is given by the marginal propensity to consume.
The ratio, thus determined, between an increment of investment and the
corresponding increment of aggregate income, both measured in wage-
units, is given by the investment multiplier.
Finally, if we assume (as a first approximation) that the employment
multiplier is equal to the investment multiplier, we can, by applying the
multiplier to the increment (or decrement) in the rate of investment
brought about by the factors first described, infer the increment of

employment.
An increment (or decrement) of employment is liable, however, to
raise (or lower) the schedule of liquidity-preference; there being three
ways in which it will tend to increase the demand for money, inasmuch as
the value of output will rise when employment increases even if the wage-
unit and prices (in terms of the wage-unit) are unchanged, but, in
addition, the wage-unit itself will tend to rise as employment improves,
and the increase in output will be accompanied by a rise of prices (in terms
of the wage-unit) owing to increasing cost in the short period.
Thus the position of equilibrium will be influenced by these
repercussions; and there are other repercussions also. Moreover, there is
not one of the above factors which is not liable to change without much
warning, and sometimes substantially. Hence the extreme complexity of
the actual course of events. Nevertheless, these seem to be the factors
which it is useful and convenient to isolate. If we examine any actual
problem along the lines of the above schematism, we shall find it more
manageable; and our practical intuition (which can take account of a more
detailed complex of facts than can be treated on general principles) will be
offered a less intractable material upon which to work.
The above is a summary of the General Theory. But the actual phenomena
of the economic system are also coloured by certain special characteristics
of the propensity to consume, the schedule of the marginal efficiency of
capital and the rate of interest, about which we can safely generalise from
experience, but which are not logically necessary.
In particular, it is an outstanding characteristic of the economic
system in which we live that, whilst it is subject to severe fluctuations in
respect of output and employment, it is not violently unstable. Indeed it
seems capable of remaining in a chronic condition of subnormal activity
for a considerable period without any marked tendency either towards
recovery or towards complete collapse. Moreover, the evidence indicates
that full, or even approximately full, employment is of rare and short-lived
occurrence. Fluctuations may start briskly but seem to wear themselves
out before they have proceeded to great extremes, and an intermediate
situation which is neither desperate nor satisfactory is our normal lot. It is
upon the fact that fluctuations tend to wear themselves out before
proceeding to extremes and eventually to reverse themselves, that the

theory of business cycles having a regular phase has been founded. The
same thing is true of prices, which; in response to an initiating cause of
disturbance, seem to be able to find a level at which they can remain, for
the time being, moderately stable.
Now, since these facts of experience do not follow of logical necessity,
one must suppose that the environment and the psychological propensities
of the modern world must be of such a character as to produce these
results. It is, therefore, useful to consider what hypothetical psychological
propensities would lead to a stable system; and, then, whether these
propensities can be plausibly ascribed, on our general knowledge of
contemporary human nature, to the world in which we live.
The conditions of stability which the foregoing analysis suggests to us
as capable of explaining the observed results are the following:
(i) The marginal propensity to consume is such that, when the output
of a given community increases (or decreases) because more (or less)
employment is being applied to its capital equipment, the multiplier
relating the two is greater than unity but not very large.
(ii) When there is a change in the prospective yield of capital or in the
rate of interest, the schedule of the marginal efficiency of capital will be
such that the change in new investment will not be in great disproportion
to the change in the former; i.e. moderate changes in the prospective yield
of capital or in the rate of interest will not be associated with very great
changes in the rate of investment.
(iii) When there is a change in employment, money-wages tend to
change in the same direction as, but not in great disproportion to, the
change in employment; i.e. moderate changes in employment are not
associated with very great changes in money-wages. This is a condition of
the stability of prices rather than of employment.
(iv) We may add a fourth condition, which provides not so much for
the stability of the system as for the tendency of a fluctuation in one
direction to reverse itself in due course; namely, that a rate of investment,
higher (or lower) than prevailed formerly, begins to react unfavourably (or
favourably) on the marginal efficiency of capital if it is continued for a
period which, measured in years, is not very large.
(i) Our first condition of stability, namely, that the multiplier, whilst
greater than unity, is not very great, is highly plausible as a psychological
characteristic of human nature. As real income increases, both the
pressure of present needs diminishes and the margin over the established
standard of life is increased; and as real income diminishes the opposite is

true. Thus it is natural at any rate on the average of the community
that current consumption should be expanded when employment
increases, but by less than the full increment of real income; and that it
should be diminished when employment diminishes, but by less than the
full decrement of real income. Moreover, what is true of the average of
individuals is likely to be also true of governments, especially in an age
when a progressive increase of unemployment will usually force the State
to provide relief out of borrowed funds.
But whether or not this psychological law strikes the reader as
plausible a priori, it is certain that experience would be extremely
different from what it is if the law did not hold. For in that case an increase
of investment, however small, would set moving a cumulative increase of
effective demand until a position of full employment had been reached;
while a decrease of investment would set moving a cumulative decrease of
effective demand until no one at all was employed. Yet experience shows
that we are generally in an intermediate position. It is not impossible that
there may be a range within which instability does in fact prevail. But, if
so, it is probably a narrow one, outside of which in either direction our
psychological law must unquestionably hold good. Furthermore, it is also
evident that the multiplier, though exceeding unity, is not, in normal
circumstances, enormously large. For, if it were, a given change in the rate
of investment would involve a great change (limited only by full or zero
employment) in the rate of consumption.
(ii) Whilst our first condition provides that a moderate change in the
rate of investment will not involve an indefinitely great change in the
demand for consumption-goods our second condition provides that a
moderate change in the prospective yield of capital-assets or in the rate of
interest will not involve an indefinitely great change in the rate of
investment. This is likely to be the case owing to the increasing cost of
producing a greatly enlarged Output from the existing equipment. If,
indeed, we start from a position where there are very large surplus
resources for the production of capital-assets, there may be considerable
instability within a certain range; but this will cease to hold good as soon
as the surplus is being largely utilised. Moreover, this condition sets a limit
to the instability resulting from rapid changes in the prospective yield of
capital-assets due to sharp fluctuations in business psychology or to
epoch-making inventions though more, perhaps, in the upward than in
the downward direction.
(iii) Our third condition accords with our experience of human nature.
For although the struggle for money-wages is, as we have pointed out
above, essentially a struggle to maintain a high relative wage, this struggle
is likely, as employment increases, to be intensified in each individual case
both because the bargaining position of the worker is improved and
because the diminished marginal utility of his wage and his improved
financial margin make him readier to run risks. Yet, all the same, these
motives will operate within limits, and workers will not seek a much
greater money-wage when employment improves or allow a very great
reduction rather than suffer any unemployment at all.
But here again, whether or not this conclusion is plausible a priori,
experience shows that some such psychological law must actually hold. For
if competition between unemployed workers always led to a very great
reduction of the money-wage, there would be a violent instability in the
price-level. Moreover, there might be no position of stable equilibrium
except in conditions consistent with full employment; since the wage-unit
might have to fall without limit until it reached a point where the effect of
the abundance of money in terms of the wage-unit on the rate of interest
was sufficient to restore a level of full employment. At no other point could
there be a resting-place.
(iv) Our fourth condition, which is a condition not so much of stability
as of alternate recession and recovery, is merely based on the presumption
that capital-assets are of various ages, wear out with time and are not all
very long-lived; so that if the rate of investment falls below a certain
minimum level, it is merely a question of time (failing large fluctuations in
other factors) before the marginal efficiency of capital rises sufficiently to
bring about a recovery of investment above this minimum. And similarly,
of course, if investment rises to a higher figure than formerly, it is only a
question of time before the marginal efficiency of capital falls sufficiently
to bring about a recession unless there are compensating changes in other
factors.
For this reason, even those degrees of recovery and recession, which
can occur within the limitations set by our other conditions of stability,
will be likely, if they persist for a sufficient length of time and are not
interfered with by changes in the other factors, to cause a reverse
movement in the opposite direction, until the same forces as before again
reverse the direction.
Thus our four conditions together are adequate to explain the
outstanding features of our actual experience; namely, that we oscillate,
avoiding the gravest extremes of fluctuation in employment and in prices
in both directions, round an intermediate position appreciably below full

employment and appreciably above the minimum employment a decline
below which would endanger life.
But we must not conclude that the mean position thus determined by
natural tendencies, namely, by those tendencies which are likely to
persist, failing measures expressly designed to correct them, is, therefore,
established by laws of necessity. The unimpeded rule of the above
conditions is a fact of observation concerning the world as it is or has been,
and not a necessary principle which cannot be changed.

C 19
C M -W
It would have been an advantage if the effects of a change in money-wages

could have been discussed in an earlier chapter. For the classical theory
has been accustomed to rest the supposedly self-adjusting character of the
economic system on an assumed fluidity of money-wages; and, when there
is rigidity, to lay on this rigidity the blame of maladjustment.
It was not possible, however, to discuss this matter fully until our own
theory had been developed. For the consequences of a change in money-
wages are complicated. A reduction in money-wages is quite capable in
certain circumstances of affording a stimulus to output, as the classical
theory supposes. My difference from this theory is primarily a difference of
analysis; so that it could not be set forth clearly until the reader was
acquainted with my own method.
The generally accepted explanation is, as I understand it, quite a
simple one. It does not depend on roundabout repercussions, such as we
shall discuss below. The argument simply is that a reduction in money-
wages will cet. par. stimulate demand by diminishing the price of the
finished product, and will therefore increase output and employment up to
the point where the reduction which labour has agreed to accept in its
money-wages is just offset by the diminishing marginal efficiency of labour
as output (from a given equipment) is increased.
In its crudest form, this is tantamount to assuming that the reduction
in money-wages will leave demand unaffected. There may be some
economists who would maintain that there is no reason why demand
should be affected, arguing that aggregate demand depends on the
quantity of money multiplied by the income-velocity of money and that
there is no obvious reason why a reduction in money-wages would reduce
either the quantity of money or its income-velocity. Or they may even
argue that profits will necessarily go up because wages have gone down.
But it would, I think, be more usual to agree that the reduction in money-
wages may have some effect on aggregate demand through its reducing the
purchasing power of some of the workers, but that the real demand of
other factors, whose money incomes have not been reduced, will be
stimulated by the fall in prices, and that the aggregate demand of the
workers themselves will be very likely increased as a result of the increased
volume of employment, unless the elasticity of demand for labour in
response to changes in money-wages is less than unity. Thus in the new
equilibrium there will be more employment than there would have been
otherwise except, perhaps, in some unusual limiting case which has no
reality in practice.
It is from this type of analysis that I fundamentally differ; or rather
from the analysis which seems to lie behind such observations as the
above. For whilst the above fairly represents, I think, the way in which
many economists talk and write, the underlying analysis has seldom been
written down in detail.
It appears, however, that this way of thinking is probably reached as
follows. In any given industry we have a demand schedule for the product
relating the quantities which can be sold to the prices asked; we have a
series of supply schedules relating the prices which will be asked for the
sale of different quantities on various bases of cost; and these schedules
between them lead up to a further schedule which, on the assumption that
other costs are unchanged (except as a result of the change in output),
gives us the demand schedule for labour in the industry relating the
quantity of employment to different levels of wages, the shape of the curve
at any point furnishing the elasticity of demand for labour. This
conception is then transferred without substantial modification to industry
as a whole; and it is supposed, by a parity of reasoning, that we have a
demand schedule for labour in industry as a whole relating the quantity of
employment to different levels of wages. It is held that it makes no
material difference to this argument whether it is in terms of money-wages
or of real wages. If we are thinking in terms of money-wages, we must, of
course, correct for changes in the value of money; but this leaves the
general tendency of the argument unchanged, since prices certainly do not
change in exact proportion to changes in money-wages.
If this is the groundwork of the argument (and, if it is not, I do not
know what the groundwork is), surely it is fallacious. For the demand
schedules for particular industries can only be constructed on some fixed
assumption as to the nature of the demand and supply schedules of other
industries and as to the amount of the aggregate effective demand. It is

invalid, therefore, to transfer the argument to industry as a whole unless
we also transfer our assumption that the aggregate effective demand is
fixed. Yet this assumption reduces the argument to an ignoratio elenchi.
For, whilst no one would wish to deny the proposition that a reduction in
money-wages accompanied by the same aggregate effective demand as
before will be associated with an increase in employment, the precise
question at issue is whether the reduction in money-wages will or will not
be accompanied by the same aggregate effective demand as before
measured in money, or, at any rate, by an aggregate effective demand
which is not reduced in full proportion to the reduction in money-wages
(i.e. which is somewhat greater measured in wage-units). But if the
classical theory is not allowed to extend by analogy its conclusions in
respect of a particular industry to industry as a whole, it is wholly unable
to answer the question what effect on employment a reduction in money-
wages will have. For it has no method of analysis wherewith to tackle the
problem. Professor Pigous Theory of Unemployment seems to me to get
out of the classical theory all that can be got out of it; with the result that
the book becomes a striking demonstration that this theory has nothing to
offer, when it is applied to the problem of what determines the volume of
actual employment as a whole.
Let us, then, apply our own method of analysis to answering the problem.
It falls into two parts. (i) Does a reduction in money-wages have a direct
tendency, cet. par., to increase employment, cet. par. being taken to mean
that the propensity to consume, the schedule of the marginal efficiency of
capital and the rate of interest are the same as before for the community as
a whole? And (2) does a reduction in money-wages have a certain or
probable.tendency to affect employment in a particular direction through
its certain or probable repercussions on these three factors?
The first question we have already answered in the negative in the
preceding chapters. For we have shown that the volume of employment is
uniquely correlated with the volume ofeffective demand measured in
wage-units, and that the effective demand, being the sum of the expected
consumption and the expected investment, cannot change, if the
propensity to consume, the schedule of marginal efficiency of capital and
the rate of interest are all unchanged. If, without any change in these
factors, the entrepreneurs were to increase employment as a whole, their

proceeds will necessarily fall short of their supply-price.
Perhaps it will help to rebut the crude conclusion that a reduction in
money-wages will increase employment because it reduces the cost of
production, if we follow up the course of events on the hypothesis most
favourable to this view, namely that at the outset entrepreneurs expect the
reduction in money-wages to have this effect. It is indeed not unlikely that
the individual entrepreneur, seeing his own costs reduced, will overlook at
the outset the repercussions on the demand for his product and will act on
the assumption that he will be able to sell at a profit a larger output than
before. If, then, entrepreneurs generally act on this expectation, will they
in fact succeed in increasing their profits? Only if the communitys
marginal propensity to consume is equal to unity, so that there is no gap
between the increment of income and the increment of consumption; or if
there is an increase in investment, corresponding to the gap between the
increment of income and the increment of consumption, which will only
occur if the schedule of marginal efficiencies of capital has increased
relatively to the rate of interest. Thus the proceeds realised from the
increased output will disappoint the entrepreneurs and employment will
fall back again to its previous figure, unless the marginal propensity to
consume is equal to unity or the reduction in money-wages has had the
effect of increasing the schedule of marginal efficiencies of capital
relatively to the rate of interest and hence the amount of investment. For if
entrepreneurs offer employment on a scale which, if they could sell their
output at the expected price, would provide the public with incomes out of
which they would save more than the amount of current investment,
entrepreneurs are bound to make a loss equal to the difference; and this
will be the case absolutely irrespective of the level of money-wages. At the
best, the date of their disappointment can only be delayed for the interval
during which their own investment in increased working capital is filling
the gap.
Thus the reduction in money-wages will have no lasting tendency to
increase employment except by virtue of its repercussion either on the
propensity to consume for the community as a whole, or on the schedule of
marginal efficiencies of capital, or on the rate of interest. There is no
method of analysing the effect of a reduction in money-wages, except by
following up its possible effects on these three factors.
The most important repercussions on these factors are likely, in
practice, to be the following:
(1) A reduction of money-wages will somewhat reduce prices. It will,

therefore, involve some redistribution of real income (a) from wage-
earners to other factors entering into marginal prime cost whose
remuneration has not been reduced, and (b) from entrepreneurs to
rentiers to whom a certain income fixed in terms of money has been
guaranteed.
What will be the effect of this redistribution on the propensity to
consume for the community as a whole? The transfer from wage-earners
to other factors is likely to diminish the propensity to consume. The effect
of the transfer from entrepreneurs to rentiers is more open to doubt. But if
rentiers represent on the whole the richer section of the community and
those whose standard of life is least flexible, then the effect of this also will
be unfavourable. What the net result will be on a balance of
considerations, we can only guess. Probably it is more likely to be adverse
than favourable.
(2) If we are dealing with an unclosed system, and the reduction of
money-wages is a reduction relatively to money-wages abroad when both
are reduced to a common unit, it is evident that the change will be
favourable to investment, since it will tend to increase the balance of trade.
This assumes, of course, that the advantage is not offset by a change in
tariffs, quotas, etc. The greater strength of the traditional belief in the
efficacy of a reduction in money-wages as a means of increasing
employment in Great Britain, as compared with the United States, is
probably attributable to the latter being, comparatively with ourselves, a
closed system.
(3) In the case of an unclosed system, a reduction of money-wages,
though it increases the favourable balance of trade, is likely to worsen the
terms of trade. Thus there will be a reduction in real incomes, except in the
case of the newly employed, which may tend to increase the propensity to
consume.
(4) If the reduction of money-wages is expected to be a reduction
relatively to money-wages in the future, the change will be favourable to
investment, because as we have seen above, it will increase the marginal
efficiency of capital; whilst for the same reason it may be favourable to
consumption. If, on the other hand, the reduction leads to the expectation,
or even to the serious possibility, of a further wage-reduction in prospect,
it will have precisely the opposite effect. For it will diminish the marginal
efficiency of capital and will lead to the postponement both of investment
and of consumption.
(5) The reduction in the wages-bill, accompanied by some reduction

in prices and in money-incomes generally, will diminish the need for cash
for income and business purposes; and it will therefore reduce pro tanto
the schedule of liquidity-preference for the community as a whole. Cet.
par. this will reduce the rate of interest and thus prove favourable to
investment. In this case, however, the effect of expectation concerning the
future will be of an opposite tendency to those just considered under (4).
For, if wages and prices are expected to rise again later on, the favourable
reaction will be much less pronounced in the case of long-term loans than
in that of short-term loans. If, moreover, the reduction in wages disturbs
political confidence by causing popular discontent, the increase in
liquidity-preference due to this cause may more than offset the release of
cash from the active circulation.
(6) Since a special reduction of money-wages is always advantageous
to an individual entrepreneur or industry, a general reduction (though its
actual effects are different) may also produce an optimistic tone in the
minds of entrepreneurs, which may break through a vicious circle of
unduly pessimistic estimates of the marginal efficiency of capital and set
things moving again on a more normal basis of expectation. On the other
hand, if the workers make the same mistake as their employers about the
effects of a general reduction, labour troubles may offset this favourable
factor; apart from which, since there is, as a rule, no means of securing a
simultaneous and equal reduction of money-wages in all industries, it is in
the interest of all workers to resist a reduction in their own particular case.
In fact, a movement by employers to revise money-wage bargains
downward will be much more strongly resisted than a gradual and
automatic lowering of real wages as a result of rising prices.
(7) On the other hand, the depressing influence on entrepreneurs of
their greater burden of debt may partly offset any cheerful reactions from
the reduction of wages. Indeed if the fall of wages and prices goes far, the
embarrassment of those entrepreneurs who are heavily indebted may soon
reach the point of insolvency with severely adverse effects on
investment. Moreover the effect of the lower price-level on the real burden
of the national debt and hence on taxation is likely to prove very adverse to
business confidence.
This is not a complete catalogue of all the possible reactions of wage
reductions in the complex real world. But the above cover, I think, those
which are usually the most important.
If, therefore, we restrict our argument to the case of a closed system,
and assume that there is nothing to be hoped, but if anything the contrary,
from the repercussions of the new distribution of real incomes on the

communitys propensity to spend, it follows that we must base any hopes
of favourable results to employment from a reduction in money-wages
mainly on an improvement in investment due either to an increased
marginal efficiency of capital under (4) or a decreased rate of interest
under (5). Let us consider these two possibilities in further detail.
The contingency, which is favourable to an increase in the marginal
efficiency of capital, is that in which money-wages are believed to have
touched bottom, so that further changes are expected to be in the upward
direction. The most unfavourable contingency is that in which money-
wages are slowly sagging downwards and each reduction in wages serves
to diminish confidence in the prospective maintenance of wages. When we
enter on a period of weakening effective demand, a sudden large reduction
of money-wages to a level so low that no one believes in its indefinite
continuance would be the event most favourable to a strengthening of
effective demand. But this could only be accomplished by administrative
decree and is scarcely practical politics under a system of free wage-
bargaining. On the other hand, it would be much better that wages should
be rigidly fixed and deemed incapable of material changes, than that
depressions should be accompanied by a gradual downward tendency of
money-wages, a further moderate wage reduction being expected to
signalise each increase of; say, 1 per cent in the amount of unemployment.
For example, the effect of an expectation that wages are going to sag by,
say, 2 per cent in the coming year will be roughly equivalent to the effect of
a rise of 2 per cent in the amount of interest payable for the same period.
The same observations apply mutatis mutandis to the case of a boom.
It follows that with the actual practices and institutions of the
contemporary world it is more expedient to aim at a rigid money-wage
policy than at a flexible policy responding by easy stages to changes in the
amount of unemployment; so far, that is to say, as the marginal
efficiency of capital is concerned. But is this conclusion upset when we
turn to the rate of interest?
It is, therefore, on the effect of a falling wage- and price-level on the
demand for money that those who believe in the self-adjusting quality of
the economic system must rest the weight of their argument; though I am
not aware that they have done so. If the quantity of money is itself a
function of the wage- and price-level, there is indeed, nothing to hope in
this direction. But if the quantity of money is virtually fixed, it is evident
that its quantity in terms of wage-units can be indefinitely increased by a
sufficient reduction in money-wages; and that its quantity in proportion to
incomes generally can be largely increased, the limit to this increase

depending on the proportion of wage-cost to marginal prime cost and on
the response of other elements of marginal prime cost to the falling wage-
unit.
We can, therefore, theoretically at least, produce precisely the same
effects on the rate of interest by reducing wages, whilst leaving the
quantity of money unchanged, that we can produce by increasing the
quantity of money whilst leaving the level of wages unchanged. It follows
that wage reductions, as a method of securing full employment, are also
subject to the same limitations as the method of increasing the quantity of
money. The same reasons as those mentioned above, which limit the
efficacy of increases in the quantity of money as a means of increasing
investment to the optimum figure, apply mutatis mutandis to wage
reductions. Just as a moderate increase in the quantity of money may exert
an inadequate influence over the long-term rate of interest, whilst an
immoderate increase may offset its other advantages by its disturbing
effect on confidence; so a moderate reduction in money-wages may prove
inadequate, whilst an immoderate reduction might shatter confidence
even if it were practicable.
There is, therefore, no ground for the belief that a flexible wage policy
is capable of maintaining a state of continuous full employment; any
more than for the belief that an open-market monetary policy is capable,
unaided, of achieving this result. The economic system cannot be made
self-adjusting along these lines.
If, indeed, labour were always in a position to take action (and were to
do so), whenever there was less than full employment, to reduce its money
demands by concerted action to whatever point was required to make
money so abundant relatively to the wage-unit that the rate of interest
would fall to a level compatible with full employment, we should, in effect,
have monetary management by the trade unions, aimed at full
employment, instead of by the banking system.
Nevertheless while a flexible wage policy and a flexible money policy
come, analytically, to the same thing, inasmuch as they are alternative
means of changing the quantity of money in terms of wage-units, in other
respects there is, of course, a world of difference between them. Let me
briefly recall to the readers mind the four outstanding considerations.
(i) Except in a socialised community where wage-policy is settled by
decree, there is no means of securing uniform wage reductions for every
class of labour. The result can only be brought about by a series of gradual,
irregular changes, justifiable on no criterion of social justice or economic
expedience, and probably completed only after wasteful and disastrous

struggles, where those in the weakest bargaining position will suffer
relatively to the rest. A change in the quantity of money, on the other
hand, is already within the power of most governments by open-market
policy or analogous measures. Having regard to human nature and our
institutions, it can only be a foolish person who would prefer a flexible
wage policy to a flexible money policy, unless he can point to advantages
from the former which are not obtainable from the latter. Moreover, other
things being equal, a method which it is comparatively easy to apply
should be deemed preferable to a method which is probably so difficult as
to be impracticable.
(ii) If money-wages are inflexible, such changes in prices as occur (i.e.
apart from administered or monopoly prices which are determined by
other considerations besides marginal cost) will mainly correspond to the
diminishing marginal productivity of the existing equipment as the output
from it is increased. Thus the greatest practicable fairness will be
maintained between labour and the factors whose remuneration is
contractually fixed in terms of money, in particular the rentier class and
persons with fixed salaries on the permanent establishment of a firm, an
institution or the State. If important classes are to have their remuneration
fixed in terms of money in any case, social justice and social expediency
are best served if the remunerations of all factors are somewhat inflexible
in terms of money. Having regard to the large groups of incomes which are
comparatively inflexible in terms of money, it can only be an unjust person
who would prefer a flexible wage policy to a flexible money policy, unless
he can point to advantages from the former which are not obtainable from
the latter.
(iii) The method of increasing the quantity of money in terms of wage-
units by decreasing the wage-unit increases proportionately the burden of
debt; whereas the method of producing the same result by increasing the
quantity of money whilst leaving the wage-unit unchanged has the
opposite effect. Having regard to the excessive burden of many types of
debt, it can only be an inexperienced person who would prefer the former.
(iv) If a sagging rate of interest has to be brought about by a sagging
wage-level, there is, for the reasons given above, a double drag on the
marginal efficiency of capital and a double reason for putting off
investment and thus postponing recovery.
It follows, therefore, that if labour were to respond to conditions of

gradually diminishing employment by offering its services at a gradually
diminishing money-wage, this would not, as a rule, have the effect of
reducing real wages and might even have the effect of increasing them,
through its adverse influence on the volume of output. The chief result of
this policy would be to cause a great instability of prices, so violent
perhaps as to make business calculations futile in an economic society
functioning after the manner of that in which we live. To suppose that a
flexible wage policy is a right and proper adjunct of a system which on the
whole is one of laissez-faire, is the opposite of the truth. It is only in a
highly authoritarian society, where sudden, substantial, all-round changes
could be decreed that a flexible wage policy could function with success.
One can imagine it in operation in Italy, Germany or Russia, but not in
France, the United States or Great Britain.
If, as in Australia, an attempt were made to fix real wages by
legislation, then there would be a certain level of employment
corresponding to that level of real wages; and the actual level of
employment would, in a closed system, oscillate violently between that
level and no employment at all, according as the rate of investment was or
was not below the rate compatible with that level; whilst prices would be in
unstable equilibrium when investment was at the critical level, racing to
zero whenever investment was below it, and to infinity whenever it was
above it. The element of stability would have to be found, if at all, in the
factors controlling the quantity of money being so determined that there
always existed some level of money-wages at which the quantity of money
would be such as to establish a relation between the rate of interest and
the marginal efficiency of capital which would maintain investment at the
critical level. In this event employment would be constant (at the level
appropriate to the legal real wage) with money-wages and prices
fluctuating rapidly in the degree just necessary to maintain this rate of
investment at the appropriate figure. In the actual case of Australia, the
escape was found, partly of course in the inevitable inefficacy of the
legislation to achieve its object, and partly in Australia not being a closed
system, so that the level of money-wages was itself a determinant of the
level of foreign investment and hence of total investment, whilst the terms
of trade were an important influence on real wages.
In the light of these considerations I am now of the opinion that the
maintenance of a stable general level of money-wages is, on a balance of
considerations, the most advisable policy for a closed system; whilst the
same conclusion will hold good for an open system, provided that
equilibrium with the rest of the world can be secured by means of

fluctuating exchanges. There are advantages in some degree of flexibility
in the wages of particular industries so as to expedite transfers from those
which are relatively declining to those which are relatively expanding. But
the money-wage level as a whole should be maintained as stable as
possible, at any rate in the short period.
This policy will result in a fair degree of stability in the price-level;
greater stability, at least, than with a flexible wage policy. Apart from
administered or monopoly prices, the price-level will only change in the
short period in response to the extent that changes in the volume of
employment affect marginal prime costs; whilst in the long period they
will only change in response to changes in the cost of production due to
new techniques and new or increased equipment.
It is true that, if there are, nevertheless, large fluctuations in
employment, substantial fluctuations in the price-level will accompany
them. But the fluctuations will be less, as I have said above, than with a
flexible wage policy.
Thus with a rigid wage policy the stability of prices will be bound up in
the short period with the avoidance of fluctuations in employment. In the
long period, on the other hand, we are still left with the choice between a
policy of allowing prices to fall slowly with the progress of technique and
equipment whilst keeping wages stable, or of allowing wages to rise slowly
whilst keeping prices stable. On the whole my preference is for the latter
alternative, on account of the fact that it is easier with an expectation of
higher wages in future to keep the actual level of employment within a
given range of full employment than with an expectation of lower wages in
future, and on account also of the social advantages of gradually
diminishing the burden of debt, the greater ease of adjustment from
decaying to growing industries, and the psychological encouragement
likely to be felt from a moderate tendency for money-wages to increase.
But no essential point of principle is involved, and it would lead me
beyond the scope of my present purpose to develop in detail the arguments
on either side.


