The “natural” rate of interest and effective demand

Keynes first took up Wicksell’s idea in his Treatise on Money (1930). In Wicksell’s writings, discrepancies between the natural and market rates had invariably been associated with expansion or contraction of bank credit. Keynes emphasized that such discrepancies may develop and continue without expansion or contraction of the money supply, because of speculation in the securities markets. For example, if the natural rate has decreased and the market rate starts to edge down in response to an excess of the household savings offered in demand for securities over the supply of new securities marketed to finance investment, securities prices will rise. This, Keynes suggested, will cause some speculators in “old” securities to enter the market and supply savers with securities from their holdings. The excess demand pressure on the market is thus relieved and the rise in prices (fall of the market rate) halted. The motive for these transactions is the speculators’ hope that they can buy back their securities at lower prices later. In the meantime, the speculators hold their funds in the form of ready money; there has been an increase in the amount of money demanded rather than, as Wicksell assumed, a decrease in the money supply.

The Wicksell–Keynes theory was an important contribution to the theory of the income-determination process. Yet there is nothing in its main elements that should have startled a pre-Wicksellian traditional economist. The natural rate is essentially the interest rate that would prevail in general equilibrium, and a market rate different from the natural rate is a disequilibrium interest rate. Traditional economics was clear enough as to the consequences that will follow if one or more of the prices in the system “gets stuck” at a disequilibrium level. The Wicksell–Keynes theory, therefore, may be regarded as a particular application of previously familiar principles.

Keynes returned to the Wicksellian theme in The General Theory of Employment, Interest and Money (1936), but in that revolutionary work he gave the theory a genuinely novel twist: he argued that the system might be seriously out of equilibrium even though the prevailing interest rate was exactly at the Wicksellian natural level. This might happen because the interest rate mechanism cannot ensure that the plans of households and business firms with regard to future consumption and production will mesh with each other. There might, for example, be an increase in household saving—that is, a decrease in the demand for current consumption goods and an increase in the planned demand for future goods. Coordination of household and business activities requires that business firms respond by shifting resources out of the production of present consumption goods and into investment activities that lay the groundwork for increased output in the future. Households, in carrying out their saving decisions, do not place contractual orders with producers for future deliveries of particular goods and services. Thus, the future demands implicit in current saving decisions may not be effectively communicated to producers, as efficient coordination would require. If producers draw up their investment plans on the basis of forecasts of future demand that do not correspond to the spending that households are prepared to undertake in the future, there will be an excess demand (or excess supply) for future output.

Such effective demand failure is not the result of changes in interest rates or in the supply of money. The logical way of dealing with it—when it occurs—is through fiscal policy measures. The effective demand doctrine is the signal contribution of Keynesian economics to income and employment theory. It is thus no coincidence that Keynesian economics has become associated with an emphasis on the use of fiscal, rather than monetary, stabilization policies.

Good introductions to the study of business cycles include Erik Lundberg (ed.), The Business Cycle in the Post-War World (1955, reprinted 1986); R.C.O. Matthews, The Business Cycle (1959, reissued 1967); Robert Aaron Gordon, Business Fluctuations, 2nd ed. (1961); Alvin Harvey Hansen, Business Cycles and National Income, expanded ed. (1964); and Henri Guitton, Fluctuations et croissance économiques, 3rd ed. (1970). Famous surveys of business cycle theories are Joseph A. Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process, 2 vol. (1939, reprinted 1982); and Gottfried Haberler, Prosperity and Depression, 5th ed. (1964). J. Tinbergen, Statistical Testing of Business-Cycle Theories, 2 vol. (1939, reissued 2 vol. in 1, 1968), attempts to verify by econometric analysis the theories surveyed in Haberler’s work. The nontheoretical approach to business-cycle research is set forth in Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles (1946); and further developed in Geoffrey Hoyt Moore, Business Cycle Indicators, 2 vol. (1961). Important articles are collected in American Economic Association, Readings in Business Cycle Theory (1944, reprinted 1980), and Readings in Business Cycles (1965). History and politics are dealt with in Vivian Walsh and Harvey Gram, Classical and Neoclassical Theories of General Equilibrium: Historical Origins and Mathematical Structure (1980); Dennis C. Mueller, Public Choice II (1989), which provides equilibrium-model-based analyses of the intersection between politics and economics; and James E. Alt and Kenneth A. Shepsle (eds.), Perspectives on Positive Political Economy (1990).

The basic principles of the modern theory of income analysis, often called macroeconomics, may be found in any contemporary textbook of economics. Two good introductions to this subject are George T. McCandless, Jr., Macroeconomic Theory (1991), neoclassical in approach; and Joseph Stiglitz, Economics (1993), Keynesian-oriented. At the intermediate level, the two competing alternatives for reaching a sound understanding of national income theory are Robert J. Barro and Vittorio Grilli, European Macroeconomics (1994), which applies the intertemporal equilibrium approach to macroeconomic analysis; and Rudiger Dornbusch and Stanley Fischer, Macroeconomics, 6th ed. (1994), which follows an IS-LM approach. Three advanced textbooks in macroeconomic theory which exhibit the high degree of formalization that has become characteristic of the macroeconomic literature since the 1970’s are Thomas J. Sargent, Macroeconomic Theory, 2nd ed. (1987), and Dynamic Macroeconomic Theory (1987); and Olivier Jean Blanchard and Stanley Fischer, Lectures on Macroeconomics (1989).

More specialized or intensive treatments of macroeconomics are John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936, reissued 1991), the classic theoretical work in the field; Seymour E. Harris (ed.), The New Economics: Keynes’ Influence on Theory and Public Policy (1947, reprinted 1973), a collection of early essays on Keynes and his ideas, representing the thinking of its time; and Gardner Ackley, Macroeconomic Analysis and Theory (1978), an introductory text. Later evaluations by leading economists of the significance and influence of Keynesian ideas may be found in Roy F. Harrod, The Life of John Maynard Keynes (1951, reissued 1982), offering insight into the genesis of Keynes’s ideas; H.G. Johnson, “The General Theory After Twenty-five Years,” The American Economic Review, 51:1–17 (1961), providing a retrospective survey from a “monetarist” point of view; Robert Lekachman (ed.), Keynes’ General Theory: Reports of Three Decades (1964); Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (1968), an interesting but difficult appraisal of the development of “Keynesian” ideas; and Herbert Stein, The Fiscal Revolution in America, rev. ed. (1990), examining the relationship between Keynesian thinking and governmental policies in the United States.

Some important perspectives on the successes and failures of economic strategies that have resulted in fluctuations are John Kenneth Galbraith, Economics and the Public Purpose (1973), and Economics in Perspective: A Critical History (1987); and Douglass C. North, Institutions, Institutional Change, and Economic Performance (1990). Two other works that offer perspectives on economic theory and its applications are Neil de Marchi and Mark Blaug (eds.), Appraising Economic Theories (1991); and Mark Blaug, The Methodology of Economics; or, How Economists Explain, 2nd ed. (1992).