The Principle of Effective Demand and the Keynesian Revolution in Equilibrium Economics

Abstract

During the 1950s economists began to try and gird the economics of Keynes with neo-classical micro-foundations, and in particular they focused on the implications of disequilibrium in one market for supply and demand in other markets.1 This project ultimately developed into what became termed the “disequilibrium approach” to macroeconomics, the fullest expression of which is found in Barro and Grossman (1976) and Malinvaud (1977). The ultimate conclusions derived from this approach were that (i) Keynesian economics was a form of disequilibrium economics, and (ii) Keynes had failed in his claim to have provided a theoretically cogent explanation of equilibrium involuntary unemployment except for the special case where nominal wages were downwardly rigid. For mainstream neo-Keynesians these conclusions led to a re-casting of Keynesian economics in terms of price rigidities, and in terms of the speed with which prices adjusted so as to yield full-employment equilibrium (Tobin, 1975). In effect, this re-casting amounted to a tacit rediscovery of a position that had been identified by Modigliani (1944) and Patinkin (1948) almost thirty years earlier. However, in the 1970s this disequilibrium—rigid prices interpretation of The General Theory was itself subjected to challenge.