ECON102: Principles of Macroeconomics (2021.A.01)

It was shown in above, for the Keynesian model to be valid, the two basic determinants of income, namely, the consumption function and independent investment, must remain constant long enough for an equilibrium of income to be reached and maintained. At the very least, it must be possible for these two variables to remain constant, even if they are not generally constant in actuality. The core of the basic fallacy of the Keynesian model is, however, that it is impossible for these variables to remain constant for the required length of time.

When income = 100, consumption = 90, savings = 10, and investment = 10, the system is supposed to be in equilibrium, because the aggregate expectations of business firms and the public are fulfilled. In the aggregate, both groups are just satisfied with the situation, so that there is allegedly no tendency for the income level to change. But aggregates are meaningful only in the world of arithmetic, not in the real world.

Business firms may receive in the aggregate just what they had expected; but this does not mean that any single firm is necessarily in an equilibrium position. Individual firms do not make earnings in the aggregate. Some may be making windfall profits, while others, technologically and managerially lagging firms, may be making losses. Regardless that, in the aggregate, these profits and losses may cancel each other (which in real-world of ever growing productivity is highly improbable to start with), each firm will have to make its own adjustments to its own particular experience.

These adjustments (improvements in production processes, new technology, new products that would agree with changing tastes of the consumers) vary widely from firm to firm and industry to industry. In fact, these changes will have eventually impact on the whole industry, as the technologically lagging firms will chase the forerunners.

In this situation, the level of investment cannot remain at 10, and the consumption function will not remain fixed, so that the level of income must change. Nothing in the Keynesian system, however, can tell us how far or in what direction any of these variables will move.

Similarly, in the Keynesian theory of the adjustment process toward the level of equilibrium, if aggregate investment is greater than aggregate saving, the economy is supposed to expand toward the level of income where aggregate saving equals aggregate investment. In the very process of expansion and technological innovation, however, the consumption (and savings) function cannot remain constant. Windfall profits will be distributed unevenly (and in an unknown fashion) among the numerous business firms, thus leading to varying types of adjustments. These adjustments may lead to an unknown increase in the volume of investment. Also, under the impetus of expansion, new firms will enter the economic system, thus changing the level of investment.

In addition, as income expands, the distribution of income among individuals in the economic system necessarily changes. It is an important fact, usually overlooked, that the Keynesian assumption of a rigid consumption function assumes a given distribution of income. Therefore, the change in the distribution of income will cause change of unknown direction and magnitude in the consumption function. Furthermore, the undoubted emergence of capital gains will change the consumption function.

As saving is not independent of investment, most of it, particularly business saving, is made in anticipation of future investment. Therefore, a change in the prospects for profitable investment will have a great influence on the savings function, and hence on the consumption function.

Thus, since the basic Keynesian determinants of income – (1) the consumption function and (2) the level of investment – cannot remain constant, they cannot determine any equilibrium level of income, even approximately. This failure of the Keynesian model is a direct result of misleading aggregative concepts:

• Consumption is not just a function of income; it depends, in a complex fashion, on the level of past income, expected future income, the phase of the business cycle, the length of the time period under discussion, on prices of commodities, on capital gains or losses, and on the consumers' cash balances and, most of all, on changes of consumers' preferences, tastes and utility expectations.
• Similarly, investment is influenced by the level of income by the expected course of future income, by anticipated consumption, and by the flow of savings. For example, a fall in savings will mean a cut in the funds available for investment, thus restricting investment.

However, the most problematic part of the Keynesian model is the assumed unique relation between income and employment. This relation assumes that techniques, technologies, the quantity and quality of equipment, and the efficiency and wage rate of labor are fixed. This assumption leaves out factors of basic importance in economic life and can be true only over an extremely short period. Keynesians, however, attempt to use this relation over long periods as a basis for predicting the volume of employment. One direct result was the Keynesian fiasco of predicting 8 million unemployed after the end of the war.