A C 19
P P
U
Professor Pigou in his Theory of Unemployment makes the volume of

employment to depend on two fundamental factors, namely (i) the real
rates of wages for which workpeople stipulate, and (2) the shape of the
Real Demand Function for Labour. The central sections of his book are
concerned with determining the shape of the latter function. The fact that
workpeople in fact stipulate, not for a real rate of wages, but for a money-
rate, is not ignored; but, in effect, it is assumed that the actual money-rate
of wages divided by the price of wage-goods can be taken to measure the
real rate demanded.
The equations which, as he says, form the starting point of the
enquiry into the Real Demand Function for Labour are given in his
Theory of Unemployment, p. 90. Since the tacit assumptions, which
govern the application of his analysis, slip in near the outset of his
argument, I will summarise his treatment up to the crucial point.
Professor Pigou divides industries into those engaged in making
wage-goods at home and in making exports the sale of which creates
claims to wage-goods abroad and the other industries: which it is
convenient to call the wage-goods industries and the non-wage-goods
industries respectively. He supposes x men to be employed in the former
and y men in the latter. The output in value of wage-goods of the x men he
calls F(x); and the general rate of wages F(x). This, though he does not
stop to mention it, is tantamount to assuming that marginal wage-cost is
equal to marginal prime cost. Further, he assumes that x + y = (x), i.e.
that the number of men employed in the wage-goods industries is a
function of total employment. He then shows that the elasticity of the real
demand for labour in the aggregate (which gives us the shape of our
quaesitum, namely the Real Demand Function for Labour) can be written
file:///D:/keyness/chapter19a.html (x) F(x) 1/8

Er = (x) F(x)
(x) F(x)
So far as notation goes, there is no significant difference between this and

my own modes of expression. In so far as we can identify Professor Pigous
wage-goods with my consumption-goods, and his other goods with my
investment-goods, it follows that his F(x) / F(x), being the value of the
output of the wage-goods industries in terms of the wage-unit, is the same
as my Cw. Furthermore, his function is (subject to the identification of
wage-goods with consumption-goods) a function of what I have called
above the employment multiplier k. For
x = ky,
so that
(x) = 1 + 1
k
Thus Professor Pigous elasticity of the real demand for labour in the
aggregate is a concoction similar to some of my own, depending partly on
the physical and technical conditions in industry (as given by his function
F) and partly on the propensity to consume wage-goods (as given by his
function ); provided always that we are limiting ourselves to the special
case where marginal labour-cost is equal to marginal prime cost.
To determine the quantity of employment, Professor Pigou then
combines with his real demand for labour, a supply function for labour.
He assumes that this is a function of the real wage and of nothing else. But,
as he has also assumed that the real wage is a function of the number of
men x who are employed in the wage-goods industries, this amounts to
assuming that the total supply of labour at the existing real wage is a
function of x and of nothing else. That is to say, n = (x), where n is the
supply of labour available at a real wage F(x).
Thus, cleared of all complication, Professor Pigous analysis amounts
to an attempt to discover the volume of actual employment from the
equations
x + y = (x)
and
n = (x).
But there are here three unknowns and only two equations. It seems clear
that he gets round this difficulty by taking n = x + y. This amounts, of
course, to assuming that there is no involuntary unemployment in the
strict sense, i.e. that all labour available at the existing real wage is in fact
employed. In this case x has the value which satisfies the equation
(x) = (x)
and when we have thus found that the value of x is equal to (say) n1, y
must be equal to (n1) n1, and total employment n is equal to (n1).
It is worth pausing for a moment to consider what this involves. It

means that, if the supply function of labour changes, more labour being
available at a given real wage (so that n1 + dn1 is now the value of x which
satisfies the equation (x) = (x)), the demand for the output of the non-
wage-goods industries is such that employment in these industries is
bound to increase by just the amount which will preserve equality between
(n1 + dn1) and (n1 + dn1). The only other way in which it is possible for
aggregate employment to change is through a modification of the
propensity to purchase wage-goods and non-wage-goods respectively such
that there is an increase of y accompanied by a greater decrease of x.
The assumption that n = x + y means, of course, that labour is always
in a position to determine its own real wage. Thus, the assumption that
labour is in a position to determine its own real wage, means that the
demand for the output of the non-wage-goods industries obeys the above
laws. In other words, it is assumed that the rate of interest always adjusts
itself to the schedule of the marginal efficiency of capital in such a way as
to preserve full employment. Without this assumption Professor Pigous
analysis breaks down and provides no means of determining what the
volume of employment will be. It is, indeed, strange that Professor Pigou
should have supposed that he could furnish a theory of unemployment
which involves no reference at all to changes in the rate of investment (i.e.
to changes in employment in the non-wage-goods industries) due, not to a
change in the supply function of labour, but to changes in (e.g.) either the
rate of interest or the state of confidence.
His title the Theory of Unemployment is, therefore, something of a
misnomer. His book is not really concerned with this subject. It is a
discussion of how much employment there will be, given the supply
function of labour, when the conditions for full employment are satisfied.
The purpose of the concept of the elasticity of the real demand for labour
in the aggregate is to show by how much full employment will rise or fall
corresponding to a given shift in the supply function of labour. Or
alternatively and perhaps better we may regard his book as a non-
causative investigation into the functional relationship which determines
what level of real wages will correspond to any given level of employment.
But it is not capable of telling us what determines the actual level of
employment; and on the problem of involuntary unemployment it has no
direct bearing.
If Professor Pigou were to deny the possibility of involuntary
unemployment in the sense in which I have defined it above, as, perhaps,
he would, it is still difficult to see how his analysis could be applied. For
his omission to discuss what determines the connection between x and y,
i.e. between employment in the wage-goods and non-wage-goods
industries respectively, still remains fatal.
Moreover, he agrees that within certain limits labour in fact often
stipulates, not for a given real wage, but for a given money-wage. But in
this case the supply function of labour is not a function of F(x) alone but
also of the money-price of wage-goods; with the result that the previous
analysis breaks down and an additional factor has to be introduced,
without there being an additional equation to provide for this additional
unknown. The pitfalls of a pseudo-mathematical method, which can make
no progress except by making everything a function of a single variable
and assuming that all the partial differentials vanish, could not be better
illustrated. For it is no good to admit later on that there are in fact other
variables, and yet to proceed without re-writing everything that has been
written up to that point. Thus if (within limits) it is a money-wage for
which labour stipulates, we still have insufficient data, even if we assume
that n = x + y, unless we know what determines the money-price of wage-
goods. For, the money-price of wage-goods will depend on the aggregate
amount of employment. Therefore we cannot say what aggregate
employment will be, until we know the money-price of wage-goods; and
we cannot know the money-price of wage-goods until we know the
aggregate amount of employment. We are, as I have said, one equation
short. Yet it might be a provisional assumption of a rigidity of money-
wages, rather than of real wages, which would bring our theory nearest to
the facts. For example, money-wages in Great Britain during the turmoil
and uncertainty and wide price fluctuations of the decade 19241934 were
stable within a range of 6 per cent, whereas real wages fluctuated by more
than 20 per cent. A theory cannot claim to be a general theory, unless it is
applicable to the case where (or the range within which) money-wages are
fixed, just as much as to any other case. Politicians are entitled to
complain that money-wages ought to be highly flexible; but a theorist
must be prepared to deal indifferently with either state of affairs. A
scientific theory cannot require the facts to conform to its own

assumptions.
When Professor Pigou comes to deal expressly with the effect of a
reduction of money-wages, he again, palpably (to my mind), introduces
too few data to permit of any definite answer being obtainable. He begins
by rejecting the argument (op. cit. p. 101) that, if marginal prime cost is
equal to marginal wage-cost, non-wage-earners incomes will be altered,
when money-wages are reduced, in the same proportion as wage-earners,
on the ground that this is only valid, if the quantity of employment
remains unaltered which is the very point under discussion. But he
proceeds on the next page (op. cit. p. 102) to make the same mistake
himself by taking as his assumption that at the outset nothing has
happened to non-wage-earners money-income, which, as he has just
shown, is only valid if the quantity of employment does not remain
unaltered-which is the very point under discussion In fact, no answer is
possible, unless other factors are included in our data.
The manner in which the admission, that labour in fact stipulates for a
given money-wage and not for a given real wage (provided that the real
wage does not fall below a certain minimum), affects the analysis, can also
be shown by pointing out that in this case the assumption that more
labour is not available except at a greater real wage, which is fundamental
to most of the argument, breaks down. For example, Professor Pigou
rejects (op. cit. p. 75) the theory of the multiplier by assuming that the rate
of real wages is given, i.e. that, there being already full employment, no
additional labour is forthcoming at a lower real wage. Subject to this
assumption, the argument is, of course, correct. But in this passage
Professor Pigou is criticising a proposal relating to practical policy; and it
is fantastically far removed from the facts to assume, at a time when
statistical unemployment in Great Britain exceeded 2,000,000 (i.e. when
there were 2,000,000 men willing to work at the existing money-wage),
that any rise in the cost of living, however moderate, relatively to the
money-wage would cause the withdrawal from the labour market of more
than the equivalent of all these 2,000,000 men.
It is important to emphasise that the whole of Professor Pigous book
is written on the assumption that any rise in the cost of living, however
moderate, relatively to the money-wage will cause the withdrawal from
the labour market ofa number of workers greater than that of all the
existing unemployed.
Moreover, Professor Pigou does not notice in this passage (op. cit.
p. 75) that the argument, which he advances against secondary
employment as a result of public works, is, on the same assumptions,

equally fatal to increased primary employment from the same policy. For
if the real rate of wages ruling in the wage-goods industries is given, no
increased employment whatever is possible except, indeed, as a result of
non-wage-earners reducing their consumption of wage-goods. For those
newly engaged in the primary employment will presumably increase their
consumption of wage-goods which will reduce the real wage and hence (on
his assumptions) lead to a withdrawal of labour previously employed
elsewhere. Yet Professor Pigou accepts, apparently, the possibility of
increased primary employment. The line between primary and secondary
employment seems to be the critical psychological point at which his good
common sense ceases to overbear his bad theory.
The difference in the conclusions to which the above differences in
assumptions and in analysis lead can be shown by the following important
passage in which Professor Pigou sums up his point of view: With
perfectly free competition among workpeople and labour perfectly mobile,
the nature of the relation (i.e. between the real wage-rates for which
people stipulate and the demand function for labour) will be very simple.
There will always be at work a strong tendency for wage-rates to be so
related to demand that everybody is employed. Hence, in stable conditions
everyone will actually be employed. The implication is that such
unemployment as exists at any time is due wholly to the fact that changes
in demand conditions are continually taking place and that frictional
resistances prevent the appropriate wage adjustments from being made
instantaneously.
He concludes (op. cit. p. 253) that unemployment is primarily due to a
wage policy which fails to adjust itself sufficiently to changes in the real
demand function for labour. Thus Professor Pigou believes that in the long
run unemployment can be cured by wage adjustments; whereas I maintain
that the real wage (subject only to a minimum set by the marginal
disutility of employment) is not primarily determined by wage
adjustments (though these may have repercussions) but by the other
forces of the system, some of which (in particular the relation between the
schedule of the marginal efficiency of capital and the rate of interest)
Professor Pigou has failed, if I am right, to include in his formal scheme.
Finally, when Professor Pigou comes to the Causation of
Unemployment he speaks, it is true, of fluctuations in the state of
demand, much as I do. But he identifies the state of demand with the Real
Demand Function for Labour, forgetful of how narrow a thing the latter is
on his definition. For the Real Demand Function for Labour depends by
definition (as we have seen above) on nothing but two factors, namely (1)
the relationship in any given environment between the total number of
men employed and the number who have to be employed in the wage-
goods industries to provide them with what they consume, and (2) the
state of marginal productivity in the wage-goods industries. Yet in Part V
of his Theory of Unemployment fluctuations in the state of the real
demand for labour are given a position of importance. The real demand
for labour is regarded as a factor which is susceptible of wide short-period
fluctuations (op. cit. Part V, chaps. vi.xii.), and the suggestion seems to
be that swings in the real demand for labour are, in combination with the
failure of wage policy to respond sensitively to such changes, largely
responsible for the trade cycle. To the reader all this seems, at first,
reasonable and familiar. For, unless he goes back to the definition,
fluctuations in the real demand for labour will convey to his mind the
same sort of suggestion as I mean to convey by fluctuations in the state of
aggregate demand. But if we go back to the definition of the real demand
for labour, all this loses its plausibility. For we shall find that there is
nothing in the world less likely to be subject to sharp short-period swings
than this factor.
Professor Pigous real demand for labour depends, by definition, on
nothing but F(x), which represents the physical conditions of production
in the wage-goods industries, and (x), which represents the functional
relationship between employment in the wage-goods industries and total
employment corresponding to any given level of the latter. It is difficult to
see a reason why either of these functions should change, except gradually
over a long period. Certainly there seems no reason to suppose that they
are likely to fluctuate during a trade cycle. For F(x) can only change slowly,
and, in a technically progressive community, only in the forward direction;
whilst (x) will remain stable, unless we suppose a sudden outbreak of thrift
in the working classes, or, more generally, a sudden shift in the propensity
to consume. I should expect, therefore, that the real demand for labour
would remain virtually constant throughout a trade cycle. I repeat that
Professor Pigou has altogether omitted from his analysis the unstable
factor, namely fluctuations in the scale of investment, which is most often
at the bottom of the phenomenon of fluctuations in employment.
I have criticised at length Professor Pigous theory of unemployment
not because he seems to me to be more open to criticism than other
economists of the classical school; but because his is the only attempt with
which I am acquainted to write down the classical theory of
unemployment precisely. Thus it has been incumbent on me to raise my
objections to this theory in the most formidable presentment in which it

has been advanced.

C 20
T E F
In Chapter 3 we have defined the aggregate supply function Z = (N),

which relates the employment N with the aggregate supply price of the
corresponding output. The employment function only differs from the
aggregate supply function in that it is, in effect, its inverse function and is
defined in terms of the wage-unit; the object of the employment function
being to relate the amount of the effective demand, measured in terms of
the wage-unit, directed to a given firm or industry or to industry as a
whole with the amount of employment, the supply price of the output of
which will compare to that amount of effective demand. Thus if an amount
of effective demand Dwr, measured in wage-units, directed to a firm or
industry calls forth an amount of employment Nr in that firm or industry,
the employment function is given by Nr = Fr(Dwr). Or, more generally, if
we are entitled to assume that Dwr is a unique function of the total
effective demand Dw, the employment function is given by Nr = Fr(Dw)
That is to say, Nr men will be employed in industry r when effective
demand is Dw.
We shall develop in this chapter certain properties of the employment

function. But apart from any interest which these may have, there are two
reasons why the substitution of the employment function for the ordinary
supply curve is consonant with the methods and objects of this book. In
the first place, it expresses the relevant facts in terms of the units to which
we have decided to restrict ourselves, without introducing any of the units
which have a dubious quantitative character. In the second place, it lends
itself to the problems of industry and output as a whole, as distinct from
the problems of a single industry or firm in a given environment, more

easily than does the ordinary supply curve for the following reasons.
The ordinary demand curve for a particular commodity is drawn on
some assumption as to the incomes of members of the public, and has to
be re-drawn if the incomes change. In the same way the ordinary supply
curve for a particular commodity is drawn on some assumption as to the
output of industry as a whole and is liable to change if the aggregate
output of industry is changed. When, therefore, we are examining the
response of individual industries to changes in aggregate employment, we
are necessarily concerned, not with a single demand curve for each
industry, in conjunction with a single supply curve, but with two families
of such curves corresponding to different assumptions as to the aggregate
employment. In the case of the employment function, however, the task of
arriving at a function for industry as a whole which will reflect changes in
employment as a whole is more practicable.
For let us assume (to begin with) that the propensity to consume is
given as well as the other factors which we have taken as given in above,
and that we are considering changes in employment in response to
changes in the rate of investment. Subject to this assumption, for every
level of effective demand in terms of wage-units there will be a
corresponding aggregate employment and this effective demand will be
divided in determinate proportions between consumption and investment.
Moreover, each level of effective demand will correspond to a given
distribution of income. It is reasonable, therefore, further to assume that
corresponding to a given level of aggregate effective demand there is a
unique distribution of it between different industries.
This enables us to determine what amount of employment in each
industry will correspond to a given level of aggregate employment. That is
to say, it gives us the amount of employment in each particular industry
corresponding to each level of aggregate effective demand measured in
terms of wage-units, so that the conditions are satisfied for the second
form of the employment function for the industry, defined above, namely
Nr = Fr(Dw) Thus we have the advantage that, in these conditions, the
individual employment functions are additive in the sense that the
employment function for industry as a whole, corresponding to a given
level of effective demand, is equal to the sum of the employment functions
for each separate industry; i.e.
Fr(Dw) = N = Nr = Fr(Dw).
Next, let us define the elasticity of employment. The elasticity of

employment for a given industry is
dNr Dwr
eer =
dDwr Nr
since it measures the response of the number of labour-units employed in

the industry to changes in the number of wage-units which are expected to
be spent on purchasing its output. The elasticity of employment for
industry as a whole we shall write
dN Dw
ee = dD
w Nr
Provided that we can find some sufficiently satisfactory method of

measuring output, it is also useful to define what may be called the
elasticity of output or production, which measures the rate at which output
in any industry increases when more effective demand in terms of wage-
units is directed towards it, namely
dOr Dwr
eor =
dDwr Or
Provided we can assume that the price is equal to the marginal prime cost,
we then have
1
Dwr = 1 e DPr
or
where Pr is the expected profit. It follows from this that if eor = 0, i.e. if the
output of the industry is perfectly inelastic, the whole of the increased
effective demand (in terms of wage-units) is expected to accrue to the
entrepreneur as profit, i.e. Dwr = Pr; whilst if eor = 1, i.e. if the elasticity
of output is unity, no part of the increased effective demand is expected to
accrue as profit, the whole of it being absorbed by the elements entering
into marginal prime cost.
Moreover, if the output of an industry is a function (Nr) of the labour
employed in it, we have
1 eor Nr "(Nr)
=
eer pwr{(Nr)}2
where pwr is the expected price of a unit of output in terms of the wage-
unit. Thus the condition eor = 1 means that "(Nr) = 0, i.e. that there are
constant returns in response to increased employment.
Now, in so far as the classical theory assumes that real wages are
always equal to the marginal disutility of labour and that the latter
increases when employment increases, so that the labour supply will fall
off; cet. par., if real wages are reduced, it is assuming that in practice it is
impossible to increase expenditure in terms of wage-units. If this were
true, the concept of elasticity of employment would have no field of
application. Moreover, it would, in this event, be impossible to increase
employment by increasing expenditure in terms of money; for money-
wages would rise proportionately to the increased money expenditure so
that there would be no increase of expenditure in terms of wage-units and
consequently no increase in employment. But if the classical assumption
does not hold good, it will be possible to increase employment by
increasing expenditure in terms of money until real wages have fallen to
equality with the marginal disutility of labour, at which point there will, by
definition, be full employment.
Ordinarily, of course, eor will have a value intermediate between zero
and unity. The extent to which prices (in terms of wage-units) will rise, i.e.
the extent to which real wages will fall, when money expenditure is
increased, depends, therefore, on the elasticity of output in response to
expenditure in terms of wage-units.
Let the elasticity of the expected price pwr in response to changes in
effective demand Dwr, namely (dpwr/dDwr) (Dwr /pwr), be written epr.
Since Or pwr = Dwr, we have

dOr Dwr dpwr Dwr
+ =1
dDwr Or dDwr pwr
or
epr + eor = 1.
That is to say, the sum of the elasticities of price and of output in response
to changes in effective demand (measured in terms of wage-units) is equal
to unity. Effective demand spends itself, partly in affecting output and
partly in affecting price, according to this law.
If we are dealing with industry as a whole and are prepared to assume
that we have a unit in which output as a whole can be measured, the same
line of argument applies, so that ep + eo = 1, where the elasticities without
a suffix r apply to industry as a whole.
Let us now measure values in money instead of wage-units and extend
to this case our conclusions in respect of industry as a whole.
If W stands for the money-wages of a unit of labour and p for the

expected price of a unit of output as a whole in terms of money, we can
write ep (= (Ddp) / (pdD)) for the elasticity of money-prices in response to
changes in effective demand measured in terms of money, and ew (=
(DdW) / (WdD)) for the elasticity of money-wages in response to changes
in effective demand in terms of money. It is then easily shown that
ep = 1 = eo(1 ew).
This equation is, as we shall see in the next chapter, first step to a
generalised quantity theory of money.
If eo = 0 or if ew = 1, output will be unaltered and prices will rise in the
same proportion as effective demand in terms of money. Otherwise they
will rise in a smaller proportion.
Let us return to the employment function. We have assumed in the

foregoing that to every level or aggregate effective demand there
corresponds a unique distribution of effective demand between the
products of each individual industry. Now, as aggregate expenditure
changes, the corresponding expenditure on the products of an individual
industry will not, in general, change in the same proportion; partly
because individuals will not, as their incomes rise, increase the amount of
the products of each separate industry, which they purchase, in the same
proportion, and partly because the prices of different commodities will
respond in different degrees to increases in expenditure upon them.
It follows from this that the assumption upon which we have worked
hitherto, that changes in employment depend solely on changes in
aggregate effective demand (in terms of wage-units), is no better than a
first approximation, if we admit that there is more than one way in which
an increase of income can be spent. For the way in which we suppose the
increase in aggregate demand to be distributed between different
commodities may considerably influence the volume of employment. If,
for example, the increased demand is largely directed towards products
which have a high elasticity of employment, the aggregate increase in
employment will be greater than if it is largely directed towards products
which have a low elasticity of employment.
In the same way employment may fall off without there having been
any change in aggregate demand, if the direction of demand is changed in
favour of products having a relatively low elasticity of employment.

These considerations are particularly important if we are concerned
with short-period phenomena in the sense of changes in the amount or
direction of demand which are not foreseen some time ahead. Some
products take time to produce, so that it is practically impossible to
increase the supply of them quickly. Thus, if additional demand is directed
to them without notice, they will show a low elasticity of employment;
although it may be that, given sufficient notice, their elasticity of
employment approaches unity.
It is in this connection that I find the principal significance of the
conception of a period of production. A product, I should prefer to say, has
a period of production n if n time-units of notice of changes in the demand
for it have to be given if it is to offer its maximum elasticity of
employment. Obviously consumption-goods, taken as a whole, have in this
sense the longest period of production, since of every productive process
they constitute the last stage. Thus if the first impulse towards the increase
in effective demand comes from an increase in consumption, the initial
elasticity of employment will be further below its eventual equilibrium-
level than if the impulse comes from an increase in investment. Moreover,
if the increased demand is directed to products with a relatively low
elasticity of employment, a larger proportion of it will go to swell the
incomes of entrepreneurs and a smaller proportion to swell the incomes of
wage-earners and other prime-cost factors; with the possible result that
the repercussions may be somewhat less favourable to expenditure, owing
to the likelihood of entrepreneurs saving more of their increment of
income than wage-earners would. Nevertheless the distinction between
the two cases must not be over-stated, since a large part of the reactions
will be much the same in both.
However long the notice given to entrepreneurs of a prospective
change in demand, it is not possible for the initial elasticity of
employment, in response to a given increase of investment, to be as great
as its eventual equilibrium value, unless there are surplus stocks and
surplus capacity at every stage of production. On the other hand, the
depletion of the surplus stocks will have an offsetting effect on the amount
by which investment increases. If we suppose that there are initially some
surpluses at every point, the initial elasticity of employment may
approximate to unity; then after the stocks have been absorbed, but before
an increased supply is coming forward at an adequate rate from the earlier
stages of production, the elasticity will fall away; rising again towards
unity as the new position of equilibrium is approached. This is subject,
however, to some qualification in so far as there are rent factors which

absorb more expenditure as employment increases, or if the rate of
interest increases. For these reasons perfect stability of prices is
impossible in an economy subject to change unless, indeed, there is
some peculiar mechanism which ensures temporary fluctuations of just
the right degree in the propensity to consume. But price-instability arising
in this way does not lead to the kind of profit stimulus which is liable to
bring into existence excess capacity. For the windfall gain will wholly
accrue to those entrepreneurs who happen to possess products at a
relatively advanced stage of production, and there is nothing which the
entrepreneur, who does not possess specialised resources of the right kind,
can do to attract this gain to himself. Thus the inevitable price-instability
due to change cannot affect the actions of entrepreneurs, but merely
directs a de facto windfall of wealth into the laps of the lucky ones
(mutatis mutandis when the supposed change is in the other direction).
This fact has, I think, been overlooked in some contemporary discussions
of a practical policy aimed at stabilising prices.
It is true that in a society liable to change such a policy cannot be
perfectly successful. But it does not follow that every small temporary
departure from price stability necessarily sets up a cumulative
disequilibrium.
We have shown that when effective demand is deficient there is under-

employment of labour in the sense that there are men unemployed who
would be willing to work at less than the existing real wage. Consequently,
as effective demand increases, employment increases, though at a real
wage equal to or less than the existing one, until a point comes at which
there is no surplus of labour available at the then existing real wage; i.e. no
more men (or hours of labour) available unless money-wages rise (from
this point onwards) faster than prices. The next problem is to consider
what will happen If, when this point has been reached, expenditure still
continues to increase.
Up to this point the decreasing return from applying more labour to a
given capital equipment has been offset by the acquiescence of labour in a
diminishing real wage. But after this point a unit of labour would require
the inducement of the equivalent of an increased quantity of product,
whereas the yield from applying a further unit would be a diminished
quantity of product. The conditions of strict equilibrium require, therefore,

that wages and prices, and consequently profits also, should all rise in the
same proportion as expenditure, the real position, including the volume
of output and employment, being left unchanged in all respects. We have
reached, that is to say, a situation in which the crude quantity theory of
money (interpreting velocity to mean income-velocity) is fully satisfied;
for output does not alter and prices rise in exact proportion to MV.
Nevertheless there are certain practical qualifications to this
conclusion which must be borne in mind in applying it to an actual case:
(1) For a time at least, rising prices may delude entrepreneurs into
increasing employment beyond the level which maximises their individual
profits measured in terms of the product. For they are so accustomed to
regard rising sale-proceeds in terms of money as a signal for expanding
production, that they may continue to do so when this policy has in fact
ceased to be to their best advantage; i.e. they may underestimate their
marginal user cost in the new price environment.
(2) Since that part of his profit which the entrepreneur has to hand on
to the rentier is fixed in terms of money, rising prices, even though
unaccompanied by any change in output, will redistribute incomes to the
advantage of the entrepreneur and to the disadvantage of the rentier,
which may have a reaction on the propensity to consume. This, however, is
not a process which will have only begun when full employment has been
attained; it will have been making steady progress all the time that the
expenditure was increasing. If the rentier is less prone to spend than the
entrepreneur, the gradual withdrawal of real income from the former will
mean that full employment will be reached with a smaller increase in the
quantity of money and a smaller reduction in the rate of interest than will
be the case if the opposite hypothesis holds. After full employment has
been reached, a further rise of prices will, if the first hypothesis continues
to hold, mean that the rate of interest will have to rise somewhat to
prevent prices from rising indefinitely, and that the increase in the
quantity of money will be less than in proportion to the increase in
expenditure; whilst if the second hypothesis holds, the opposite will be the
case. It may be that, as the real income of the rentier is diminished, a point
will come when, as a result of his growing relative impoverishment, there
will be a change-over from the first hypothesis to the second, which point
may be reached either before or after full employment has been attained.
There is, perhaps, something a little perplexing in the apparent asymmetry

between inflation and deflation. For whilst a deflation of effective demand
below the level required for full employment will diminish employment as
well as prices, an inflation of it above this level will merely affect prices.
This asymmetry is, however, merely a reflection of the fact that, whilst
labour is always in a position to refuse to work on a scale involving a real
wage which is less than the marginal disutility of that amount of
employment, it is not in a position to insist on being offered work on a
scale involving a real wage which is not greater than the marginal disutility
of that amount of employment.

