Keynes’ criticism of classical theory
• Keynes argues that Micro economics
assumptions are not applicable to Macro Economic
– Macro is not just the sum of micro,
– For example, it is good for an individual to save, but if the
entire population saves, then it affects total demand in the
– If total or aggregate demand falls, then goods are not sold,
and this discourages investors.
– Private Investment will fall, and as investment falls, output,
income and employment also falls.
– The result: the economy may go into a recession.
Savings and Consumption
• Neo-classical economics called for higher S,
assuming that all S is automatically invested.
• Keynes pointed out that unlike Neo-classical
assumption, savings are not automatically invested.
• This is because those who save are different from those
• Also he pointed out that saving is a leakage from the
income stream, it is a form of hoarding, or money not
spent. He called it “Liquidity Preference”.
• Hence increase in Total Savings leads to decrease in
Total Consumption, and of Effective Demand at the
Savings as leakage
Rs.50,000, not all
of it is used for
hoarding of cash
leads to fall in the
amount of cash
sent back into
circulation at the
Savings and Consumption
• Further, Consumption demand is a function of
Income, as Income increases, Consumption also
increases but not at the same rate.
• C =f(Y)
• C < Y .
• Since Y = C + S, as Y , S also .
• Savings are thus a function of Income, not of the
rate of interest alone.
• S =f(Y), as NY increases, total savings also
• But there is no guarantee that this S = Investment.
• Keynes analysis of Investment was
different from the Neo-classical theory.
• Investment = Autonomous (Government) Investment
+ Induced (Private) Investment.
• Autonomous Investment is not motivated by profit.
• Induced Investment is affected by expected profit.
Profits increase if there is sufficient consumption
(Effective D) in the economy.
• Thus expected profit has a greater impact on Induced
investment than rate of interest.
• Neo-classical theory had assumed that Investment is
affected by rate of interest alone.
Investment and Savings
• If Q = Rs.1000, Y = Rs.1000, C =
Rs.800, and S = Rs.200.
• But Investment need not be only Rs.200.
• Entrepreneurs may invest more than 200,
say Rs.300, or may invest less, say
• If they invest less, it leads to recession.
• If they invest more, it leads to expansion.
Impact of reducing wage rate
• Keynes did not agree with Pigou, that fall in w-rate will
increase employment at the macro level. It can do so
at the micro level.
• But if all wages fell in an economy, then total income
• When income falls, consumption demand also falls.
• When consumption demand or effective demand falls,
it discourages private investment.
• So investment falls, leading to fall in employment.
• Therefore wage cuts leads to greater unemployment
and recessionary trends.
Investment = Saving
• Keynes pointed out that those who save need not
be those who invest.
• Investment is done independently by entrepreneurs.
• It is not limited by level of savings by households.
• Investment leads to increase in NY,
• When NY then Savings .
• So causation is from ex ante I ex post S.
• The causation is from Investment to Savings, not
Savings to Investment.
• This is an important causation shown by Keynes.
Investment is equal to Savings, ex post and is the cause
Instability of Capitalist Systems
• Investment = Autonomous (Government
investment) + Induced (Private) investment.
• Induced Investment is highly unstable.
• If total D falls, expenditure falls, and private sector does
not have the incentive to Investment.
• Recessions and Inflation are common in capitalist
• Even if there is equilibrium, it can be at less than full
• Laissez faire is not possible, government must take up
measures to revive the economy.