monetary theory

I am planning a sequence of posts on re-reading Keynes, where I will try to go through the General Theory. This first post explains my motivations for re-reading Keynes. As always, my primary motive is self-education; this will force me to go through the book again — I first read it in my first year graduate course on Macroeconomics at Stanford in 1975, when our teacher Duncan Foley was having doubts about modern macro theories, and decided to go back to the original sources. At the time, I could not understand it at all, and resorted to secondary sources, mainly Leijonhufvud, to make sense of it. Secondarily, i hope to be able to summarize Keynes’ insights to make them relevant and useful to a contemporary audience. Thirdly, there are many experts, especially Paul Davidson, on this blog, who will be able to prevent me from making serious mistakes in interpretation.

Reasons for Studying Keynes

The heart has its reasons of which reason knows nothing.” Blaise Pascal

In line with the objectives of the WEA Pedagogy Blog, I am initiating a study group with the aim of [re-]reading Keynes’ classic The General Theory of Employment, Interest and Money. There are many reasons why I think this is a worthwhile enterprise. I hope to make weekly posts summarizing various aspects of the book, as we slog through the work, which can be difficult going in some parts. At the very least, this will force me to re-read Keynes, something I have been meaning to do for a long time. In this first post, I would like to explain my motivation in doing this exercise. Read More


The Global Financial Crisis of 2007 has led to a renewed interest in Keynesian theories. In particular, Krugman in “The Return of Depression Economics” argued that Keynesian ideas remain relevant to understanding 6196411489_a5cf9e16fc_bcontemporary recessions. To motivate this, he has used a real world example of the Capitol Hill Baby-Sitting Cooperative (BSC). According to an analysis by economists who were members of the Cooperative, the BSC suffered from a recession due to a shortage of “scrip”, the currency used to exchange baby-sitting services.

Krugman’s analysis is based on an intuitive and heuristic analysis by Sweeney and Sweeney (1977). However, the BSC is a very simple single good economy, where the sole function of money is to allow for inter-temporal trade. This simplicity allows for a rigorous analytic treatment. Our research was motivated by the idea of analytically validating the intuitive insights of the Sweeneys and Krugman. Is the BSC a Keynesian economy? Can a shortfall of money create a recession in this economy? A simple model which displays Keynesian effects should be useful in building understanding of these phenomenon in more complex situations.

A few authors who have analyzed the BSC economy have found Keynesian effects under the assumption of fixed prices. But in presence of fixed prices, the existence of an optimal quantity of money, and recession for low money is a triviality. The Keynesian rejection of neutrality of money is not based solely on sticky prices. In this paper, we create a simple model of the BSC economy to investigate the presence of Keynesian phenomena. The model leads to strange and paradoxical results, not available in earlier analyses. We list these results below.

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FullEmplWe are used to thinking that there is progress in knowledge. As we gain experience, the collective wisdom of mankind increases. The story of economics in the twentieth century provides the most amazing example of the opposite: How precious knowledge of vital importance for the welfare of humanity was gained and then lost. Many studies show that a meaningful job is the most important determinant of life satisfaction, and among the thing most desired by the general public. Economists learned how to create full employment, leading to a period of tremendous prosperity. How and why these lessons were forgotten provides a perfect illustration of the thesis that knowledge is shaped to protect the interests of the powerful.

Before the Great Depression of 1929, dominant economic theories stated that the free market automatically eliminates unemployment. Obviously, a theory which does not recognize the existence of a problem cannot provide solutions. Before the Great Depression, the economy was booming, with jobs for all and high levels of production. After 1929, factories lay idle, there was massive and persistent unemployment, and correspondingly high level of general misery. Why did unemployment persist, and how could we get the economy back to full employment of all the resources now lying idle? The revolutionary accomplishment of Keynes was to recognize the source of the problem, and provide an effective remedy.

Keynes argued that the key to the problem was depressed investor expectations about the future. Investors were afraid to produce goods because they did not foresee any demand. If they did take a risk and start producing, the demand would be created, because they would provide jobs to people in the process of production. People with jobs would have income and demand goods. Thus a favorable future forecast would create a self-fulfilling prophecy. People were not demanding goods because they did not have jobs. Producers were not providing jobs because they did not see any demand. This deadlock could be broken by the government in several ways. Lowering interest rates and making money cheaply available would reduce the costs of production, and might induce producers to take a risk on starting investments and production. Indeed, just printing a lot of money and throwing it from helicopters would be enough – people with money would demand goods, and producers would start hiring people to fulfill the demand for goods. The “Helicopter Money” scheme could fail for a number of reasons. The alternative was for government to step into the gap, and start hiring people itself. Even meaningless jobs like digging ditches and filling them up again would be enough to start off a chain reaction which would lead to full employment.  Using the secrets of Keynesian demand management, Western governments managed to achieve near full employment, and widespread prosperity for fifty years.

Unfortunately, general prosperity of the 99% does not suit the interests of the 1%. Full employment leads to an unruly labor class, who can walk out of unsatisfactory jobs to find a better one. Secondly, direct government investment can interfere with business profits. Thirdly, before the Keynesian era, politicians understood that business confidence was essential to economic prosperity and votes. Keynes freed the government from this dependence, much to the annoyance of business leaders.

