THE KEYNESIAN THEORY OF PRICES

Çerban-Oprescu George-Laurentiu
Academy of Economic Studies of Bucharest, Faculty of Economics, Romana Square no.6, Room 0318
[email protected], 0723203472
Çerban-Oprescu Anca-Teodora
Academy of Economic Studies, Bucharest, Faculty of International Business and Economics, Romana
Square no. 6, [email protected]

Every time when a crisis casts shadow over the economy, all the economists seem to remember about
“long forgotten” Keynesian theory. Although just a few economists think about themselves as traditional
Keynesians, the economic policies inspired by Lord Keynes are still alive. For instance, the fundamental
goal of any central bank is to avoid inflation which means to assure prices stability. Is not this the Keynes
ideal: economic progress with full employment and fixed prices? Let’s take a look of the current subprime
crisis. The best solution found by FED is to cut the interest rate and to cheapen the loans. If Keynes will be
alive he surely would be delighted by the FED’s acts. The purpose of this paper is to analyze the
Keynesian theory of prices in order to find the extent in which the solutions found by Keynes are still valid.

Key words: macroeconomics, theory of prices, liquidity, interest rate, economic crisis

Introduction
Few were the theories that had a sufficiently strong impact to change the course of economic thought and
to create what Shumpeter called „classic situations” in Economics. The last „classic situation” in the
history of economic thought was created by the „general theory” elaborated by John Maynard Keynes
in 1936. This theory was proposed by the most famous British economist of those times, the one that had
acquired a star status once with the publication of a shot work [Keynes, 1919] about the „Cartagena
peace” brought about the Versailles treaty, a status that the economist maintained and never abandoned.
This is only one of the arguments that explain why Keynes’ theory was received and readily adopted by
the majority of the economists with a speed and openness never met before. Another reason is obviously
linked to the historic context in which Keynes published The General Theory of Employment, Interest
and Money. His theory had been launched at the best time possible, immediately after the great economic
crisis 1929-1933, when the specter of depression had not yet been completely erased from the memory of
people, and the negative consequences of the crisis had not yet totally disappeared from economic
activity. Having at disposal the case study offered for free by the Great Depression, Keynes makes an
analysis of the phenomenology of the economic crisis in order to offer solutions by means of which
to avoid the re-occurrence of such episodes in the economic activity.
In Keynes’ vision, the most serious consequence of the economic crisis was represented by the fast
growing rate of unemployment which directly affected the welfare and peace of society. For this reason,
the main purpose of Keynes was to solve once and for all the problem of occupation and the solution
proposed was a bold one and apparently, innovative: the state had to indirectly intervene in the economic
activity by stimulating aggregate demand by means of manipulating the interest rate and control of
monetary mass. Moreover, the Keynesian analysis proposed a total separation from what Keynes called
classic economy. The new economic theory was base on a holistic approach of economic activity and
introduce in the economic language original terms such as: investment multiplying, preference for
liquidity, cash trap, aggregate demand, aggregate offer, anti-cycle fiscal policies etc. In this context, it is no
surprise the fact that Keynesian theory was regarded by many generations of economists as the solution to
all economic problems.
Relevant for the peak and decline of the doctrine initiated by Lord Keynes if the affirmation of Milton
Friedman – otherwise a moderate critic of Keynesianism - in 1968: „In a certain way we are all Keynesian
now, on the other way, nobody is Keynesian now. We all use the Keynesian analytical language but none
of us is still accepting the primary conclusions of Keynesians.”[Friedman, 1968:15].

