professor leontief on lord keynes 1

7/30/2019 Professor Leontief on Lord Keynes 1

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Professor Leontief on Lord KeynesAuthor(s): Ira O. Scott, Jr.Reviewed work(s):Source: The Quarterly Journal of Economics, Vol. 63, No. 4 (Nov., 1949), pp. 554-567Published by: Oxford University Press

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PROFESSOR LEONTIEF ON LORD KEYNES1IIn Chapter XIX of The New Economics,2 rofessorLeontiefexamines what he considers to be the fundamentalpostulates ofKeynes' GeneralTheory. As a modernclassicist,he is concernedwith evaluatingthe Keynesian assumptionsand theireffect ponclassicaldoctrine. He imputesto Keynes twopostulateswhich,healleges,Keynes substitutes orthe singleunderlyingssumptionof

thetraditional heory. The Keynesianpostulates oncern hesupplyof abor and thedemandformoney, espectively.3 rofessor eontiefasserts that the Keynesian theory s not more but less "general"than the classical theory,because the two postulates in questionreplace in his view-- the single classical assumptionregardingeconomicchoice,which,ofcourse, ftruewould be contrary o theprinciple fparsimony.Accordingto ProfessorLeontief,Keynes assumes, (1) thatmoneywages are rigiddownward, nd (2) that the rate of interestis insensitive o an increase n the quantityofmoneyand is also,therefore,igiddownward. I wish to question the assertionthatKeynesassumes, s a basic postulate, downward igiditynmoneywages; though, n theotherhand, wish to assertthatthephenom-enon actuallyoccurs. I shall agree that Keynes does assume,as ab-sic postullabte,downwardrigidityn the rate of interest;but, Ialtstoproposeto questionProfessor eontief's nterpretationf iquid-itypreferencend to restore he Keynesian theoryof the demandfor-moneyo its proper tation n economictheory. In fine, mustadd thateven ifthe GeneralTheoryhould be shownto restupon agreater umber f ssumptions hantheclassical ystem, heprincipleofparlsimonys a monitory ather hana prohibitoryommandmentt4

1. I wishto acknowledge theassistance gained from nnumerableconversa-tions with ProfessorRichard S. flowey, University of Kansas, and to thankDoctor Jamnes obin, Harvard University,who read the manuscriptand mademany helpfulsuggestions. Responsibility forthe views expressed in the paperis, of course,my own.2. A collectionofKeynesian literature, dited by Seymour E. Harris (NewYork: AlfredA. Kiopf, 1947).3. "The natureofthesupply of abor and that ofthe demand formnloneyrethe twoprinciplepointsofdivergencebetweenthe basic postulates of the GeneralTheory nd the teachingsof the classical doctrine." Op. cit., p).233.4. Though it is not,thepurpose of this note toodiscuss the relative "gener-ality" of the two systems, the followingobservations appear to be pertinent.Manifestly, here sno definition f 'generalitby"eneall accepte(l1y economists.554

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PROFESSOR LEONTIEF ON LORD KEYNES 555AlthoughProfessor eontiefdeals firstwiththe supplyoflaborand thenwith the demandformoney,his argumentwould proceed

more ogicallyn theoppositedirection. That is to say,he wouldbemoremethodicalwerehefirst o imply hefallaciousnessf the theoryof iquiditypreference,hento insert hepostulateof rigidwages inorder to enable the Keynesian model to be at underemploymentequilibrium,nd finally o occupyhimselfwith destructivenalysisof the atter ssumption s it appears nhisspecialcontext.However,I shallfollow he order mployedby Professor eontief.IITo let ProfessorLeontief introducehis case, I may quote:"Traditional analysis considers the aggregate quantity of laborsupplied, n the case wherethis supply s a competitive ne,to be afunction ftherealwage rate; Keynes on the contraryssumesthatup to a certainpoint defined y himas thepoint offull employ-ment one particular evel of moneywages exists at which thesupplyof labor is perfectlylasticand belowwhichno labor can behired t all. The deliberate xclusion fthe costof iving s a deter-minantoflabor supplymakes the latter ndependent f the level ofrealwages."5Thefirst eynesian ostulate hen, ccordingoProfessoreontief,is that wages are rigid downward.6But Keynes at no point in his

