Wyandanch Library

Overview

John Maynard Keynes' The General Theory of Employment, Interest, and Money (1936) is one of the most influential and controversial works in the history of economics. Written during the Great Depression, the book dismantled the classical orthodoxy that free markets naturally tend toward full employment and replaced it with a framework in which aggregate demand -- the total spending in an economy -- is the primary driver of output and employment. Keynes argued that economies can settle into prolonged periods of high unemployment not because of any malfunction, but because the existing level of demand is simply insufficient to employ everyone willing to work. The implication was revolutionary: government intervention through fiscal and monetary policy is not only justified but necessary to prevent human suffering during downturns.

The General Theory is dense, deliberately provocative, and at times intentionally obscure. Keynes was writing against the professional consensus of his era, and he knew it. The book introduced a constellation of ideas -- the consumption function, the multiplier, liquidity preference, marginal efficiency of capital, animal spirits -- that collectively reshaped macroeconomic theory and policy for the next century. Whether or not you agree with Keynes' prescriptions, understanding his framework is essential for operating in a world where central banks and treasuries actively manage aggregate demand. Every recession, every stimulus package, every interest rate decision traces its intellectual lineage back to this book.

The Rejection of Say's Law

Classical economics rested on Say's Law: supply creates its own demand. The idea, in simplified form, is that the act of producing goods generates exactly enough income to purchase those goods. There can be no general glut -- no economy-wide shortfall of demand -- because every dollar paid in production becomes a dollar available for spending. Unemployment, in this framework, is always voluntary or frictional.

Keynes rejected this entirely. He argued that income earned in production does not automatically get spent. People save, and saving represents a leakage from the circular flow of income. If desired saving exceeds desired investment, total spending falls short of total output, inventories pile up, firms cut production, and workers lose their jobs. The economy can reach an equilibrium -- a stable resting point -- at less than full employment. This was the revolutionary insight: equilibrium does not mean prosperity. An economy can be in balance and still have millions of people out of work.

The Consumption Function and the Multiplier

Keynes introduced the consumption function to describe how households allocate income between spending and saving. His key concept was the marginal propensity to consume (MPC) -- the fraction of each additional dollar of income that gets spent rather than saved. If the MPC is 0.80, then for every extra dollar of income, 80 cents gets spent and 20 cents gets saved.

This seemingly simple idea powers one of Keynes' most important tools: the multiplier effect. When the government spends an additional $1 billion on infrastructure, that money does not simply add $1 billion to GDP. The construction workers who receive that income spend 80% of it -- $800 million -- at local businesses. Those businesses and their employees then spend 80% of their new income -- $640 million -- and so on. The total increase in GDP is:

Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.80) = 5

So an initial $1 billion in government spending generates $5 billion in total economic output. The multiplier magnifies the effect of fiscal policy, which is why Keynesians argue that deficit spending during recessions is not wasteful but productive -- the return on investment, measured in additional output, exceeds the initial outlay.

The multiplier also works in reverse. A $1 billion cut in spending does not reduce GDP by $1 billion -- it reduces it by $5 billion, as the withdrawal cascades through the economy. This is why austerity during recessions can be self-defeating.

Liquidity Preference Theory

Classical economists treated the interest rate as the price that equilibrates saving and investment: if people want to save more, the interest rate falls, making borrowing cheaper and stimulating investment until saving and investment are back in balance. Keynes offered a fundamentally different explanation.

In Keynes' framework, the interest rate is determined by the supply and demand for money, not by the supply and demand for loanable funds. He called this liquidity preference -- the desire to hold wealth in liquid form (cash) rather than in illiquid assets (bonds, investments). People hold money for three reasons:

Transactional motive: You need cash for day-to-day purchases. The amount you hold depends on your income level.
Precautionary motive: You hold cash as a buffer against unexpected expenses or emergencies. The amount depends on your degree of uncertainty about the future.
Speculative motive: You hold cash when you believe bond prices will fall (interest rates will rise). If you expect rates to rise, holding bonds means capital losses, so you prefer to hold cash and wait for better prices.

The speculative motive is the critical innovation. It means that the demand for money is sensitive to interest rates and expectations, and it introduces the possibility of a liquidity trap -- a situation where interest rates are so low that everyone expects them to rise, so everyone hoards cash regardless of how much money the central bank creates. In a liquidity trap, monetary policy becomes impotent. You cannot push on a string. This is why Keynes emphasized fiscal policy (direct government spending) over monetary policy during severe downturns.