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Significance and role of price in the Keynesian macroeconomics
The fundamental hypothesis of Economics presupposes that there is a reciprocal determination between
prices and the whole economic activity: on the one side current prices offer fundamental information to
economic agents because based on the comparison between current prices and estimations regarding future
prices, individuals decide about activities they are going to start, and, on the other hand, the decisions and
activities of economic agents influence, by means of supply and demand, the price. So, any economic
theory can only be coherent under the circumstances that it succeeds in funding itself on a coherent theory
of price, something that the Keynesian theory did not manage to accomplish.
Being perfectly aware of the role that prices play in the economic system, John Maynard Keynes devotes
an entire chapter out of The General Theory of Employment, Interest and Money to the theory of price. The
British economist proposes a new theory of price, different from the classic one, one that would bring
arguments in support of his new general economic theory. In the theory of price advanced by Keynes, the
level of prices on one market is determined by the cost of production factors and production level. The
extension of the proposition from a microeconomic level to a macroeconomic level brings about a
modification determined by individual demand and aggregate demand. The latter obeys to the law of
„macro psychology” issued by Keynes – marginal inclination towards consumption. Consequently, the
British economist adopts an economic analysis borrowed from classic economy of which he so much
wanted to be separated. Much like the supporters of the objective theory of value, Keynes pays attention to
the way in which the cost of production factors influences the final price of goods. Keynes’ innovation in
this domain is to propose a simplification which he himself considers unrealistic, but which is very suitable
to support his conclusions. The simplification proposed by Keynes says that the retributions of all the
factors of production modify in the same proportion the marginal cost [Keynes, 1970:303]. If this
hypothesis is accepted, then one may say that the level of prices is directly related to the level of wages and
employment. In this way, the level of wages, that is, the price of labor becomes an essential factor in
establishing final price.
From this perspective, one may easily observe that Keynes’ vision does not essentially differ from that of
the marxists. Yet, the purpose of Keynes differs from the one of Marx. If Marx uses this premise to justify
the necessity to replace one economic system with another, Keynes appeals to the above mentioned
hypothesis to sustain an expansionist monetary policy meant to reduce unemployment rate because for
Keynes „..for Keynes the unemployment cause was not the wrong employment policy but the problems of
the monetary and loan system.”[Mises, 1980]. Keynes argues that: Thus if there is perfectly elastic supply
so long as there is unemployment, and perfectly inelastic supply so soon as full employment is reached,
and if effective demand changes in the same proportion as the quantity of money, the Quantity Theory of
Money can be enunciated as follows: “So long as there is unemployment, employment will change in the
same proportion as the quantity of money; and when there is full employment, prices will change in the
same proportion as the quantity of money” [Keynes, 1970:304]. This way, Keynesian offers a new
monetary theory according to which, as long as there is unemployment, the growth of monetary fund does
not influence price, only employment. If full employment is not achieved, the growth of monetary mass
will not have any effect upon the level of prices, but merely a beneficial effect on the rate of
unemployment. Thus, monetary policy may decisively contribute to the accomplishment of every
government’s fundamental objective – full employment. This conclusion is crucial, it offers the best
theoretic argument for an active monetary policy which, by expanding credit produces what Ludwig von
Mises called: „the stones into bread miracle”[Mises, 1980].
Nevertheless, Keynes had enough analytic sense and economic knowledge to realize that the
simplifications to which he had appealed were sufficiently significant to put to doubt the relevance of his
new theory. This is why the British economist felt the duty to improve the model by adding a few essential
restrictions: 1) the effective demand does not modify proportionate to the monetary quantity; 2) as the level
of employment rises, there will be declining or not constant output; 3) resources are not perfectly inter-
changeable; 4) wages will incline to rise before full employment; 5) remuneration of production factors
does not always modify in the same proportion [Keynes, 1970:304].Examining the extent in which these
restrictions are modifying the initial model, Keynes reaches to the following conclusion: the increase of the
quantity of money when the employment is not full is influencing the level of unemployment and also the
level of prices. In this context, the role of prices theory, Keynes argues is “the analysis of the relation
between changes in the quantity of money and changes in the price-level with a view to determining the
elasticity of prices in response to changes in the quantity of money” [Keynes, 1970:305]. Hence, the
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