C 21
T T P
So long as economists are concerned with what is called the theory of

value, they have been accustomed to teach that prices are governed by the
conditions of supply and demand; and, in particular, changes in marginal
cost and the elasticity of short-period supply have played a prominent
part. But when they pass in volume II, or more often in a separate treatise,
to the theory of money and prices, we hear no more of these homely but
intelligible concepts and move into a world where prices are governed by
the quantity of money, by its income-velocity, by the velocity of circulation
relatively to the volume of transactions, by hoarding, by forced saving, by
inflation and deflation et hoc genus omne; and little or no attempt is made
to relate these vaguer phrases to our former notions of the elasticities of
supply and demand. If we reflect on what we are being taught and try to
rationalise it, in the simpler discussions it seems that the elasticity of
supply must have become zero and demand proportional to the quantity of
money; whilst in the more sophisticated we are lost in a haze where
nothing is clear and everything is possible. We have all of us become used
to finding ourselves sometimes on the one side of the moon and
sometimes on the other, without knowing what route or journey connects
them, related, apparently, after the fashion of our waking and our
dreaming lives.
One of the objects of the foregoing chapters has been to escape from
this double life and to bring the theory of prices as a whole back to close
contact with the theory of value. The division of economics between the
theory of value and distribution on the one hand and the theory of money
on the other hand is, I think, a false division. The right dichotomy is, I
suggest, between the theory of the individual industry or firm and of the
rewards and the distribution between different uses of a given quantity of
resources on the one hand, and the theory of output and employment as a
whole on the other hand. So long as we limit ourselves to the study of the
individual industry or firm on the assumption that the aggregate quantity
of employed resources is constant, and, provisionally, that the conditions
of other industries or firms are unchanged, it is true that we are not
concerned with the significant characteristics of money. But as soon as we
pass to the problem of what determines output and employment as a
whole, we require the complete theory of a monetary economy.
Or, perhaps, we might make our line of division between the theory of
stationary equilibrium and the theory of shifting equilibrium meaning
by the latter the theory of a system in which changing views about the
future are capable of influencing the present situation. For the importance
of money essentially flows from its being a link between the present and
the future. We can consider what distribution of resources between
different uses will be consistent with equilibrium under the influence of
normal economic motives in a world in which our views concerning the
future are fixed and reliable in all respects; with a further division,
perhaps, between an economy which is unchanging and one subject to
change, but where all things are foreseen from the beginning. Or we can
pass from this simplified propaedeutic to the problems of the real world in
which our previous expectations are liable to disappointment and
expectations concerning the future affect what we do to-day. It is when we
have made this transition that the peculiar properties of money as a link
between the present and the future must enter into our calculations. But,
although the theory of shifting equilibrium must necessarily be pursued in
terms of a monetary economy, it remains a theory of value and
distribution and not a separate theory of money. Money in its significant
attributes is, above all, a subtle device for linking the present to the future;
and we cannot even begin to discuss the effect of changing expectations on
current activities except in monetary terms. We cannot get rid of money
even by abolishing gold and silver and legal tender instruments. So long as
there exists any durable asset, it is capable of possessing monetary
attributes and, therefore, of giving rise to the characteristic problems of a
monetary economy.
In a single industry its particular price-level depends partly on the rate of

remuneration of the factors of production which enter into its marginal
cost, and partly on the scale of output. There is no reason to modify this
conclusion when we pass to industry as a whole. The general price-level
depends partly on the rate of remuneration of the factors of production
which enter into marginal cost and partly on the scale of output as a whole,
i.e. (taking equipment and technique as given) on the volume of
employment. It is true that, when we pass to output as a whole, the costs of
production in any industry partly depend on the output of other
industries. But the more significant change, of which we have to take
account, is the effect of changes in demand both on costs and on volume.
It is on the side of demand that we have to introduce quite new ideas when
we are dealing with demand as a whole and no longer with the demand for
a single product taken in isolation, with demand as a whole assumed to be
unchanged.
If we allow ourselves the simplification of assuming that the rates of

remuneration of the different factors of production which enter into
marginal cost all change in the same proportion, i.e. in the same
proportion as the wage-unit, it follows that the general price-level (taking
equipment and technique as given) depends partly on the wage-unit and
partly on the volume of employment. Hence the effect of changes in the
quantity of money on the price-level can be considered as being
compounded of the effect on the wage-unit and the effect on employment.
To elucidate the ideas involved, let us simplify our assumptions still
further, and assume (1) that all unemployed resources are homogeneous
and interchangeable in their efficiency to produce what is wanted, and (2)
that the factors of production entering into marginal cost are content with
the same money-wage so long as there is a surplus of them unemployed. In
this case we have constant returns and a rigid wage-unit, so long as there
is any unemployment. It follows that an increase in the quantity of money
will have no effect whatever on prices, so long as there is any
unemployment, and that employment will increase in exact proportion to
any increase in effective demand brought about by the increase in the
quantity of money; whilst as soon as full employment is reached, it will
thenceforward be the wage-unit and prices which will increase in exact
proportion to the increase in effective demand. Thus if there is perfectly
elastic supply so long as there is unemployment, and perfectly inelastic
supply so soon as full employment is reached, and if effective demand
changes in the same proportion as the quantity of money, the quantity

theory of money can be enunciated as follows: So long as there is
unemployment, employment will change in the same proportion as the
quantity of money; and when there is full employment, prices will change
in the same proportion as the quantity of money.
Having, however, satisfied tradition by introducing a sufficient
number of simplifying assumptions to enable us to enunciate a quantity
theory of money, let us now consider the possible complications which will
in fact influence events:
(1) Effective demand will not change in exact proportion to the
quantity of money.
(2) Since resources are not homogeneous, there will be diminishing,
and not constant, returns as employment gradually increases.
(3) Since resources are not interchangeable, some commodities will
reach a condition of inelastic supply whilst there are still unemployed
resources available for the production of other commodities.
(4) The wage-unit will tend to rise, before full employment has been
reached.
(5) The remunerations of the factors entering into marginal cost will
not all change in the same proportion.
Thus we must first consider the effect of changes in the quantity of
money on the quantity of effective demand; and the increase in effective
demand will, generally speaking, spend itself partly in increasing the
quantity of employment and partly in raising the level of prices. Thus
instead of constant prices in conditions of unemployment, and of prices
rising in proportion to the quantity of money in conditions of full
employment, we have in fact a condition of prices rising gradually as
employment increases. The theory of prices, that is to say, the analysis of
the relation between changes in the quantity of money and changes in the
price-level with a view to determining the elasticity of prices in response to
changes in the quantity of money, must, therefore, direct itself to the five
complicating factors set forth above.
We will consider each of them in turn. But this procedure must not be
allowed to lead us into supposing that they are, strictly speaking,
independent. For example, the proportion, in which an increase in
effective demand is divided in its effect between increasing output and
raising prices, may affect the way in which the quantity of money is related
to the quantity of effective demand. Or, again, the differences in the
proportions, in which the remunerations of different factors change, may
influence the relation between the quantity of money and the quantity of
effective demand. The object of our analysis is, not to provide a machine,
or method of blind manipulation, which will furnish an infallible answer,
but to provide ourselves with an organised and orderly method of thinking
out particular problems; and, after we have reached a provisional
conclusion by isolating the complicating factors one by one, we then have
to go back on ourselves and allow, as well as we can, for the probable
interactions of the factors amongst themselves. This is the nature of
economic thinking. Any other way of applying our formal principles of
thought (without which, however, we shall be lost in the wood) will lead us
into error. It is a great fault of symbolic pseudo-mathematical methods of
formalising a system of economic analysis, such as we shall set down in
section vi of this chapter, that they expressly assume strict independence
between the factors involved and lose all their cogency and authority if this
hypothesis is disallowed; whereas, in ordinary discourse, where we are not
blindly manipulating but know all the time what we are doing and what
the words mean, we can keep at the back of our heads the necessary
reserves and qualifications and the adjustments which we shall have to
make later on, in a way in which we cannot keep complicated partial
differentials at the back of several pages of algebra which assume that
they all vanish. Too large a proportion of recent mathematical economics
are merely concoctions, as imprecise as the initial assumptions they rest
on, which allow the author to lose sight of the complexities and
interdependencies of the real world in a maze of pretentious and unhelpful
symbols.
(1) The primary effect of a change in the quantity of money on the quantity
of effective demand is through its influence on the rate of interest. If this
were the only reaction, the quantitative effect could be derived from the
three elements (a) the schedule of liquidity-preference which tells us by
how much the rate of interest will have to fall in order that the new money
may be absorbed by willing holders, (b) the schedule of marginal
efficiencies which tells us by how much a given fall in the rate of interest
will increase investment, and (c) the investment multiplier which tells us
by how much a given increase in investment will increase effective demand
as a whole.
But this analysis, though it is valuable in introducing order and

method into our enquiry, presents a deceptive simplicity, if we forget that
the three elements (a), (b) and (c) are themselves partly dependent on the
complicating factors (2), (3), (4) and (5) which we have not yet considered.
For the schedule of liquidity-preference itself depends on how much of the
new money is absorbed into the income and industrial circulations, which
depends in turn on how much effective demand increases and how the
increase is divided between the rise of prices, the rise of wages, and the
volume of output and employment. Furthermore, the schedule of marginal
efficiencies will partly depend on the effect which the circumstances
attendant on the increase in the quantity of money have on expectations of
the future monetary prospects. And finally the multiplier will be
influenced by the way in which the new income resulting from the
increased effective demand is distributed between different classes of
consumers. Nor, of course, is this list of possible interactions complete.
Nevertheless, if we have all the facts before us, we shall have enough
simultaneous equations to give us a determinate result. There will be a
determinate amount of increase in the quantity of effective demand which,
after taking everything into account, will correspond to, and be in
equilibrium with, the increase in the quantity of money. Moreover, it is
only in highly exceptional circumstances that an increase in the quantity of
money will be associated with a decrease in the quantity of effective
demand.
The ratio between the quantity of effective demand and the quantity
of money closely corresponds to what is often called the income-velocity
of money; except that effective demand corresponds to the income the
expectation of which has set production moving, not to the actually
realised income, and to gross, not net, income. But the income-velocity of
money is, in itself, merely a name which explains nothing. There is no
reason to expect that it will be constant. For it depends, as the foregoing
discussion has shown, on many complex and variable factors. The use of
this term obscures, I think, the real character of the causation, and has led
to nothing but confusion.
(2) As we have shown above (Chapter 4), the distinction between
diminishing and constant returns partly depends on whether workers are
remunerated in strict proportion to their efficiency. If so, we shall have
constant labour-costs (in terms of the wage-unit) when employment
increases. But if the wage of a given grade of labourers is uniform
irrespective of the efficiency of the individuals, we shall have rising labour-
costs, irrespective of the efficiency of the equipment. Moreover, if
equipment is non-homogeneous and some part of it involves a greater

prime cost per unit of output, we shall have increasing marginal prime
costs over and above any increase due to increasing labour-costs.
Hence, in general, supply price will increase as output from a given
equipment is increased. Thus increasing output will be associated with
rising prices, apart from any change in the wage-unit.
(3) Under (2) we have been contemplating the possibility of supply
being imperfectly elastic. If there is a perfect balance in the respective
quantities of specialised unemployed resources, the point of full
employment will be reached for all of them simultaneously. But, in
general, the demand for some services and commodities will reach a level
beyond which their supply is, for the time being, perfectly inelastic, whilst
in other directions there is still a substantial surplus of resources without
employment. Thus as output increases, a series of bottle-necks will be
successively reached, where the supply of particular commodities ceases to
be elastic and their prices have to rise to whatever level is necessary to
divert demand into other directions.
It is probable that the general level of prices will not rise very much as
output increases, so long as there are available efficient unemployed
resources of every type. But as soon as output has increased sufficiently to
begin to reach the bottle-necks, there is likely to be a sharp rise in the
prices of certain commodities.
Under this heading, however, as also under heading (2), the elasticity
of supply partly depends on the elapse of time. If we assume a sufficient
interval for the quantity of equipment itself to change, the elasticities of
supply will be decidedly greater eventually. Thus a moderate change in
effective demand, coming on a situation where there is widespread
unemployment, may spend itself very little in raising prices and mainly in
increasing employment; whilst a larger change, which, being unforeseen,
causes some temporary bottle-necks to be reached, will spend itself in
raising prices, as distinct from employment, to a greater extent at first
than subsequently.
(4) That the wage-unit may tend to rise before full employment has
been reached, requires little comment or explanation. Since each group of
workers will gain, cet. par., by a rise in its own wages, there is naturally for
all groups a pressure in this direction, which entrepreneurs will be more
ready to meet when they are doing better business. For this reason a
proportion of any increase in effective demand is likely to be absorbed in
satisfying the upward tendency of the wage-unit.
Thus, in addition to the final critical point of full employment at

which money-wages have to rise, in response to an increasing effective
demand in terms of money, fully in proportion to the rise in the prices of
wage-goods, we have a succession of earlier semi-critical points at which
an increasing effective demand tends to raise money-wages though not
fully in proportion to the rise in the price of wage-goods; and similarly in
the case of a decreasing effective demand. In actual experience the wage-
unit does not change continuously in terms of money in response to every
small change in effective demand; but discontinuously. These points of
discontinuity are determined by the psychology of the workers and by the
policies of employers and trade unions. In an open system, where they
mean a change relatively to wage-costs elsewhere, and in a trade cycle,
where even in a closed system they may mean a change relatively to
expected wage-costs in the future, they can be of considerable practical
significance. These points, where a further increase in effective demand in
terms of money is liable to cause a discontinuous rise in the wage-unit,
might be deemed, from a certain point of view, to be positions of semi-
inflation, having some analogy (though a very imperfect one) to the
absolute inflation (cf. Chapter 21 below) which ensues on an increase in
effective demand in circumstances of full employment. They have,
moreover, a good deal of historical importance. But they do not readily
lend themselves to theoretical generalisations.
(5) Our first simplification consisted in assuming that the
remunerations of the various factors entering into marginal cost all change
in the same proportion. But in fact the rates of remuneration of different
factors in terms of money will show varying degrees of rigidity and they
may also have different elasticities of supply in response to changes in the
money-rewards offered. If it were not for this, we could say that the price-
level is compounded of two factors, the wage-unit and the quantity of
employment.
Perhaps the most important element in marginal cost which is likely
to change in a different proportion from the wage-unit, and also to
fluctuate within much wider limits, is marginal user cost. For marginal
user cost may increase sharply when employment begins to improve, if (as
will probably be the case) the increasing effective demand brings a rapid
change in the prevailing expectation as to the date when the replacement
of equipment will be necessary.
Whilst it is for many purposes a very useful first approximation to
assume that the rewards of all the factors entering into marginal prime-
cost change in the same proportion as the wage-unit, it might be better,
perhaps, to take a weighted average of the rewards of the factors entering

into marginal prime-cost, and call this the cost-unit. The cost-unit, or,
subject to the above approximation, the wage-unit, can thus be regarded as
the essential standard of value; and the price-level, given the state of
technique and equipment, will depend partly on the cost-unit, and partly
on the scale of output, increasing, where output increases, more than in
proportion to any increase in the cost-unit, in accordance with the
principle of diminishing returns in the short period. We have full
employment when output has risen to a level at which the marginal return
from a representative unit of the factors of production has fallen to the
minimum figure at which a quantity of the factors sufficient to produce
this output is available.
When a further increase in the quantity of effective demand produces no

further increase in output and entirely spends itself on an increase in the
cost-unit fully proportionate to the increase in effective demand, we have
reached a condition which might be appropriately designated as one of
true inflation. Up to this point the effect of monetary expansion is entirely
a question of degree, and there is no previous point at which we can draw a
definite line and declare that conditions of inflation have set in. Every
previous increase in the quantity of money is likely, in so far as it increases
effective demand, to spend itself partly in increasing the cost-unit and
partly in increasing output.
It appears, therefore, that we have a sort of asymmetry on the two
sides of the critical level above which true inflation sets in. For a
contraction of effective demand below the critical level will reduce its
amount measured in cost-units; whereas an expansion of effective demand
beyond this level will not, in general, have the effect of increasing its
amount in terms of cost-units. This result follows from the assumption
that the factors of production, and in particular the workers, are disposed
to resist a reduction in their money-rewards, and that there is no
corresponding motive to resist an increase. This assumption is, however,
obviously well founded in the facts, due to the circumstance that a change,
which is not an all-round change, is beneficial to the special factors
affected when it is upward and harmful when it is downward.
If, on the contrary, money-wages were to fall without limit whenever
there was a tendency for less than full employment, the asymmetry would,
indeed, disappear. But in that case there would be no resting-place below

full employment until either the rate of interest was incapable of falling
further or wages were zero. In fact we must have some factor, the value of
which in terms of money is, if not fixed, at least sticky, to give us any
stability of values in a monetary system.
The view that any increase in the quantity of money is inflationary
(unless we mean by inflationary merely that prices are rising) is bound up
with the underlying assumption of the classical theory that we are always
in a condition where a reduction in the real rewards of the factors of
production will lead to a curtailment in their supply.
With the aid of the notation introduced in Chapter 20 we can, if we wish,

express the substance of the above in symbolic form.
Let us write MV = D where M is the quantity of money, V its income-
velocity (this definition differing in the minor respects indicated above
from the usual definition) and D the effective demand. If, then, V is
constant, prices will change in the same proportion as the quantity of
money provided that ep ( = (Dpd) / (pdD)) is unity. This condition is
satisfied (see Chapter 20 above) if eo = 0 or if ew = 1. The condition ew = 1
means that the wage-unit in terms of money rises in the same proportion
as the effective demand, since ew = (DdW) / (WdD) and the condition eo =
0 means that output no longer shows any response to a further increase in
effective demand, since eo = (DdO) / (OdD). Output in either case will be
unaltered. Next, we can deal with the case where income-velocity is not
constant, by introducing yet a further elasticity, namely the elasticity of
effective demand in response to changes in the quantity of money,
ed = MdD
DdM
This gives us
Mdp = e e
p d
pdM
where
ep = 1 ee eo(1 ew);
so that
e = ed (1 ew)ed eeeo = ed(1 ee eo + ee eo ew)
where e without suffix (= (Mdp) / (pdM)) stands for the apex of this
pyramid and measures the response of money-prices to changes in the
quantity of money.
Since this last expression gives us the proportionate change in prices
in response to a change in the quantity of money, it can be regarded as a
generalised statement of the quantity theory of money. I do not myself
attach much value to manipulations of this kind; and I would repeat the
warning, which I have given above, that they involve just as much tacit
assumption as to what variables are taken as independent (partial
differentials being ignored throughout) as does ordinary discourse, whilst
I doubt if they carry us any further than ordinary discourse can. Perhaps
the best purpose served by writing them down is to exhibit the extreme
complexity of the relationship between prices and the quantity of money,
when we attempt to express it in a formal manner. It is, however, worth
pointing out that, of the four terms ed, ew, ee and eo upon which the effect
on prices of changes in the quantity of money depends, ed stands for the
liquidity factors which determine the demand for money in each situation,
ew for the labour factors (or, more strictly, the factors entering into prime-
cost) which determine the extent to which money-wages are raised as
employment increases, and ee and eo for the physical factors which
determine the rate of decreasing returns as more employment is applied to
the existing equipment.
If the public hold a constant proportion of their income in money,
ed = 1; if money-wages are fixed, ew = 0; if there are constant returns
throughout so that marginal return equals average return, ee eo = 1; and if
there is full employment either of labour or of equipment, ee eo = 0.
Now e = 1, if ed = 1, and ew = 1; or if ed = 1, ew = 0 and ee eo =

0; or if ed = 1 and eo = 0. And obviously there is a variety of other special
eases in which e = 1. But in general e is not unity; and it is, perhaps, safe
to make the generalisation that on plausible assumptions relating to the
real world, and excluding the case of a flight from the currency in which
ed and ew become large, e is, as a rule, less than unity.
So far, we have been primarily concerned with the way in which changes in
the quantity of money affect prices in the short period. But in the long run
is there not some simpler relationship?

This is a question for historical generalisation rather than for pure
theory. If there is some tendency to a measure of long-run uniformity in
the state of liquidity-preference, there may well be some sort of rough
relationship between the national income and the quantity of money
required to satisfy liquidity-preference, taken as a mean over periods of
pessimism and optimism together. There may be, for example, some fairly
stable proportion of the national income more than which people will not
readily keep in the shape of idle balances for long periods together,
provided the rate of interest exceeds a certain psychological minimum; so
that if the quantity of money beyond what is required in the active
circulation is in excess of this proportion of the national income, there will
be a tendency sooner or later for the rate of interest to fall to the
neighbourhood of this minimum. The falling rate of interest will then, cet.
par., increase effective demand, and the increasing effective demand will
reach one or more of the semi-critical points at which the wage-unit will
tend to show a discontinuous rise, with a corresponding effect on prices.
The opposite tendencies will set in if the quantity of surplus money is an
abnormally low proportion of the national income. Thus the net effect of
fluctuations over a period of time will be to establish a mean figure in
conformity with the stable proportion between the national income and
the quantity of money to which the psychology of the public tends sooner
or later to revert.
These tendencies will probably work with less friction in the upward
than in the downward direction. But if the quantity of money remains very
deficient for a long time, the escape will be normally found in changing the
monetary standard or the monetary system so as to raise the quantity of
money, rather than in forcing down the wage-unit and thereby increasing
the burden of debt. Thus the very long-run course of prices has almost
always been upward. For when money is relatively abundant, the wage-
unit rises; and when money is relatively scarce, some means is found to
increase the effective quantity of money.
During the nineteenth century, the growth of population and of
invention, the opening-up of new lands, the state of confidence and the
frequency of war over the average of (say) each decade seem to have been
sufficient, taken in conjunction with the propensity to consume, to
establish a schedule of the marginal efficiency of capital which allowed a
reasonably satisfactory average level of employment to be compatible with
a rate of interest high enough to be psychologically acceptable to wealth-
owners. There is evidence that for a period of almost one hundred and fifty
years the long-run typical rate of interest in the leading financial centres
was about 5 per cent, and the gilt-edged rate between 3 and 3 per cent;
and that these rates of interest were modest enough to encourage a rate of
investment consistent with an average of employment which was not
intolerably low. Sometimes the wage-unit, but more often the monetary
standard or the monetary system (in particular through the development
of bank-money), would be adjusted so as to ensure that the quantity of
money in terms of wage-units was sufficient to satisfy normal liquidity-
preference at rates of interest which were seldom much below the
standard rates indicated above. The tendency of the wage-unit was, as
usual, steadily upwards on the whole, but the efficiency of labour was also
increasing. Thus the balance of forces was such as to allow a fair measure
of stability of prices; the highest quinquennial average for Sauerbecks
index number between 1820 and 1914 was only 50 per cent above the
lowest. This was not accidental. It is rightly described as due to a balance
of forces in an age when individual groups of employers were strong
enough to prevent the wage-unit from rising much faster than the
efficiency of production, and when monetary systems were at the same
time sufficiently fluid and sufficiently conservative to provide an average
supply of money in terms of wage-units which allowed to prevail the
lowest average rate of interest readily acceptable by wealth-owners under
the influence of their liquidity-preferences. The average level of
employment was, of course, substantially below full employment, but not
so intolerably below it as to provoke revolutionary changes.
To-day and presumably for the future the schedule of the marginal
efficiency of capital is, for a variety of reasons, much lower than it was in
the nineteenth century. The acuteness and the peculiarity of our
contemporary problem arises, therefore, out of the possibility that the
average rate of interest which will allow a reasonable average level of
employment is one so unacceptable to wealth-owners that it cannot be
readily established merely by manipulating the quantity of money. So long
as a tolerable level of employment could be attained on the average of one
or two or three decades merely by assuring an adequate supply of money
in terms of wage-units, even the nineteenth century could find a way. If
this was our only problem now if a sufficient degree of devaluation is all
we need we, to-day, would certainly find a way.
But the most stable, and the least easily shifted, element in our
contemporary economy has been hitherto, and may prove to be in future,
the minimum rate of interest acceptable to the generality of wealth-
owners. If a tolerable level of employment requires a rate of interest much
below the average rates which ruled in the nineteenth century, it is most
doubtful whether it can be achieved merely by manipulating the quantity
of money. From the percentage gain, which the schedule of marginal
efficiency of capital allows the borrower to expect to earn, there has to be
deducted (1) the cost of bringing borrowers and lenders together, (2)
income and sur-taxes and (3) the allowance which the lender requires to
cover his risk and uncertainty, before we arrive at the net yield available to
tempt the wealth-owner to sacrifice his liquidity. If, in conditions of
tolerable average employment, this net yield turns out to be infinitesimal,
time-honoured methods may prove unavailing.
To return to our immediate subject, the long-run relationship between
the national income and the quantity of money will depend on liquidity-
preferences. And the long-run stability or instability of prices will depend
on the strength of the upward trend ofthe wage-unit (or, more precisely, of
the cost-unit) compared with the rate of increase in the efficiency of the
productive system.