Marginal Efficiency of Capital and Animal Spirits

Investment, in Keynes' framework, is the most volatile and most important component of aggregate demand. Firms invest when they expect the return on a new project (what Keynes called the marginal efficiency of capital) to exceed the cost of borrowing. But here is the problem: that expected return depends on forecasts about the future -- future demand, future costs, future competition -- and those forecasts are inherently uncertain.

Keynes argued that investment decisions are not primarily driven by cold calculation. They are driven by animal spirits -- waves of optimism and pessimism, confidence and fear, that sweep through the business community and become self-reinforcing. When entrepreneurs feel confident, they invest, which creates income, which creates more demand, which validates the confidence. When confidence collapses, the reverse spiral takes hold. Investment dries up, incomes fall, demand contracts, and the pessimism is confirmed.

This is not irrationality in the pejorative sense. Keynes' point is that when the future is genuinely uncertain -- not merely risky in a calculable way -- rational actors have no choice but to rely on convention, herd behavior, and gut instinct. The economy's mood matters because it shapes the decisions that determine output and employment.

The Beauty Contest and Market Behavior

Keynes offered one of the most famous metaphors in financial economics: the beauty contest. Imagine a newspaper competition where you win by picking the face that other contestants will judge most beautiful. You do not pick the face you find most attractive. You pick the face you think others will pick. And the truly sophisticated player picks the face she thinks others think others will pick.

This is how Keynes saw financial markets. Professional investors are not primarily trying to estimate intrinsic value. They are trying to anticipate what the crowd will value next. The market is a game of expectations about expectations, and it can remain detached from fundamental value for extended periods. This is the origin of the line often attributed to Keynes: "Markets can stay irrational longer than you can stay solvent." Whether or not he said those exact words, the sentiment runs throughout the General Theory. The implication for investors is sobering: being right about value is not enough if the market disagrees with you for longer than your capital can survive.

The Paradox of Thrift and Sticky Wages

The paradox of thrift is one of Keynes' most counterintuitive and powerful ideas. If every household simultaneously decides to save more -- a perfectly rational response to economic uncertainty -- the collective effect is catastrophic. More saving means less spending, which means less income for businesses, which means layoffs, which means less income for households, which means even less spending. The attempt to save more actually reduces total saving because it reduces total income. Individual rationality produces collective irrationality.

Keynes also addressed why wages do not simply fall during recessions to restore full employment, as classical theory predicted. He argued that wages are sticky downward for both institutional and psychological reasons: workers resist nominal pay cuts, labor contracts are fixed, and even if wages could be cut, the resulting deflation would increase the real burden of debt and reduce spending further. The result is involuntary unemployment -- people who want to work at the prevailing wage but cannot find jobs because aggregate demand is insufficient.

Why This Matters

Whether one agrees with Keynes or not, understanding the General Theory is non-negotiable for any investor or analyst operating in the modern economy. Keynesian frameworks underpin the policy responses you see in every recession: stimulus packages, quantitative easing, deficit spending, interest rate cuts. The 2008 financial crisis response, the COVID-era stimulus, and every central bank decision about interest rates are direct descendants of Keynesian thinking. Concepts like the liquidity trap, the multiplier, and the paradox of thrift are part of the standard vocabulary of macroeconomic analysis. Investors who want to anticipate policy responses to economic downturns -- and profit from the asset price effects of those responses -- need to understand the theoretical framework that informs them.

The beauty contest metaphor should also be tattooed on every investor's forearm. Markets are not physics. They are populated by humans making decisions under uncertainty, guided by convention, narrative, and the behavior of other humans. Keynes understood this at a level that much of modern finance still struggles to incorporate.

Key Takeaways

Say's Law is wrong: supply does not automatically create its own demand. Economies can reach equilibrium at less than full employment when aggregate demand is insufficient.
The multiplier effect amplifies changes in spending through the economy. With an MPC of 0.80, each dollar of new spending generates five dollars of total output.
Liquidity preference theory explains interest rates as the price of parting with liquidity, not the reward for saving. The speculative motive introduces the possibility of a liquidity trap.
Animal spirits -- confidence, fear, and herd psychology -- drive investment decisions more than rational calculation, creating self-reinforcing cycles of boom and bust.
The paradox of thrift: when everyone saves more simultaneously, total income and total saving both fall. Individual rationality becomes collective irrationality.
Sticky wages and involuntary unemployment are real phenomena that prevent markets from self-correcting through wage flexibility alone.
The beauty contest metaphor: financial markets are games of expectations about expectations, and prices can stay detached from fundamental value for extended periods.
Markets can stay irrational longer than you can stay solvent -- being right about value is meaningless if your timing is wrong and your capital runs out.