ProfessorLeontief measures "generality" in terms of fundamental postulates,Keynes in terms ofemploymentequilibria.Professor Leontief does perform great service in distinguishingbetweenpostulates and deducible conclusions when he reprimands those of Keynes'disciples who maintain that the classicists assume unemploymentto be non-existent.5. Op. cit., p. 233. The downward rigidity n money wages is, it is true,indispensable to Keynes' definitionof involuntary unemployment. I am notconcerned n this paper, however,with the role that wage rigidityplays in thiscontext. Rather, I am interested n examining the contentionof neoclassiciststo the effect hat the Keynesian system requiressuch a rigidity n order to be atunderemployment quilibrium. Dr. Lawrence R. Klein, in his admirable tracton the nature of The Keynesian Revolution New York: Macmillan, 1947), hasclearly relieved the Keynesian model of any theoretical dependence upon thedefinition f involuntaryunemploymentwhich appears in Thc General Theory.Cf. The Keynesian Revolution, p. 80-90.6. Cf. also The New Econonoics,Chapter XIV, "The General Theory,"by G. Tiaberler. Professor Baberler apparently agrees with Professor Leontief.Quotingfrom . 167 in the Haberler chapter:"Keynes assumes that (money)wagesare rigiddownward. If this assumption,which s certainlynot entirely nrealistic,is rigidlyadhered to, most of his conclusionsfollow: Under-employment quilib-rium is radically changed. Obviously, under-employmentequilibrium withflexiblewages is impossible wages and prices must then fall continuously,which can hardlyoccur withoutfurther onsequences and cannot wellbe describedas an equilibrium position."



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556 QUARTERLY JOURNAL OF ECONOMICSwritings xplicitly tates such an assumeption.7 ProfessorLeontiefdoes not say thatKeynes makes an explicit tatement o that effect;he imputes the postulate to Keynes in what he considersto be alogical clarificationf Keynes' thesis. I believe the supposed ogicalnecessity or hepostulate,which eemsobvious to Professor eontief,to be invalid; and I shall attemptto show that it is a result, nProfessor Leontief'smind, of his misinterpretationf the othermatter f iquidity reference;hat, n short,fthismisinterpretationis corrected, ny logical necessity ora postulate of wage rigiditydisappears.Parenthetically,wishto accountfor he spacewhich he subjectofwage rigidity ccupies in The Geineral heory. Keynes devotedManifestly, Professor Haberler is tying the Keynesian argument to thepostulate of rigid wages. He continues in a similar vein on p. 169: " . . . it ispointed out (in Chapter 19 of the General Theory) that a reduction in moneywages will usually influence mployment,but in an indirectfashion, through tsrepercussionsupon the propensity o consume, efficiencyf capital, or the rate ofinterest. The last mentioned route, via the interestrate, is the one most thor-oughly exploredby Keynes and the Keynesians. As wages and prices are allowedto fall, money is released from the transactions sphere, interest rates fall, andfull employment s eventually restored by a stimulation of investment. Thisamounts to giving up the idea of under-employment quilibrium under a regimeof flexibleprices and wages except in two limitingcases: Full employment nsybe preventedfrombeing reached via this route, (a) ifthe liquidity trap preventsa fall in the rate of interest . . or (b) if investment s quite insensitiveto a fallin the interest ate. Keynes himself egardedboth thesesituations not as actuallyexisting but as future possibilities. But what ifwe do regard them as actuallyexisting which as a short-runproposition,allowing for dynamic disturbancesthroughunfavorableexpectations, etc., would be byno means absurd? We wouldstill not have established a stable under-employment quilibrium, for wages andprices would still continue to fall."

There seems to be some difficulty ere with the meaning of equilibrium.I should presume that by an equilibrium at less than full employment,Keynessimply meant the condition where there are no forces nherent n the economicsystem which tend to raise the level of employmentto that of full employment.This is precisely the condition which exists when the liquidity trap halts thedecline of the rate of interest,or when the schedule of the marginal efficiency fcapital has an interestelasticity of zero. That is to say, in either of these cases,there would be nothing further o gain from a reduction in money wages. Itwould follow, perforce,that the unemployed would not, theoretically at least,continue to offer hemselves at lower money wage rates. If the unemployedblindlydid so, the factthat prices and wages would continue to fall, approachingzero as a limit, s irrelevant. For there s nothing n Keynes' definition f under-employment equilibrium that precludes such a downward spiral of prices. Thepoint is that in these two situations, the economistwould no longer be justifiedin advising the labor unions to accept lower money wages. It follows that inthese limitingcases cited by Professor Haberler we have conditions of under-employment equilibria without he assumption of rigidwages. It is the rigidityin the rate of nterest rthe perfectlynelasticscheduleof the marginal nefficiencyof capital which brings about the condition of equilibrium.7. Cf. op. cit. Chapter XI, "The General Theory," by Abba P. Lerner,reprintedfromthe InternationalLabour Review,October 1936.



