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In the “State of Long-Term Expectations,” Keynes argued that “as the organization of investment market improves,” there was a growing risk for “the capital development of a country” to become “the by-product of the activities of a casino”. Based on your reading of section 3 and 5 of the chapter, discuss why Keynes believed the development of financial markets could make the capitalist investment more unstable. Why did Keynes anticipate the state to take “an ever greater responsibility” for directly organizing investment?

Neoclassical Theory

Circular Flow




Spending (Effective Demand)

Saving, Taxes, Imports

Investment, Gov spending, Exports

Exports and Imports

  • Gold Standard; Free Flow of Capital
  • Trade Surplus  Gold inflow  Domestic prices rise  domestic goods more expensive, foreign goods cheaper  Exports fall, Imports rise
  • Trade deficit  …  Exports rise, imports fall

Capital Market

Saving or Investment

Interest rate



S*, I*


Simple Macroeconomic Model

Keynes on Saving

Keynes on Saving

Saving or Investment

Interest rate



S1, I1




S2, I2

Neoclassical Theory of Investment


Interest rate






Keynes, Chapter 12

  • Canvas, home page, week 15
  • Click on “Chapter 12”

Keynes on Investment


Interest rate

Prospective yield





Keynes on Investment

  • 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.

Keynes on 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 community’s 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 those who own them or contemplate purchasing them has seriously declined.

Keynes on Investment

  • (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.

Keynes on Investment

  • (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 of a 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.

Keynes on Investment

  • (4) … 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.

Keynes on “Beauty Contest”

  • It is not a case of choosing those which, to the best of one’s 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.

Keynes on Financial Market

  • 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.

Keynes on Financial Market

  • 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.

Keynes on Financial Market

  • 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.

Keynes on Socialization 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.

Keynes on Socialization of Investment (Ch. 24, Section III)

  • 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.

Keynes on Socialization of Investment (Ch. 24, Section III)

  • I conceive, therefore, that a somewhat comprehensive socialization 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.

Stabilizing An Unstable Capitalism?

Minsky’s Profit Equation

  • National Income: W + Π + T + D (wages + profit + taxes + depreciation)
  • National Expenditures: C + I + G + (X-M) (personal consumption + investment + government consumption + net exports)
  • Macroeconomic Equilibrium:
  • W + Π + T + D = C + I + G + (X-M)
  • Π = (I – D) + (C – W) + (G – T) + (X – M)

Small Government Capitalism

  • If household, government, and trade sectors are in balance
  • Π = I – D
  • “Workers spend what they earn, capitalists earn what they spend”

Minsky’s Total Profit (Great Depression)

Big Government Capitalism

  • Assume household sector and trade are in balance
  • Π = (I-D) + (G-T)
  • Increase in government deficits helps to offset fall of investment
  • Government sector needs to be sufficiently big (roughly as big as private investment)

Minsky’s Total Profit (Great Recession)

Minsky’s Total Profit (Covid-19 Recession)

Stabilizing Unstable Capitalism

  • Big Government: stabilizes capitalist profit during recessions
  • Central Bank (lender of last resort): stabilizes asset prices during financial crises

Socialization of Risk

  • Socialization of Risk without Socialization of Investment
  • Capitalists: make investment decisions to make private profits but (largely) no longer bear the consequences of bad decision-making
  •  Encourage risky investment and financing behaviors
  •  Financial fragility
  •  Financial Crisis
  •  Force big government/central bank to intervene
  •  Validate the riskier financial structure

Does Government Debt Matter?


Throughout the remainder of the General Theory, Keynes consistently assumed that the rate of utilization of the productive capacity of physical capital declined sharply in times of depression, and the number of employed workers declined sharply as well. Keynes’s theory was addressed to those obvious realities of depression in an insightful and coherent manner. But because it is an equally obvious fact of capitalist depressions that the real wages of workers did not increase when employment decreased, Keynes’s adherence to the marginal productivity theory that wages were always equal to the workers’ marginal productivity contradicted the rest of his theory.

As we have frequently pointed out in this book, the contradictions in a great thinker’s theory (and Keynes was a logician of the first order) give the best insights into the thinker’s ideological orientation. Keynes wished to furnish capitalist governments with theoretical insights that would help to save capitalism. In doing so, it was necessary for him to abandon some tenets of neoclassical theory. But, as we will see, he wanted to retain as much neoclassical ideology as possible. So he adhered to both the marginal productivity theory of distribution and the belief that the free market efficiently allocated resources (once full employment was attained), despite the fact that both these tenets of neoclassical ideology were logically tied to the belief that the free market automatically created a full employment, Pareto optimal situation. Even with theorists having the extraordinary logical ability of Keynes, ideology very frequently wins out over logic.

