Can Relative Price Changes Induce D2 to Fill the Gap?
Keynes’s primary level of attack on classical theory involved the expansion
of demand into two distinct classes with different determinants. Keynes’s
claim that the classical demand relationship, where all spending was related
and equal to income, is required to validate Say’s Law and this classically
assumed demand relationship was not compatible with ‘the facts of experience’.
The next step required Keynes to demonstrate that a change in relative
prices via a gross substitution effect could not resurrect Say’s Law. In classical
theory, all income earned in any accounting period is divided – on the
basis of time preference – between spending income on currently produced
consumption goods and services and spending on current investment goods
that will be used to produce goods for future consumption. In other words, all
income earned in this period is always spent on the current products of
industry. In Keynes’s analysis, however, time preference determines how
much of current income is spent on currently produced consumption goods
and how much is not spent on consumption goods but is instead saved by
purchasing liquid assets. Accordingly, in Keynes’s system, there is a second
decision step, liquidity preference, where the income earner determines in
what liquid assets should his/her saved income be stored in order to be used
to transfer purchasing power of saving to a future time period. Since all
liquid assets have certain essential properties (Keynes, 1936, chap. 17) –
namely they are non-producible and non-substitutable for the products of
industry, the demand for liquid assets does not per se create a demand for the
products of industry.
Keynes developed his theory of liquidity preference in order to demonstrate
that any explanation of involuntary unemployment required specifying
‘The Essential Properties of Interest and Money’ (Keynes, 1936, chap. 17),
which differentiates his theory from old classical, new classical, old Keynesian
and new Keynesian theory, that is, from all mainstream macroeconomic
theories not only in Keynes’s time but in mainstream economics of the
twenty-first century.
These essential properties are:
1. the elasticity of productivity of all liquid assets including money was
zero or negligible; and
2. the elasticity of substitution between liquid assets (including money) and
reproducible goods was zero or negligible.
The zero elasticity of productivity of money means that when the demand
for money (liquidity) increases, entrepreneurs cannot hire labour to produce
more money to meet this change in demand for a non-reproducible (in the
private sector) good. In other words, a zero elasticity of productivity means
that money does not grow on trees! In classical theory, on the other hand,
money is either a reproducible commodity or the existence of money does not
affect, in any way, the demand for producible goods and services; that is,
money is neutral (by assumption). In many neoclassical textbook models,
peanuts are the money commodity or numeraire. Peanuts may not grow on
trees, but they do grow on the roots of bushes. The supply of peanuts can
easily be augmented by the hiring of additional workers by private sector
entrepreneurs.
The zero elasticity of substitution ensures that the portion of income that is
not spent on consumption producibles will find, in Frank Hahn’s terminology,
‘resting places’ in the demand for non-producibles. Some forty years
after Keynes, Hahn rediscovered Keynes’s point that Say’s Law would be
violated and involuntary unemployment could occur whenever there are ‘resting
places for savings in other than reproducible assets’ (Hahn, 1977, p. 31).
The existence of non-reproducible goods that would be demanded for stores
of new ‘savings’ means that all income earned by engaging in the production
of goods is not, in the short or long run, necessarily spent on products
producible by labour.
If the gross substitution axiom were applicable, however, any new savings
would increase the price of non-producibles (whose supply curve is, by
definition, perfectly inelastic). This relative price rise in non-producibles
would, under the gross substitution axiom, induce savers to substitute reproducible
durables for non-producibles in their wealth holdings and therefore
non-producibles could not be ultimate resting places for savings. As the price
of non-reproducibles rose the demand for these non-producibles would spill
over into a demand for producible goods (see Davidson, 1972, 1977, 1980).
Thus the acceptance of the gross substitution axiom denies the logical possibility
of involuntary unemployment as long as all prices are perfectly flexible.
To overthrow the axiom of gross substitution in an intertemporal context is
truly heretical. It changes the entire perspective as to what is meant by
‘rational’ or ‘optimal’ savings, as to why people save or what they save. For
example, it would deny the life cycle hypothesis. Indeed, Danziger et al.
(1982–3) have shown that the facts regarding consumption spending by the
elderly are incompatible with the notion of intertemporal gross substitution
of consumption plans which underlie both life cycle models and overlapping
generation models currently so popular in mainstream macroeconomic theory.
In the absence of a universal axiom of gross substitution, however, income
effects (for example the Keynesian multiplier) predominate and can swamp
any hypothetical classical substitution effects. Just as in non-Euclidean geometry
lines that are apparently parallel often crash into each other, in the
Keynes–Post Keynesian non-Euclidean economic world, an increased demand
for ‘savings’, even if it raises the relative price of non-producibles, will
not spill over into a demand for producible goods.