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PROFESSOR LEONTIEF ON LORD KEYNES 557manypages to the subject,but he probablydid so because he wrotewithoneeye cocked n thedirection f the counselsof state. In otherwords,Keynesfelt t wouldbe politicallynexpedient o ask the aborunionsto accept lowermoneywages. In the first lace, he realizedthat it would be foolhardy o expecta single abor union to acceptlowermoneywages; for t would thereby uffer loss in real wagesto thebenefitfthe restofthe economy. In thesecondplace,Keyneswas, ifanything, ot a socialist; and he undoubtedly bhorredthethought fa wage deflationt thebehestofan authoritarianovern-ment. It was as a resultof his personalpredilections,herefore,ndofpoliticalrealities n the Great Britain of 1935, that Keynes con-centratedhisattention n alternative venuesto fullemployment.However,Keynesnot only rejectedtheclassicalprescriptionorfullemploymentn practicalgrounds, ut fortheoretical easonsaswell. He knewthat f abor unionsvoluntarilyccepted owermoneywages, full employmentwould not necessarilyfollow.8 Keynesreasoned s follows:Givena condition f ess thanfullemployment,ifunemployedworkers fferhemselves t a wage essthan thegoingrate, wages and marginalcosts would necessarilyfall. But sinceincomeswouldfall,parnpass, with the decline n themarginal ostof labor, therewould be a commensurate ecrease in demand,andentrepreneurs ould have no reason to increasetotal employmentoverthe givenunderemploymentevel.9Keynes was aware, of course,of the fact that a reduction nmoneywages mighthave the ndirect ffectf ncreasing mploymentvia the rate of interest. To follow the argumentemployedbyKeynesians nd modern lassicists like,1 s incomesfall, essmoneyis neededfortransactions, oards ncrease, he rate ofinterest alls,and investment nd employment ise. However, I have alreadynotedthe impracticabilityf such a policy. Furthermore,t takes

8. On this account Keynes consideredthe workers n their intuitive appre-hension, to be superioras economiststo the theoristswho embrace the classicaldoctrine. Cf. The GeneralTheory,p. 14.9. Similar reasoning,of course, applies to the correlativebut equally falla-cious argument ometimesmade by abor leaders: an appeal forhigherwages on thegroundthat an increase in wages would increase effectivedemand and eraploy-ment.To deal sensiblywith the relationshipbetween a change in the wage rateand the level of employment,a general equilibrium model is required. Thedichotomyofpriceand distribution heory ccordingto the traditional approach,with the oversimplificationmplicit n economic analysis which artificially epar-ates the producers' and consumers' market, necessarily yields a meaninglesssolution.1. Cf.note 6 above; also LapsesfromFull Employment,London: Macmillan,1945) for the Pigovian version.



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558 QUARTERLY JOURNAL OF ECONOMICSno great magination o visualize thedamageprobably ustainedbythe schedule fthemarginal fficiencyfcapitalwere uch a programto be embarkedupon. And furthermore,o clinchthe Keynesianargument rom theoretical tandpoint, he road to full mploymentmay be blockedby thenatureof the demand formoney.I must postpone until later a considerationof the Letontiefversion f thedemandformoney. It is sufficiento say at thispointthatthepostulateofwage rigiditys a gratuitous ne. Keyneswasmotivated by considerations ther than theoretical n calling ourattention o wage rigidities.Moreover, s has beensuggested, shallshow that thispostulate s notonlynotexplicitbut, n addition, hatit is not implicitn theKeynesian system.Surnri-igly enough, after attributing he assumptionof rigidwages to Keynes,Professor eontiefproceedsto denyits empiricalvalidity.2 -lt ironically, xcepting, fcourse,the case ofthe total-itarian tate, the existence fwage rigiditymaybe asserted.If moneywages are rigiddownward and a cursory urveyoflabor management elationswill show that theyare - the worker'sbehavior may not be completelyconsistentwith the assumptionregarding conomic hoicewhichunderlies lassicaleconomic heory.In thisrespect, believeKeynes' insightntotheworker's sychologywas superior o the hedonistic alculuswhich s fundamentaln thetraditional octrine. Even thoughwe treatall workers s economicmen or more correctly, s human beings endowedwith as muchirrationality s the rest of us, I cannot accept a supply of labortheory ast in the classical mold as empirically ound. In the firstplace, a bargainingworker lways hopes that hiscutofthe "economicpie" willbe larger fhe obtainsa highermoneywage.' In thesecondplace, even though heworker e forewarned hat his realizationofhighermoneywageswill eave himno betteroff, e (and certainlyshould share his irrationalityn a comparablesituation)would beirrational nough to choose the higher bsolute level of wages andprices. This would be the case, I believe, fforno otherreason thanthat the workerwouldfeelbetteroffwith the inflatedpay check.These factsofworker sychology, hichwillnotbe deniedby many,are overlooked y Professor eontief.In the following aragraphshe describes nd criticizes Key-

2. Professor l-'aberlerevidently would not agree with Professor Leontiefon thispoint. Cf. note 6, above.3. Moreover, a highermoney wage received by a single labor union willmean higher real wages for that segment of labor. To this extent, the moneyillusion is riot a r.naiifestation f irrationality,but ratherof rationality on thepart of the workler.