C 22
N T C
Since we claim to have shown in the preceding chapters what determines

the volume of employment at any time, it follows, if we are right, that our
theory must be capable of explaining the phenomena of the trade cycle.
If we examine the details of any actual instance of the trade cycle, we
shall find that it is highly complex and that every element in our analysis
will be required for its complete explanation. In particular we shall find
that fluctuations in the propensity to consume, in the state of liquidity-
preference, and in the marginal efficiency of capital have all played a part.
But I suggest that the essential character of the trade cycle and, especially,
the regularity of time-sequence and of duration which justifies us in calling
it a cycle, is mainly due to the way in which the marginal efficiency of
capital fluctuates. The trade cycle is best regarded, I think, as being
occasioned by a cyclical change in the marginal efficiency of capital,
though complicated and often aggravated by associated changes in the
other significant short-period variables of the economic system. To
develop this thesis would occupy a book rather than a chapter, and would
require a close examination of facts. But the following short notes will be
sufficient to indicate the line of investigation which our preceding theory
suggests.
By a cyclical movement we mean that as the system progresses in, e.g. the
upward direction, the forces propelling it upwards at first gather force and
have a cumulative effect on one another but gradually lose their strength
until at a certain point they tend to be replaced by forces operating in the
opposite direction; which in turn gather force for a time and accentuate
one another, until they too, having reached their maximum development,
wane and give place to their opposite. We do not, however, merely mean
by a cyclical movement that upward and downward tendencies, once

started, do not persist for ever in the same direction but are ultimately
reversed. We mean also that there is some recognisable degree of
regularity in the time-sequence and duration of the upward and downward
movements.
There is, however, another characteristic of what we call the trade
cycle which our explanation must cover if it is to be adequate; namely, the
phenomenon of the crisis the fact that the substitution of a downward
for an upward tendency often takes place suddenly and violently, whereas
there is, as a rule, no such sharp turning-point when an upward is
substituted for a downward tendency.
Any fluctuation in investment not offset by a corresponding change in
the propensity to consume will, of course, result in a fluctuation in
employment. Since, therefore, the volume of investment is subject to
highly complex influences, it is highly improbable that all fluctuations
either in investment itself or in the marginal efficiency of capital will be of
a cyclical character. One special case, in particular, namely, that which is
associated with agricultural fluctuations, will be separately considered in a
later section of this chapter. I suggest, however, that there are certain
definite reasons why, in the case of a typical industrial trade cycle in the
nineteenth-century environment, fluctuations in the marginal efficiency of
capital should have had cyclical characteristics. These reasons are by no
means unfamiliar either in themselves or as explanations of the trade
cycle. My only purpose here is to link them up with the preceding theory.
I can best introduce what I have to say by beginning with the later stages
of the boom and the onset of the crisis.
We have seen above that the marginal efficiency of capital depends,
not only on the existing abundance or scarcity of capital-goods and the
current cost of production of capital-goods, but also on current
expectations as to the future yield of capital-goods. In the case of durable
assets it is, therefore, natural and reasonable that expectations of the
future should play a dominant part in determining the scale on which new
investment is deemed advisable. But, as we have seen, the basis for such
expectations is very precarious. Being based on shifting and unreliable
evidence, they are subject to sudden and violent changes.
Now, we have been accustomed in explaining the crisis to lay stress

on the rising tendency of the rate of interest under the influence of the
increased demand for money both for trade and speculative purposes. At
times this factor may certainly play an aggravating and, occasionally
perhaps, an initiating part. But I suggest that a more typical, and often the
predominant, explanation of the crisis is, not primarily a rise in the rate of
interest, but a sudden collapse in the marginal efficiency of capital.
The later stages of the boom are characterised by optimistic
expectations as to the future yield of capital-goods sufficiently strong to
offset their growing abundance and their rising costs of production and,
probably, a rise in the rate of interest also. It is of the nature of organised
investment markets, under the influence of purchasers largely ignorant of
what they are buying and of speculators who are more concerned with
forecasting the next shift of market sentiment than with a reasonable
estimate of the future yield of capital-assets, that, when disillusion falls
upon an over-optimistic and over-bought market, it should fall with
sudden and even catastrophic force. Nloreover, the dismay and
uncertainty as to the future which accompanies a collapse in the marginal
efficiency of capital naturally precipitates a sharp increase in liquidity-
preference and hence a rise in the rate of interest. Thus the fact that a
collapse in the marginal efficiency of capital tends to be associated with a
rise in the rate of interest may seriously aggravate the decline in
investment. But the essence of the situation is to be found, nevertheless, in
the collapse in the marginal efficiency of capital, particularly in the case of
those types of capital which have been contributing most to the previous
phase of heavy new investment. Liquidity-preference, except those
manifestations of it which are associated with increasing trade and
speculation, does not increase until after the collapse in the marginal
It is this, indeed, which renders the slump so intractable. Later on, a
decline in the rate of interest will be a great aid to recovery and, probably,
a necessary condition of it. But, for the moment, the collapse in the
marginal efficiency of capital may be so complete that no practicable
reduction in the rate of interest will be enough. If a reduction in the rate of
interest was capable of proving an effective remedy by itself; it might be
possible to achieve a recovery without the elapse of any considerable
interval of time and by means more or less directly under the control of the
monetary authority. But, in fact, this is not usually the case; and it is not so
easy to revive the marginal efficiency of capital, determined, as it is, by the
uncontrollable and disobedient psychology of the business world. It is the
return of confidence, to speak in ordinary language, which is so

insusceptible to control in an economy of individualistic capitalism. This is
the aspect of the slump which bankers and business men have been right
in emphasising, and which the economists who have put their faith in a
purely monetary remedy have underestimated.
This brings me to my point. The explanation of the time-element in
the trade cycle, of the fact that an interval of time of a particular order of
magnitude must usually elapse before recovery begins, is to be sought in
the influences which govern the recovery of the marginal efficiency of
capital. There are reasons, given firstly by the length of life of durable
assets in relation to the normal rate of growth in a given epoch, and
secondly by the carrying-costs of surplus stocks, why the duration of the
downward movement should have an order of magnitude which is not
fortuitous, which does not fluctuate between, say, one year this time and
ten years next time, but which shows some regularity of habit between, let
us say, three and five years.
Let us recur to what happens at the crisis. So long as the boom was
continuing, much of the new investment showed a not unsatisfactory
current yield. The disillusion comes because doubts suddenly arise
concerning the reliability of the prospective yield, perhaps because the
current yield shows signs of falling off, as the stock of newly produced
durable goods steadily increases. If current costs of production are thought
to be higher than they will be later on, that will be a further reason for a
fall in the marginal efficiency of capital. Once doubt begins it spreads
rapidly. Thus at the outset of the slump there is probably much capital of
which the marginal efficiency has become negligible or even negative. But
the interval of time, which will have to elapse before the shortage of capital
through use, decay and obsolescence causes a sufficiently obvious scarcity
to increase the marginal efficiency, may be a somewhat stable function of
the average durability of capital in a given epoch. If the characteristics of
the epoch shift, the standard time-interval will change. If, for example, we
pass from a period of increasing population into one of declining
population, the characteristic phase of the cycle will be lengthened. But we
have in the above a substantial reason why the duration of the slump
should have a definite relationship to the length of life of durable assets
and to the normal rate of growth in a given epoch.
The second stable time-factor is due to the carrying-costs of surplus
stocks which force their absorption within a certain period, neither very
short nor very long. The sudden cessation of new investment after the
crisis will probably lead to an accumulation of surplus stocks of unfinished
goods. The carrying-costs of these stocks will seldom be less than 10 per
cent. per annum. Thus the fall in their price needs to be sufficient to bring
about a restriction which provides for their absorption within a period of;
say, three to five years at the outside. Now the process of absorbing the
stocks represents negative investment, which is a further deterrent to
employment; and, when it is over, a manifest relief will be experienced.
Moreover, the reduction in working capital, which is necessarily attendant
on the decline in output on the downward phase, represents a further
element of disinvestment, which may be large; and, once the recession has
begun, this exerts a strong cumulative influence in the downward
direction. In the earliest phase of a typical slump there will probably be an
investment in increasing stocks which helps to offset disinvestment in
working-capital; in the next phase there may be a short period of
disinvestment both in stocks and in working-capital; after the lowest point
has been passed there is likely to be a further disinvestment in stocks
which partially offsets reinvestment in working-capital; and, finally, after
the recovery is well on its way, both factors will be simultaneously
favourable to investment. It is against this background that the additional
and superimposed effects of fluctuations of investment in durable goods
must be examined. When a decline in this type of investment has set a
cyclical fluctuation in motion there will be little encouragement to a
recovery in such investment until the cycle has partly run its course.
Unfortunately a serious fall in the marginal efficiency of capital also
tends to affect adversely the propensity to consume. For it involves a
severe decline in the market value of stock exchange equities. Now, on the
class who take an active interest in their stock exchange investments,
especially if they are employing borrowed funds, this naturally exerts a
very depressing influence. These people are, perhaps, even more
influenced in their readiness to spend by rises and falls in the value of their
investments than by the state of their incomes. With a stock-minded
public as in the United States to-day, a rising stock-market may be an
almost essential condition of a satisfactory propensity to consume; and
this circumstance, generally overlooked until lately, obviously serves to
aggravate still further the depressing effect of a decline in the marginal
When once the recovery has been started, the manner in which it
feeds on itself and cumulates is obvious. But during the downward phase,
when both fixed capital and stocks of materials are for the time being
redundant and working-capital is being reduced, the schedule of the
marginal efficiency of capital may fall so low that it can scarcely be
corrected, so as to secure a satisfactory rate of new investment, by any

practicable reduction in the rate of interest. Thus with markets organised
and influenced as they are at present, the market estimation of the
marginal efficiency of capital may suffer such enormously wide
fluctuations that it cannot be sufficiently offset by corresponding
fluctuations in the rate of interest. Moreover, the corresponding
movements in the stock-market may, as we have seen above, depress the
propensity to consume just when it is most needed. In conditions of
laissez-faire the avoidance of wide fluctuations in employment may,
therefore, prove impossible without a far-reaching change in the
psychology of investment markets such as there is no reason to expect. I
conclude that the duty of ordering the current volume of investment
cannot safely be left in private hands.
The preceding analysis may appear to be in conformity with the view of

those who hold that over-investment is the characteristic of the boom, that
the avoidance of this over-investment is the only possible remedy for the
ensuing slump, and that, whilst for the reasons given above the slump
cannot be prevented by a low rate of interest, nevertheless the boom can
be avoided by a high rate of interest. There is, indeed, force in the
argument that a high rate of interest is much more effective against a
boom than a low rate of interest against a slump.
To infer these conclusions from the above would, however,
misinterpret my analysis; and would, according to my way of thinking,
involve serious error. For the term over-investment is ambiguous. It may
refer to investments which are destined to disappoint the expectations
which prompted them or for which there is no use in conditions of severe
unemployment, or it may indicate a state of affairs where every kind of
capital-goods is so abundant that there is no new investment which is
expected, even in conditions of full employment, to earn in the course of
its life more than its replacement cost. It is only the latter state of affairs
which is one of over-investment, strictly speaking, in the sense that any
further investment would be a sheer waste of resources. Moreover, even if
over-investment in this sense was a normal characteristic of the boom, the
remedy would not lie in clapping on a high rate of interest which would
probably deter some useful investments and might further diminish the
propensity to consume, but in taking drastic steps, by redistributing

incomes or otherwise, to stimulate the propensity to consume.
According to my analysis, however, it is only in the former sense that
the boom can be said to be characterised by over-investment. The
situation, which I am indicating as typical, is not one in which capital is so
abundant that the community as a whole has no reasonable use for any
more, but where investment is being made in conditions which are
unstable and cannot endure, because it is prompted by expectations which
are destined to disappointment.
It may, of course, be the case indeed it is likely to be that the
illusions of the boom cause particular types of capital-assets to be
produced in such excessive abundance that some part of the output is, on
any criterion, a waste of resources; which sometimes happens, we may
add, even when there is no boom. It leads, that is to say, to misdirected
investment. But over and above this it is an essential characteristic of the
boom that investments which will in fact yield, say, 2 per cent in
conditions of full employment are made in the expectation of a yield of;
say, 6 per cent, and are valued accordingly. When the disillusion comes,
this expectation is replaced by a contrary error of pessimism, with the
result that the investments, which would in fact yield 2 per cent in
conditions of full employment, are expected to yield less than nothing; and
the resulting collapse of new investment then leads to a state of
unemployment in which the investments, which would have yielded 2 per
cent in conditions of full employment, in fact yield less than nothing. We
reach a condition where there is a shortage of houses, but where
nevertheless no one can afford to live in the houses that there are.
Thus the remedy for the boom is not a higher rate of interest but a
lower rate of interest! For that may enable the so-called boom to last. The
right remedy for the trade cycle is not to be found in abolishing booms and
thus keeping us permanently in a semi-slump; but in abolishing slumps
and thus keeping us permanently in a quasi-boom.
The boom which is destined to end in a slump is caused, therefore, by
the combination of a rate of interest, which in a correct state of expectation
would be too high for full employment, with a misguided state of
expectation which, so long as it lasts, prevents this rate of interest from
being in fact deterrent. A boom is a situation in which over-optimism
triumphs over a rate of interest which, in a cooler light, would be seen to
be excessive.
Except during the war, I doubt if we have any recent experience of a
boom so strong that it led to full employment. In the United States
employment was very satisfactory in 192829 on normal standards; but I

have seen no evidence of a shortage of labour, except, perhaps, in the case
of a few groups of highly specialised workers. Some bottle-necks were
reached, but output as a whole was still capable of further expansion. Nor
was there over-investment in the sense that the standard and equipment
of housing was so high that everyone, assuming full employment, had all
he wanted at a rate which would no more than cover the replacement cost,
without any allowance for interest, over the life of the house; and that
transport, public services and agricultural improvement had been carried
to a point where further additions could not reasonably be expected to
yield even their replacement cost. Quite the contrary. It would be absurd
to assert of the United States in 1929 the existence of over-investment in
the strict sense. The true state of affairs was of a different character. New
investment during the previous five years had been, indeed, on so
enormous a scale in the aggregate that the prospective yield of further
additions was, coolly considered, falling rapidly. Correct foresight would
have brought down the marginal efficiency of capital to an
unprecedentedly low figure; so that the boom could not have continued
on a sound basis except with a very low long-term rate of interest, and an
avoidance of misdirected investment in the particular directions which
were in danger of being over-exploited. In fact, the rate of interest was
high enough to deter new investment except in those particular directions
which were under the influence of speculative excitement and, therefore,
in special danger of being over-exploited; and a rate of interest, high
enough to overcome the speculative excitement, would have checked, at
the same time, every kind of reasonable new investment. Thus an increase
in the rate of interest, as a remedy for the state of affairs arising out of a
prolonged period of abnormally heavy new investment, belongs to the
species of remedy which cures the disease by killing the patient.
It is, indeed, very possible that the prolongation of approximately full
employment over a period of years would be associated in countries so
wealthy as Great Britain or the United States with a volume of new
investment, assuming the existing propensity to consume, so great that it
would eventually lead to a state of full investment in the sense that an
aggregate gross yield in excess of replacement cost could no longer be
expected on a reasonable calculation from a further increment of durable
goods of any type whatever. Moreover, this situation might be reached
comparatively soon say within twenty-five years or less. I must not be
taken to deny this, because I assert that a state of full investment in the
strict sense has never yet occurred, not even momentarily.
Furthermore, even if we were to suppose that contemporary booms

are apt to be associated with a momentary condition of full investment or
over-investment in the strict sense, it would still be absurd to regard a
higher rate of interest as the appropriate remedy. For in this event the case
of those who attribute the disease to under-consumption would be wholly
established. The remedy would lie in various measures designed to
increase the propensity to consume by the redistribution of incomes or
otherwise; so that a given level of employment would require a smaller
volume of current investment to support it.
It may be convenient at this point to say a word about the important

schools of thought which maintain, from various points of view, that the
chronic tendency of contemporary societies to under-employment is to be
traced to under-consumption; that is to say, to social practices and to a
distribution of wealth which result in a propensity to consume which is
unduly low.
In existing conditions or, at least, in the condition which existed
until lately where the volume of investment is unplanned and
uncontrolled, subject to the vagaries of the marginal efficiency of capital as
determined by the private judgment of individuals ignorant or speculative,
and to a long-term rate of interest which seldom or never falls below a
conventional level, these schools of thought are, as guides to practical
policy, undoubtedly in the right. For in such conditions there is no other
means of raising the average level of employment to a more satisfactory
level. If it is impracticable materially to increase investment, obviously
there is no means of securing a higher level of employment except by
increasing consumption.
Practically I only differ from these schools of thought in thinking that
they may lay a little too much emphasis on increased consumption at a
time when there is still much social advantage to be obtained from
increased investment. Theoretically, however, they are open to the
criticism of neglecting the fact that there are two ways to expand output.
Even if we were to decide that it would be better to increase capital more
slowly and to concentrate effort on increasing consumption, we must
decide this with open eyes after well considering the alternative. I am
myself impressed by the great social advantages of increasing the stock of
capital until it ceases to be scarce. But this is a practical judgment, not a

theoretical imperative.
Moreover, I should readily concede that the wisest course is to
advance on both fronts at once. Whilst aiming at a socially controlled rate
of investment with a view to a progressive decline in the marginal
efficiency of capital, I should support at the same time all sorts of policies
for increasing the propensity to consume. For it is unlikely that full
employment can be maintained, whatever we may do about investment,
with the existing propensity to consume. There is room, therefore, for both
policies to operate together; to promote investment and, at the same
time, to promote consumption, not merely to the level which with the
existing propensity to consume would correspond to the increased
investment, but to a higher level still. If to take round figures for the
purpose of illustration the average level of output of to-day is 15 per cent
below what it would be with continuous full employment, and if 10 per
cent of this output represents net investment and 90 per cent of it
consumption if, furthermore, net investment would have to rise 50 per
cent in order to secure full employment with the existing propensity to
consume, so that with full employment output would rise from 100 to 115,
consumption from 90 to 100 and net investment from 10 to 15: then we
might aim, perhaps, at so modifying the propensity to consume that with
full employment consumption would rise from 90 to 103 and net
investment from 10 to 12.
Another school of thought finds the solution of the trade cycle, not in
increasing either consumption or investment, but in diminishing the
supply of labour seeking employment; i.e. by redistributing the existing
volume of employment without increasing employment or output.
This seems to me to be a premature policy much more clearly so
than the plan of increasing consumption. A point comes where every
individual weighs the advantages of increased leisure against increased
income. But at present the evidence is, I think, strong that the great
majority of individuals would prefer increased income to increased leisure;
and I see no sufficient reason for compelling those who would prefer more
income to enjoy more leisure.
It may appear extraordinary that a school of thought should exist which

finds the solution for the trade cycle in checking the boom in its early
stages by a higher rate of interest. The only line of argument, along which
any justification for this policy can be discovered, is that put forward by
Mr D. H. Robertson, who assumes, in effect, that full employment is an
impracticable ideal and that the best that we can hope for is a level of
employment much more stable than at present and averaging, perhaps, a
little higher.
If we rule out major changes of policy affecting either the control of
investment or the propensity to consume, and assume, broadly speaking, a
continuance of the existing state of affairs, it is, I think, arguable that a
more advantageous average state of expectation might result from a
banking policy which always nipped in the bud an incipient boom by a rate
of interest high enough to deter even the most misguided optimists. The
disappointment of expectation, characteristic of the slump, may lead to so
much loss and waste that the average level of useful investment might be
higher if a deterrent is applied. It is difficult to be sure whether or not this
is correct on its own assumptions; it is a matter for practical judgment
where detailed evidence is wanting. It may be that it overlooks the social
advantage which accrues from the increased consumption which attends
even on investment which proves to have been totally misdirected, so that
even such investment may be more beneficial than no investment at all.
Nevertheless, the most enlightened monetary control might find itself in
difficulties, faced with a boom of the 1929 type in America, and armed
with no other weapons than those possessed at that time by the Federal
Reserve System; and none of the alternatives within its power might make
much difference to the result. However this may be, such an outlook seems
to me to be dangerously and unnecessarily defeatist. It recommends, or at
least assumes, for permanent acceptance too much that is defective in our
existing economic scheme.
The austere view, which would employ a high rate of interest to check
at once any tendency in the level of employment to rise appreciably above
the average of; say, the previous decade, is, however, more usually
supported by arguments which have no foundation at all apart from
confusion of mind. It flows, in some cases, from the belief that in a boom
investment tends to outrun saving, and that a higher rate of interest will
restore equilibrium by checking investment on the one hand and
stimulating savings on the other. This implies that saving and investment
can be unequal, and has, therefore, no meaning until these terms have
been defined in some special sense. Or it is sometimes suggested that the
increased saving which accompanies increased investment is undesirable
and unjust because it is, as a rule, also associated with rising prices. But if
this were so, any upward change in the existing level of output and
employment is to be deprecated. For the rise in prices is not essentially
due to the increase in investment; it is due to the fact that in the short
period supply price usually increases with increasing output, on account
either of the physical fact of diminishing return or of the tendency of the
cost-unit to rise in terms of money when output increases. If the
conditions were those of constant supply-price, there would, of course, be
no rise of prices; yet, all the same, increased saving would accompany
increased investment. It is the increased output which produces the
increased saving; and the rise of prices is merely a by-product of the
increased output, which will occur equally if there is no increased saving
but, instead, an increased propensity to consume. No one has a legitimate
vested interest in being able to buy at prices which are only low because
output is low.
Or, again, the evil is supposed to creep in if the increased investment
has been promoted by a fall in the rate of interest engineered by an
increase in the quantity of money. Yet there is no special virtue in the pre-
existing rate of interest, and the new money is not forced on anyone; it
is created in order to satisfy the increased liquidity-preference which
corresponds to the lower rate of interest or the increased volume of
transactions, and it is held by those individuals who prefer to hold money
rather than to lend it at the lower rate of interest. Or, once more, it is
suggested that a boom is characterised by capital consumption, which
presumably means negative net investment, i.e. by an excessive propensity
to consume. Unless the phenomena of the trade cycle have been confused
with those of a flight from the currency such as occurred during the post-
war European currency collapses, the evidence is wholly to the contrary.
Moreover, even if it were so, a reduction in the rate of interest would be a
more plausible remedy than a rise in the rate of interest for conditions of
under-investment. I can make no sense at all of these schools of thought;
except, perhaps, by supplying a tacit assumption that aggregate output is
incapable of change. But a theory which assumes constant output is
obviously not very serviceable for explaining the trade cycle.
In the earlier studies of the trade cycle, notably by Jevons, an explanation

was found in agricultural fluctuations due to the seasons, rather than in
the phenomena of industry. In the light of the above theory this appears as
an extremely plausible approach to the problem. For even to-day
fluctuation in the stocks of agricultural products as between one year and
another is one of the largest individual items amongst the causes of
changes in the rate of current investment; whilst at the time when Jevons
wrote and more particularly over the period to which most of his
statistics applied this factor must have far outweighed all others.
Jevonss theory, that the trade cycle was primarily due to the fluctuations
in the bounty of the harvest, can be re-stated as follows. When an
exceptionally large harvest is gathered in, an important addition is usually
made to the quantity carried over into later years. The proceeds of this
addition are added to the current incomes of the farmers and are treated
by them as income; whereas the increased carry-over involves no drain on
the income-expenditure of other sections of the community but is financed
out of savings. That is to say, the addition to the carry-over is an addition
to current investment. This conclusion is not invalidated even if prices fall
sharply. Similarly when there is a poor harvest, the carry-over is drawn
upon for current consumption, so that a corresponding part of the income-
expenditure of the consumers creates no current income for the farmers.
That is to say, what is taken from the carry-over involves a corresponding
reduction in current investment. Thus, if investment in other directions is
taken to be constant, the difference in aggregate investment between a
year in which there is a substantial addition to the carry-over and a year in
which there is a substantial subtraction from it may be large; and in a
community where agriculture is the predominant industry it will be
overwhelmingly large compared with any other usual cause of investment
fluctuations. Thus it is natural that we should find the upward turning-
point to be marked by bountiful harvests and the downward turning-point
by deficient harvests. The further theory, that there are physical causes for
a regular cycle of good and bad harvests, is, of course, a different matter
with which we are not concerned here.
More recently, the theory has been advanced that it is bad harvests,
not good harvests, which are good for trade, either because bad harvests
make the population ready to work for a smaller real reward or because
the resulting redistribution of purchasing-power is held to be favourable to
consumption. Needless to say, it is not these theories which I have in mind
in the above description of harvest phenomena as an explanation of the
trade cycle.
The agricultural causes of fluctuation are, however, much less

important in the modern world for two reasons. In the first place
agricultural output is a much smaller proportion of total output. And in
the second place the development of a world market for most agricultural
products, drawing upon both hemispheres, leads to an averaging out of the
effects of good and bad seasons, the percentage fluctuation in the amount
of the world harvest being far less than the percentage fluctuations in the
harvests of individual countries. But in old days, when a country was
mainly dependent on its own harvest, it is difficult to see any possible
cause of fluctuations in investment, except war, which was in any way
comparable in magnitude with changes in the carry-over of agricultural
products.
Even to-day it is important to pay close attention to the part played by
changes in the stocks of raw materials, both agricultural and mineral, in
the determination of the rate of current investment. I should attribute the
slow rate of recovery from a slump, after the turning-point has been
reached, mainly to the deflationary effect of the reduction of redundant
stocks to a normal level. At first the accumulation of stocks, which occurs
after the boom has broken, moderates the rate of the collapse; but we have
to pay for this relief later on in the damping-down of the subsequent rate
of recovery. Sometimes, indeed, the reduction of stocks may have to be
virtually completed before any measurable degree of recovery can be
detected. For a rate of investment in other directions, which is sufficient to
produce an upward movement when there is no current disinvestment in
stocks to set off against it, may be quite inadequate so long as such
disinvestment is still proceeding.
We have seen, I think, a signal example of this in the earlier phases of
Americas New Deal. When President Roosevelts substantial loan
expenditure began, stocks of all kinds and particularly of agricultural
products still stood at a very high level. The New Deal partly consisted
in a strenuous attempt to reduce these stocks by curtailment of current
output and in all sorts of ways. The reduction of stocks to a normal level
was a necessary process a phase which had to be endured. But so long as
it lasted, namely, about two years, it constituted a substantial offset to the
loan expenditure which was being incurred in other directions. Only when
it had been completed was the way prepared for substantial recovery.
Recent American experience has also afforded good examples of the
part played by fluctuations in the stocks of finished and unfinished goods
inventories as it is becoming usual to call them in causing the minor
oscillations within the main movement of the trade cycle. Manufacturers,
setting industry in motion to provide for a scale of consumption which is

expected to prevail some months later, are apt to make minor
miscalculations, generally in the direction of running a little ahead of the
facts. When they discover their mistake they have to contract for a short
time to a level below that of current consumption so as to allow for the
absorption of the excess inventories; and the difference of pace between
running a little ahead and dropping back again has proved sufficient in its
effect on the current rate of investment to display itself quite clearly
against the background of the excellently complete statistics now available
in the United States.

C 23
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L ,S M T
U -C
For some two hundred years both economic theorists and practical men
did not doubt that there is a peculiar advantage to a country in a
favourable balance of trade, and grave danger in an unfavourable balance,
particularly if it results in an efflux of the precious metals. But for the past
one hundred years there has been a remarkable divergence of opinion. The
majority of statesmen and practical men in most countries, and nearly half
of them even in Great Britain, the home of the opposite view, have
remained faithful to the ancient doctrine; whereas almost all economic
theorists have held that anxiety concerning such matters is absolutely
groundless except on a very short view, since the mechanism of foreign
trade is self-adjusting and attempts to interfere with it are not only futile,
but greatly impoverish those who practise them because they forfeit the
advantages of the international division of labour. It will be convenient, in
accordance with tradition, to designate the older opinion as mercantilism
and the newer as free trade, though these terms, since each of them has
both a broader and a narrower signification, must be interpreted with
reference to the context.
Generally speaking, modern economists have maintained not merely
that there is, as a rule, a balance of gain from the international division of
labour sufficient to outweigh such advantages as mercantilist practice can
fairly claim, but that the mercantilist argument is based, from start to
finish, on an intellectual confusion.
Marshall,for example, although his references to mercantilism are not
altogether unsympathetic, had no regard for their central theory as such
and does not even mention those elements of truth in their contentions
which I shall examine below. In the same way, the theoretical concessions
which free-trade economists have been ready to make in contemporary
controversies, relating, for example, to the encouragement of infant
industries or to the improvement of the terms of trade, are not concerned
with the real substance of the mercantilist case. During the fiscal
controversy of the first quarter of the present century I do not remember
that any concession was ever allowed by economists to the claim that
protection might increase domestic employment. It will be fairest,
perhaps, to quote, as an example, what I wrote myself. So lately as 1923, as
a faithful pupil of the classical school who did not at that time doubt what
he had been taught and entertained on this matter no reserves at all, I
wrote: If there is one thing that Protection can not do, it is to cure
Unemployment . . . There are some arguments for Protection, based upon
its securing possible but improbable advantages, to which there is no
simple answer. But the claim to cure Unemployment involves the
Protectionist fallacy in its grossest and crudest form. As for earlier
mercantilist theory, no intelligible account was available; and we were
brought up to believe that it was little better than nonsense. So absolutely
overwhelming and complete has been the domination of the classical
school.
Let me first state in my own terms what now seems to me to be the

element of scientific truth in mercantilist doctrine. We will then compare
this with the actual arguments of the mercantilists. It should be
understood that the advantages claimed are avowedly national advantages
and are unlikely to benefit the world as a whole.
When a country is growing in wealth somewhat rapidly, the further
progress of this happy state of affairs is liable to be interrupted, in
conditions of laissez-faire, by the insufficiency of the inducements to new
investment. Given the social and political environment and the national
characteristics which determine the propensity to consume, the well-being
of a progressive state essentially depends, for the reasons we have already
explained, on the sufficiency of such inducements. They may be found
either in home investment or in foreign investment (including in the latter
the accumulation of the precious metals), which, between them, make up
aggregate investment. In conditions in which the quantity of aggregate
investment is determined by the profit motive alone, the opportunities for

home investment will be governed, in the long run, by the domestic rate of
interest; whilst the volume of foreign investment is necessarily determined
by the size of the favourable balance of trade. Thus, in a society where
there is no question of direct investment under the aegis of public
authority, the economic objects, with which it is reasonable for the
government to be preoccupied, are the domestic rate of interest and the
balance of foreign trade.
Now, if the wage-unit is somewhat stable and not liable to
spontaneous changes of significant magnitude (a condition which is
almost always satisfied), if the state of liquidity-preference is somewhat
stable, taken as an average of its short-period fluctuations, and if banking
conventions are also stable, the rate of interest will tend to be governed by
the quantity of the precious metals, measured in terms of the wage-unit,
available to satisfy the communitys desire for liquidity. At the same time,
in an age in which substantial foreign loans and the outright ownership of
wealth located abroad are scarcely practicable, increases and decreases in
the quantity of the precious metals will largely depend on whether the
balance of trade is favourable or unfavourable.
Thus, as it happens, a preoccupation on the part of the authorities
with a favourable balance of trade served both purposes; and was,
furthermore, the only available means of promoting them. At a time when
the authorities had no direct control over the domestic rate of interest or
the other inducements to home investment, measures to increase the
favourable balance of trade were the only direct means at their disposal for
increasing foreign investment; and, at the same time, the effect of a
favourable balance of trade on the influx of the precious metals was their
only indirect means of reducing the domestic rate of interest and so
increasing the inducement to home investment.
There are, however, two limitations on the success of this policy which
must not be overlooked. If the domestic rate of interest falls so low that the
volume of investment is sufficiently stimulated to raise employment to a
level which breaks through some of the critical points at which the wage-
unit rises, the increase in the domestic level of costs will begin to react
unfavourably on the balance of foreign trade, so that the effort to increase
the latter will have overreached and defeated itself. Again, if the domestic
rate of interest falls so low relatively to rates of interest elsewhere as to
stimulate a volume of foreign lending which is disproportionate to the
favourable balance, there may ensue an efflux of the precious metals
sufficient to reverse the advantages previously obtained. The risk of one or
other of these limitations becoming operative is increased in the case of a

