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The 'theory' of effective demand

Nobody could deny by now that the core of GT is a theory of the determination of output (or employment) by effective demand. Let us begin by discussing that theory, which is explained in a clear and succinct way in the article in The Quarterly Journal of Economics (Keynes, 1937).

It is to be noted, among other things, that the theory supposes a certain mature capitalist market economy like that of the United Kingdom in the 1930s. Keynes's following statement is worth quoting in that connection:

The theory can be summed up by saying that, given the psychology of the public, the level of output and employment as a whole depends on the amount of investment. I put it in this way, not because this is the only factor on which aggregate output depends, but because it is usual in a complex system to regard as causa causans that factor which is most prone to sudden and wide fluctuation.

(Keynes, 1937, p. 221)

In contrast to the relatively stable behaviour of consumption, unstable investment, depending on uncertain and doubtful long-term prospects, plays a strategic role as causa causans in determining output as a whole.12 That proposition has, it should be noted, a crucial importance in the case of schematizing the 'causal nexus' in complex systems such as those considered by Keynes.

In the article in The Quarterly Journal of Economics, Keynes explicitly assumes a two-sector model composed of one consumption-goods industry and one investment-goods industry. Then he explains the multiplier formula thus:

[T]here is always a formula, ... relating the output of consumption goods which it pays to produce to the output of investment goods; and I have given attention to it in my book under the name of Multiplier.

(Keynes, 1937, p. 220)

This formula would, I think, be verified not with reference to an individual unit, but merely with reference to the behaviour of aggregates, namely, aggregate investment, aggregate consumption, aggregate saving, and aggregate output, in such a way that, given a certain marginal propensity to consume, when there is an increment of aggregate investment, aggregate output will necessarily increase by an amount which is k times the increment of investment. As to consumption, it will increase by an amount which is k - 1 times the increment of investment.

It is very important to note that the quantitative and deterministic character of the multiplier is decisively significant in Keynes's theory of effective demand, and that its working will proceed quite independently of any individual's behaviour.

The theory of effective demand, though disclosed in the formula of the investment multiplier process, would essentially be a behavioural mechanism under the institutional set-up of a capitalist market economy. However, that theory is a typical instance which clarifies 'the vital difference between the theory of economic behaviour of the aggregate and the theory of the individual unit' (GT, p. 85). Therefore, it is obvious that one could never grasp it in virtue of the atomic hypothesis, even though the amount of investment is an outcome of 'the collective behaviour of individual entrepreneurs' (GT, p. 63).

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