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PROFESSOR LEONTIEF ON LORD KEYNES 559nesian utility unction. "In contrast o theclassical,this Keynesianutility unction ould nclude, mong the ultimate onstituents f anindividual'spreferencearieties,not only the physical quantities of(future nd present)commodities nd servicesbut also the moneypricesofat least some of them. In particular hemoneywage ratewould be considered s entering irectly heworker's tility unction:confronted itha choicebetweentwo or moresituations n both ofwhich his real income and his real effortre thesanu, lut inone ofwhich both the moneywage rates (and, consequently,lso the pricesof consumers' oods) are higher han in theother,he would show adefinite referenceor he former. A classicalhomo conomicuswouldfindneither f the two alternatives o be moreattractive han theother."From such a monetaryutility function, monetary upplycurve of labor can be easily derived. In contrast to its classicalcounterpart,t willshowthelabor supplyas dependentnot onlyonthe relativebut also on the absolute pricesand wage rates ..."Althoughneat and internally onsistent, ue 'psychological'interpretationsfthemonetary lementoftheKeynesian theory fwages are hardly appropriate. They contradict he common senseofeconomicbehavior. The referenceo thefact thatno workerhaseverbeen seenbargaining or ealwages even f rue isobviouslybesidethepoint, incewhilebargainingnterms fdollars heworker,as any one else, can stillbe guidedin his behaviorby the real pur-chasing powerof his income. Moreover,the 'psychological' nter-pretation fthemonetary lement n consumers'behaviordeprivesKeynes' unemployment oncept of its principalattribute. Whyshould any givenrate of employment r unemployment e called'involuntary' f it is determined hroughconsciouspreference orhighermoneywagesas against argerreal income?"4

4. TheNewEconomics,pp. 235-6. In thispassage, ProfessorLeontief reiter-ates a stand on The GeneralTheory aken earlier nhisarticle,"The FundamentalAssumptionof Mr. Keynes' Monetary Theory ofUnemployment,"thisJournal,November 1936, pp. 192-197. At that time, ProfessorLeontief imputed onlyone basic postulate to the Keynesian system: that pertainingto the supply oflabor. It was ProfessorLeontief's contentionthat the fundamental differencebetween Keynes and the classicists lay in the former'srefusal to accept thelatter's homogeneityostulate s applicable to the supply of labor.If we let z representthe supply of labor, y the wage rate,and x1,x2, . . Xnthe prices ofwage goods, the classical supply functionmay then be expressedas

z = f(y, X1,X2, . * *Xn)f(ty, tXtX2, . . . txn) = tbf(y, X1,X2, . Xn)whereb = 0That is, the classical supply function s homogeneousofthe zero degree.



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560 QUARTERLY JOURNAL OF ECONOMICSThe underlyingmplicationntheseparagraphs o the effect hatlaborerscalculate according o strict conomic choice is simplynot

warranted y the factsof economicexperience. It is precisely hiskind of nflexiblehinking n the partof classical economic heoriststhat renders conomictheory o vulnerableto attack by specialistsThe referencemade by ProfessorLeontief to the homogeneityostulate ssimply an econometrician'sway of saying that the money llusionof The GeneralTheory amounted to a serious departure from the fundamental assumptionregardingeconomic choice of classical economic theory. In a later rejoinder,"The GeneralTheory ofEmployment," thisJournal,February 1937,pp. 209-223,Keynes agreed that this difference etween the two systemsdoes exist. (For anevaluation of the relative importance of this difference, ee The Keynesian