country which is large and internationally important by the fact that, in
conditions where the current output of the precious metals from the mines
is on a relatively small scale, an influx of money into one country means an
efflux from another; so that the adverse effects of rising costs and falling
rates of interest at home may be accentuated (if the mercantilist policy is
pushed too far) by falling costs and rising rates of interest abroad.
The economic history of Spain in the latter part of the fifteenth and in
the sixteenth centuries provides an example of a country whose foreign
trade was destroyed by the effect on the wage-unit of an excessive
abundance of the precious metals. Great Britain in the pre-war years of the
twentieth century provides an example of a country in which the excessive
facilities for foreign lending and the purchase of properties abroad
frequently stood in the way of the decline in the domestic rate of interest
which was required to ensure full employment at home. The history of
India at all times has provided an example of a country impoverished by a
preference for liquidity amounting to so strong a passion that even an
enormous and chronic influx of the precious metals has been insufficient
to bring down the rate of interest to a level which was compatible with the
growth of real wealth.
Nevertheless, if we contemplate a society with a somewhat stable
wage-unit, with national characteristics which determine the propensity to
consume and the preference for liquidity, and with a monetary system
which rigidly links the quantity of money to the stock of the precious
metals, it will be essential for the maintenance of prosperity that the
authorities should pay close attention to the state of the balance of trade.
For a favourable balance, provided it is not too large, will prove extremely
stimulating; whilst an unfavourable balance may soon produce a state of
persistent depression.
It does not follow from this that the maximum degree of restriction of
imports will promote the maximum favourable balance of trade. The
earlier mercantilists laid great emphasis on this and were often to be found
opposing trade restrictions because on a long view they were liable to
operate adversely to a favourable balance. It is, indeed, arguable that in
the special circumstances of mid-nineteenth-century Great Britain an
almost complete freedom of trade was the policy most conducive to the
development of a favourable balance. Contemporary experience of trade
restrictions in post-war Europe offers manifold examples of ill-conceived
impediments on freedom which, designed to improve the favourable
balance, had in fact a contrary tendency.
For this and other reasons the reader must not reach a premature
conclusion as to the practical policy to which our argument leads up.
There are strong presumptions of a general character against trade
restrictions unless they can be justified on special grounds. The
advantages of the international division of labour are real and substantial,
even though the classical school greatly overstressed them. The fact that
the advantage which our own country gains from a favourable balance is
liable to involve an equal disadvantage to some other country (a point to
which the mercantilists were fully alive) means not only that great
moderation is necessary, so that a country secures for itself no larger a
share of the stock of the precious metals than is fair and reasonable, but
also that an immoderate policy may lead to a senseless international
competition for a favourable balance which injures all alike. And finally, a
policy of trade restrictions is a treacherous instrument even for the
attainment of its ostensible object, since private interest, administrative
incompetence and the intrinsic difficulty of the task may divert it into
producing results directly opposite to those intended.
Thus, the weight of my criticism is directed against the inadequacy of
the theoretical foundations of the laissez-faire doctrine upon which I was
brought up and which for many years I taught; against the notion that
the rate of interest and the volume of investment are self-adjusting at the
optimum level, so that preoccupation with the balance of trade is a waste
of time. For we, the faculty of economists, prove to have been guilty of
presumptuous error in treating as a puerile obsession what for centuries
has been a prime object of practical statecraft.
Under the influence of this faulty theory the City of London gradually
devised the most dangerous technique for the maintenance of equilibrium
which can possibly be imagined, namely, the technique of bank rate
coupled with a rigid parity of the foreign exchanges. For this meant that
the objective of maintaining a domestic rate of interest consistent with full
employment was wholly ruled out. Since, in practice, it is impossible to
neglect the balance of payments, a means of controlling it was evolved
which, instead of protecting the domestic rate of interest, sacrificed it to
the operation of blind forces. Recently, practical bankers in London have
learnt much, and one can almost hope that in Great Britain the technique
of bank rate will never be used again to protect the foreign balance in
conditions in which it is likely to cause unemployment at home.
Regarded as the theory of the individual firm and of the distribution
of the product resulting from the employment of a given quantity of
resources, the classical theory has made a contribution to economic
thinking which cannot be impugned. It is impossible to think clearly on

the subject without this theory as a part of ones apparatus of thought. I
must not be supposed to question this in calling attention to their neglect
of what was valuable in their predecessors. Nevertheless, as a contribution
to statecraft, which is concerned with the economic system as a whole and
with securing the optimum employment of the systems entire resources,
the methods of the early pioneers of economic thinking in the sixteenth
and seventeenth centuries may have attained to fragments of practical
wisdom which the unrealistic abstractions of Ricardo first forgot and then
obliterated. There was wisdom in their intense preoccupation with keeping
down the rate of interest by means of usury laws (to which we will return
later in this chapter), by maintaining the domestic stock of money and by
discouraging rises in the wage-unit; and in their readiness in the last resort
to restore the stock of money by devaluation, if it had become plainly
deficient through an unavoidable foreign drain, a rise in the wage-unit,or
any other cause.
The early pioneers of economic thinking may have hit upon their maxims
of practical wisdom without having had much cognisance of the
underlying theoretical grounds. Let us, therefore, examine briefly the
reasons they gave as well as what they recommended. This is made easy by
reference to Professor Heckschers great work on Mercantilism, in which
the essential characteristics of economic thought over a period of two
centuries are made available for the first time to the general economic
reader. The quotations which follow are mainly taken from his pages.
(1) Mercantilists thought never supposed that there was a self-
adjusting tendency by which the rate of interest would be established at
the appropriate level. On the contrary they were emphatic that an unduly
high rate of interest was the main obstacle to the growth of wealth; and
they were even aware that the rate of interest depended on liquidity-
preference and the quantity of money. They were concerned both with
diminishing liquidity-preference and with increasing the quantity of
money, and several of them made it clear that their preoccupation with
increasing the quantity of money was due to their desire to diminish the
rate of interest. Professor Heckscher sums up this aspect of their theory as
follows:
The position of the more perspicacious mercantilists was in this respect, as

in many others, perfectly clear within certain limits. For them, money was
to use the terminology of to-day a factor of production, on the same
footing as land, sometimes regarded as artificial wealth as distinct from
the natural wealth; interest on capital was the payment for the renting of
money similar to rent for land. In so far as mercantilists sought to discover
objective reasons for the height of the rate of interest and they did so
more and more during this period they found such reasons in the total
quantity of money. From the abundant material available, only the most
typical examples will be selected, so as to demonstrate first and foremost
how lasting this notion was, how deep-rooted and independent of practical
considerations.
Both of the protagonists in the struggle over monetary policy and the
East India trade in the early 1620s in England were in entire agreement
on this point. Gerard Malynes stated, giving detailed reason for his
assertion, that Plenty of money decreaseth usury in price or rate (Lex
Mercatoria and Maintenance of Free Trade, 1622). His truculent and
rather unscrupulous adversary, Edward Misselden, replied that The
remedy for Usury may be plenty of money (Free Trade or the Meanes to
make Trade Florish, same year). Of the leading writers of half a century
later, Child, the omnipotent leader of the East India Company and its most
skilful advocate, discussed (1668) the question of how far the legal
maximum rate of interest, which he emphatically demanded, would result
in drawing the money of the Dutch away from England. He found a
remedy for this dreaded disadvantage in the easier transference of bills of
debt, if these were used as currency, for this, he said, will certainly supply
the defect of at least one-half of all the ready money we have in use in the
nation. Petty, the other writer, who was entirely unaffected by the clash of
interests, was in agreement with the rest when he explained the natural
fall in the rate of interest from 10 per cent to 6 per cent by the increase in
the amount of money (Political Arithmetick, 1676), and advised lending at
interest as an appropriate remedy for a country with too much Coin
(Quantulumcunque concerning Money, 1682).
This reasoning, naturally enough, was by no means confined to
England. Several years later (1701 and 1706), for example, French
merchants and statesmen complained of the prevailing scarcity of coin
(disette des espces) as the cause of the high interest rates, and they were
anxious to lower the rate of usury by increasing the circulation of money.
The great Locke was, perhaps, the first to express in abstract terms the
relationship between the rate of interest and the quantity of money in his
controversy with Petty. He was opposing Pettys proposal of a maximum
rate of interest on the ground that it was as impracticable as to fix a
maximum rent for land, since the natural Value of Money, as it is apt to
yield such an yearly Income by Interest, depends on the whole quantity of
the then passing Money of the Kingdom, in proportion to the whole Trade
of the Kingdom (i.e. the general Vent of all the commodities). Locke
explains that money has two values: (i) its value in use which is given by
the rate of interest and in this it has the Nature of Land, the Income of one
being called Rent, of the other, Use, and (2) its value in exchange and in
this it has the Nature of a Commodity, its value in exchange depending
only on the Plenty or Scarcity of Money in proportion to the Plenty or
Scarcity of those things and not on what Interest shall be. Thus Locke was
the parent of twin quantity theories. In the first place he held that the rate
of interest depended on the proportion of the quantity of money (allowing
for the velocity of circulation) to the total value of trade. In the second
place he held that the value of money in exchange depended on the
proportion of the quantity of money to the total volume of goods in the
market. But standing with one foot in the mercantilist world and with
one foot in the classical world he was confused concerning the relation
between these two proportions, and he overlooked altogether the
possibility of fluctuations in liquidity-preference. He was, however, eager
to explain that a reduction in the rate of interest has no direct effect on the
price-level and affects prices only as the Change of Interest in Trade
conduces to the bringing in or carrying out Money or Commodity, and so
in time varying their Proportion here in England from what it was before,
i.e. if the reduction in the rate of interest leads to the export of cash or an
increase in output. But he never, I think, proceeds to a genuine synthesis.
How easily the mercantilist mind distinguished between the rate of
interest and the marginal efficiency of capital is illustrated by a passage
(printed in 1621) which Locke quotes from A Letter to a friend concerning
Usury: High Interest decays Trade. The advantage from Interest is greater
than the Profit from Trade, which makes the rich Merchants give over, and
put out their Stock to Interest, and the lesser Merchants Break. Fortrey
(Englands Interest and Improvement, 1663) affords another example of
the stress laid on a low rate of interest as a means of increasing wealth.
The mercantilists did not overlook the point that, if an excessive
liquidity-preference were to withdraw the influx of precious metals into
hoards, the advantage to the rate of interest would be lost. In some cases
(e.g. Mun) the object of enhancing the power of the State led them,
nevertheless, to advocate the accumulation of state treasure. But others
frankly opposed this policy:
Schrtter, for instance, employed the usual mercantilist arguments in

drawing a lurid picture of how the circulation in the country would be
robbed of all its money through a greatly increasing state treasury . . . he,
too, drew a perfectly logical parallel between the accumulation of treasure

by the monasteries and the export surplus of precious metals, which, to
him, was indeed the worst possible thing which he could think of.
Davenant explained the extreme poverty of many Eastern nations who
were believed to have more gold and silver than any other countries in the
world by the fact that treasure is suffered to stagnate in the Princes
Coffers . . . If hoarding by the state was considered, at best, a doubtful
boon, and often a great danger, it goes without saying that private
hoarding was to be shunned like the pest. It was one of the tendencies
against which innumerable mercantilist writers thundered, and I do not
think it would be possible to find a single dissentient voice.
(2) The mercantilists were aware of the fallacy of cheapness and the
danger that excessive competition may turn the terms of trade against a
country. Thus Malynes wrote in his Lex Mercatoria (1622): Strive not to
undersell others to the hurt of the Commonwealth, under colour to
increase trade: for trade doth not increase when commodities are good
cheap, because the cheapness proceedeth of the small request and scarcity
of money, which maketh things cheap: so that the contrary augmenteth
trade when there is plenty of money, and commodities become dearer
being in request. Professor Heckscher sums up as follows this strand in
mercantilist thought:
In the course of a century and a half this standpoint was formulated again
and again in this way, that a country with relatively less money than other
countries must sell cheap and buy dear . . .
Even in the original edition of the Discourse of the Common Weal,
that is in the middle of the 16th century, this attitude was already
manifested. Hales said, in fact, And yet if strangers should be content to
take but our wares for theirs, what should let them to advance the price of
other things (meaning: among others, such as we buy from them), though
ours were good cheap unto them? And then shall we be still losers, and
they at the winning hand with us, while they sell dear and yet buy ours
good cheap, and consequently enrich themselves and impoverish us. Yet
had I rather advance our wares in price, as they advance theirs, as we now
do; though some be losers thereby, and yet not so many as should be the
other way. On this point he had the unqualified approval of his editor
several decades later (1581). In the 17th century, this attitude recurred
again without any fundamental change in significance. Thus, Malynes
believed this unfortunate position to be the result of what he dreaded
above all things, i.e. a foreign under-valuation of the English exchange . . .
The same conception then recurred continually. In his Verbum Sapienti
(written 1665, published 1691), Petty believed that the violent efforts to
increase the quantity of money could only cease when we have certainly
more money than any of our Neighbour States (though never so little),
both in Arithmetical and Geometrical proportion. During the period

between the writing and the publication of this work, Coke declared, If our
Treasure were more than our Neighbouring Nations, I did not care
whether we had one fifth part of the Treasure we now have (1675).
(3) The mercantilists were the originals of the fear of goods and the
scarcity of money as causes of unemployment which the classicals were to
denounce two centuries later as an absurdity:
One of the earliest instances of the application of the unemployment

argument as a reason for the prohibition of imports is to be found in
Florence in the year 1426 . . . .The English legislation on the matter goes
back to at least 1455 . . . .An almost contemporary French decree of 1466,
forming the basis of the silk industry of Lyons, later to become so famous,
was less interesting in so far as it was not actually directed against foreign
goods. But it, too, mentioned the possibility of giving work to tens of
thousands of unemployed men and women. It is seen how very much this
argument was in the air at the time . . .
The first great discussion of this matter, as of nearly all social and
economic problems, occurred in England in the middle of the i6th century
or rather earlier, during the reigns of Henry VIII and Edward VI. In this
connection we cannot but mention a series of writings, written apparently
at the latest in the 1530s, two of which at any rate are believed to have
been by Clement Armstrong . . . He formulates it, for example, in the
following terms: By reason of great abundance of strange merchandises
and wares brought yearly into England hath not only caused scarcity of
money, but hath destroyed all handicrafts, whereby great number of
common people should have works to get money to pay for their meat and
drink, which of very necessity must live idly and beg and steal.
The best instance to my knowledge of a typically mercantilist
discussion of a state of affairs of this kind is the debates in the English
House of Commons concerning the scarcity of money, which occurred in
1621, when a serious depression had set in, particularly in the cloth export.
The conditions vere described very clearly by one of the most influential
members of parliament, Sir Edwin Sandys. He stated that the farmer and
the artificer had to suffer almost everywhere, that looms were standing
idle for want of money in the country, and that peasants were forced to
repudiate their contracts, not (thanks be to God) for want of fruits of the
earth, but for want of money. The situation led to detailed enquiries into
where the money could have got to, the want of which was felt so bitterly.
Numerous attacks were directed against all persons who were supposed to
have contributed either to an export (export surplus) of precious metals, or
to their disappearance on account of corresponding activities within the
country.
Mercantilists were conscious that their policy, as Professor Heckscher puts

it, killed two birds with one stone. On the one hand the country was rid
of an unwelcome surplus of goods, which was believed to result in
unemployment, while on the other the total stock of money in the country
was increased, with the resulting advantages of a fall in the rate of
interest.
It is impossible to study the notions to which the mercantilists were
led by their actual experiences, without perceiving that there has been a
cbronic tendency throughout human history for the propensity to save to
be stronger than the inducement to invest. The weakness of the
inducement to invest has been at all times the key to the economic
problem. To-day the explanation of the weakness of this inducement may
chiefly lie in the extent of existing accumulations; whereas, formerly, risks
and hazards of all kinds may have played a larger part. But the result is the
same. The desire of, the individual to augment his personal wealth by
abstaining from consumption has usually been stronger than the
inducement to the entrepreneur to augment the national wealth by
employing labour on the construction of durable assets.
(4) The mercantilists were under no illusions as to the nationalistic
character of their policies and their tendency to promote war. It was
national advantage and relative strength at which they were admittedly
aiming.
We may criticise them for the apparent indifference with which they
accepted this inevitable consequence of an international monetary system.
But intellectually their realism is much preferable to the confused thinking
of contemporary advocates of an international fixed gold standard and
laissez-faire in international lending, who believe that it is precisely these
policies which will best promote peace.
For in an economy subject to money contracts and customs more or
less fixed over an appreciable period of time, where the quantity of the
domestic circulation and the domestic rate of interest are primarily
determined by the balance of payments, as they were in Great Britain
before the war, there is no orthodox means open to the authorities for
countering unemployment at home except by struggling for an export
surplus and an import of the monetary metal at the expense of their
neighbours. Never in history was there a method devised ofsuch efficacy
for setting each countrys advantage at variance with its neighbours as the
international gold (or, formerly, silver) standard. For it made domestic
prosperity directly dependent on a competitive pursuit of markets and a
competitive appetite for the precious metals. When by happy accident the
new supplies of gold and silver were comparatively abundant, the struggle
might be somewhat abated. But with the growth of wealth and the
diminishing marginal propensity to consume, it has tended to become
increasingly internecine. The part played by orthodox economists, whose
common sense has been insufficient to check their faulty logic, has been
disastrous to the latest act. For when in their blind struggle for an escape,
some countries have thrown off the obligations which had previously
rendered impossible an autonomous rate of interest, these economists
have taught that a restoration of the former shackles is a necessary first
step to a general recovery.
In truth the opposite holds good. It is the policy of an autonomous
rate of interest, unimpeded by international preoccupations, and of a
national investment programme directed to an optimum level of domestic
employment which is twice blessed in the sense that it helps ourselves and
our neighbours at the same time. And it is the simultaneous pursuit of
these policies by all countries together which is capable of restoring
economic health and strength internationally, whether we measure it by
the level of domestic employment or by the volume of international trade.
The mercantilists perceived the existence of the problem without being

able to push their analysis to the point of solving it. But the classical school
ignored the problem, as a consequence of introducing into their premisses
conditions which involved its non-existence; with the result of creating a
cleavage between the conclusions of economic theory and those of
common sense. The extraordinary achievement of the classical theory was
to overcome the beliefs of the natural man and, at the same time, to be
wrong. As Professor Heckscher expresses it:
If, then, the underlying attitude towards money and the material from
which money was created did not alter in the period between the Crusades
and the 18th century, it follows that we are dealing with deep-rooted
notions. Perhaps the same notions have persisted even beyond the 500
years included in that period, even though not nearly to the same degree as
the fear of goods. With the exception of the period of laissez-faire, no age
has been free from these ideas. It was only the unique intellectual tenacity
of laissez-faire that for a time overcame the beliefs of the natural man on
this point.
It required the unqualified faith of doctrinaire laissez-faire to wipe
out the fear of goods . . . [which] is the most natural attitude of the
natural man in a money economy. Free Trade denied the existence of

factors which appeared to be obvious, and was doomed to be discredited in
the eyes of the man in the street as soon as laissez-faire could no longer
hold the minds of men enchained in its ideology.
I remember Bonar Laws mingled rage and perplexity in face of the

economists, because they were denying what was obvious. He was deeply
troubled for an explanation. One recurs to the analogy between the sway of
the classical school of economic theory and that of certain religions. For it
is a far greater exercise of the potency of an idea to exorcise the obvious
than to introduce into mens common notions the recondite and the
remote.
There remains an allied, but distinct, matter where for centuries, indeed
for several millenniums, enlightened opinion held for certain and obvious
a doctrine which the classical school has repudiated as childish, but which
deserves rehabilitation and honour. I mean the doctrine that the rate of
interest is not self-adjusting at a level best suited to the social advantage
but constantly tends to rise too high, so that a wise government is
concerned to curb it by statute and custom and even by invoking the
sanctions of the moral law.
Provisions against usury are amongst the most ancient economic
practices of which we have record. The destruction of the inducement to
invest by an excessive liquidity-preference was the outstanding evil, the
prime impediment to the growth of wealth, in the ancient and medieval
worlds. And naturally so, since certain of the risks and hazards of
economic life diminish the marginal efficiency of capital whilst others
serve to increase the preference for liquidity. In a world, therefore, which
no one reckoned to be safe, it was almost inevitable that the rate of
interest, unless it was curbed by every instrument at the disposal of
society, would rise too high to permit of an adequate inducement to invest.
I was brought up to believe that the attitude of the Medieval Church to
the rate of interest was inherently absurd, and that the subtle discussions
aimed at distinguishing the return on money-loans from the return to
active investment were merely jesuitical attempts to find a practical escape
from a foolish theory. But I now read these discussions as an honest
intellectual effort to keep separate what the classical theory has
inextricably confused together, namely, the rate of interest and the
marginal efficiency of capital. For it now seems clear that the disquisitions
of the schoolmen were directed towards the elucidation of a formula which
should allow the schedule of the marginal efficiency of capital to be high,
whilst using rule and custom and the moral law to keep down the rate of
interest.
Even Adam Smith was extremely moderate in his attitude to the usury
laws. For lie was well aware that individual savings may be absorbed either
by investment or by debts, and that there is no security that they will find
an outlet in the former. Furthermore, he favoured a low rate of interest as
increasing the chance of savings finding their outlet in new investment
rather than in debts; and for this reason, in a passage for which he was
severely taken to task by Bentham, he defended a moderate application of
the usury laws. Moreover, Benthams criticisms were mainly on the ground
that Adam Smiths Scotch caution was too severe on projectors and that a
maximum rate of interest would leave too little margin for the reward of
legitimate and socially advisable risks. For Bentham understood by
projectors all such persons, as, in the pursuit of wealth, or even of any
other object, endeavour, by the assistance of wealth, to strike into any
channel of invention . . . upon all such persons as, in the line of any of their
pursuits, aim at anything that can be called improvement . . . It falls, in
short, upon every application of the human powers, in which ingenuity
stands in need of wealth for its assistance. Of course Bentham is right in
protesting against laws which stand in the way of taking legitimate risks.
A prudent man, Bentham continues, will not, in these circumstances,
pick out the good projects from the bad, for he will not meddle with
projects at all.
It may be doubted, perhaps, whether the above is just what Adam
Smith intended by his term. Or is it that we are hearing in Bentham
(though writing in March 1787 from Crichoff in White Russia) the voice of
nineteenth-century England speaking to the eighteenth? For nothing short
of the exuberance of the greatest age of the inducement to investment
could have made it possible to lose sight of the theoretical possibility of its
insufficiency.
It is convenient to mention at this point the strange, unduly neglected

prophet Silvio Gesell (18621930), whose work contains flashes of deep
insight and who only just failed to reach down to the essence of the matter.
In the post-war years his devotees bombarded me with copies of his works;
yet, owing to certain palpable defects in the argument, I entirely failed to
discover their merit. As is often the case with imperfectly analysed
intuitions, their significance only became apparent after I had reached my
own conclusions in my own way. Meanwhile, like other academic
economists, I treated his profoundly original strivings as being no better
than those of a crank. Since few of the readers of this book are likely to be
well acquainted with the significance of Gesell, I will give to him what
would be otherwise a disproportionate space.
Gesell was a successful German merchant in Buenos Aires who was
led to the study of monetary problems by the crisis of the late eighties,
which was especially violent in the Argentine, his first work, Die
Reformation im Mnzwesen als Brcke zum socialen Staat, being
published in Buenos Aires in 1891. His fundamental ideas on money were
published in Buenos Aires in the same year under the title Nervus rerum,
and many books and pamphlets followed until he retired to Switzerland in
1906 as a man of some means, able to devote the last decades of his life to
the two most delightful occupations open to those who do not have to earn
their living, authorship and experimental farming.
The first section of his standard work was published in 1906 at Les
Hauts Geneveys, Switzerland, under the title Die Verwirklichung des
Rechtes auf dem vollen
Arbeitsertrag, and the second section in 1911 at Berlin under the title
Die neue Lehre vom Zins. The two together were published in Berlin and
in Switzerland during the war (1916) and reached a sixth edition during his
lifetime under the title Die natrliche Wirtschaftsordnung durch Freiland
und Freigeld, the English version (translated by Mr Philip Pye) being
called The Natural Economic Order. In April 1919 Gesell joined the short-
lived Soviet cabinet of Bavaria as their Minister of Finance, being
subsequently tried by court-martial. The last decade of his life was spent in
Berlin and Switzerland and devoted to propaganda. Gesell, drawing to
himself the semi-religious fervour which had formerly centred round
Henry George, became the revered prophet of a cult with many thousand
disciples throughout the world. The first international convention of the
Swiss and German FreilandFreigeld Bund and similar organisations from
many countries was held in Basle in 1923. Since his death in 1930 much of
the peculiar type of fervour which doctrines such as his are capable of
exciting has been diverted to other (in my opinion less eminent) prophets.
Dr Buchi is the leader of the movement in England, but its literature seems
to be distributed from San Antonio, Texas, its main strength lying to-day
in the United States, where Professor Irving Fisher, alone amongst

academic economists, has recognised its significance.
In spite of the prophetic trappings with which his devotees have
decorated him, Gesells main book is written in cool, scientific language;
though it is suffused throughout by a more passionate, a more emotional
devotion to social justice than some think decent in a scientist. The part
which derives from Henry George,though doubtless an important source
of the movements strength, is of altogether secondary interest. The
purpose of the book as a whole may be described as the establishment of
an anti-Marxian socialism, a reaction against laissez-faire built on
theoretical foundations totally unlike those of Marx in being based on a
repudiation instead of on an acceptance of the classical hypotheses, and on
an unfettering of competition instead of its abolition. I believe that the
future will learn more from the spirit of Gesell than from that of Marx. The
preface to The Natural Economic Order will indicate to the reader, if he
will refer to it, the moral quality of Gesell. The answer to Marxism is, I
think, to be found along the lines of this preface.
Gesells specific contribution to the theory of money and interest is as
follows. In the first place, he distinguishes clearly between the rate of
interest and the marginal efficiency of capital, and he argues that it is the
rate of interest which sets a limit to the rate of growth of real capital. Next,
he points out that the rate of interest is a purely monetary phenomenon
and that the peculiarity of money, from which flows the significance of the
money rate of interest, lies in the fact that its ownership as a means of
storing wealth involves the holder in negligible carrying charges, and that
forms of wealth, such as stocks of commodities which do involve carrying
charges, in fact yield a return because of the standard set by money. He
cites the comparative stability of the rate of interest throughout the ages as
evidence that it cannot depend on purely physical characters, inasmuch as
the variation of the latter from one epoch to another must have been
incalculably greater than the observed changes in the rate of interest; i.e.
(in my terminology) the rate of interest, which depends on constant
psychological characters, has remained stable, whilst the widely
fluctuating characters, which primarily determine the schedule of the
marginal efficiency of capital, have determined not the rate of interest but
the rate at which the (more or less) given rate of interest allows the stock
of real capital to grow.
But there is a great defect in Gesells theory. He shows how it is only
the existence of a rate of money interest which allows a yield to be
obtained from lending out stocks of commodities. His dialogue between
Robinson Crusoe and a stranger is a most excellent economic parable as

good as anything of the kind that has been written to demonstrate this
point. But, having given the reason why the money-rate of interest unlike
most commodity rates of interest cannot be negative, he altogether
overlooks the need of an explanation why the money-rate of interest is
positive, and he fails to explain why the money-rate of interest is not
governed (as the classical school maintains) by the standard set by the
yield on productive capital. This is because the notion of liquidity-
preference had escaped him. He has constructed only half a theory of the
rate of interest.
The incompleteness of his theory is doubtless the explanation of his
work having suffered neglect at the hands of the academic world.
Nevertheless he had carried his theory far enough to lead him to a
practical recommendation, which may carry with it the essence of what is
needed, though it is not feasible in the form in which he proposed it. He
argues that the growth of real capital is held back by the money-rate of
interest, and that if this brake were removed the growth of real capital
would be, in the modern world, so rapid that a zero money-rate of interest
would probably be justified, not indeed forthwith, but within a
comparatively short period of time. Thus the prime necessity is to reduce
the money-rate of interest, and this, he pointed out, can be effected by
causing money to incur carrying-costs just like other stocks of barren
goods. This led him to the famous prescription of stamped money, with
which his name is chiefly associated and which has received the blessing of
Professor Irving Fisher. According to this proposal currency notes (though
it would clearly need to apply as well to some forms at least of bank-
money) would only retain their value by being stamped each month, like
an insurance card, with stamps purchased at a post office. The cost of the
stamps could, of course, be fixed at any appropriate figure. According to
my theory it should be roughly equal to the excess of the money-rate of
interest (apart from the stamps) over the marginal efficiency of capital
corresponding to a rate of new investment compatible with full
employment. The actual charge suggested by Gesell was 1 per mil. per
week, equivalent to 5.2 per cent per annum. This would be too high in
existing conditions, but the correct figure, which would have to be changed
from time to time, could only be reached by trial and error.
The idea behind stamped money is sound. It is, indeed, possible that
means might be found to apply it in practice on a modest scale. But there
are many difficulties which Gesell did not face. In particular, he was
unaware that money was not unique in having a liquidity-premium
attached to it, but differed only in degree from many other articles,
deriving its importance from having a greater liquidity-premium than any
other article. Thus if currency notes were to be deprived of their liquidity-
premium by the stamping system, a long series of substitutes would step
into their shoes bank-money, debts at call, foreign money, jewellery and
the precious metals generally, and so forth. As I have mentioned above,
there have been times when it was probably the craving for the ownership
of land, independently of its yield, which served to keep up the rate of
interest; though under Gesells system this possibility would have been
eliminated by land nationalisation.
The theories which we have examined above are directed, in substance, to

the constituent of effective demand which depends on the sufficiency of
the inducement to invest. It is no new thing, however, to ascribe the evils
of unemployment to the insufficiency of the other constituent, namely, the
insufficiency of the propensity to consume. But this alternative
explanation of the economic evils of the day equally unpopular with the
classical economists played a much smaller part in sixteenth- and
seventeenth-century thinking and has only gathered force in
comparatively recent times.
Though complaints of under-consumption were a very subsidiary
aspect of mercantilist thought, Professor Heckscher quotes a number of
examples of what he calls the deep-rooted belief in the utility of luxury
and the evil of thrift. Thrift, in fact, was regarded as the cause of
unemployment, and for two reasons: in the first place, because real income
was believed to diminish by the amount of money which did not enter into
exchange, and secondly, because saving was believed to withdraw money
from circulation. In 1598 Laffemas (Les Trsors et richesses pour mettre
lEstat en Splendeur) denounced the objectors to the use of French silks on
the ground that all purchasers of French luxury goods created a livelihood
for the poor, whereas the miser caused them to die in distress. In 1662
Petty justified entertainments, magnificent shews, triumphal arches, etc.,
on the ground that their costs flowed back into the pockets of brewers,
bakers, tailors, shoemakers and so forth. Fortrey justified excess of
apparel. Von Schrtter (1686) deprecated sumptuary regulations and
declared that he would wish that display in clothing and the like were even
greater. Barbon (1690) wrote that Prodigality is a vice that is prejudicial to
the Man, but not to trade . . . Covetousness is a Vice, prejudicial both to