Keynes rejected the notion that if a capitalist economy started from a situation of full employment, then the rate of interest would automatically equate saving and investment and thus keep aggregate demand equal to aggregate supply. His major departures from the doctrines that comprised the neoclassical theory of automaticity were twofold: First, although he accepted the neoclassical notion that saving was influenced by the rate of interest, he insisted that the level of aggregate income was a far more important influence on the amount of saving than was the rate of interest. Second, he argued that saving and investment did not determine the rate of interest. The interest rate was a price that equalized the demand and supply of money—something quite different from (although not unrelated to) investment and saving.

These were very important departures indeed, because, although Keynes was unaware of it, they destroyed not only the neoclassical theory of the automaticity of the market but also the two other pillars of neoclassical ideology—the marginal productivity theory of distribution and the theory that a free, competitive market will result in a Pareto optimal allocation of resources. Keynes wanted to achieve the first result (the destruction of the belief in the automaticity of the market) but leave the other two concepts intact.

The principle that underlay his departure from the neoclassical theory of saving was referred to by Keynes as the “consumption function.” He insisted that the level of consumption and the level of saving were primarily a “function of the level of income,” that is, they were determined primarily by the level of income. He admitted that “substantial changes in the rate of interest … may make some difference”17 in the level of saving, but this influence was much less important than the influence exerted by the level of income:

For a man’s habitual standard of life usually has 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. … 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 toward accumulation. … These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases.18

The consumption function depicted the relation of saving and consumption to the level of income. The relationship between a change in income and the resultant change in saving (or the ratio of the change in saving to the change in income) was defined as the “marginal propensity to save.” The relationship between a change in income and the resultant change in consumption (or the ratio of the change in consumption to the change in income) was defined as the “marginal propensity to consume.” The marginal propensity to consume and the marginal propensity to save were both assumed to be less than one, and neither was primarily determined by or among the primary determinants of the rate of interest.

Keynes’s second major departure from the neoclassical theory of the automaticity of the market was his rejection of the neoclassical theory of the determination of the interest rate:

The propensity to consume … determines for each individual how much of his income he will consume and how much he will reserve [save] 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. … 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 of time …? In other words, what is the degree of his liquidity-preference—where an individual’s liquidity preference is given by a schedule of the amounts of his resources … which he will wish to retain in the form of money in different sets of circumstances? …

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 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. … 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.19

The rate of interest was determined, then, by the demand for and supply of money. At any given time the supply of money was constant at a level determined by the actions of the central bank or the monetary authorities. The demand for money—which was the same as the liquidity preference—was, according to Keynes, determined by three motives:

(i) the transactions motive, i.e. the need for 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.20

The portion of demand for money that arose from the speculative motive was related to the rate of interest. To understand this relationship, we must understand how the price of a bond (or a security, or any kind of interest-paying I.O.U.) reflects the rate of interest. If we purchase a bond that promises to pay us $1,000 in one year, and the rate of interest is 3 percent, then the current value of that bond is approximately $970 (the extra $30 being the interest we will earn in one year). If, however, the day after we purchase that bond, the rate of interest rises to 6 percent, then the value of a $1,000 bond falls to approximately $940 (the extra $60 being the interest that can be earned at 6 percent). It is obvious that if we are then forced to sell the bond, we will suffer a loss. Moreover, even if we do not anticipate being forced to sell the bond, but we do expect the interest rate to rise to 6 percent, then we are better off not to buy the bond when the interest rate is 3 percent. If we instead hold the cash and wait for the interest rate to go up, then (if our expectation about the change in the interest rate proves to be correct) we can buy the bond for $940 rather than $970, and apply the extra $30 toward the purchase of another bond with which to earn more interest.

Therefore, in Keynes’s view, a portion of the demand for money depended on expectations about what will happen to the interest rate in the future. When the interest rate was very high (in relation to previous rates, or what was considered a normal rate), very few people would expect it to go even higher in the future; consequently, very few people would hold cash for speculative purposes. At lower interest rates, more people would be inclined to believe that the interest rate would increase; consequently, more money would be held for speculative purposes by those who expected the interest rate to rise in the future. Therefore, the amount of money demanded for speculative purposes declined as the interest rate rose, and increased as the interest rate fell.

Figure 15.3 illustrates Keynes’s theory of the interest rate and its relation to saving and investment. It can be contrasted to the orthodox neoclassical view illustrated in Figure 15.2. In part (a) of the figure, the demand for money reflects in part the speculative motive and hence declines as the interest rate rises. With the original supply of money (determined by the monetary authorities) r1 was the interest rate that equated the demand for and supply of money. But at r1 there was an excess of saving over investment, as illustrated in part (b). If this situation persisted, then aggregate demand would be less than aggregate supply. All output could not be sold. Businesses, unable to sell all that they had produced, found that their inventories of unsold goods were increasing. Each business saw only its own problem: that it had produced more than it could sell. It therefore reduced production in the next period. Most businesses, being in the same situation, did the same thing. The results were a large reduction of production, a decrease in employment, and a decline in income. With the decline in income, however, even less would be spent on goods and services in the next period. So businessmen again found that even at the lower level of production, they were unable to sell all they had produced. They again cut back production, and the downward spiral continued.

