The General Theory of Employment, Interest, and Money - critical summary review

Originally published in 1936 as English economist’s John Maynard Keynes last book, “The General Theory of Employment, Interest, and Money” is still one of the great classics of economic theory. Written during the Great Depression of the 1930s, “The General Theory of Employment, Interest, and Money” seeks to make sense of unemployment and economic depression. Keynes managed to make unthinkable ideas thinkable, and his work is still instructive for the economic developments of today, including the financial crash of 2008. So, get ready to learn what made Keynes’ work so revolutionary. 

The General Theory

Keynes was writing during a time of mass unemployment and was therefore naturally preoccupied with trying to understand how unemployment came about and what could be done to remedy it. Classical economic thinking up to that point had provided a marginal explanation for the causes of unemployment, at best, but no economist had yet thought about the causes for economic depression and recession.

With his “General Theory,” Keynes managed to revolutionize economic thinking at the time: he showed how unemployment was a result of inadequate demand. He believed that government intervention could be used to remedy unemployment, and was therefore disliked by many supporters of the free market economy.

Keynes theory can be summarized in four main points: 

1. Economies often suffer from a lack in demand which causes involuntary unemployment.
2. The economy has no or very little automatic tendency to correct this lack in demand, and if it does exist, it operates very slowly.
3. Unemployment can be reduced quickly through government policies that increase demand.
4. Increasing the money supply does not always convince the private sector to spend more. This is when governments can invest and close the gap between consumption and production.

These four points are at odds with classic economic theory that had formed the status quo up to that time. But what was classical economic theory all about?

Classical economics

Before Keynes’ “General Theory of Employment, Interest, and Money,” economics operated on two fundamental assumptions, the first of these being that “the wage is equal to the marginal product of labour.” This meant that an employee’s wage is the same as the amount of money that would be lost to the company if that person were not employed by the company.

The second assumption of classical economics is, “The utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment.” This means that the wage is always just high enough to encourage an employee to deliver the amount of work needed to cover his wage.

To a certain extent, unemployment can be explained with these two fundamentals in mind: if the wage is too low, an employee might refuse to work. Following on from these two principles, there are four ways in which unemployment can be remedied, according to Keynes. First, the foresight and organization can be improved to reduce unemployment. Second, the marginal disutility of labor can be decreased so that people want to work. Third and fourth, either the marginal physical productivity of labor, or the prices of non-wage goods can be increased to combat unemployment. However, according to classical theory, involuntary unemployment simply does not exist. 

Another fundamental operating principle of classical economics is Say’s Law. This is the assumption that the production of a product creates demand for another product - in other words, that supply creates its own demand. Say’s Law supported the view that a capitalist economy will naturally provide full employment and can function independently of government interventions.

However, looking at an economy with Say’s Law in mind, depressions and recessions cannot be explained. Classical economics, therefore, was insufficient to explain the mass unemployment and general economic recession of the Great Depression in the 1930s.

The Great Depression led many to think at the time that capitalism was a failure. However, Keynes believed that the cause of mass unemployment was a narrow and technical one. According to Keynes, there was no need to replace the whole car - just the alternator - to solve the problem of mass unemployment. While many at the time argued that only mass government intervention could save the economy, Keynes believed that even small government interventions could have a transformative effect.

Basics of the General Theory

While much of Keynes’ theory deviated from classic economics, he did agree with it on one point, namely that labor and employment are interdependent. He writes, “Thus if employment increases, then, in the short period, the reward per unit of labour in terms of wage-goods must, in general, decline and profits increase.” The more people are employed, the less they cost in wages and the more profits are made.    

Whenever an entrepreneur employs people, he has two forms of expenses: the factor cost and the user cost. Factor cost is the amount of money an entrepreneur pays out to the factors of production for their services. The user cost is the amount of money the entrepreneur pays to other entrepreneurs for purchases he needs to make from them, as well as the cost of employing equipment. The income of the entrepreneur is the value of the output of production minus the user and factor costs.