Man and Trade. In 1695 Cary argued that if everybody spent more, all
would obtain larger incomes and might then live more plentifully.
But it was by Bernard Mandevilles Fable of the Bees that Barbons
opinion was mainly popularised, a book convicted as a nuisance by the
grand jury of Middlesex in 1723, which stands out in the history of the
moral sciences for its scandalous reputation. Only one man is recorded as
having spoken a good word for it, namely Dr Johnson, who declared that it
did not puzzle him, but opened his eyes into real life very much. The
nature of the books wickedness can be best conveyed by Leslie Stephens
summary in the Dictionary of National Biography:
Mandeville gave great offence by this book, in which a cynical system of

morality was made attractive by ingenious paradoxes . . . His doctrine that
prosperity was increased by expenditure rather than by saving fell in with
many current economic fallacies not yet extinct. Assuming with the
ascetics that human desires were essentially evil and therefore produced
private vices and assuming with the common view that wealth was a
public benefit, he easily showed that all civilisation implied the
development of vicious propensities . . .
The text of the Fable of the Bees is an allegorical poem The Grumbling
Hive, or Knaves turned honest, in which is set forth the appalling plight of
a prosperous community in which all the citizens suddenly take it into
their heads to abandon luxurious living, and the State to cut down
armaments, in the interests of Saving:
No Honour now could be content,

To live and owe for what was spent,
Livries in Brokers shops are hung;
They part with Coaches for a song;
Sell stately Horses by whole sets
and Country-Houses to pay debts.
Vain cost is shunnd as moral Fraud;
They have no Forces kept Abroad;
Laugh at th Esteem of Foreigners,
And empty Glory got by Wars;
They fight, but for their Countrys sake,
When Right or Libertys at Stake.
The haughty Chloe
Contracts th expensive Bill of Fare,
And wears her strong Suit a whole Year.
And what is the result?
Now mind the glorious Hive, and see

How Honesty and Trade agree:
The Shew is gone, it thins apace;
And looks with quite another Face,
For twas not only they that went,
By whom vast sums were yearly spent;
But Multitudes that lived on them,
Were daily forcd to do the same.
In vain to other Trades theyd fly;
All were oer-stocked accordingly.
The price of Land and Houses falls;
Miraclous Palaces whose Walls,
Like those of Thebes, were raisd by Play,
Are to be let . . .
The Building Trade is quite destroyd,
Artificers are not employd;
No limner for his Art is famd,
Stone-cutters, Carvers are not namd.
So The Moral is:
Bare Virtue cant make Nations live

In Splendour. They that would revive
A Golden Age, must be as free,
For Acorns as for Honesty.
Two extracts from the commentary which follows the allegory will show
that the above was not without a theoretical basis:
As this prudent economy, which some people call Saving, is in private

families the most certain method to increase an estate, so some imagine
that, whether a country be barren or fruitful, the same method if generally
pursued (which they think practicable) will have the same effect upon a
whole nation, and that, for example, the English might be much richer
than they are, if they would be as frugal as some of their neighbours. This,
I think, is an error.
On the contrary, Mandeville concludes:
The great art to make a nation happy, and what we call flourishing,
consists in giving everybody an opportunity of being employed; which to
compass, let a Governments first care be to promote as great a variety of
Manufactures, Arts and Handicrafts as human wit can invent; and the
second to encourage Agriculture and Fishery in all their branches, that the
whole Earth may be forced to exert itself as well as Man. It is from this
Policy and not from the trifling regulations of Lavishness and Frugality
that the greatness and felicity of Nations must be expected; for let the
value of Gold and Silver rise or fall, the enjoyment of all Societies will ever
depend upon the Fruits of the Earth and the Labour of the People; both
which joined together are a more certain, a more inexhaustible and a more
real Treasure than the Gold of Brazil or the Silver of Potosi.
No wonder that such wicked sentiments called down the opprobrium of

two centuries of moralists and economists who felt much more virtuous in
possession of their austere doctrine that no sound remedy was
discoverable except in the utmost of thrift and economy both by the
individual and by the state. Pettys entertainments, magnificent shews,
triumphal arches, etc. gave place to the penny-wisdom of Gladstonian
finance and to a state system which could not afford hospitals, open
spaces, noble buildings, even the preservation of its ancient monuments,
far less the splendours of music and the drama, all of which were
consigned to the private charity or magnanimity of improvident
individuals.
The doctrine did not reappear in respectable circles for another
century, until in the later phase of Malthus the notion of the insufficiency
of effective demand takes a definite place as a scientific explanation of
unemployment. Since I have already dealt with this somewhat fully in my
essay on Malthus, it will be sufficient if I repeat here one or two
characteristic passages which I have already quoted in my essay:
We see in almost every part of the world vast powers of production which
are not put into action, and I explain this phenomenon by saying that from
the want of a proper distribution of the actual produce adequate motives
are not furnished to continued production . . . I distinctly maintain that an
attempt to accumulate very rapidly, which necessarily implies a
considerable diminution of unproductive consumption, by greatly
impairing the usual motives to production must prematurely check the
progress of wealth . . . But if it be true that an attempt to accumulate very
rapidly will occasion such a division between labour and profits as almost
to destroy both the motive and the power of future accumulation and
consequently the power of maintaining and employing an increasing
population, must it not be acknowledged that such an attempt to
accumulate, or that saving too much, may be really prejudicial to a

country?
The question is whether this stagnation of capital, and subsequent
stagnation in the demand for labour arising from increased production
without an adequate proportion of unproductive consumption on the part
of the landlords and capitalists, could take place without prejudice to the
country, without occasioning a less degree both of happiness and wealth
than would have occurred if the unproductive consumption of the
landlords and capitalists had been so proportioned to the natural surplus
of the society as to have continued uninterrupted the motives to
production, and prevented first an unnatural demand for labour and then
a necessary and sudden diminution of such demand. But if this be so, how
can it be said with truth that parsimony, though it may be prejudicial to
the producers, cannot be prejudicial to the state; or that an increase of
unproductive consumption among landlords and capitalists may not
sometimes be the proper remedy for a state of things in which the motives
to production fail?
Adam Smith has stated that capitals are increased by parsimony, that
every frugal man is a public benefactor, and that the increase of wealth
depends upon the balance of produce above consumption. That these
propositions are true to a great extent is perfectly unquestionable . . . But it
is quite obvious that they are not true to an indefinite extent, and that the
principles of saving, pushed to excess, would destroy the motive to
production. If every person were satisfied with the simplest food, the
poorest clothing, and the meanest houses, it is certain that no other sort of
food, clothing, and lodging would be in existence . . . The two extremes are
obvious; and it follows that there must be some intermediate point, though
the resources of political economy may not be able to ascertain it, where,
taking into consideration both the power to produce and the will to
consume, the encouragement to the increase of wealth is the greatest.
Of all the opinions advanced by able and ingenious men, which I have
ever met with, the opinion of M. Say, which states that, Un produit
consomm ou detruit est un dbouch ferm (I. i. ch. 15), appears to me to
be the most directly opposed to just theory, and the most uniformly
contradicted by experience. Yet it directly follows from the new doctrine,
that commodities are to be considered only in their relation to each other
not to the consumers. What, I would ask, would become of the demand
for commodities, if all consumption except bread and water were
suspended for the next half-year? What an accumulation of commodities!
Quels debouchs! What a prodigious market would this event occasion!
Ricardo, however, was stone-deaf to what Malthus was saying. The last
echo of the controversy is to be found in John Stuart Mills discussion of
his wages-fund theory, which in his own mind played a vital part in his
rejection of the later phase of Malthus, amidst the discussions of which he
had, of course, been brought up. Mills successors rejected his wages-fund
theory but overlooked the fact that Mills refutation of Malthus depended
on it. Their method was to dismiss the problem from the corpus of
economics not by solving it but by not mentioning it. It altogether
disappeared from controversy. Mr Cairncross, searching recently for traces
of it amongst the minor Victorians, has found even less, perhaps, than
might have been expected. Theories of under-consumption hibernated
until the appearance in 1889 of The Physiology of Industry, by J. A.
Hobson and A. F. Mummery, the first and most significant of many
volumes in which for nearly fifty years Mr Hobson has flung himself with
unflagging, but almost unavailing, ardour and courage against the ranks of
orthodoxy. Though it is so completely forgotten to-day, the publication of
this book marks, in a sense, an epoch in economic thought.
The Physiology of Industry was written in collaboration with A. F.
Mummery. Mr Hobson has told how the book came to be written as
follows:
It was not until the middle eighties that my economic heterodoxy began to
take shape. Though the Henry George campaign against land values and
the early agitation of various socialist groups against the visible oppression
of the working classes, coupled with the revelations of the two Booths
regarding the poverty of London, made a deep impression on my feelings,
they did not destroy my faith in Political Economy. That came from what
may be called an accidental contact. While teaching at a school in Exeter I
came into personal relations with a business man named Mummery,
known then and afterwards as a great mountaineer who had discovered
another way up the Matterhorn and who, in 1895, was killed in an attempt
to climb the famous Himalayan mountain Nanga Parbat. My intercourse
with him, I need hardly say, did not lie on this physical plane. But he was a
mental climber as well, with a natural eye for a path of his own finding and
a sublime disregard of intellectual authority. This man entangled me in a
controversy about excessive saving, which he regarded as responsible for
the under-employment of capital and labour in periods of bad trade. For a
long time I sought to counter his arguments by the use of the orthodox
economic weapons. But at length he convinced me and I went in with him
to elaborate the over-saving argument in a book entitled The Physiology of
Industry, which was published in 1889. This was the first open step in my
heretical career, and I did not in the least realise its momentous
consequences. For just at that time I had given up my scholastic post and
was opening a new line of work as University Extension Lecturer in
Economics and Literature. The first shock came in a refusal of the London
Extension Board to allow me to offer courses of Political Economy. This
was due, I learned, to the intervention of an Economic Professor who had
read my book and considered it as equivalent in rationality to an attempt
to prove the flatness of the earth. How could there be any limit to the
amount of useful saving when every item of saving went to increase the
capital structure and the fund for paying wages? Sound economists could
not fail to view with horror an argument which sought to check the source
of all industrial progress. Another interesting personal experience helped
to bring home to me the sense of my iniquity. Though prevented from
lecturing on economics in London, I had been allowed by the greater
liberality of the Oxford University Extension Movement to address
audiences in the Provinces, confining myself to practical issues relating to
working-class life. Now it happened at this time that the Charity
Organisation Society was planning a lecture campaign upon economic
subjects and invited me to prepare a course. I had expressed my
willingness to undertake this new lecture work, when suddenly, without
explanation, the invitation was withdrawn. Even then I hardly realised
that in appearing to question the virtue of unlimited thrift I had
committed the unpardonable sin.
In this early work Mr Hobson with his collaborator expressed himself with
more direct reference to the classical economics (in which he had been
brought up) than in his later writings; and for this reason, as well as
because it is the first expression of his theory, I will quote from it to show
how significant and well-founded were the authors criticisms and
intuitions. They point out in their preface as follows the nature of the
conclusions which they attack:
Saving enriches and spending impoverishes the community along with the
individual, and it may be generally defined as an assertion that the
effective love of money is the root of all economic good. Not merely does it
enrich the thrifty individual himself, but it raises wages, gives work to the
unemployed, and scatters blessings on every side. From the daily papers to
the latest economic treatise, from the pulpit to the House of Commons,
this conclusion is reiterated and re-stated till it appears positively impious
to question it. Yet the educated world, supported by the majority of
economic thinkers, up to the publication of Ricardos work strenuously
denied this doctrine, and its ultimate acceptance was exclusively due to
their inability to meet the now exploded wages-fund doctrine. That the
conclusion should have survived the argument on which it logically stood,
can be explained on no other hypothesis than the commanding authority
of the great men who asserted it. Economic critics have ventured to attack
the theory in detail, but they have shrunk appalled from touching its main
conclusions. Our purpose is to show that these conclusions are not
tenable, that an undue exercise of the habit of saving is possible, and that
such undue exercise impoverishes the Community, throws labourers out of
work, drives down wages, and spreads that gloom and prostration through
the commercial world which is known as Depression in Trade . . .
The object of production is to provide utilities and conveniences for

consumers, and the process is a continuous one from the first handling of
the raw material to the moment when it is finally consumed as a utility or a
convenience. The only use of Capital being to aid the production of these
utilities and conveniences, the total used will necessarily vary with the
total of utilities and conveniences daily or weekly consumed. Now saving,
while it increases the existing aggregate of Capital, simultaneously reduces
the quantity of utilities and conveniences consumed; any undue exercise of
this habit must, therefore, cause an accumulation of Capital in excess of
that which is required for use, and this excess will exist in the form of
general over-production.
In the last sentence of this passage there appears the root of Hobsons
mistake, namely, his supposing that it is a ease of excessive saving causing
the actual accumulation of capital in excess of what is required, which is,
in fact, a secondary evil which only occurs through mistakes of foresight;
whereas the primary evil is a propensity to save in conditions of full
employment more than the equivalent of the capital which is required,
thus preventing full employment except when there is a mistake of
foresight. A page or two later, however, he puts one half of the matter, as it
seems to me, with absolute precision, though still overlooking the possible
rle of changes in the rate of interest and in the state of business
confidence, factors which he presumably takes as given:
We are thus brought to the conclusion that the basis on which all economic
teaching since Adam Smith has stood, viz. that the quantity annually
produced is determined by the aggregates of Natural Agents, Capital, and
Labour available, is erroneous, and that, on the contrary, the quantity
produced, while it can never exceed the limits imposed by these
aggregates, may be, and actually is, reduced far below this maximum by
the check that undue saving and the consequent accumulation of over-
supply exerts on production; i.e. that in the normal state of modern
industrial Communities, consumption limits production and not
production consumption.
Finally he notices the bearing of his theory on the validity of the orthodox
Free Trade arguments:
We also note that the charge of commercial imbecility, so freely launched

by orthodox economists against our American cousins and other
Protectionist Communities, can no longer be maintained by any of the
Free Trade arguments hitherto adduced, since all these are based on the
assumption that over-supply is impossible.
The subsequent argument is, admittedly, incomplete. But it is the first

explicit statement of the fact that capital is brought into existence not by
the propensity to save but in response to the demand resulting from actual
and prospective consumption. The following portmanteau quotation
indicates the line of thought:
It should be clear that the capital of a community cannot be

advantageously increased without a subsequent increase in consumption
of commodities . . . Every increase an saving and in capital requires, in
order to be effectual, a corresponding increase in immediately future
consumption. And when we say future consumption, we do not refer to a
future of ten, twenty, or fifty years hence, but to a future that is but little
removed from the present . . . If increased thrift or caution induces people
to save more in the present, they must consent to consume more in the
future. No more capital can economically exist at any point in the
productive process than is required to furnish commodities for the current
rate of consumption.It is clear that my thrift in no wise affects the total
economic thrift of the community, but only determines whether a
particular portion of the total thrift shall have been exercised by myself or
by somebody else. We shall show how the thrift of one part of the
community has power to force another part to live beyond their income.
Most modern economists deny that consumption could by any possibility
be insufficient. Can we find any economic force at work which might incite
a community to this excess, and if there be any such forces are there not
efficient checks provided by the mechanism of commerce? It will be
shown, firstly, that in every highly organised industrial society there is
constantly at work a force which naturally operates to induce excess of
thrift; secondly, that the checks alleged to be provided by the mechanism
of commerce are either wholly inoperative or are inadequate to prevent
grave commercial evil. The brief answer which Ricardo gave to the
contentions of Malthus and Chalmers seems to have been accepted as
sufficient by most later economists. Productions are always bought by
productions or services; money is only the medium by which the exchange
is effected. Hence the increased production being always accompanied by
a correspondingly increased ability to get and consume, there is no
possibility of Over-production (Ricardo, Prin. of Pol. Econ. p. 362).
Hobson and Mummery were aware that interest was nothing whatever
except payment for the use of money. They also knew well enough that
their opponents would claim that there would be such a fall in the rate of
interest (or profit) as will act as a check upon Saving, and restore the
proper relation between production and consumption. They point out in
reply that if a fall of Profit is to induce people to save less, it must operate
in one of two ways, either by inducing them to spend more or by inducing
them to produce less. As regards the former they argue that when profits
fall the aggregate income of the community is reduced, and we cannot
suppose that when the average rate of incomes is falling, individuals will
be induced to increase their rate of consumption by the fact that the

premium upon thrift is correspondingly diminished; whilst as for the
second alternative, it is so far from being our intention to deny that a fall
of profit, due to over-supply, will check production, that the admission of
the operation of this check forms the very centre of our argument.
Nevertheless, their theory failed of completeness, essentially on account of
their having no independent theory of the rate of interest; with the result
that Mr Hobson laid too much emphasis (especially in his later books) on
under-consumption leading to over-investment, in the sense of
unprofitable investment, instead of explaining that a relatively weak
propensity to consume helps to cause unemployment by requiring and not
receiving the accompaniment of a compensating volume of new
investment, which, even if it may sometimes occur temporarily through
errors of optimism, is in general prevented from happening at all by the
prospective profit falling below the standard set by the rate of interest.
Since the war there has been a spate of heretical theories of under-
consumption, of which those of Major Douglas are the most famous. The
strength of Major Douglass advocacy has, of course, largely depended on
orthodoxy having no valid reply to much of his destructive criticism. On
the other hand, the detail of his diagnosis, in particular the so-called A + B
theorem, includes much mere mystification. If Major Douglas had limited
his B-items to the financial provisions made by entrepreneurs to which no
current expenditure on replacements and renewals corresponds, he would
be nearer the truth. But even in that case it is necessary to allow for the
possibility of these provisions being offset by new investment in other
directions as well as by increased expenditure on consumption. Major
Douglas is entitled to claim, as against some of his orthodox adversaries,
that he at least has not been wholly oblivious of the outstanding problem
of our economic system. Yet he has scarcely established an equal claim to
rank a private, perhaps, but not a major in the brave army of heretics
with Mandeville, Malthus, Gesell and Hobson, who, following their
intuitions, have preferred to see the truth obscurely and imperfectly rather
than to maintain error, reached indeed with clearness and consistency and
by easy logic but on hypotheses inappropriate to the facts.

C 24
C N S
P T
G T M L
The outstanding faults of the economic society in which we live are its
failure to provide for full employment and its arbitrary and inequitable
distribution of wealth and incomes. The bearing of the foregoing theory on
the first of these is obvious. But there are also two important respects in
which it is relevant to the second.
Since the end of the nineteenth century significant progress towards
the removal of very great disparities of wealth and income has been
achieved through the instrument of direct taxation income tax and
surtax and death duties especially in Great Britain. Many people would
wish to see this process carried much further, but they are deterred by two
considerations; partly by the fear of making skilful evasions too much
worth while and also of diminishing unduly the motive towards risk-
taking, but mainly, I think, by the belief that the growth of capital depends
upon the strength of the motive towards individual saving and that for a
large proportion of this growth we are dependent on the savings of the rich
out of their superfluity. Our argument does not affect the first of these
considerations. But it may considerably modify our attitude towards the
second. For we have seen that, up to the point where full employment
prevails, the growth of capital depends not at all on a low propensity to
consume but is, on the contrary, held back by it; and only in conditions of
full employment is a low propensity to consume conducive to the growth
of capital. Moreover, experience suggests that in existing conditions saving
by institutions and through sinking funds is more than adequate, and that
measures for the redistribution of incomes in a way likely to raise the
propensity to consume may prove positively favourable to the growth of

capital.
The existing confusion of the public mind on the matter is well
illustrated by the very common belief that the death duties are responsible
for a reduction in the capital wealth of the country. Assuming that the
State applies the proceeds of these duties to its ordinary outgoings so that
taxes on incomes and consumption are correspondingly reduced or
avoided, it is, of course, true that a fiscal policy of heavy death duties has
the effect of increasing the communitys propensity to consume. But
inasmuch as an increase in the habitual propensity to consume will in
general (i.e. except in conditions of full employment) serve to increase at
the same time the inducement to invcst, the inference commonly drawn is
the exact opposite of the truth.
Thus our argument leads towards the conclusion that in
contemporary conditions the growth of wealth, so far from being
dependent on the abstinence of the rich, as is commonly supposed, is more
likely to be impeded by it. One of the chief social justifications of great
inequality of wealth is, therefore, removed. I am not saying that there are
no other reasons, unaffected by our theory, capable of justifying some
measure of inequality in some circumstances. But it does dispose of the
most important of the reasons why hitherto we have thought it prudent to
move carefully. This particularly affects our attitude towards death duties:
for there are certain justifications for inequality of incomes which do not
apply equally to inequality of inheritances.
For my own part, I believe that there is social and psychological
justification for significant inequalities of incomes and wealth, but not for
such large disparities as exist to-day. There are valuable human activities
which require the motive of money-making and the environment of
private wealth-ownership for their full fruition. Moreover, dangerous
human proclivities can be canalised into comparatively harmless channels
by the existence of opportunities for money-making and private wealth,
which, if they cannot be satisfied in this way, may find their outlet in
cruelty, the reckless pursuit of personal power and authority, and other
forms of self-aggrandisement. It is better that a man should tyrannise over
his bank balance than over his fellow-citizens; and whilst the former is
sometimes denounced as being but a means to the latter, sometimes at
least it is an alternative. But it is not necessary for the stimulation of these
activities and the satisfaction of these proclivities that the game should be
played for such high stakes as at present. Much lower stakes will serve the
purpose equally well, as soon as the players are accustomed to them. The
task of transmuting human nature must not be confused with the task of
managing it. Though in the ideal commonwealth men may have been
taught or inspired or bred to take no interest in the stakes, it may still be
wise and prudent statesmanship to allow the game to be played, subject to
rules and limitations, so long as the average man, or even a significant
section of the community, is in fact strongly addicted to the money-making
passion.
There is, however, a second, much more fundamental inference from our
argument which has a bearing on the future of inequalities of wealth;
namely, our theory of the rate of interest. The justification for a
moderately high rate of interest has been found hitherto in the necessity of
providing a sufficient inducement to save. But we have shown that the
extent of effective saving is necessarily determined by the scale of
investment and that the scale of investment is promoted by a low rate of
interest, provided that we do not attempt to stimulate it in this way beyond
the point which corresponds to full employment. Thus it is to our best
advantage to reduce the rate of interest to that point relatively to the
schedule of the marginal efficiency of capital at which there is full
employment.
There can be no doubt that this criterion will lead to a much lower
rate of interest than has ruled hitherto; and, so far as one can guess at the
schedules of the marginal efficiency of capital corresponding to increasing
amounts of capital, the rate of interest is likely to fall steadily, if it should
be practicable to maintain conditions of more or less continuous full
employment unless, indeed, there is an excessive change in the
aggregate propensity to consume (including the State).
I feel sure that the demand for capital is strictly limited in the sense
that it would not be difficult to increase the stock of capital up to a point
where its marginal efficiency had fallen to a very low figure. This would
not mean that the use of capital instruments would cost almost nothing,
but only that the return from them would have to cover little more than
their exhaustion by wastage and obsolescence together with some margin
to cover risk and the exercise of skill and judgment. In short, the aggregate
return from durable goods in the course of their life would, as in the case
of short-lived goods, just cover their labour-costs of production plus an
allowance for risk and the costs of skill and supervision.
Now, though this state of affairs would be quite compatible with some
measure of individualism, yet it would mean the euthanasia of the rentier,
and, consequently, the euthanasia of the cumulative oppressive power of
the capitalist to exploit the scarcity-value of capital. Interest to-day
rewards no genuine sacrifice, any more than does the rent of land. The
owner of capital can obtain interest because capital is scarce, just as the
owner of land can obtain rent because land is scarce. But whilst there may
be intrinsic reasons for the scarcity of land, there are no intrinsic reasons
for the scarcity of capital. An intrinsic reason for such scarcity, in the sense
of a genuine sacrifice which could only be called forth by the offer of a
reward in the shape of interest, would not exist, in the long run, except in
the event of the individual propensity to consume proving to be of such a
character that net saving in conditions of full employment comes to an end
before capital has become sufficiently abundant. But even so, it will still be
possible for communal saving through the agency of the State to be
maintained at a level which will allow the growth of capital up to the point
where it ceases to be scarce.
I see, therefore, the rentier aspect of capitalism as a transitional phase
which will disappear when it has done its work. And with the
disappearance of its rentier aspect much else in it besides will suffer a sea-
change. It will be, moreover, a great advantage of the order of events which
I am advocating, that the euthanasia of the rentier, of the functionless
investor, will be nothing sudden, merely a gradual but prolonged
continuance of what we have seen recently in Great Britain, and will need
no revolution.
Thus we might aim in practice (there being nothing in this which is
unattainable) at an increase in the volume of capital until it ceases to be
scarce, so that the functionless investor will no longer receive a bonus; and
at a scheme of direct taxation which allows the intelligence and
determination and executive skill of the financier, the entrepreneur et hoc
genus omne (who are certainly so fond of their craft that their labour could
be obtained much cheaper than at present), to be harnessed to the service
of the community on reasonable terms of reward.
At the same time we must recognise that only experience can show
how far the common will, embodied in the policy of the State, ought to be
directed to increasing and supplementing the inducement to invest; and
how far it is safe to stimulate the average propensity to consume, without
foregoing our aim of depriving capital of its scarcity-value within one or
two generations. It may turn out that the propensity to consume will be so
easily strengthened by the effects of a falling rate of interest, that full
employment can be reached with a rate of accumulation little greater than