Revolution, . 83.)Assuming that the validity of the money illusion, or rigidityin moneywages, is accepted, this same money illusion, Professor Leontief argues, mustlogically be applied to all supply and demand functions n the Keynesian system.The same view is expressedby Dr. JamesTobin in his article on "Money WageRates and Employment," The New Economics,pp. 572-587 - a definitive reat-mentof the nasty problemof tracingthe effect f changes in moneywage rateson the level of employment. To quote Dr. Tobin: "Without the retentionofthe homogeneitypostulate' for ll supply and demand functions xcept the laborsupplyfunction, he Keynesian moneywage doctrine cannot be maintained ....When the existence of variable factorsother than labor is admitted, Keynesiantheory requires that these factors be fully employed and that their prices beperfectly lexible. This is where the 'homogeneity postulate' - the assumptionof 'rational' behavior - enters with respect to the supply functionsof thesefactors. If the sellers of these factors were, like the sellers of labor, influencedby the 'money illusion', their prices would be rigid lilie wages and there couldbe unemployment f these factors. A change in the money wage rate could thenalter theemploymentof labor by causing a substitution betweenlabor and otherfactors.""Keynes, since he assumes away the existenceof other factors,presentsnoreason for this distinctionbetween labor and other factors. Lerner, however,asserts that it is 'plausible and in conformitywith the assumption of rationalityofentrepreneursnd capital owners,who would rather get somethingforthe useof theirpropertythan let it be idle, while labor has non-rationalmoney-wagedemands.' " (op. cit., p. 582). Dr. Tobin, however, takes issue with ProfessorLerner and argues that it is just as reasonable to expect the sellers ofthese otherfactorsto have nonrationalmoney price demands as wage earners.Similarly,withtheconsumptionfunction, r. Tobin argues: "The Keynesianconsumptionfunction,which is crucial to the Keynesian solution to the moneywage problem, s framed n real terms ... This is the application of the 'homo-geneity postulate' to the consumptionfunction. If 'money illusion' occurredinconsumptionand saving decisions, real consumptionexpenditurewould dependon the level ofmoney ncome as well as on the level of real income .... A changein the money wage rate, changingthe level ofmoney incomes and prices,wouldalter the real demand forconsumptiongoods and therefore, ffect he volume ofboth output and employment. Here again, therefore, etentionof the 'homo-geneitypostulate' is an essential assumptionforKeynesian moneywage doctrine."But if wage-earnersare victims of a 'money illusion' when they act assellersof abor, whyshould theybe expectedto become 'rational' when they comeinto the marketas consumers?" (op. cit. p. 583.)Although t is my purpose in thispaper to show that theKeynesian systemis not dependent, fundamentally,upon the wage rigidity, t is interesting nd



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PROFESSOR LEONTIEF ON LORD KEYNES 561inother ocial sciences. If the economic heorist spiresto a positionof nfluencenpublic policyhe mustsufficientlyomplicatehis theoryso as to give proper ecognition o the rrational lements f society'seconomicbehavior. This is not the place to dwell at greater engthon the shortcomings f classical economic theory with respect touseful to deal with the problemposed by the countless rigiditieswhich,ofcourse,exist in the real world. As for the Tobin application of the money illusion tosupplyfunctions therthan labor, t seems obvious that the homogeneity ostulatecorrectly escribes the supply of the fixedplant and equipment. Once the entre-preneur s saddled with fixed ostshewill operate as long as he can defrayvariablecosts. Rigidities n the prices of variable factorsotherthan labor are irrelevalt,since iflabor is to be substituted, t will be substituted forplant anrd quipment,not for raw materials or goods in process.But suppose we admit, what I do not believe to be true,that the suppliersof capital equipment are beset by the money illusion, and if you please, in theshort run! Even in this situation, can anyone soberly maintain that, say, tenmillions of unemployed aborerscould be brought nto employmentby acceptinglower money wages? Anyone making such a plea would have to show that theelasticityof the demand for labor is sufficiently reater than unity to make upforthe decrease in expenditureson capital equipment in order to maintain thelevel of effective emand. To my knowledge, the discovery of this fact remainsfor the economistof the future. Surely, the burden of proof ies on the shouldersof himwho makes the plea.In any event, in a worldof mperfectmarkets and rigidities n price policies,the entrepreneur s more sensitiveto changes in effective emand than to changesin marginal costs. Even if wages fall, the entrepreneur s not likely to increaseemployment n the short run unless effective emand increases.Of course, n a sense, all unemployment s voluntary. That is, fullemploy-ment could always be achieved by reducing money wages sufficientlyo cause areversion to a handicraft society. But such a solution to the problem of massunemployment mplies the untenable assumption of a change in tastes involvinga transference f demand from the highly fabricated goods of the roundaboutprocess of production to goods which can be produced by a handicraftsociety.Needless to say, the solution of the problem of unemploymentby means of a"Molly McGuire" movement on a mass scale would be intolerable.As for the Tobin consumptionfunction, t seems to me that more is beingmade out of the money illusion than should be. All that the money illusionmeans when applied to the suppliersof labor is that they associate a higherrealwage with a higher moneywage. In reality,this does not amount to irrationalbehavior, but rather rational behavior; because an individual workeror laborunion that obtains an increase in money wages will find ts real wages have risenabove what they would have been had the increase in money wages not beenachieved, at least momentarily.