The total income of an economy (aggregate income) resulting from employment is the factor cost plus the entrepreneur’s profit. This means that the amount of employment depends on the amount of income the entrepreneur is expected to receive from the corresponding output. That’s because an entrepreneur will always seek to maximize his own income – he will only offer as much employment as will result in the lowest possible factor costs and highest possible proceeds.

If the entrepreneur’s proceeds exceed the aggregate supply price, then the entrepreneur is motivated to increase employment. In mathematical terms, this can be explained through two functions: the aggregate supply function (Z = ϕ(N)) (Z = phi of N??), with Z being the aggregate supply price and N the number of employees; and the aggregate demand function (D= f(N)) (D equals a function of N?), with D being the entrepreneur’s proceeds.

The meeting point of the two functions defines the volume of employment. This intersection is called the effective demand and is the point at which the entrepreneur’s expectation of profits is maximized.

Principle of Effective Demand

Whenever the employment increases, the aggregate real income increases as well. This, in turn, causes a rise in aggregate consumption, but not by as much as the rise in income. Therefore, if an employer were to increase employment to meet the new demand, he would be making a loss.

This is where governments can step in to help the economy and alleviate unemployment. Through investment, Keynes writes, the gap between consumption and production is closed. Therefore, the equilibrium level of employment (the level at which an employer is neither motivated to increase nor decrease labor) is dependent on the amount of investment. 

The equilibrium level of employment can never exceed full employment. However, it also does not necessarily equal full employment. It can only be at full employment when “by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.”

To put it simply: zero unemployment is only possible when consumption and production are at equal levels, which can be reached by both natural consumption on behalf of the population, and designed intervention in the form of investments by governments. 

That is why Keynes is also opposed to the idea of savings – he believes that to keep the economy going, investments from private and public sectors are needed.

The amount of employment depends on the propensity of a population to consume, as well as the rate of new investments. If, for example, both consumption and investment end up being more than the effective demand, the volume of employment will be below the supply of labor available, and unemployment is created. 

The author puts it this way: “If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment.”

Explaining an economic crisis

Keynes’ General Theory can also help explain trade cycles, namely the fluctuation of economic booms and busts. Economic cycles seem to follow a regular pattern: they build up to a certain point, until the upward movement is reversed, and an economic crisis occurs. Moreover, this crisis is of a sudden nature, almost like a catastrophe. 

Economic slumps in the forms of recession or depression have usually been described as being caused by an increasing rate of interest. However, economic crises are actually caused by a sudden collapse in the marginal efficiency of capital, or the expected rate of return of an investment.

Let’s look at economic booms first: towards the end of an economic boom, optimistic expectations reign supreme. It is believed that future profits are going to offset the present increasing demands of production. 

Keynes elaborates on this idea, saying: “It is of the nature of organised investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.”

While the marginal efficiency of capital collapses, there is a sharp increase in preferring liquidity, and therefore the rate of interest rises as well. So rather than the rate of interest causing a crisis, it is simply accompanying it. 

That is why, to alleviate an economic crisis, decreasing the rate of interest does not make a difference, as had long been assumed. It is important to realize that recovery can only begin once a certain time has elapsed and a confidence in the value of money has been regained.

Final Notes

Classical economic theory is insufficient to explain mass unemployment and economic depression. Supply does not create demand. Outside forces, such as government intervention, are needed to alleviate unemployment. That is because the volume of employment is always defined by the effective demand of an economy, and this can usually not be met simply by private spending. To keep an economy afloat, it is always better to spend than to save money.

It is also important to remember that the human psyche plays an important role in economic crises – first, confidence in the value of money needs to be reestablished before a general economic upswing can happen.

12min Tip

Now that you have learned about the basics of economic theory, why not read Thomas Sowell’s “Economic Facts and Fallacies”?