1. The Keynesian RevolutionJohn Maynard Keynes wrote his Treatise on Money and his General Theory under theimpact of the Great Depression in Europe in 1936 (Skidelsky, 2009, pp. 64ff). Theworld economy had severely contracted; unemployment was sharply on the rise, notonly in the United States but also in Europe, and money supply had collapsed (p. 68).Hence, the fundamental question that Keynes sought to answer with his theory washow to lift an ailing economy out of a slump and back to full employment. Neo-classical economists before Keynes had turned to Say’s Law for aresponse. Jean-Baptiste Say had postulated that money did not have an intrinsic value;it was a means of exchange which, after an economic transaction, would beexchanged for a new good as soon as possible for fear of sudden depreciation (Grant& Brue, 2007, pp. 130f). In other words, every economic transaction and thereby, the production of every single good, would directly engender a corresponding demand for other goods (ibid.). Keynes (1936) inferred that, if this were to be true, there wouldalways be demand for products and therefore a demand for labour (p. 26). If it weretrue, involuntary unemployment could not occur (ibid.).Keynes refuted Say’s Law however on the premise that money was not only ameans of exchange but also a store of value (Fletcher, 1987, p. 18). The moreindividuals decided to hold money in cash (or in “liquidity”) for various reasons
, theless money was available in the banks that could have been given out to entrepreneursas a loan to stimulate investment (Skidelsky, 2008, p. 94). At the same time,entrepreneurs could not be certain how much of their liquidity individuals would bewilling to spend on consumption goods, so that they had little indication of how muchto produce without losing money (ibid.). This is where Keynes’s model starts. Toreduce uncertainty, to boost investment and to achieve full employment, he noted, itshould be the government’s role to spur demand for consumption and investmentgoods (Skidelsky, 2008, pp. 166f; p. 176). This would prompt entrepreneurs to investmoney and to create jobs. Keynes (1936) identified the level of income as the primedeterminant for people’s propensity to consume (pp. 90f) and concluded that a policywhich increased people’s net income would also induce them to spend more and to
Motives for holding liquidity can be to have a means of transaction for a purchase, to keep liquidity safe in theexpectancy of a bank run or to speculate (Fletcher, 1987, pp. 101ff; Grant & Brue, 2007, p. 436).