It is of interest to note, as Dr. Tobin has done, that, abstracting fromexpectations, consumers' real wealth might be increased, possibly leading toincreased consumption expenditures,by a general deflationofwages and prices.(Cf. op. cit.p. 584. Also, James Tobin, "The Fallacies of Lord Keynes' GeneralTheory: Comment," this Journal, November 1948, pp. 763-770, esp. p. 769.)Thlis is the 'Pigou effect,' nvestigated by ProfessorDon Patinkin in his recentarticle, "Price Flexibilityand Full Employment." (AmericanEconomic Review,September 1948, pp. 543-564.) In otherwords, abstractingfrom xpectations,areduction n prices may have a stimulatory ffect ia the propensityto consumeas a consequenceof an appreciation n the value of assets held in the form f cash."



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562 QUARTERLY JOURNAL OF ECONOMICSmodernpsychology. It is enoughto underscore he superiornsightevincedby Keynes and revealedso clearly n a comparison f theKeynesiantheory fthesupplyof aborwiththat of the classicists.It mustbe admitted hatmanagement nd laboralikearehardlyunconcernedbout realwages,though heydeal interms fmonetaryunits. This is not to say, on theotherhand,that theworker as notusuallyfoundhis real incomerising, t least temporarily, ith anincrease n moneywages. Consequently,he is primarily oncernedwithmoney, ather hanreal,wages. As for heperhapsunnecessarilyobscureKeynesiandefinitionfunemployment,heKeynesianworkerobviously ssociates higher eal ncomewith highermoney ncorae,whetherhis expectations re fulfilled r not. It is elementary hatthe breadwinnersmoreconscious fthemonetary alue ofhistake-homepay than of tsrealvalue,subject, s the atter s, to theerraticmovements fthepricesofthousandsofcommodities.5Professor eontief s doubtlesscorrectn criticizing eynes' useof theword,"involuntary,"when he asks: "Why shouldany givenrate ofemployment runemployment e called involuntary,'f t isdeterminedhrough onsciouspreferenceorhighermoneywages asagainst largerreal income?"6 However, I should parrywith thequestion: "Has Professor eontief, ranyoneelse,ever seen a workerconfrontedy sucha choice?" But on withthe Leontief ase.In orderto make The GeneralTheorymorepalatable, ProfessorLeontiefpositsa minimumwage law in deference o theKeynesianwage rigidity.7 Withtheminimumwage law, Professor eontief son familiarground. All that is necessarynow, says our modernclassicist, s to inflate ll pricesexceptwages. However,ProfessorLeontiefmust dispose of one more obstacle, liquiditypreference,which, funexorcized,wouldrendernugatory he classicist's rescrip-tionof nflation. The discussionmustturn, herefore,o the secondbasic postulate,whichpertains o thedemandformoney, nd whichI mustinvestigate o some extentbefore ompletingmy evaluationofProfessor eontief's reatment fthe Keynesian supplyof labor.

IIIProfessorLeontief s, I believe, correct n assigning iquiditypreferencen important olein theKeynesiansystem. I feel,how-5. It is true that labor unions are presently paying closer attention tochanges in price indices than formerly.Whetheror not this fact will eliminatethe downwardstickiness n wages remains to be seen.6. Cf. footnote4, p. 559f.7. This he does while at the same time scoring Keynes' reluctance toclothe his wage rigidityin institutional raiment (op. cit. p. 239). A case inpoint s Keynes' engthy igressionnlaborunion trategy oted bove.



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PROFESSOR LEONTIEF ON LORD KEYNES 563ever,that certain spectsofthe Leontiefnterpretation erit urtherreflection. n Professor eontief's yes, iquidity referencesnothingmore than the velocityof the circulation f money n new, if lessfashionable, ress. Before tatingmymost seriousobjections o theLeontiefnterpretationfKeynes, wishto examinehis confusion fthevelocity fthe circulation fmoneywiththedemandformoney.8In Keynes, all money s divided betweenthat used to satisfy hetransactionsmotiveononehand and thespeculative nd precaution-ary motiveson the otherhand,Ml and M2 respectively. We have:

