The Significance of the Principle of Effective Demand
Post Keynesian economics accepts Keynes’s (1936, chap. 2) ‘Principle of
Effective Demand’ as the basis for all macroeconomic theory that is applicable
to an entrepreneurial economy. Keynes was primarily a monetary theorist.
The words money, currency and monetary appear in the titles of most of his
major volumes in economics. Post Keynesian theory evolves from Keynes’s
revolutionary approach to analysing a money-using, entrepreneur economy.
Addressing the General Theory chiefly to his ‘fellow economists’ (Keynes,
1936, p. v), Keynes insisted that:
the postulates of the classical theory are applicable to a special case only and not
to the general case … 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. (Keynes, 1936, p. 3)
Elsewhere I (Davidson, 1984) have argued that all variants of mainstream
macroeconomic theory, whether it be rational expectations (new classical)
theory, monetarism (old classical theory), old (neoclassical synthesis)
Keynesian or new Keynesian theory, are founded on three fundamental classical
postulates and, as Keynes specifically noted:
the classical theory is only applicable to full employment, [and therefore] it is
fallacious to apply it to the problems of involuntary unemployment. … The
classical theorists resemble Euclidean geometers in a non-Euclidean world, 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
that 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 today in economics. (Keynes, 1936, p. 16)
Keynes’s principle of effective demand basically overturned three restrictive
classical postulates. Once freed of these postulates, Keynes (1936, p. 26) could
logically demonstrate why Say’s Law is not a ‘true law’ when we model an
economy which possesses real-world characteristics; and until we get our
theory to accurately mirror and apply to the ‘facts of experience’, there is little
hope of getting our policies right. That message is just as relevant today.
To throw over an axiom is to reject what the faithful believe are ‘universal
truths’. Keynes’s revolution in economic theory was therefore truly a revolt
since it aimed at rejecting basic mainstream axioms in order to develop a
logical foundation for a non-Say’s Law model more closely related to the real
world in which we happen to live. In the light of Keynes’s analogy to
geometry, Post Keynesian theory might be called non-Euclidean economics!
The restrictive classical axioms rejected by Keynes in his revolutionary
logical analysis were (i) the gross substitution axiom, (ii) the neutrality of
money axiom and (iii) the axiom of an ergodic economic world. The characteristics
of the real world which Keynes believed could be modelled only by
overthrowing these axioms are:
1. money matters in the long and short run; that is money and liquidity
preference are not neutral, they affect real decision making;
2. the economic system is moving through calendar time from an irrevocable
past to an uncertain future. Important decisions involving production,
investment and consumption activities are, therefore, often taken in an
uncertain environment;
3. forward contracts in money terms are a human institution developed to
efficiently organize time-consuming production and exchange processes.
The money-wage contract is the most ubiquitous of these contracts.
Modern production economies are on a money-wage contract based system,
or what Keynes called an ‘entrepreneur system’; and
4. unemployment, rather than full employment, is a common laissez-faire
situation in a market-oriented, monetary production economy.
Post Keynesian economics accepts Keynes’s (1936, chap. 2) ‘Principle of
Effective Demand’ as the basis for all macroeconomic theory that is applicable
to an entrepreneurial economy. Keynes was primarily a monetary theorist.
The words money, currency and monetary appear in the titles of most of his
major volumes in economics. Post Keynesian theory evolves from Keynes’s
revolutionary approach to analysing a money-using, entrepreneur economy.
Addressing the General Theory chiefly to his ‘fellow economists’ (Keynes,
1936, p. v), Keynes insisted that:
the postulates of the classical theory are applicable to a special case only and not
to the general case … 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. (Keynes, 1936, p. 3)
Elsewhere I (Davidson, 1984) have argued that all variants of mainstream
macroeconomic theory, whether it be rational expectations (new classical)
theory, monetarism (old classical theory), old (neoclassical synthesis)
Keynesian or new Keynesian theory, are founded on three fundamental classical
postulates and, as Keynes specifically noted:
the classical theory is only applicable to full employment, [and therefore] it is
fallacious to apply it to the problems of involuntary unemployment. … The
classical theorists resemble Euclidean geometers in a non-Euclidean world, 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
that 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 today in economics. (Keynes, 1936, p. 16)
Keynes’s principle of effective demand basically overturned three restrictive
classical postulates. Once freed of these postulates, Keynes (1936, p. 26) could
logically demonstrate why Say’s Law is not a ‘true law’ when we model an
economy which possesses real-world characteristics; and until we get our
theory to accurately mirror and apply to the ‘facts of experience’, there is little
hope of getting our policies right. That message is just as relevant today.
To throw over an axiom is to reject what the faithful believe are ‘universal
truths’. Keynes’s revolution in economic theory was therefore truly a revolt
since it aimed at rejecting basic mainstream axioms in order to develop a
logical foundation for a non-Say’s Law model more closely related to the real
world in which we happen to live. In the light of Keynes’s analogy to
geometry, Post Keynesian theory might be called non-Euclidean economics!
The restrictive classical axioms rejected by Keynes in his revolutionary
logical analysis were (i) the gross substitution axiom, (ii) the neutrality of
money axiom and (iii) the axiom of an ergodic economic world. The characteristics
of the real world which Keynes believed could be modelled only by
overthrowing these axioms are:
1. money matters in the long and short run; that is money and liquidity
preference are not neutral, they affect real decision making;
2. the economic system is moving through calendar time from an irrevocable
past to an uncertain future. Important decisions involving production,
investment and consumption activities are, therefore, often taken in an
uncertain environment;
3. forward contracts in money terms are a human institution developed to
efficiently organize time-consuming production and exchange processes.
The money-wage contract is the most ubiquitous of these contracts.
Modern production economies are on a money-wage contract based system,
or what Keynes called an ‘entrepreneur system’; and
4. unemployment, rather than full employment, is a common laissez-faire
situation in a market-oriented, monetary production economy.
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