The story of how Keynesian theories were ridiculed and discredited, and completely fallacious pre-Keynesian theories were re-furbished to take their place is long and complex, and cannot be detailed here. The punchline is that the remedies to today’s economic ills are known, but they are not being implemented because they go against the interests of the powerful. There has been a huge increase in debt globally; Debt forgiveness would remove the heavy weight dragging down aggregate demand which is weighing down the economy. Helicopter money is being dropped but into the vaults of the banks instead of the pockets of the public, and Keynes is being blamed for the lack of effectiveness of this ridiculous policy. Zero interest loans to producers are not working, so negative interest rates are being talked about. Meanwhile, everyone ignores the elephant in the room, a fully effective Keynesian theory which explains exactly how we can stimulate aggregated demand to revive the global economy.

Above 700 Words published in Express Tribune on Tuesday 30th  For short posts on diverse Topics see my author page on LinkedIn. Other works: Index . More material on Keynesian Economics. Some additional materials for readers of WEA Blogs:

Some of ideas are taken from Kalecki’s insightful note on why captains of industry resist full employment, even though it bring benefits to them as well. There is very strong evidence from multiple sources that their is a finance mafia in operation globally, which thrives on poor economic performance. This enables them to make multi-billion dollar loans and reap in interest payments. Enforcement of austerity is a crucial element in this scheme, since creation of Sovereign money — which is also done indirectly by deficit financing – by states would deprive them of their most valuable weapon — they have money while others don’t.  Keeping an economy starved of the money lubricant required for smooth functioning helps the 1% at tremendous cost to the 99%

Many leading economists have come to agree with Nobel Laureate Stiglitz that modern economic theory represents the triumph of ideology over science. One of the core victories of ideology is the famous Quantity Theory of Money (QTM). The QTM teaches us that money is veil – it only affects prices, and has no real effect on the economy. One must look through this veil to understand the working of the real economy. Nothing could be further from the truth.

In fact, the QmoneymoneyTM itself is a veil which hides the real and important functions of money in an economy. The Great Depression of 1929 opened the eyes of everyone to the crucial role money plays in the real economy. For a brief period afterwards, Keynesian theories emerged to illuminate real role of money, and to counteract errors of orthodox economics. Economists believed in the QTM, that money doesn’t matter, and also that the free market automatically eliminates unemployment. Keynes started his celebrated book “The General Theory of Employment, Interest and Money” by asserting that both of these orthodox ideas were wrong. He explained why free markets cannot remove unemployment, and also how money plays a crucial role in creating full employment. He argued that in response to the Depression, the government should expand the money supply, create programs for employment, undertake expansionary fiscal policy, and run large budget deficits if necessary.

Free market economists believe that markets work best when left alone, and any type of government intervention to help the economy can only have harmful effects. Even after the Great Depression, they continued to argue that the government intervention would only cause further harm, and the free market would automatically resolve the problems. However, it was obvious to all that the massive amount of misery called for urgent action. QTM was discredited and mainstream economists accepted Keynesian ideas, rejecting free market ideologies. US President  Franklin Delano Roosevelt (FDR) started his campaign with orthodox promises to balance the budget but converted to Keynesianism when faced with the severe hardships imposed by the Great Depression. He later said that “to balance our budget in 1933 or 1934 or 1935 would have been a crime against the American people.” In the 1960’s, the aphorism that “We are all Keynesians now” became widely accepted.

Free market ideologues like Friedman and Hayek patiently bided their time, while preparing the grounds for a counter-attack. Their opportunity came when stagflation – high unemployment together with high inflation – occurred in the 1970’s as a result of the Arab oil embargo. They skillfully manipulated public opinion to create the impression that economic problems were due to Keynesian economic theories, and could be resolved by switching to free market policies. The rising influence of free market ideology was reflected in the election of Reagan and Thatcher, who rejected Keynesian doctrines. Milton Friedman re-packaged old wine in new bottles, and the QTM went from being a discredited eccentric view to the dominant orthodoxy. Throughout the world, including Pakistan, monetary policy had been based on the Keynesian idea the money supply should be large enough to create full employment, but not so large as to create inflation. However, monetarists succeeded in persuading many academics and policy makers of the pre-Keynesian ideas that money only affects prices, and has no long run effects on the real economy.  Central Bankers were persuaded to abandon the Keynesian idea of using expansionary monetary policy to fight unemployment. Instead, they started to focus on inflation targets. Forgetting the hard learned lessons of the Great Depression led to The Global Financial Crisis. Excess money creation for speculation led to a boom in housing and stock markets, followed by a crash very much like that of the Great Depression. Chastened Central Bankers remembered Keynes and took some actions necessary to prevent a collapse of the banking system. A deeper understanding of money could have prevented the Great Recession which followed. The truth is exactly opposite of the QTM idea that money does not affect the real economy. In fact, money plays a central role in the real economy. The mystery of why, even after repeated rejections, such an obviously wrong theory continues to dominate will be addressed in later articles.