M =M1 + M2Ml T (Y)M2 L (r)The demand formoneyfor ransactions s thena function f ncome;whereas, hedemand formoneyas an asset is a function fthe rateofinterest.9The V ofthe quantityequation, to the contrary, oesnotprovideus with uchuseful ools ofanalysis,for t is thevelocityof circulation fall money n the system. t is in this confusion fV withM2 that we shall findthe key to the error n the Leontief

interpretation.Accordingto ProfessorLeontief, "The theory of liquiditypreferencerovides heKeynesiansystemwitha deflationarymech-anism whichdefeats,throughthe process of automatic hoarding,everytendency oward nflationaryeduction f involuntary nem-ployment."' In this tatement rofessor eontief etrayshisclassicalbias and preoccupationwith inflation s a prescription or fullemployment.It willserve mypurposeto consider he Leontief nterpretationintwoparts,depending n theposition f he rateof nterest elativelyto the liquiditypreferencechedule. Let us first ssumetherateofinterest o be above the level where t becomes insensitive o thequantityofM2, i.e., above the pointwhere he nterest lasticity fthe liquiditypreferencecheduleapproaches nfinity.n this range,it is certainly orrect, o quote Professor eontief gain, that "Thetheory f iquidity reference rovides he Keynesiansystemwitha

deflationarymechanismwhich defeats every tendencytowardinflationary eduction of involuntaryunemployment."' True, in8. Cf. TheNew Economics,ChapterXLI,"Keynes and Traditional Theory,"by R. F. Harrod, p. 603.9. For a statistical investigation of the shape of the "L" function seeJames Tobin, "Liquidity Preference nd Monetary Policy," Reviewof EconomicStatistics,May 1947, pp. 130-1.1. The New Economics, p. 238.2. Cf. preceding footnote. Italics mine.



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564 QUARTERLY JOURNAL OF ECONOMICSKeynes we do not reachfull employment hrough nflation.3How-ever, this is not to say that Keynes deniesthat the prescriptionfincreasing he quantityof money achieves full employment. t isonly with regard to the mechanismby which an increase in thequantityofmoney ffectshe price evelthat Keynes parts companywith the classicists. And here the divergencebetween the twosystems s clear!Let us grantforpurposesofthe argument he wage rigidity fthe Leontief nterpretation. he classicistrecommends n increasein the quantityofmoney. Then, according o the classicists,peoplewillfind n theirpossession quantityof cash greater han their ac-customed holdings. In trying o ridthemselves f the excess, theywillforceup the price evel,Professor eontief's upply and demandcurvesfor abor are raised,and involuntary nemployments wipedout.4It is at this point that my earlier reference o the Keynesiantreatment f moneybecomes significant. Starting again with theassumption funemploymentnd rigidwages,the Keynesian agreestoan increasenthequantity fmoney. But, contraryotheclassicalbelief, hisexpandedmoney upplywillnotresult n inflation.Let ussupposethecentral ankexpands hequantity fmoney ncirculationby purchasingecurities ntheopenmarket.Former ecurityholdersfind heir ash holdings ncreased bove their ccustomed evel. Dotheythenmake haste to the consumers'marketto exchangetheirexcessholdings fcash forgoods? Of coursenot!' They tryto get

3. By inflation, mean a rise n themoney pricesof commodities. Hence, anincrease in the quantity ofmoney would not entail inflationunless accompaniedby an increased demand forcommodities,or unless there s full employment ndthe interest rate falls, thereby causing an increase in the rate of investment.Abstractingfromfrictions, uch increased investmentcould take place withoutcausing inflation f therewere unemployedresources n the economy.4. Op. cit.,p. 236.5. Cf. op. cit.,ChapterXIV, p. 170. ProfessorHaberler apparentlyshares,tosomeextentat least, ProfessorLeontief'sviews on thissubject. QuotingProfessorHaberler: . . . "we must assume, it seems to me, that consumption s not only afunctionof income but also of wealth (and liquid wealth in particular)." (Italicsmine.)Strictly,consumption (that is, the absolute magnitude of expendituresonconsumergoods) is some functionofincome. We have:C = F (Y)The shape of the consumptionfunction s in turndeterminedby a host of othervariables, whichwe would normallytake as parameters,such as wealth, the taxstructure, he social security ystem, xpectationsregarding he future vailabilityof consumergoods, the stock of consumerdurables on hand, price expectations,governmentpolicy (e.g. "E' Bond campaigns), advertising,the status of thriftas a social virtue, he extentofnational self-sufficiency,he ratio of dividends tocorporationprofits, he relation betweenurban and rural population, the extent



