230 Economic Theory: An Introductioning are 1) the profit margin which business men expect from their
investment (marginal efficiency of capital), and 2) the rate of
interest, the amount of money businessmen will have to pay for
the privilege of borrowing the original capital. Thus, only if
marginal efficiency of capital exceeds the rate of interest will the
investment be undertaken. Since the marginal efficiency of
capital is not easily manipulated, Keynes focuses his attention on
the more flexible factor, the interest rate.
According to classical economics, the interest rate determines
the general supply of savings in the economy. Those who save
feel that the interest rate is a sufficient reward for the postpone
ment of consumption. Thus the rate of interest would adjust itself
until it reached the point where the amounts of money saved and
the amounts of money borrowed would be the same. Therefore,
the rate of interest acts as a balancing force between consump
tion and investment.
Keynes, however, maintains that the interest rate is not related
to savings or investment, but rather is the result of speculation.
If speculators feel that stock prices are going to go up, causing
interest rates to drop, they will invest large sums. The net effect
of speculation tends to result in self-fulfilling prophecies; thus,
interest rates are tied more to fluctuations in the stock market
than to savings.
This observation was used by Keynes to explain how, during
the Great Depression in America, when investment dwindled,
there was not a significant lowering of interest rates due to the
great supply of savings. Once the depression began, Keynes
claims, people needed their savings and consumed them quickly.
With no great supply of savings, interest rates never dropped,
and the equilibrium between consumption and investment was
not restored. Keynes saw that the economy was in balance but
not at the previous high investment level. How then can a
depressed economy be stimulated?
Keynes saw government involvement as the answer to the
problem. The government alone was capable of both increasing
the marginal efficiency of capital and lowering the interest rate.
By providing men with work, even essentially non productive
work, the government could put money into the hands of
consumers, thus stimulating spending. This is called “pump
priming.” With aggregate demand increased by pump priming,