April 20, 2016

How Keynes messed macro up

Comment on ‘The real tail wagging’


Meade summarized the Keynesian Revolution: “Keynes’s intellectual revolution was to shift economists from thinking normally in terms of a model of reality in which a dog called savings wagged his tail labelled investment to thinking in terms of a model in which a dog called investment wagged his tail labelled savings.”

The fact is that Keynes, too, did not realize that household saving and business investment develop independently. There is no tail-wagging at all.

The formal basis of the General Theory is given with: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

This two-liner is conceptually and logically defective because Keynes never came to grips with profit and therefore “discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12).

As a result, all I=S/IS-LM models are false since Keynes and Hicks (2011; 2014). After-Keynesians did not get the point until today.

Keynes’s foundational propositions have to be replaced. The most elementary economic configuration is the pure consumption economy which is given as follows:
(i) Yw=WL wage income Yw is equal to wage rate W times working hours L,
(ii) O=RL output O is equal to productivity R times working hours L,
(iii) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

For the graphical representation see here.

At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of budget balancing, i.e. C=Yw and market clearing, i.e. X=O. Note that the ray in the southeastern quadrant is NOT a linear production function; the ray tracks ANY underlying production function. Note also that W is the AVERAGE wage rate if the individual wage rates are different among the employees, which is normally the case. Under the INITIAL conditions of budget balancing and market clearing holds P=W/R.

If the wage rate W is lowered, the market clearing price P falls. If the number of working hours L is increased the price remains constant, provided productivity R does not change. If productivity decreases the price rises. If productivity increases the price falls. In any case, labor gets the whole product, the real wage is invariably equal to the productivity, and profit for the business sector as a whole is zero. All changes in the system are reflected by the market clearing price. The elementary consumption economy is reproducible for an indefinite number of periods at any level of employment.

In the next period, the households save. The result is shown here.

Consumption expenditure C falls below Yw and with it the market clearing price P. With perfect price flexibility there are NO unsold quantities and NO change of inventory. The product market is always cleared and there is no such thing as an inventory investment. So we have household sector saving but no business sector investment, that is, monetary saving which is given by Sm=Yw-C is NOT equal to investment I=0 as in Keynes’s formal foundations.

The crucial result is that the business sector makes a monetary loss which is exactly equal to the household sector’s saving, i.e. Qm=-Sm. Therefore, loss is the exact counterpart of saving; by consequence, profit is the exact counterpart of dissaving. This is the most elementary form of the Profit Law. It follows directly from the profit definition Qm=C-Ym. The sector balances always add up to zero, i.e. Qm+Sm=0.

The correct profit equation for the investment economy reads Qm=Yd+I-Sm (2014, p. 8, eq. (18)). Legend: Qm monetary profit, Yd distributed profit, I investment expenditures, Sm monetary saving.

The crucial point is that business investment and household sector saving develop independently (2013). Their difference I-Sm co-determines the monetary profit of the business sector Qm.

The Keynesian Revolution did not really happen. Keynes merely replaced one false causality by another false causality.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. URL
Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money.  London, Basingstoke: Macmillan.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL