The General Theory of Employment, Interest, and Money

Keynes coined this phrase to describe the psychological and emotional factors that influence consumer and investor behavior beyond rational calculation. Instincts such as optimism or fear can trigger significant fluctuations in investment and consumption, affecting the business cycle and economic stability. In emphasizing “animal spirits,” Keynes draws attention to the inherently unpredictable nature of markets and the need for policies that can help moderate collective swings in confidence.

The General Theory is written against the earlier prevailing school of thought that assumed markets are self-correcting through flexible prices and wages. Keynes challenges this framework by asserting that involuntary unemployment can persist if aggregate demand is insufficient. By critiquing classical assumptions, Keynes lays the groundwork for a fundamentally new way of understanding how and why recessions occur, as well as how governments can combat them.

The actual level of expenditure on goods and services that sets the economy’s equilibrium level of employment and output. Unlike potential or theoretical demand, effective demand is shaped by current spending decisions in both the private and public sectors. By highlighting the difference between theoretical supply-driven models and real-world spending levels, Keynes illuminates why insufficient effective demand can result in prolonged unemployment.

Unlike classical economists, who defined interest rate as merely a price balancing the supply and demand of loanable funds, Keynes sees it as reflecting liquidity preferences and expectations. Keynes argues that central banks and monetary policy have significant power to influence interest rates, which can stimulate or dampen investment. This view contrasts with the classical notion that interest rates are purely determined by saving and investment decisions in free markets.

The desire to hold cash or easily convertible assets instead of committing funds to long-term investments. Keynes proposes that this preference is influenced by interest rates, economic outlook, and risk perception, all of which affect how much money individuals and businesses wish to keep on hand. By elevating the concept of liquidity preference, Keynes stresses the psychological and situational factors that influence overall investment and spending decisions.

The expected rate of return on additional units of investment, accounting for both the cost of capital and anticipated future earnings. Keynes uses this concept to explain how businesses decide whether investing in new projects is worthwhile. If the marginal efficiency of capital falls below the prevailing interest rate, firms are less likely to invest, contributing to economic slowdowns or recessions when confidence wanes.

MPC measures the proportion of additional income that individuals will spend rather than save. A higher MPC suggests that increases in income lead to greater consumption, thus boosting aggregate demand. Keynes highlights this concept to show why government policies that put money into consumers’ hands—like tax cuts or direct transfers—can spur economic activity more effectively when the MPC is high.

The multiplier effect in Keynes’s framework describes how an initial injection of spending (such as government expenditures) can lead to a more than proportional increase in total economic output. Because recipients of new spending often re-spend a portion of that money, each dollar circulates repeatedly through the economy, amplifying the overall impact. By quantifying this ripple effect, Keynes demonstrates why targeted fiscal stimulus can significantly reduce unemployment and support recovery.

Closely tied to the concept of the marginal propensity to consume, propensity to save indicates the portion of additional income individuals choose to set aside rather than spend. Keynes argues that when the propensity to save is too high, aggregate demand can stagnate, leading to underinvestment and unemployment. Balancing saving and spending are essential for preventing prolonged economic downturns and maintaining sufficient levels of demand.

In classical economics, Say’s Law holds that supply creates its own demand. Directly challenging this idea, Keynes argues that general gluts—periods of widespread unemployment—can indeed occur when total spending (aggregate demand) lags behind what the economy is capable of producing. By refuting Say’s Law, Keynes makes a case for active government intervention to stimulate demand, rather than waiting for markets to self-correct.