Keynes Did Not Use Pigou as a Strawman in the General Theory: Pigou Was Trapped by His Marshallian, Partial Equilibrium Approach in His 1933 the Theory of Unemployment

Abstract

The economics profession’s failure to recognize that Keynes’s IS-LP(LM) model of chapters 15 and 21 of the General Theory, incorporating Uncertainty and Expectations, is the main message of the General Theory, has led to the failure to recognize that Keynes’s critique of Pigou’s partial equilibrium, the Marshallian model of the macroeconomy, as presented in Chapter Two and the Appendix to chapter 19, is not only entirely correct but understated. Keynes recognized Pigou’s treatment as the best that had been produced up to that time by any of the neoclassical economists. However, Pigou could not model any of the interdependencies of the macroeconomy because he had basically been operating with functions with only one, independent variable-the real wage. Pigou had no Liquidity Preference Function (LM function). He had no clearly defined consumption function with an MPC that would allow him to apply the investment multiplier. Pigou’s theory of the rate of interest was that the rate of interest was determined by the neoclassical Demand for investment and supply of savings, exactly what Keynes had shown was impossible on pp.179-182 of the GT and which Keynes described as a “nonsense” theory. At best, Pigou was operating with a poorly specified IS equation alone. Keynes’s Appendix to chapter 19 is actually very straightforward because it demonstrates repeatedly that Pigou’s macro version of his micro model is simply incorrectly specified and allows no accurate calculation of either aggregate output or aggregate income to be made. Keynes does acknowledge Pigou’s microeconomic structure, which he calls ‘concoctions’, as being valuable. Keynes, in fact, improved Pigou’s mathematical modelling in a manner that allowed him to specify and incorporate expectations and uncertainty into his D-Z model that lead to the specification of a set of multiple equilibria, which Keynes called the Aggregate Supply Curve. This model supports the IS-LP(LM) model.