Keynes’s primary level of attack on classical theory involved the expansion
of demand into two distinct classes with different determinants. Keynes’s
claim that the classical demand relationship, where all spending was related
and equal to income, is required to validate Say’s Law and this classically
assumed demand relationship was not compatible with ‘the facts of experience’.
The next step required Keynes to demonstrate that a change in relative
prices via a gross substitution effect could not resurrect Say’s Law. In classical
theory, all income earned in any accounting period is divided – on the
basis of time preference – between spending income on currently produced
consumption goods and services and spending on current investment goods
that will be used to produce goods for future consumption. In other words, all
income earned in this period is always spent on the current products of
industry. In Keynes’s analysis, however, time preference determines how
much of current income is spent on currently produced consumption goods
and how much is not spent on consumption goods but is instead saved by
purchasing liquid assets. Accordingly, in Keynes’s system, there is a second
decision step, liquidity preference, where the income earner determines in
what liquid assets should his/her saved income be stored in order to be used
to transfer purchasing power of saving to a future time period. Since all
liquid assets have certain essential properties (Keynes, 1936, chap. 17) –
namely they are non-producible and non-substitutable for the products of
industry, the demand for liquid assets does not per se create a demand for the
products of industry.
Keynes developed his theory of liquidity preference in order to demonstrate
that any explanation of involuntary unemployment required specifying
‘The Essential Properties of Interest and Money’ (Keynes, 1936, chap. 17),
which differentiates his theory from old classical, new classical, old Keynesian
and new Keynesian theory, that is, from all mainstream macroeconomic
theories not only in Keynes’s time but in mainstream economics of the
twenty-first century.
These essential properties are:
1. the elasticity of productivity of all liquid assets including money was
zero or negligible; and
2. the elasticity of substitution between liquid assets (including money) and
reproducible goods was zero or negligible.
The zero elasticity of productivity of money means that when the demand
for money (liquidity) increases, entrepreneurs cannot hire labour to produce
more money to meet this change in demand for a non-reproducible (in the
private sector) good. In other words, a zero elasticity of productivity means
that money does not grow on trees! In classical theory, on the other hand,
money is either a reproducible commodity or the existence of money does not
affect, in any way, the demand for producible goods and services; that is,
money is neutral (by assumption). In many neoclassical textbook models,
peanuts are the money commodity or numeraire. Peanuts may not grow on
trees, but they do grow on the roots of bushes. The supply of peanuts can
easily be augmented by the hiring of additional workers by private sector
entrepreneurs.
The zero elasticity of substitution ensures that the portion of income that is
not spent on consumption producibles will find, in Frank Hahn’s terminology,
‘resting places’ in the demand for non-producibles. Some forty years
after Keynes, Hahn rediscovered Keynes’s point that Say’s Law would be
violated and involuntary unemployment could occur whenever there are ‘resting
places for savings in other than reproducible assets’ (Hahn, 1977, p. 31).
The existence of non-reproducible goods that would be demanded for stores
of new ‘savings’ means that all income earned by engaging in the production
of goods is not, in the short or long run, necessarily spent on products
producible by labour.
If the gross substitution axiom were applicable, however, any new savings
would increase the price of non-producibles (whose supply curve is, by
definition, perfectly inelastic). This relative price rise in non-producibles
would, under the gross substitution axiom, induce savers to substitute reproducible
durables for non-producibles in their wealth holdings and therefore
non-producibles could not be ultimate resting places for savings. As the price
of non-reproducibles rose the demand for these non-producibles would spill
over into a demand for producible goods (see Davidson, 1972, 1977, 1980).
Thus the acceptance of the gross substitution axiom denies the logical possibility
of involuntary unemployment as long as all prices are perfectly flexible.
To overthrow the axiom of gross substitution in an intertemporal context is
truly heretical. It changes the entire perspective as to what is meant by
‘rational’ or ‘optimal’ savings, as to why people save or what they save. For
example, it would deny the life cycle hypothesis. Indeed, Danziger et al.
(1982–3) have shown that the facts regarding consumption spending by the
elderly are incompatible with the notion of intertemporal gross substitution
of consumption plans which underlie both life cycle models and overlapping
generation models currently so popular in mainstream macroeconomic theory.
In the absence of a universal axiom of gross substitution, however, income
effects (for example the Keynesian multiplier) predominate and can swamp
any hypothetical classical substitution effects. Just as in non-Euclidean geometry
lines that are apparently parallel often crash into each other, in the
Keynes–Post Keynesian non-Euclidean economic world, an increased demand
for ‘savings’, even if it raises the relative price of non-producibles, will
not spill over into a demand for producible goods.
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