at present. In this event a scheme for the higher taxation of large incomes
and inheritances might be open to the objection that it would lead to full
employment with a rate of accumulation which was reduced considerably
below the current level. I must not be supposed to deny the possibility, or
even the probability, of this outcome. For in such matters it is rash to
predict how the average man will react to a changed environment. If,
however, it should prove easy to secure an approximation to full
employment with a rate of accumulation not much greater than at present,
an outstanding problem will at least have been solved. And it would
remain for separate decision on what scale and by what means it is right
and reasonable to call on the living generation to restrict their
consumption, so as to establish in course of time, a state of full investment
for their successors.
In some other respects the foregoing theory is moderately conservative in

its implications. For whilst it indicates the vital importance of establishing
certain central controls in matters which are now left in the main to
individual initiative, there are wide fields of activity which are unaffected.
The State will have to exercise a guiding influence on the propensity to
consume partly through its scheme of taxation, partly by fixing the rate of
interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely
that the influence of banking policy on the rate of interest will be sufficient
by itself to determine an optimum rate of investment. I conceive,
therefore, that a somewhat comprehensive socialisation of investment will
prove the only means of securing an approximation to full employment;
though this need not exclude all manner of compromises and of devices by
which public authority will co-operate with private initiative. But beyond
this no obvious case is made out for a system of State Socialism which
would embrace most of the economic life of the community. It is not the
ownership of the instruments of production which it is important for the
State to assume. If the State is able to determine the aggregate amount of
resources devoted to augmenting the instruments and the basic rate of
reward to those who own them, it will have accomplished all that is
necessary. Moreover, the necessary measures of socialisation can be
introduced gradually and without a break in the general traditions of
society.
Our criticism of the accepted classical theory of economics has

consisted not so much in finding logical flaws in its analysis as in pointing
out that its tacit assumptions are seldom or never satisfied, with the result
that it cannot solve the economic problems of the actual world. But if our
central controls succeed in establishing an aggregate volume of output
corresponding to full employment as nearly as is practicable, the classical
theory comes into its own again from this point onwards. If we suppose
the volume of output to be given, i.e. to be determined by forces outside
the classical scheme of thought, then there is no objection to be raised
against the classical analysis of the manner in which private self-interest
will determine what in particular is produced, in what proportions the
factors of production will be combined to produce it, and how the value of
the final product will be distributed between them. Again, if we have dealt
otherwise with the problem of thrift, there is no objection to be raised
against the modern classical theory as to the degree of consilience between
private and public advantage in conditions of perfect and imperfect
competition respectively. Thus, apart from the necessity of central controls
to bring about an adjustment between the propensity to consume and the
inducement to invest, there is no more reason to socialise economic life
than there was before.
To put the point concretely, I see no reason to suppose that the
existing system seriously misemploys the factors of production which are
in use. There are, of course, errors of foresight; but these would not be
avoided by centralising decisions. When 9,000,000 men are employed out
of 10,000,000 willing and able to work, there is no evidence that the
labour of these 9,000,000 men is misdirected. The complaint against the
present system is not that these 9,000,000 men ought to be employed on
different tasks, but that tasks should be available for the remaining
1,000,000 men. It is in determining the volume, not the direction, of
actual employment that the existing system has broken down.
Thus I agree with Gesell that the result of filling in the gaps in the
classical theory is not to dispose of the Manchester System, but to
indicate the nature of the environment which the free play of economic
forces requires if it is to realise the full potentialities of production. The
central controls necessary to ensure full employment will, of course,
involve a large extension of the traditional functions of government.
Furthermore, the modern classical theory has itself called attention to
various conditions in which the free play of economic forces may need to
be curbed or guided. But there will still remain a wide field for the exercise
of private initiative and responsibility. Within this field the traditional

advantages of individualism will still hold good.
Let us stop for a moment to remind ourselves what these advantages
are. They are partly advantages of efficiency the advantages of
decentralisation and of the play of self-interest. The advantage to
efficiency of the decentralisation of decisions and of individual
responsibility is even greater, perhaps, than the nineteenth century
supposed; and the reaction against the appeal to self-interest may have
gone too far. But, above all, individualism, if it can be purged of its defects
and its abuses, is the best safeguard of personal liberty in the sense that,
compared with any other system, it greatly widens the field for the exercise
of personal choice. It is also the best safeguard of the variety of life, which
emerges precisely from this extended field of personal choice, and the loss
of which is the greatest of all the losses of the homogeneous or totalitarian
state. For this variety preserves the traditions which embody the most
secure and successful choices of former generations; it colours the present
with the diversification of its fancy; and, being the handmaid of
experiment as well as of tradition and of fancy, it is the most powerful
instrument to better the future.
Whilst, therefore, the enlargement of the functions of government,
involved in the task of adjusting to one another the propensitv to consume
and the inducement to invest, would seem to a nineteenth-century
publicist or to a contemporary American financier to be a terrific
encroachment on individualism, I defend it, on the contrary, both as the
only practicable means of avoiding the destruction of existing economic
forms in their entirety and as the condition of the successful functioning of
individual initiative.
For if effective demand is deficient, not only is the public scandal of
wasted resources intolerable, but the individual enterpriser who seeks to
bring these resources into action is operating with the odds loaded against
him. The game of hazard which he plays is furnished with many zeros, so
that the players as a whole will lose if they have the energy and hope to
deal all the cards Hitherto the increment of the worlds wealth has fallen
short of the aggregate of positive individual savings; and the difference has
been made up by the losses of those whose courage and initiative have not
been supplemented by exceptional skill or unusual good fortune. But if
effective demand is adequate, average skill and average good fortune will
be enough.
The authoritarian state systems of to-day seem to solve the problem of
unemployment at the expense of efficiency and of freedom. It is certain
that the world will not much longer tolerate the unemployment which,
apart from brief intervals of excitement, is associated and, in my
opinion, inevitably associated with present-day capitalistic
individualism. But it may be possible by a right analysis of the problem to
cure the disease whilst preserving efficiency and freedom.
I have mentioned in passing that the new system might be more

favourable to peace than the old has been. It is worth while to repeat and
emphasise that aspect. War has several causes. Dictators and others such,
to whom war offers, in expectation at least, a pleasurable excitement, find
it easy to work on the natural bellicosity of their peoples. But, over and
above this, facilitating their task of fanning the popular flame, are the
economic causes of war, namely, the pressure of population and the
competitive struggle for markets. It is the second factor, which probably
played a predominant part in the nineteenth century, and might again,
that is germane to this discussion.
I have pointed out in the preceding chapter that, under the system of
domestic laissez-faire and an international gold standard such as was
orthodox in the latter half of the nineteenth century, there was no means
open to a government whereby to mitigate economic distress at home
except through the competitive struggle for markets. For all measures
helpful to a state of chronic or intermittent under-employment were ruled
out, except measures to improve the balance of trade on income account.
Thus, whilst economists were accustomed to applaud the prevailing
international system as furnishing the fruits of the international division
of labour and harmonising at the same time the interests of different
nations, there lay concealed a less benign influence; and those statesmen
were moved by common sense and a correct apprehension of the true
course of events, who believed that if a rich, old country were to neglect
the struggle for markets its prosperity would droop and fail. But if nations
can learn to provide themselves with full employment by their domestic
policy (and, we must add, if they can also attain equilibrium in the trend of
their population), there need be no important economic forces calculated
to set the interest of one country against that of its neighbours. There
would still be room for the international division of labour and for
international lending in appropriate conditions. But there would no longer
be a pressing motive why one country need force its wares on another or
repulse the offerings of its neighbour, not because this was necessary to
enable it to pay for what it wished to purchase, but with the express object
of upsetting the equilibrium of payments so as to develop a balance of
trade in its own favour. International trade would cease to be what it is,
namely, a desperate expedient to maintain employment at home by forcing
sales on foreign markets and restricting purchases, which, if successful,
will merely shift the problem of unemployment to the neighbour which is
worsted in the struggle, but a willing and unimpeded exchange of goods
and services in conditions of mutual advantage.
Is the fulfilment of these ideas a visionary hope? Have they insufficient

roots in the motives which govern the evolution of political society? Are
the interests which they will thwart stronger and more obvious than those
which they will serve?
I do not attempt an answer in this place. It would need a volume of a
different character from this one to indicate even in outline the practical
measures in which they might be gradually clothed. But if the ideas are
correct an hypothesis on which the author himself must necessarily base
what he writes it would be a mistake, I predict, to dispute their potency
over a period of time. At the present moment people are unusually
expectant of a more fundamental diagnosis; more particularly ready to
receive it; eager to try it out, if it should be even plausible. But apart from
this contemporary mood, the ideas of economists and political
philosophers, both when they are right and when they are wrong, are more
powerful than is commonly understood. Indeed the world is ruled by little
else. Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct economist.
Madmen in authority, who hear voices in the air, are distilling their frenzy
from some academic scribbler of a few years back. I am sure that the
power of vested interests is vastly exaggerated compared with the gradual
encroachment of ideas. Not, indeed, immediately, but after a certain
interval; for in the field of economic and political philosophy there are not
many who are influenced by new theories after they are twenty-five or
thirty years of age, so that the ideas which civil servants and politicians
and even agitators apply to current events are not likely to be the newest.
But, soon or late, it is ideas, not vested interests, which are dangerous for
good or evil.
8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : Appendix 1

A 1
P E F E
C P E
Page Line Correction
[Chapter 6] 6 For possession read possessions
[Chapter 7] 12 For has read had
[Chapter
13 For 23 read 19
10]
[Chapter footnote I, line
For th read the
10] 2
[Chapter
21 For security read precautionary
13]
[Chapter
9 For than read that
16]
[Chapter For output read the stock of assets in
32
17] general
[Chapter
25 For their read its
17]
[Chapter
31 For or read of
17]
[Chapter
28 For three read four
19]
[Chapter
4 For technique read techniques
19]
[Chapter
23 For income read incomes
22]
[Chapter
7 For Mercantilist read Mercantilists
23]
These corrections come to light in preparing various foreign editions of

The General Theory, in preparing the variorum version of earlier drafts
which appears in volume XIV, or in setting this book for press. The
corrections do not cover more substantial errors such as the unsatisfactory
file:///D:/keyness/appendix1.html 1/2
presentation of aggregate supply and demand on Chapter 3 or the

inadequate derivation of the equations on Chapter 21.
https://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/appendix1.html

A 2
From The Economic Journal, September 1936
F N U
S
In my General Theory of Employment, Interest and Money, Chapter 8, I

made a brief attempt to illustrate the wide range of fluctuations in net
investment, basing myself on certain calculations by Mr Colin Clark for
Great Britain and by Mr Kuznets for the United States.
In the case of Mr Kuznets figures I pointed out (Chapter 8) that his
allowances for depreciation, etc., included no deduction at all in respect of
houses and other durable commodities in the hands of individuals. But
the table which immediately followed this did not make it sufficiently clear
to the reader that the first line relating to gross capital formation
comprised much wider categories of capital goods than the second line
relating to entrepreneurs depreciation, etc.; and I was myself misled on
the next page, where I expressed doubts as to the sufficiency of the latter
item in relation to the former (forgetting that the latter related only to a
part of the former). The result was that the table as printed considerably
under-stated the force of the phenomenon which I was concerned to
describe, since a complete calculation in respect of depreciation, etc.,
covering all the items in the first line of the table, would lead to much
larger figures than those given in the second line. Some correspondence
with Mr Kuznets now enables me to explain these important figures more
fully and clearly, and in the light of later information.
Mr Kuznets divides his aggregate of gross capital formation (as he
calls it) for the United States into a number of categories as follows:
(1) Consumers Durable Commodities
These comprise motor-cars, furniture and house equipment and other
more or less durable articles, apart from houses, purchased and owned by
those who consume them. Whether or not these items should be included
in investment depends (so far as the definition is concerned) on whether

the expenditure on them when it is initially made is included in current
saving or in current expenditure; and it depends (so far as the practical
application is concerned) on whether in subsequent years the owners feel
under a motive to make provision for current depreciation out of their
incomes even when they are not replacing or renewing them. Doubtless it
is not possible to draw a hard-and-fast line. But it is probable that few
individuals feel it necessary in such cases to make a financial provision for
depreciation apart from actual repairs and renewals. This, in combination
with the difficulty of obtaining proper statistics and of drawing a clear line,
makes it preferable, I think, to exclude such equipment from investment
and to include it in consumption-expenditure in the year in which it is
incurred. This is in accordance with the definition of consumption given in
my General Theory, p. 54.
I shall, therefore, exclude this category from the final calculation;
though I hope to deal with the problem more thoroughly at a later time.
Nevertheless it may be interesting to quote Mr Kuznets estimates, which
are of substantial magnitude:
(Millions of dollars.)
1925 1926 1927 1928 1929 1930 1931 1932 1933
Consumers
durable 8,664 9,316 8,887 9,175 10,058 7,892 5,885 4,022 3,737
commodities
The above figure for 1929 includes 3,400 million dollars for motor-cars,
whilst the depreciation in respect of the same item for that year is
estimated at 2,500 million dollars.
(2) Residential Construction
This is an important and highly fluctuating item which should
undoubtedly be included in investment, and not in consumption
expenditure, since houses are usually regarded as purchased out of savings
and not out of income, and are often owned by others than the occupiers.
In the Bulletin from which these figures are taken Mr Kuznets gives no
estimate for the annual rate of depreciation, etc. More recently, however,
his colleague, Mr Solomon Fabricant, has published such estimates, which
I have used in the following table:
1925 1926 1927 1928 1929 1930 1931 1932 1933
Residential 3,050 2,965 2,856 3,095 2,127 1,222 900 311 276
construction
Depreciation* 1,554 1,676 1,754 1,842 1,911 1,901 1,698 1,460 1,567
Net
1,496 1,289 1,102 1,253 216 679 798 1,149 1,291
investment
* These figures are calculated in terms of current (reproduction) costs. Mr

Fabricant has also provided estimates in terms of original cost, which for the
years prior to 1932 are considerably lower.
(3) Business Fixed Capital

Mr Kuznets here distinguishes expenditure on new producers durable
goods and business construction from the net change in business
inventories, i.e. in working and liquid capital; and we shall, therefore, deal
with the latter under a separate heading.
The amount of the deduction to obtain net investment in respect of
parts, repairs and servicing, and repairs and maintenance of business
construction as distinct from depreciation and depletion, which is not
made good, depends, of course, on whether the former have been included
in gross investment. Mr Kuznets gives a partial estimate for the former but
the figures given below exclude these items both from gross and from net
investment. But whilst the result of deducting both the repairs item and
the depreciation item probably corresponds fairly closely to my net
investment, the two deductions taken separately do not closely correspond
to my deductions for user cost and supplementary cost; so that it is not
possible to calculate from Mr Kuznets data a figure corresponding to my
(gross) investment.
The following table gives in the first line the formation of gross
capital destined for business use, exclusive of parts, repairs and servicing,
and repairs and maintenance of business construction, and excluding
changes in business inventories; and in the second line the estimated
depreciation and depletion on the same items:
1925 1926 1927 1928 1929 1930 1931 1932 1933
Gross
business
capital 9,070 9,815 9,555 10,019 11,396 9,336 5,933 3,205 2,894
formation
(as above)
Depreciation
and 5,685 6,269 6,312 6,447 7,039 6,712 6,154 5,092 4,971
depletion*
Net 3,385 3,546 3,243 3,572 4,357 2,624 221 1,887 2,077
investment
* These figures are not taken from Mr Kuznets memoranda, hut from Mr
Fabricants later and revised estimates. As before they are in terms of current
(replacement) cost. In terms of original cost they are appreciably lower prior
to 1931 and higher subsequently.
(4) Business Inventories

For the financial gains or losses arising out of this item there appear
to be fairly adequate statistics in the United States, though not in this
country. Mr Kuznets figures are as follows:
1925 1926 1927 1928 1929 1930 1931 1932 1933
Net gain or
loss in
916 2,664 176 511 1,800 100 500 2,250 2,250
business
inventories
This table covers not only manufacturers stocks but also stocks of farmers,
mines, traders, government agencies, etc. From 1929 onwards the figures
given in Mr Kuznets memorandum of 1934 proved to require correction.
Those given above are provisional and approximate estimates, pending the
publication of revised figures by the National Bureau.
(5) Public Construction and Borrowing
The relevant figure in this context is not so much the gross (or net)
expenditure on construction, as the amount of expenditure met out of a
net increase in borrowing. That is to say in the case of public authorities
and the like, their net investment may be best regarded as being measured
by the net increase in their borrowing. In so far as their expenditures are
met by compulsory transfer from the current income of the public, they
have no correlative in private saving; whilst public saving, if we were to
find a satisfactory definition for this concept, would be subject to quite
different psychological influences from private saving. I have touched on
the problem in my General Theory, footnote. I propose, therefore, to
insert in place of the figures of public construction the loan expenditure
of public bodies.
Mr Kuznets has very kindly supplied me with figures for the net
changes in the amount of public debt (Federal, State and local)
outstanding in the United States, which, except for minor changes in the
Governments cash balances, represent the amount of public expenditure
not covered by taxes and other revenues. This is given below in parallel
with his estimates of the amount of construction by public authorities. The
interesting result emerges that up to 1928 there was a net reduction in the
public debt in spite of a large expenditure on public construction, and that
even up to 1931 some part of public construction was met out of revenue.
The excess of borrowing over construction in 1932 and 1933 represents, of
course, various measures of public relief.
1925 1926 1927 1928 1929 1930 1931 1932 1933
Public
2,717 2,612 3,045 3,023 2,776 3,300 2,906 2,097 1,659
construction
Net change
in
outstanding 43 280 244 50 +441 +1,712 +2,822 +2,565 +2,796
public
debt**
* See Mr Kuznets Bulletin, Table II, line 22, brought up to date on the basis
of more recent data.
** See col. 9 of the table given in the appendix below.
(6) Foreign Investment

Finally, we have the net change in claims countries, estimated by Mr
Kuznets as follows:
1925 1926 1927 1928 1929 1930 1931 1932 1933
428 44 606 957 312 371 326 40 293
(7) Aggregate Net Investment

We are now in a position to combine the above items into a single
aggregate. This total is not quite comprehensive, since it excludes
construction by semi-public agencies, and a small amount unallocable
construction. But Mr Kuznets is of the opinion that both omissions are
quite minor in character and could not much affect the movements of net
investment in the table which now follows.
1925 1926 1927 1928 1929 1930 1931 1932 1933
Residential
1,496 1,289 1,102 1,253 216 679 798 1,149 1,291
construction
Business 3,385 3,546 3,243 3,572 4,357 2,624 221 1,887 2,077
fixed capital
Business
916 2,664 176 511 1,800 100 500 2,250 2,250
inventories
Net loan
expenditures
43 280 244 10 441 1,712 2,822 2,565 2,796
by public
authorities
Foreign
428 44 606 957 312 371 326 40 293
investment
Aggregate
net 6,182 7,263 4,531 6,283 7,126 4,128 1,629 2,681 2,529
investment
It is evident that this table is of first-class importance for the

interpretation of business fluctuations in the United States. In matters of
detail the following points stand out:
(a) The arrears of residential construction at the end of 1933 must
have been enormous. For there had been no net investment in this field
since 1925. This does not mean, of course, that the actual state of housing
was so bad as this. Some gross investment in housing continued
throughout, and the gradual deterioration in the state of accommodation,
through obsolescence and decay not made good, does not impair forthwith
to an equal extent the actual accommodation available for the time being.
(b) The part played by fluctuations in business inventories is very
marked, especially in accentuating the depression at the bottom of the
slump. The increase in inventories in 1929 was probably for the most part
designed to meet demand which did not fully materialise; whilst the small
further increase in 1930 represented accumulations of unsold stocks. In
1932 and 1933, manufacturers met current demand to an extraordinary
extent out of stocks, so that effective demand fell largely behind actual
consumption. But this, fortunately, is a state of affairs which could not
continue indefinitely. A further depletion of stocks on this scale could not
possibly take place, since the stocks were no longer there. A level of
business inventories so low as that which existed in the United States at
the end of 1933 was an almost certain herald of some measure of recovery.
In general an aggregate of net investment which is based on an increase in
business inventories beyond normal is clearly precarious; and it is easy to
see in retrospect that a large growth of inventories in 1929, coupled with a
decline in residential construction, was ominous. The figures for 1934,
1935, and 1936 will be most interesting when we have them. One would
expect that the recovery of the two former years has been based on a
return of inventories to normal and on public loan expenditure, but that by

1936 durable investment was beginning to supplant inventories in making
up the total. It is on the continued steadiness of the first two items of the
above table at figures not less than those of 1925 to 1928 that the
maintenance of prosperity must depend; and it is for this reason that a low
long-term rate of interest is so vitally important.
(c) The manner in which the changes in public loan expenditure came
in to moderate the fluctuations, which would have occurred otherwise, is
very apparent. The manner in which from 1931 Federal borrowing took the
place of State and local borrowing, as shown in the Appendix below, is
striking. From 30 June 1924, to 30 June 1930, Federal loans outstanding
fell from 21 to 15 billions, whilst in the same period State and local loans
rose from 10 to 16 billions, the total remaining unchanged; whereas from
30 June 1930 to 30 June 1935, Federal loans rose from 15 to 26 billions
and the others from 16 only to 17 billions. The appendix, which gives the
figures of public borrowing up to 30 June 1935, shows contrary,
perhaps, to the general impression that public borrowing was at its
height in 1931, and that in 193435 it was but little more than in 192930.
(d) When comparable figures of income are available, we shall be able
to make some computations as to the value of the Multiplier in the
conditions of the United States, though there are many statistical
difficulties still to overcome. If, however, as a very crude, preliminary test
we take the Dept. of Commerce estimates of income (uncorrected for price
changes), we find that during the large movements of the years from 1929
to 1932 the changes in money-incomes were from three to five times the
changes in net investment shown above. In 1933 incomes and investment
both increased slightly, but the movements were too narrow to allow the
ratio of the one to the other to be calculated within a reasonable margin of
error.
J. M. KEYNES
AN A 2
T N O I P
D
Total outstanding issues Net outstanding issues
Date Federal State, Combined Federal State, Combined Net Average

(30 (2) county, (4) (5) county, (7) change for
June) city, city, (8) calendar

(1) etc. (3) etc. (6) year (9)
1924 20,982 11,633 32,615 20,627 9,921 30,548
1925 20,211 12,830 33,041 19,737 10,975 30,712 +164 43
1926 19,384 13,664 33,048 18,790 11,672 30,462 250 280
1927 18,251 14,735 32,986 17,542 12,610 30,152 310 244
1928 17,318 15,699 33,017 16,522 13,452 29,974 178 10
1929 16,639 16,760 33,399 15,773 14,358 30,131 +157 +441
1930 15,922 17,985 33,907 14,969 15,887 30,856 +725 +1,712
1931 16,520 19,188 35,708 16,098 17,457 33,555 +2,699 +2,822
1932 19,161 19,635 35,796 18,673 17,828 36,501 +2,946 +2,565
1933 22,158 19,107 41,265 21,613 17,072 36,685 +2,184 +2,796
1934 26,480 18,942 45,422 25,323 16,771 42,094 +3,409 +2,173
1935 27,645 19,277 46,922 26,137 16,895 43,032 +938
(Source: Report of the Secretary of the Treasury for year ended 30 June
1935, p. 424.)
Total outstanding issues exclude a small volume of matured and non-
interest bearing obligations (see ibid., p. 379).
Net outstanding issues are equal to total outstanding issues less those
held in U.S. Government trust funds, or owned by U.S. Government or by
governmental agencies and held in sinking funds.
The table above does not include the contingent debt of the Federal
Government, i.e. obligations guaranteed by the United States. These,
comprising largely debt issues of the Federal Farm Mortgage Corporation,
Home Owners Loan Corporation and the Reconstruction Finance
Corporation, were as follows:
Date Millions of dollars
30 June 1934 691
31 December 1934 3,079
30 June 1935 4,151
31 December 1935 4,525
(See Cost of Government in the United States, by the National Industrial

Conference Board, pub. no. 223, New York, 1936, Table 26, p. 68.)

A 3
From The Economic Journal, March 1939
R M R W
O
An article by Mr J. G. Dunlop in this Journal (September 1938, Vol.

XLVIII, p. 413) on The Movement of Real and Money Wage Rates, and
the note by Mr L. Tarshis printed below [in the Economic Journal, March
1939] (p. 150), clearly indicate that a common belief to which I acceded in
my General Theory of Employment needs to be reconsidered. I there said:
It would be interesting to see the results of a statistical enquiry into the

actual relationship between changes in money wages and changes in real
wages. In the case of a change peculiar to a particular industry one would
expect the change in real wages to be in the same direction as the change
in money wages. But in the case of changes in the general level of wages, it
will be found, I think, that the change in real wages associated with a
change in money wages, so far from being usually in the same direction, is
almost always in the opposite direction. . .This is because, in the short
period, falling money wages and rising real wages are each, for
independent reasons, likely to accompany decreasing employment; labour
being readier to accept wage-cuts when employment is falling off, yet real
wages inevitably rising in the same circumstances on account of the
increasing marginal return to a given capital equipment when output is
diminished.
But Mr Dunlops investigations into the British statistics appear to show

that, when money wages are rising, real wages have usually risen also;
whilst, when money wages are falling, real wages are no more likely to rise
than to fall. And Mr Tarshis has reached broadly similar results in respect
of recent years in the United States.
In the passage quoted above from my General Theory I was accepting,
without taking care to check the facts for myself, a belief which has been
widely held by British economists up to the last year or two. Since the
material on which Mr Dunlop mainly depends namely, the indices of

real and money wages prepared by Mr G. H. Wood and Prof. Bowley
have been available to all of us for many years, it is strange that the
correction has not been made before. But the underlying problem is not
simple, and is not completely disposed of by the statistical studies in
question.
First of all it is necessary to distinguish between two different
problems. In the passage quoted above I was dealing with the reaction of
real wages to changes in output, and had in mind situations where changes
in real and money wages were a reflection of changes in the level of
employment caused by changes in effective demand. This is, in fact, the
case which, if I understand them rightly, Mr Dunlop and Mr Tarshis have
primarily in view. But there is also the case where changes in wages reflect
changes in prices or in the conditions governing the wage bargain which
do not correspond to, or are not primarily the result of, changes in the
level of output and employment and are not caused by (though they may
cause) changes in effective demand. This question I discussed in a
different part of my General Theory (namely Chapter 19, Changes in
Money Wages), where I reached the conclusion that wage changes, which
are not in the first instance due to changes in output, have complex
reactions on output which may be in either direction according to
circumstances and about which it is difficult to generalise. It is with the
first problem only that I am concerned in what follows.
The question of the influence on real wages of periods of boom and
depression has a long history. But we need not go farther back than the
period of the eighties and nineties of the last century, when it was the
subject of investigation by various official bodies before which Marshall
gave evidence or in the work of which he took part. I was myself brought
up upon the evidence he gave before the Gold and Silver Commission in
1887 and the Indian Currency Committee in 1899.
It is not always clear whether Marshall has in mind a rise in money
wages associated with a rise in output, or one which merely reflects a
change in prices (due, for example, to a change in the standard which was
the particular subject on which he was giving evidence); but in some
passages it is evident that he is dealing with changes in real wages at times
when output is expanding. It is clear, however, that his conclusion is
based, not like some later arguments on priori grounds arising out of
increasing marginal cost in the short period, but on statistical grounds
which showed so he thought that in the short period wages were
stickier than prices. In his preliminary memorandum for the Gold and
Silver Commission (Official Papers, p. 19) he wrote: [During a slow and

gradual fall of prices] a powerful friction tends to prevent money wages in
most trades from falling as fast as prices; and this tends almost
imperceptibly to establish a higher standard of living among the working
classes, and to diminish the inequalities of wealth. These benefits are often
ignored; but in my opinion they are often nearly as important as the evils
which result from that gradual fall of prices which is sometimes called a
depression of trade. And when Mr chaplin asked him (op. cit., p. 99), You
think that during a period of depression the employed working classes
have been getting more than they did before? he replied, More than they
did before, on the average.
Subsequently, as appears from an important letter of April 1897
(hitherto unpublished) to Foxwell, who held somewhat strongly the
opposite opinion, Marshalls opinion became rather more tentative;
though the following extract refers more to his general attitude towards
rising prices than to their particular effect on real wages:
You know, my views on this matter are (a) not very confident, (b) not very
warmly advocated by me, (c) not very old, (d) based entirely on non-
academic arguments & observation.
In the years 68 to 77 I was strongly on the side you now advocate. The
observation of events in Bristol made me doubt. In 85, or 86 I wrote a
Memn for the Comn on Depression showing a slight preference for rising
prices. But in the following two years I studied the matter closely, I read
and analysed the evidence of business men before that Commission; & by
the time the Gold & Silver Commission came, I had just turned the corner.
Since then I have read a great deal, but almost exclusively of a non-
academic order on the subject: & was thinking about it duhng a great part
of the evidence given by business men & working men before the Labour
Commission. I have found a good deal that is new to strengthen my new
conviction, nothing to shake it. I am far from certain I am right. I am
absolutely certain that the evidence brought forward in print to the
contrary in England and America (I have not read largely for other
countries) does not prove what it claims to, & does not meet or anticipate
my arguments, in the simple way you seem to imagine.
Shortly afterwards he began to work at his evidence for the Indian