Under these circumstances, businesses had little or no incentive to expand their capital goods (because excess capacity already existed), and, therefore, investment fell drastically. Expenditures of all types plummeted. As income declined, saving declined more than proportionately. This process continued until the declines in income had reduced saving to the point where it no longer exceeded the reduced level of investment. At this low level of income, equilibrium was restored. Leakages from the income-expenditure flow were again equal to the injections into it. The economy was stabilized, but at a level where high unemployment and considerable unused productive capacity existed.

But the problem, as posed in Figure 15.3, was easily remedied. The monetary authorities could increase the supply of money to the point where was the prevailing rate of interest (in Figure 15.3). At that interest rate, saving equaled investment, aggregate demand equaled aggregate supply, and there was no problem. There were some situations, in Keynes’s view, in which monetary policy (increasing or decreasing the money supply) was sufficient to maintain full employment. But there were also some situations in which monetary policy was not sufficient. Keynes was more interested in these situations because he believed them to be more realistic characterizations of the actual conditions that both precipitated and sustained depressions in capitalist economies.

The first such situation occurred when the distribution of income was so unequal (thereby increasing saving by putting more income into the hands of the wealthy, who saved much more than did workers) and the full-employment level of output and income was so high that, regardless of how low the rate of interest sank, saving and investment could not be equated. This situation is illustrated in Figure 15.4, which is self-explanatory.

But Keynes did not believe that it required such a drastic discrepancy between saving and investment to create a situation in which monetary policy was unable to prevent a disastrous depression. It was possible, he argued, that if the rate of interest that would equate the full-employment levels of saving and investment was very low, monetary policy might not be able to lower the interest rate sufficiently. If monetary authorities pushed the rate of interest so low that nearly everyone expected the interest rate to rise significantly in the future, then people would prefer to hold cash rather than securities even when the monetary authorities dramatically increased the amount of money in the system:

Circumstances may develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. … 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 of cash [into private hoards].21

Such a situation is depicted in Figure 15.5. It can be seen that when the rate of interest approaches some minimum point, the demand for money flattens out, indicating that even with large increases in the supply of money, most of the increased money supply will be held in private hoards. In Figure 15.5, a large increase in the money supply results in a very small decline in the rate of interest and still leaves an excess of saving over investment.

In either of the situations depicted in Figures 15.4 and 15.5, the free, competitive market would lead society into a disastrous depression; monetary policy would be useless in preventing the social calamity. It was obvious that something more fundamental and more powerful was needed.

Keynes’s analysis was not, in its essentials, drastically different from those offered by Marx (Chapter 9) and Hobson (Chapter 13). The principal cause of a depression was, in the opinion of all three thinkers, the inability of capitalists to find sufficient investment opportunities to offset the increasing levels of saving generated by economic growth. Keynes’s unique contribution was to show how the relation of saving to income could lead to a stable but depressed level of income, with widespread unemployment.

Marx had believed the disease to be incurable. Hobson had prescribed measures to equalize the distribution of income and thereby reduce saving as a cure. Could Hobson’s prescription work? This probably is not a very meaningful question. In most industrial capitalist countries, wealth and economic power determine political power, and those who wield power have never been willing to sacrifice it to save the economic system.

In the United States, for example, out of 300,000 nonfinancial corporations existing in 1925, the largest 200 made considerably more profit than the other 299,800 combined. The wealthiest 5 percent of the population owned virtually all the stocks and bonds and received in excess of 30 percent of the income. Needless to say, this 5 percent dominated American politics. In these circumstances, speculating about what would happen if the income and wealth were radically redistributed amounts to mere daydreaming. Keynes’s answer to the problem was more realistic. Government could step in when saving exceeded investment, borrow the excess saving, then spend the money on socially useful projects that would not increase the economy’s productive capacity or decrease the investment opportunities of the future. This government spending would increase the injections into the spending stream and create a full-employment equilibrium. In doing so, it would not add to the capital stock. Therefore, unlike investment spending, it would not make a full-employment level of production more difficult to attain in the next period. Keynes summarized his position thus:

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 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.22

What type of expenditures ought the government to make? Keynes himself had a predilection toward useful public works such as the construction of schools, hospitals, parks, and other public conveniences. He realized, however, that this would probably benefit middle- and lower-income recipients much more than it would the wealthy. Because the wealthy had the political power, they would probably insist on policies that would not redistribute income away from them. He realized that it might be politically necessary to channel this spending into the hands of the large corporations, even though little that was beneficial to society would be accomplished directly.

If the Treasury were to fill