Academic journal article Review of Social Economy

Explaining the Aggregate Price Level with Keynes's Principle of Effective Demand

Academic journal article Review of Social Economy

Explaining the Aggregate Price Level with Keynes's Principle of Effective Demand

Article excerpt

Abstract The mainstream view of Keynes's principle of effective demand is that it states something about quantities--and about quantities only. The principle is held to determine the levels of output and employment in a world not governed by Say's law. This paper argues that the principle of effective demand goes beyond this to explain not only 'real' activity levels but also the aggregate price level. A variant of the post-Keynesian D/Z-model is brought together with Marxian reproduction schemes to derive this result.

Keywords: effective demand, multiplier, post-Keynesianism, D/Z-model, reproduction schemes

INTRODUCTION

Many would agree that Keynes's principle of effective demand states something about quantities--or 'quantity reactions', respectively. As Milgate puts it:

   The formal proposition is that saving and investment are brought
   into equality by variations in the level of income (output). This is
   the principle of effective demand. (1982: 78)

The famous "Keynesian cross" (Samuelson 1948, Ch. 12), which has crucially shaped economists' imagination of how "quantity reactions" might work, is in "real" terms: there are no prices in that model. Yet, when Keynes introduced the principle of effective demand in Chapter 3 of the General Theory (Keynes 1973a: 25), he did so in terms of two nominal functions, D and Z, which he calls "expected proceeds" and "the aggregate supply price", respectively. These two functions intersect at what Keynes calls the point of effective demand.

This paper is concerned with theory only; no empirical claims are made. The paper aims at disentangling the price and quantity components of the two functions D and Z in order to show that the principle of effective demand explains both of them, separately and individually. By "explain" we mean that--under certain assumptions about the "given" and "independent" variables Keynes enumerates on p. 245 of the General Theory (1)--the principle of effective demand will produce a precise theoretical forecast for both the level of output and the price level.

The expedience of such an approach might be disputed on the grounds that Keynes himself has expressed his dislike for the concept of the aggregate price level. He writes: "(T)he well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purpose of causal analysis" (Keynes 1973a: 39). Still, he kept using this concept throughout the General Theory, especially in Chapter 21 on "The Theory of Prices".

Two post-Keynesian economists, Sidney Weintraub and Paul Davidson, share the merit of having rescued Keynes's D/Z-analysis from oblivion. (2) Weintraub (1958: 39) was the first to draw D- and Z-curves; and Davidson has perhaps been the most influential advocate of the D/Z-model ever since (cf. Davidson 1994: Ch. 2; Davidson 2002: Ch. 2). Weintraub and Davidson maintain that the price level implicit in D and the price level implicit in Z must be equal under all circumstances. Here, however, we will distinguish the price component in Z, which we will label the "supply price level", from the price component in D, referred to as the "expected demand price level". (3) A variant of the post-Keynesian D/Z-model will be developed that distinguishes between the expected demand and supply price levels. In line with Chick's (1983: 85-86) exposition, we will argue that supply prices are merely notional magnitudes, whereas demand prices are "real" in the sense that they are observable in the marketplace. Entrepreneurs have to form expectations about these demand prices. The supply price level and the expected demand price level are not identical for all conceivable levels of employment. Only at the point of effective demand these two price levels will be equal (see below).

If demand price expectations are correct, the expected demand price level equals the demand price level that is observable in the marketplace. …

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