Currency Committee which seems to have had the effect of confirming him
in his previous opinion. His final considered opinion is given in Question
11,781:
I will confess that, for ten or fifteen years after I began to study political
economy, I held the common doctrine, that a rise of prices was generally
beneficial to business men directly, and indirectly to the working classes.
But, after that time, I changed my views, and I have been confirmed in my
new opinions by finding that they are largely held in America, which has
recently passed through experiences somewhat similar to those of England
early in the century. The reasons for the change in my opinion are rather
long, and I gave them at some length before the Gold and Silver
Commission. I think, perhaps, I had better content myself now with calling
your attention to the fact that the statistical aspect of the matter is in a
different position now. The assertions that a rise in prices increased the
real wages of the worker were so consonant with the common opinion of
people who had not specially studied the matter, that it was accepted
almost as an axiom; but, within the last ten years, the statistics of wages
have been carried so far in certain countries, and especially in England and
America, that we are able to bring it to the test. I have accumulated a great
number of facts, but nearly everything I have accumulated is implied in
this table. It is copied from the article by Mr Bowley in the Economic
Journal for last December. It is the result of work that has been going on
for a number of years, and seems to me to be practically decisive. It
collects the average wages in England from the year 1844 to the year 1891,
and then calculates what purchasing power the wages would give at the
different times, and it shows that the rise of real wages after 1873 when
prices were falling was greater than before 1873 when prices were rising.
Here follows a table from Prof. Bowleys article in this Journal for
December 1898. Marshalls final conclusion was crystallised in a passage
in the Principles (Book VI, ch. VIII, 6):
[When prices rise the employer] will therefore be more able and more
willing to pay the high wages; and wages will tend upwards. But
experience shows that (whether they are governed by sliding scales or not)
they seldom rise as much in proportion as prices; and therefore they do
not rise nearly as much in proportion as profits.
Although Marshalls evidence before the Indian Currency Committee was

given in 1899, Prof. Bowleys statistics on which he was relying do not
relate effectively to a date later than 1891 (or 1893 at latest). It is clear, I
think, that Marshalls generalisation was based on experience from 1880
to 1886 which did in fact bear it out. If we divide the years from 1880 to
1914 into successive periods of recovery and depression, the broad result,
allowing for trend, appears to be as follows:
Real wages
18801884 Recovery Falling
18841886 Depression Rising
18861890 Recovery Rising
18901896 Depression Falling

According to this, Marshalls generalisation holds for the periods from

1880 to 1884 and from 1884 to 1886, but for no subsequent periods. It
seems that we have been living all these years on a generalisation which
held good, by exception, in the years 188086, which was the formative
period in Marshalls thought in this matter, but has never once held good
in the fifty years since he crystallised it! For Marshalls view mainly
prevailed, and Foxwells contrary opinion was discarded as the heresy of
an inflationist. It is to be observed that Marshall offered his generalisation
merely as an observed statistical fact, and, beyond explaining it as
probably due to wages being stickier than prices, he did not attempt to
support it by priori reasoning. The fact that it has survived as a dogma
confidently accepted by my generation must be explained, I think, by the
more theoretical support which it has subsequently received.
To my statement that Marshalls generalisation has remained
uncorrected until recently there is, however, an important exception. In
his Industrial Fluctuations, published in 1927, Professor Pigou pointed
out (p. 217) that the upper halves of trade cycles have, on the whole, been
associated with higher rates of real wages than the lower halves, and he
printed in support of this a large scale chart for the period from 1850 to
1910. Subsequently, however, he seems to have reverted to the Marshallian
tradition, and in his Theory of Unemployment, published in 1933, he
writes (p. 296):
In general, the translation of inertia from real wage-rates to money wage-

rates causes real rates to move in a manner not compensatory, but
complementary, to movements in the real demand function. Real wage-
rates not merely fail to fall when the real demand for labour is falling, but
actually rise; and, in like manner, when the real demand for labour is
expanding, real wage-rates fall.
About that time M. Rueff had attracted much attention by the publication
of statistics which purported to show that a rise in real wages tended to go
with an increase in unemployment, Prof. Pigou points out that these
statistics are vitiated by the fact that M. Rueff divided money wages by the
wholesale index instead of by the cost-of-living index, and he does not
agree with M. Rueff that the observed rise in real wages was the main
cause of the increased unemployment with which it was associated. But he
concludes, nevertheless (p. 300), on a balance of considerations, that

there can be little doubt that in modern industrial communities this latter
tendency (i.e. for shifts in real demand to be associated with shifts in the
opposite sense in the rate of real wages for which work people stipulate) is
predominant.
Like Marshall, Prof. Pigou based his conclusion primarily on the
stickiness of money wages relatively to prices. But my own readiness to
accept the prevailing generalisation, at the time when I was writing my
General Theory, was much influenced by an priori argument, which had
recently won wide acceptance, to be found in Mr R. F. Kahns article on
The Relation of Home Investment to Employment, published in the
Economic Journal for June 1931. The supposed empirical fact, that in the
short period real wages tend to move in the opposite direction to the level
of output, appeared, that is to say, to be in conformity with the more
fundamental generalisations that industry is subject to increasing
marginal cost in the short period, that for a closed system as a whole
marginal cost in the short period is substantially the same thing as
marginal wage cost, and that in competitive conditions prices are governed
by marginal cost; all this being subject, of course, to various qualifications
in particular cases, but remaining a reliable generalisation by and large.
I now recognise that the conclusion is too simple, and does not allow
sufficiently for the complexity of the facts. But I still hold to the main
structure of the argument, and believe that it needs to be amended rather
than discarded. That I was an easy victim of the traditional conclusion
because it fitted my theory is the opposite of the truth. For my own theory
this conclusion was inconvenient, since it had a tendency to offset the
influence of the main forces which I was discussing and made it necessary
for me to introduce qualifications, which I need not have troubled with if I
could have adopted the contrary generalisation favoured by Foxwell, Mr
Dunlop and Mr Tarshis. In particular, the traditional conclusion played an
important part, it will be remembered, in the discussions, some ten years
ago, as to the effect of expansionist policies on employment, at a time
when I had not developed my own argument in as complete a form as I did
subsequently. I was already arguing at that time that the good effect of an
expansionist investment policy on employment, the fact of which no one
denied, was due to the stimulant which it gave to effective demand. Prof.
Pigou, on the other hand, and many other economists explained the
observed result by the reduction in real wages covertly effected by the rise
in prices which ensued on the increase in effective demand. It was held
that public investment policies (and also an improvement in the trade
balance through tariffs) produced their effect by deceiving, so to speak, the

working classes into accepting a lower real wage, effecting by this means
the same favourable influence on employment which, according to these
economists, would have resulted from a more direct attack on real wages
(e.g. by reducing money wages whilst enforcing a credit policy calculated
to leave prices unchanged). If the falling tendency of real wages in periods
of rising demand is denied, this alternative explanation must, of course,
fall to the ground. Since I shared at the time the prevailing belief as to the
facts, I was not in a position to make this denial. If, however, it proves
right to adopt the contrary generalisation, it would be possible to simplify
considerably the more complicated version of my fundamental
explanation which I have expounded in my General Theory. My practical
conclusions would have, in that case, fortiori force. If we can advance
farther on the road towards full employment than I had previously
supposed without seriously affecting real hourly wages or the rate of
profits per unit of output, the warnings of the anti-expansionists need
cause us less anxiety.
Nevertheless, we should, I submit, hesitate somewhat and carry our
inquiries further before we discard too much of our former conclusions
which, subject to the right qualifications, have priori support and have
survived for many years the scrutiny of experience and common sense. I
offer, therefore, for further statistical investigation an analysis of the
elements of the problem with a view to discovering at what points the
weaknesses of the former argument emerge. There are five heads which
deserve separate consideration.
First of all, are the statistics on which Mr Dunlop and Mr Tarshis are
relying sufficiently accurate and sufficiently uniform in their indications to
form the basis of a reliable induction?
For example, in so recent a compilation as the League of Nations
World Economic Survey 193738, prepared by Mr J. E. Meade, the
traditional conclusion receives support, not on priori recently available
statistics. I quote the following from pp. 5455:
During the great depression after 1929, the demand for goods and services
diminished, and in consequence the price of commodities fell rapidly. In
most countries, as can be seen from the graph on p. 52, hourly money
wages were reduced as the demand for labour fell; but in every case there
was a greater fall in prices, so that hourly real wages rose. . .[It is then
explained that the same was not true of weekly wages.]. . .Since the
recovery, the opposite movements may be observed. In most countries,
increased demand for goods and services has caused commodity prices to
rise more rapidly than hourly money wages, and the hourly real wage has
fallen. . .In the United States and France, however, the rise in money
wages was so rapid between 1936 and 1937 that the hourly real wage
continued to rise. . .When real hourly wages are raised i.e. when the
margin between commodity prices and the money-wage cost becomes less
favourable employers are likely to diminish the amount of employment
which they offer to labour. While there were, no doubt, other influences
affecting the demand for labour, the importance of this factor is well
illustrated by the graph on p. 53. In the case of all the countries
represented for which information is available, the fall in commodity
prices between 1929 and 1932 caused a rise in the hourly real wage, and
this was accompanied by a diminution in employment. . .(it is shown that
on the recovery there has been a greater variety of experience). . .
This authoritative study having international scope indicates that the new
generalisations must be accepted with reserve. In any case Mr Tarshiss
scatter diagram printed below [in the Economic Journal, March 1939] (p.
150), whilst it shows a definite preponderance in the south-west and
north-east compartments and a high coefficient of association, includes a
considerable number of divergent cases, and the absolute range of most of
the scatter is extremely small, with a marked clustering in the
neighbourhood of the zero line for changes in real wages; and much the
same is true of Mr Dunlops results. The great majority of Mr Tarshiss
observations relate to changes of less than 1.5 per cent. In the introduction
to his Wages and Income in the United Kingdom since 1860, Prof. Bowley
indicates that this is probably less than the margin of error for statistics of
this kind. This general conclusion is reinforced by the fact that it is hourly
wages which are relevant in the present context, for which accurate
statistics are not available. Moreover, in the post-scriptum to his note, Mr
Tarshis explains that whilst real wages tend to move in the same direction
as money wages, they move in the opposite direction, though only slightly,
to the level of output as measured by man-hours of employment; from
which it appears that Mr Tarshiss final result is in conformity with my
original assumption, which is, of course, concerned with hourly wages. It
seems possible, therefore, taking account of Mr Meades results, that I may
not, after all, have been seriously wrong.
Furthermore, for reasons given below, it is important to separate the
observations according as the absolute level of employment is distinctly
good or only mediocre. It may be that we can analyse our results so as to
give two distinct generalisations according to the absolute level reached by

employment. If, at the present stage of the inquiry, we are to make any
single statistical generalisation, I should prefer one to the effect that, for
fluctuations within the range which has been usual in the periods
investigated which seldom approach conditions of full employment, short-
period changes in real wages are usually so small compared with the
changes in other factors that we shall not often go far wrong if we treat real
wages as substantially constant in the short period (a very helpful
simplification if it is justified). The conclusion, that changes in real wages
are not usually an important factor in short-period fluctuations until the
point of full employment is approaching, is one which has been already
reached by Dr Kalecki on the basis of his own investigations.
It may be that we have under-estimated the quantitative effect of a factor

of which we have always been aware. Our argument assumed that, broadly
speaking, labour is remunerated in terms of its own composite product, or
at least that the price of wage-goods moves in the same way as the price of
output as a whole. But no one has supposed that this was strictly the case
or was better than an approximation; and it may be that the proportion of
wage-goods, which are not the current product of the labour in question
and the prices of which are not governed by the marginal cost of such
product, is so great as to interfere with the reliability of our
approximation. House-rent and goods imported on changing terms of
trade are leading examples of this factor. If in the short period rents are
constant and the terms of trade tend to improve when money wages rise
and to deteriorate when money wages fall, our conclusion will be upset in
practice in spite of the rest of our premisses holding good.
In the case of this country one has been in the habit of supposing that
these two factors have in fact tended to offset one another, though the
opposite might be the case in the raw-material countries. For whereas
rents, being largely fixed, rise and fall less than money wages, the price of
imported food-stuffs tends to rise more than money wages in periods of
activity and to fall more in periods of depression. At any rate both Mr
Dunlop and Mr Tarshis claim to show that fluctuations in the terms of
trade (terms of foreign trade in Mr Dunlops British inquiry and terms of
trade between industry and agriculture in Mr Tarshiss American inquiry)
are not sufficient to affect the general tendency of their results, though
they clearly modify them quantitatively to a considerable extent.

Nevertheless, the effect of expenditure on items such as rent, gas,
electricity, water, transport, etc., of which the prices do not change
materially in the short period, needs to be separately calculated before we
can be clear. If it should emerge that it is this factor which explains the
results, the rest of our fundamental generalisations would remain
undisturbed. It is important, therefore, if we are to understand the
situation, that the statisticians should endeavour to calculate wages in
terms of the actual product of the labour in question.
Has the identification of marginal cost with marginal wage cost introduced
a relevant error? In my General Theory of Employment, I have argued
that this identification is dangerous in that it ignores a factor which I have
called marginal user cost. It is unlikely, however, that this can help us in
the present context. For marginal user cost is likely to increase when
output is increasing, so that this factor would work in the opposite
direction from that required to explain our present problem, and would be
an additional reason for expecting prices to rise more than wages. Indeed,
one would, on general grounds, expect marginal total cost to increase
more, and not less, than marginal wage cost.
Is it the assumption of increasing marginal real cost in the short period

which we ought to suspect? Mr Tarshis finds part of the explanation here;
and Dr Kalecki is inclined to infer approximately constant marginal real
cost. But there is an important distinction which we have to make. We
should all agree that if we start from a level of output very greatly below
capacity, so that even the most efficient plant and labour are only partially
employed, marginal real cost may be expected to decline with increasing
output, or, at the worst, remain constant. But a point must surely come,
long before plant and labour are fully employed, when less efficient plant
and labour have to be brought into commission or the efficient
organisation employed beyond the optimum degree of intensiveness. Even
if one concedes that the course of the short-period marginal cost curve is
downwards in its early reaches, Mr Kahns assumption that it eventually
turns upwards is, on general common-sense grounds, surely beyond
reasonable question; and that this happens, moreover, on a part of the

curve which is highly relevant for practical purposes. Certainly it would
require more convincing evidence than yet exists to persuade me to give
up this presumption.
Nevertheless, it is of great practical importance that the statisticians
should endeavour to determine at what level of employment and output
the short-period marginal-cost curve for the composite product as a whole
begins to turn upward and how sharply it rises after the turning-point has
been reached. This knowledge is essential for the interpretation of the
trade cycle. It is for this reason that I suggested above that the
observations of the relative movement of real and money wages should be
separately classified according to the average level of employment which
had been reached.
It may prove, indeed, at any rate in the case of statistics relating to
recent years that the level of employment has been preponderantly so low
that we have been living more often than not on the reaches of the curve
before the critical point of upturn has been attained. It should be noticed
that Mr Tarshiss American figures relate only to the period from 1932 to
1938, during the whole of which period there has been such intense
unemployment in the United States, both of labour and of plant, that it
would be quite plausible to suppose that the critical point of the marginal
cost curve had never been reached. If this has been the case, it is important
that we should know it. But such an experience must not mislead us into
supposing that this must necessarily be the case, or into forgetting the
sharply different theory which becomes applicable after the turning-point
has been reached.
If, indeed, the shape of the marginal-cost curve proves to be such that
we tend to be living, with conditions as they are at present, more often to
the left than to the right of its critical point, the practical case for a planned
expansionist policy is considerably reinforced; for many caveats to which
we must attend after this point has been reached can be, in that case,
frequently neglected. In taking it as my general assumption that we are
often on the right of the critical point, I have been taking the case in which
the practical policy which I have advocated needs the most careful
handling. In particular the warnings given, quite rightly, by Mr D. H.
Robertson of the dangers which may arise when we encourage or allow the
activity of the system to advance too rapidly along the upward slopes of the
marginal-cost curve towards the goal of full employment, can be more
often neglected, for the time being at least, when the assumption which I
have previously admitted as normal and reasonable is abandoned.
There remains the question whether the mistake lies in the approximate
identification of marginal cost with price, or rather in the assumption that
for output as a whole they bear a more or less proportionate relationship
to one another irrespective of the intensity of output. For it may be the
case that the practical workings of the laws of imperfect competition in the
modern quasi-competitive system are such that, when output increases
and money wages rise, prices rise less than in proportion to the increase in
marginal money cost. It is scarcely likely, perhaps, that the narrowing gap
could be sufficient to prevent a decline in real wages in a phase in which
marginal real cost was increasing rapidly. But it might be sufficient to
offset the effect on real wages of a modest rise in marginal real cost, and
even to dominate the situation in the event of the marginal real cost curve
proving to be almost horizontal over a substantial portion of its relevant
length.
It is evidently possible that some such factor should exist. It might be,
in a sense, merely an extension of the stickiness of prices of which we have
already taken account in II above. Apart from those prices which are
virtually constant in the short period, there are obviously many others
which are, for various reasons, more or less sticky. But this factor would be
particularly likely to emerge when output increases, in so far as producers
are influenced in their practical price policies and in their exploitation of
the opportunities given them by the imperfections of competition, by their
long-period average cost, and are less attentive than economists to their
short-period marginal cost. Indeed, it is rare for anyone but an economist
to suppose that price is predominantly governed by marginal cost. Most
business men are surprised by the suggestion that it is a close calculation
of short-period marginal cost or of marginal revenue which should
dominate their price policies. They maintain that such a policy would
rapidly land in bankruptcy anyone who practised it. And if it is true that
they are producing more often than not on a scale at which marginal cost
is falling with an increase in output, they would clearly be right; for it
would be only on rare occasions that they would be collecting anything
whatever towards their overhead. It is, beyond doubt, the practical
assumption of the producer that his price policy ought to be influenced by
the fact that he is normally operating subject to decreasing average cost,
even if in the short-period his marginal cost is rising. His effort is to
maintain prices when output falls and, when output increases, he may
raise them by less than the full amount required to offset higher costs
including higher wages. He would admit that this, regarded by him as the
reasonable, prudent and far-sighted policy, goes by the board when, at the
height of the boom, he is overwhelmed by more orders than he can supply;
but even so he is filled with foreboding as to the ultimate consequences of
his being forced so far from the right and reasonable policy of fixing his
prices by reference to his long-period overhead as well as his current costs.
Rightly ordered competition consists, in his opinion, in a proper pressure
to secure an adjustment of prices to changes in long-period average cost;
and the suggestion that he is becoming a dangerous and anti-social
monopolist whenever, by open or tacit agreement with his competitors, he
endeavours to prevent prices from hollowing short-period marginal cost,
however much this may fall away from long-period average cost, strikes
him as disastrous. (It is the failure of the latest phase of the New Deal in
the United States, in contrast to the earliest phase, of which the opposite is
true, to distinguish between price agreements for maintaining prices in
right relation to average long-period cost and those which aim at obtaining
a monopolistic profit in excess of average long-period cost which strikes
him as particularly unfair.)
Thus, since it is the avowed policy of industrialists to be content with
a smaller gross profit per unit of output when output increases than when
it declines, it is not unlikely that this policy may be, at least partially,
operative. It would be of great interest if the statisticians could show in
detail in what way gross profit per unit of output changes in different
industries with a changing ratio between actual and capacity output. Such
an investigation should distinguish, if possible, between the effect of
increasing output on unit-profit and that of higher costs in the shape of
higher money wages and other expenses. If it should appear that
Increasing output as such has a tendency to decrease unit-profit, it would
follow that the policy suggested above is actual as well as professed. If,
however, the decline in unit-profit appears to be mainly the result of a
tendency of prices to offset higher costs incompletely, irrespective of
changes in the level of output, then we have merely an example of the
stickiness of prices arising out of the imperfection of competition intrinsic
to the market conditions. Unfortunately it is often difficult or impossible to
distinguish clearly between the effects of the two influences, since higher
money costs and increasing output will generally go together.
A well-known statistical phenomenon which ought to have put me on
my guard confirms the probability of constant or diminishing, rather than
increasing, profit per unit of output when output increases. I mean the
stability of the proportion of the national dividend accruing to labour,
irrespective apparently of the level of output as a whole and of the phase of

the trade cycle. This is one of the most surprising, yet best-established,
facts in the whole range of economic statistics, both for Great Britain and
for the United States. The following figures summarise briefly what are, I
believe, the undisputed facts:
1911 40.7 1924 43.0 1928 43.0 1932 43.0

1925 40.8 1929 42.4 1933 42.7
1926 42.0 1930 41.1 1934 42.0
1927 43.0 1931 43.7 1935 41.8
. . .
1919 34.9 1923 39.3 1927 37.0 1931 34.9

1920 37.4 1924 37.6 1928 35.8 1932 36.0
1921 35.0 1925 37.1 1929 36.1 1933 37.2
1922 37.0 1926 36.7 1930 35.0 1934 35.8
The fluctuations in these figures from year to year appear to be of a

random character, and certainly give no significant indications of any
tendency to move against labour in years of increasing output. It is the
stability of the ratio for each country which is chiefly remarkable, and this
appears to be a long-run, and not merely a short-period, phenomenon.
Moreover, it would be interesting to discover whether the difference
between the British and the American ratio is due to a discrepancy in the
basis of reckoning adopted in the two sets of statistics or to a significant
difference in the degrees of monopoly prevalent in the two countries or to
technical conditions.
In any case, these facts do not support the recently prevailing
assumptions as to the relative movements of real wages and output, and
are inconsistent with the idea of there being any marked tendency to
increasing unit-profit with increasing output. Indeed, even in the light of
the above considerations, the result remains a bit of a miracle. For even if
price policies are such as to cause unit-profit to decrease in the same
circumstances as those in which marginal real cost is increasing, why
should the two quantities be so related that, regardless of other conditions,
the movement of the one almost exactly offsets the movement of the
other? I recently offered the problem of explaining this, as Edgeworth

would have called it, to the research students at Cambridge. The only
solution was offered by Dr Kalecki in the brilliant article which has been
published in Econometrica. Dr Kalecki here employs a highly original
technique of analysis into the distributional problem between the factors
of production in conditions of imperfect competition, which may prove to
be an important piece of pioneer work. But the main upshot is what I have
indicated above, and Dr Kalecki makes, to the best of my understanding,
no definite progress towards explaining why, when there is a change in the
ratio of actual to capacity output, the corresponding changes in the degree
of the imperfection of competition should so exactly offset other changes.
Nor does he explain why the distribution of the product between capital
and labour should be stable in the long run, beyond suggestion that
changes of one kind always just serve to offset changes of another; yet it is
very surprising that on balance there should have been a constant degree
of monopoly over the last twenty years or longer. His own explanation is
based on the assumptions that marginal real costs are constant, that the
degree of the imperfection of the market changes in the opposite direction
to output, but that this change is precisely offset by the fact that the prices
of basic raw materials (purchased by the system from outside) relatively to
money wages increase and decrease with output. Yet there is no obvious
reason why these changes should so nearly offset one another; and it
would seem safer not to assume that marginal real costs are constant, but
to conclude that in actual fact, when output changes, the change in the
degree of the imperfection of the market is such as to offset the combined
effect of changes in marginal costs and of changes in the prices of
materials bought from outside the system relatively to money wages. It
may be noticed that Dr Kaleckis argument assumes the existence of an
opposite change in the degree of the imperfection of competition (or in the
degree in which producers take advantage of it) when output increases
from that expected by Mr R. F. Harrod in his study on The Trade Cycle.
There Mr Harrod expects an increase; here constancy or a decrease seems
to be indicated. Since Mr Harrod gives grounds for his conclusions which
are prima facie plausible, this is a further reason for an attempt to put the
issue to a more decisive statistical test.
To state the case more exactly, we have five factors which fluctuate in
the short period with the level of output:
1. The price of wage-goods relative to the price of the product;
2. The price of goods bought from outside the system relatively to

money wages;
3. The marginal wage cost;
4. The marginal user cost (I attach importance to including this factor

because it helps to bridge the discontinuity between an increase of
output up to short-period capacity and an increase of output
involving an increase beyond the capacity assumed in short-period
conditions); and
5. The degree of the imperfection of competition.
And it appears that, for reasons which are not yet clear, these factors taken
in conjunction have no significant influence on the distribution between
labour and capital of the income resulting from the output. Whatever a
more complete inquiry into the problem may bring forth, it is evident that
Mr Dunlop, Mr Tarshis and Dr Kalecki have given us much to think about,
and have seriously shaken the fundamental assumptions on which the
short-period theory of distribution has been based hitherto; it seems
that for practical purposes a different set of simplifications from those
adopted hitherto are preferable. Meanwhile I am comforted by the fact
that their conclusions tend to confirm the idea that the causes of short-
period fluctuation are to be found in changes in the demand for labour,
and not in changes in its real-supply price; though I complain a little that I
in particular should be criticised for conceding a little to the other view by
admitting that, when the changes in effective demand to which I myself
attach importance have brought about a change in the level of output, the
real-supply price for labour would in fact change in the direction assumed
by the theory I am opposing as if I was the first to have entertained the
fifty-year-old generalisation that, trend eliminated, increasing output is
usually associated with a falling real wage.
I urge, nevertheless, that we should not be too hasty in our revisions,
and that further statistical enquiry is necessary before we have a firm
foundation of fact on which to reconstruct our theory of the short period.
In particular we need to know:
i. How the real hourly wage changes in the short period, not merely in
relation to the money wage, but in relation to the percentage which
actual output bears to capacity output;
ii. How the purchasing power of the industrial money wage in terms of
its own product changes when output changes; and
iii. How gross profit per unit of output changes (a) when money costs
change, and (b) when output changes.
J. M. KEYNES
This web edition published by:

eBooks@Adelaide
The University of Adelaide Library
University of Adelaide
South Australia 5005
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8/18/2017 General Theory of Employment, Interest, and Money, by Keynes : contents

General Theory of Employment,

Preface to the German Edition

Preface to the Japanese Edition

Preface to the French Edition

18. The General Theory of Employment Re-Stated

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General Theory of Employment,

This book is chiefly addressed to my fellow economists. I hope that it will

depended on the constant advice and constructive criticism of Mr R.F.

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General Theory of Employment,

Alfred Marshall, on whose Principles of Economics all contemporary

and results, which discard formal analysis. The most important

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General Theory of Employment,

Alfred Marshall, on whose Principles of Economics all contemporary

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General Theory of Employment,

For a hundred years or longer, English Political Economy has been

to the same influence and authority as Alfred Marshall, your position

It is shown that, generally speaking, the actual level of output and

treatment of money and prices. The following analysis registers my final

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General Theory of Employment,

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General Theory of Employment,

Most treatises on the theory of value and production are primarily

(b) a decrease in the marginal disutility of labour, as expressed by the

wages into conformity with the marginal disutility of the amount of

Though the struggle over money-wages between individuals and groups is

We must now define the third category of unemployment, namely

classical doctrine and to work out the behaviour of a system in which

In emphasising our point of departure from the classical system, we must

What constitutes the means of payment for commodities is simply

As a corollary of the same doctrine, it has been supposed that any

The whole of a mans income is expended in the purchase of services and

It is true that it would not be easy to quote comparable passages from

theory of production and employment can be worked out (like Mills) as

towards the rate of interest, the classical theory of unemployment, the

At different points in this chapter we have made the classical theory to

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General Theory of Employment,

employment is indeterminate except in so far as the marginal disutility of

A brief summary of the theory of employment to be worked out in the

output over what the community chooses to consume when employment is

(3) The amount of labour N which the entrepreneurs decide to employ

and apparent cruelty as an inevitable incident in the scheme of progress,

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General Theory of Employment,

That the units, in terms of which economists commonly work, are

commencement of the period. On this basis an attempt is made to erect a

On every particular occasion, let it be remembered, an entrepreneur is

quantity of employment. When, for purposes of description or rough

incapable of being substituted for one another, there is no awkwardness;