The Meaning of Saving and Investment Further Considered

January 9, 2020

The actual economic system are also coloured by certain special characteristics of the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest, about which we can safely generalise from experience, but which are not logically necessary.

In particular, it is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable.

It seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any tendency towards recovery or towards complete collapse.

Moreover, full employment has proven to be a rare and short-lived occurrence.

Fluctuations may start briskly but seem to wear themselves out before they have proceeded to great extremes, and an intermediate situation which is neither desperate nor satisfactory is our normal lot.

This is why fluctuations tend to wear themselves out before proceeding to extremes and eventually to reverse themselves, that the theory of business cycles having a regular phase has been founded.

The same thing is true of prices, which, in response to an initiating cause of disturbance, seem to be able to find a level at which they can remain, for the time being, moderately stable. Now, since these facts of experience do not follow of logical necessity, one must suppose that the environment and the psychological propensities of the modern world must be of such a character as to produce these results.

It is, therefore, useful to consider what hypothetical psychological propensities would lead to a stable system; and, then, whether these propensities can be plausibly ascribed, on our general knowledge of contemporary human nature, to the world in which we live. The conditions of stability which the foregoing analysis suggests to us as capable of explaining the observed results are the following=

  1. The marginal propensity to consume is such that, when the output of a given community increases (or decreases) because more (or less) employment is being applied to its capital equipment, the multiplier relating the two is greater than unity but not very large.

  2. When there is a change in the prospective yield of capital or in the rate of interest, the schedule of the marginal efficiency of capital will be such that the change in new investment will not be in great disproportion to the change in the former ; i.e. moderate changes in the prospective yield of capital or in the rate of interest will not be associated with very great changes in the rate of investment.

  3. When there is a change in employment, money-wages tend to change in the same direction as, but not in great disproportion to, the change in employment; i.e. moderate changes in employment are not associated with very great chances in money-wages. This is a condition of the stability of prices rather than of employment.

  4. We may add a fourth condition, which provides not so much for the stability of the system as for the tendency of a fluctuation in one direction to reverse itself in due course; namely, that a rate of investment, higher (or lower) than prevailed formerly, begins to react unfavourably (or favourably) on the marginal efficiency of capital if it is continued for a period which, measured in years, is not very large.

(i) Our first condition of stability, namely, that the multiplier, whilst greater than unity, is not very great, is highly plausible as a psychological characteristic of human nature. As real income increases, both the pressure of present needs diminishes and the margin over the established standard of life is increased; and as real income diminishes the opposite is true.

Thus it is natural — at any rate on the average of the community — that current consumption should be expanded when employment increases) but by less than the full increment of real income; and that it should be diminished when employment diminishes, but by less than the full decrement of real income. Moreover, what is true of the average of individuals is likely to be also true of governments especially in an age when a progressive increase of unemployment will usually force the State to provide relief out of borrowed funds. But whether or not this psychological law strikes the reader as plausible a priori, it is certain that experience would be extremely different from what it is if the law did not hold. For in that case an increase of investment, however small, would set moving a cumulative increase of effective demand until a position of full employment had been reached; while a decrease of investment would set moving a cumulative decrease of effective demand until no one at all was employed. Yet experience shows that we are generally in an intermediate position.

There might be a range within which instability does in fact prevail. But, if so, it is probably a narrow one, outside of which in either direction our psychological law must unquestionably hold good. Furthermore, it is also evident that the multiplier, though exceeding unity, is not, in normal circumstances, enormously large. For, if it were, a given change in the rate of investment would involve a great change (limited only by full or zero employment) in the rate of consumption. (ii) Whilst our first condition provides that a moderate change in the rate of investment will not involve an indefinitely great change in the demand for consumption-goods our second condition provides that a moderate change in the prospective yield of capital-assets or in the rate of interest will not involve an indefinitely great change in the rate of investment.

This is likely to be the case owing to the increasing cost of producing a greatly enlarged output from the existing equipment. If, indeed, we start from a position where there are very large surplus resources for the production of capital-assets, there may be considerable instability within a certain range; but this will cease to hold good as soon as the surplus is being largely utilised. Moreover, this condition sets a limit to the instability resulting from rapid changes in the prospective yield of capital-assets due to sharp fluctuations in business psychology or to epoch-making inventions — though more, perhaps, in the upward than in the downward direction.

(iii) Our third condition accords with our experience of human nature. For although the struggle for money-wages is, as we have pointed out above, essentially a struggle to maintain a high relative wage, this struggle is likely, as employment increases, to be intensified in each individual case both because the bargaining position of the worker is improved and because the diminished marginal utility of his wage and his improved financial margin make him readier to run risks. Yet, all the same, these motives will operate within limits, and workers will not seek a much greater money-wage when employment improves or allow a very great reduction rather than suffer any unemployment at all.

But here again, whether or not this conclusion is plausible a priori, experience shows that some such psychological law must actually hold. For if competition between unemployed workers always led to a very great reduction of the money-wage, there would be a violent instability in the price-level. Moreover, there might be no position of stable equilibrium except in conditions consistent with full employment; since the wage-unit might have to fall without limit until it reached a point where the effect of the abundance of money in terms of the wage-unit on the rate of interest was sufficient to restore a level of full employment.

At no other point could there be a resting-place.[3]

(iv) Our fourth condition, which is a condition not so much of stability as of alternate recession and recovery, is merely based on the presumption that capital-assets are of various ages, wear out with time and are not all very long-lived; so that if the rate of investment falls below a certain minimum level, it is merely a question of time (failing large fluctuations in other factors) before the marginal efficiency of capital rises sufficiently to bring about a recovery of investment above this minimum.

Similarly, if investment rises to a higher figure than formerly, it is only a question of time before the marginal efficiency of capital falls sufficiently to bring about a recession unless there are compensating changes in other factors. For this reason, even those degrees of recovery and recession, which can occur within the limitations set by our other conditions of stability, will be likely, if they persist for a sufficient length of time and are not interfered with by changes in the other factors, to cause a reverse movement in the opposite direction, until the same forces as before again reverse the direction.

Thus, our four conditions together are adequate to explain the outstanding features of our actual experience; — namely, that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.

But we must not conclude that the mean position thus determined by “natural” tendencies, namely, by those tendencies which are likely to persist, failing measures expressly designed to correct them, is, therefore, established by laws of necessity. The unimpeded rule of the above conditions is a fact of observation concerning the world as it is or has been, and not a necessary principle which cannot be changed.

Author’s Footnotes

  1. We are ignoring at this stage certain complications which arise when the employment functions of different products have different curvatures within the relevant range of employment. See Chapter 20 below.

  2. Defined in Chapter 20 below.

  3. The effects of changes in the wage-unit will be considered in detail in Chapter 19


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