Keynes’s Rejection of Say’s Law
Say’s Law, if accepted, makes macroeconomic demand management policies
redundant. We have seen earlier that in the classical model a decision to
refrain from current consumption is equivalent to a decision to consume more
in the future. This decision therefore automatically implies that resources
need to be diverted to the production of investment goods which will be
needed to provide the flow of future consumption goods. An increase in
saving automatically becomes an increase in investment expenditure via adjustment
of the interest rate. In the classical model, saving is in effect just
another form of spending. The principles underlying Say’s Law raised their
head during discussions relating to anti-depression economic policy during
the interwar period. Ralph Hawtrey, a strong advocate of the ‘Treasury View’,
argued forcefully that public works programmes would be useless since such
expenditures would simply ‘crowd out’ an equivalent amount of private spending.
Such views only make sense in the context of a fully employed economy
(Deutscher, 1990).
A principal objective of writing the General Theory was to provide a
theoretical refutation of Say’s Law, something Malthus over a century earlier
had tried and failed to do. In Keynes’s model output and employment are
determined by effective demand, and the operation of the labour market
cannot guarantee full employment. The interest rate is determined in the
money market rather than by saving and investment decisions. Variations in
the marginal efficiency of investment bring about variations in real output via
the multiplier effect and as a result saving adjusts to investment through
changes in income. Hence in Keynes’s model any inequality between planned
investment and planned saving leads to quantity adjustments rather than
equilibrating adjustments of the rate of interest. By demonstrating the flaws
inherent in wage and price flexibility as a method of returning the economy
to full employment following a negative demand shock, Keynes effectively
reversed Say’s Law. In Keynes’s world of underemployment equilibrium,
demand creates supply!
Say’s Law, if accepted, makes macroeconomic demand management policies
redundant. We have seen earlier that in the classical model a decision to
refrain from current consumption is equivalent to a decision to consume more
in the future. This decision therefore automatically implies that resources
need to be diverted to the production of investment goods which will be
needed to provide the flow of future consumption goods. An increase in
saving automatically becomes an increase in investment expenditure via adjustment
of the interest rate. In the classical model, saving is in effect just
another form of spending. The principles underlying Say’s Law raised their
head during discussions relating to anti-depression economic policy during
the interwar period. Ralph Hawtrey, a strong advocate of the ‘Treasury View’,
argued forcefully that public works programmes would be useless since such
expenditures would simply ‘crowd out’ an equivalent amount of private spending.
Such views only make sense in the context of a fully employed economy
(Deutscher, 1990).
A principal objective of writing the General Theory was to provide a
theoretical refutation of Say’s Law, something Malthus over a century earlier
had tried and failed to do. In Keynes’s model output and employment are
determined by effective demand, and the operation of the labour market
cannot guarantee full employment. The interest rate is determined in the
money market rather than by saving and investment decisions. Variations in
the marginal efficiency of investment bring about variations in real output via
the multiplier effect and as a result saving adjusts to investment through
changes in income. Hence in Keynes’s model any inequality between planned
investment and planned saving leads to quantity adjustments rather than
equilibrating adjustments of the rate of interest. By demonstrating the flaws
inherent in wage and price flexibility as a method of returning the economy
to full employment following a negative demand shock, Keynes effectively
reversed Say’s Law. In Keynes’s world of underemployment equilibrium,
demand creates supply!
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