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PROFESSOR LEONTIEF ON LORD KEYNES 565rid of theirexcess money assets by biddingagainst each other andthecentral ankfor ecurities, hereby riving hepricesofsecuritiesup and the interest ate down to a level wheretheyare content oholdthe incremento themoney upply. Investmentncreases, ndequilibriumt fullemployments obtained without nflation.The point is that in the classical systemthe holders of theincrement o the money supply treat this increment s income.The fallacy n this presumption s clearlyrevealed n the Keynesiananalysis. This increment fmoney s treated s an asset, not in thegeneral ccounting ense, but as an asset in the Keynesiansense ofmoneyheld to satisfy hespeculativeorprecautionarymotives. TheV ofthequantity heory quation, then,does not provideus withamicroscope fsufficientowerto detectthefundamentalworkings fthe economy. The superiority fthe Keynesian instrumenthouldbe obvious.I shall turnbriefly o the situationwherein he rate ofinterestis rigiddownward, .e., thecase inwhich heinterest lasticity ftheliquiditypreferencechedule approaches nfinity,nd an increase nthe quantity fmoneyhas no effectnthe rateof nterest. This caseis sometimes eferred o as the liquidity rapor twopercent ase. Itof education, expectations as to the future evel of incomes, and perhaps (cfHarold Lubbell, "Effects of Redistributionof Income on Consumers' Expendi-tures," American Economic Review,March 1947, pp. 157-170) the distributionofincome. All of these factors combine to determinethe public's attitude towardsaving or consumption at various levels of national income. ProfessorHaberlerevidently wishes to include in this list of variables which determinethe shape ofthe consumptionfunction,not only wealth, but also some variable reflectingheproportionof wealth held in liquid form. He apparently feels that the post-warinflationary rend n prices was due in part to holdings of wealth in the form ofcash and in the quasi-liquid formof governmentbonds. (Cf. "Causes and CuresofInflation," by GottfriedHaberler,ReviewofEconomicsand Statistics,February1948, pp. 10-14). It seems more plausible to me that the post-war upward shiftin the consumption functionbe explained by the dearth of consumer durablessustained by the war, plus expectations of furtherprice rises. In otherwords,it does not seem necessary to concede that people have suddenly decided toconvert their assets into consumergoods in order to explain the upward move-mentof the consumptionfunctionfollowing n the wake of war.Of course, ifmonetary policy is successful in stimulatingnew investment,incomes and consumptionwill rise. And ifthe economy is at or approachingfullemployment, prices will rise. But this price inflation s due, directly,to theincrement to income flow and only indirectlyto the increase in the quantity ofmoney. In thisevent,and particularly fopenmarketoperationsare accompaniedby additional income stemmingfromdeficitfinancing n the part of the govern-ment, the marginal propensity to consume may approach unity due to priceexpectations, with a runaway inflation n the offing. It would surelybe agreed,however, that such a state of affairswould be abnormal, reminiscent, .g. of thecatastrophicGermanmonetaryexperimentfollowingWorld War I, and need notdetain us further t this juncture.



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566 QUARTERLY JOURNAL OF ECONOMICSis evidently histrapwhichProfessor eontiefhas in mind whenherefers o the " . . . deflationary echanismwhichdefeats, hroughheprocessof automatichoarding, very tendencytoward inflationaryreduction f nvoluntarynemployment."6If I understand imcorrectly,rofessor eontief eniestheveryexistence ftheliquidity rap. Evidently, nhisopinion, eopleholdmoney obuycommodities. If thepricesofcommodities ise orfall,people hold moreor less money,respectively, n orderto keep thepurchasingpowerof theirholdingsconstant. If this be the case,liquiditypreference annot vitiate the inflationary rocess, sinceindividualswould be willing o increase theirholdingsof cash onlyas theprice evel rises. In otherwords, fthe quantityofmoney sincreased, eoplewilltryto ridthemselves fthe increment fcash.In so doing, they will forceprices up to a level at whichtheyarewilling o holdtheincrement fmoney. That is,priceswillrise to apointwherethepurchasing oweroftheir ash holdings s the sameas itwas before hequantityofmoneywas increased.Hereagain theunsurmountablebstacleswhichmodern lassicistsnecessarilyncounterwhen hey ttempt oreduceKeynes toclassicalstaturebecomeapparent. The Leontief elineation ftheKeynesiansystem is inaccurate,as he refuses to pay close attentionto therespectiveroles whichMl = T (Y) and M2 = L (r) play in theKeynesian system. He insistson definingiquiditypreferencenterms fthek oftheCambridge ashbalance version fthequantitytheory.7 n Keynes,ofcourse, he ncrementfmoney snot treatedas income. The investor inds hepricesofsecurities,and,housing,et. al., too high. Consequently,he adds to his holdingsof cashanticipating n eventual upswingin the rate of interest, herebynullifying he effect fan increase n the quantityofmoneyon therate of nterest.8Hence, this s one9of theKeynesiancases inwhich6. Cf. note 1, p. 563. Italics mine. It should be pointed out that Keynesenvisaged this rigidity n the rate of interest as only a remote, but probableeventuality. Despite this fact,Professor Leontief apparently devotes his entireattention to this case.7. Where all M = kY and k is definedas the constant proportionof theirincomeswhich individuals hold measured in real terms.

8. It is true that in a purely static model the demand formoneywould beproportionalto prices. But abstraction fromuncertainty s unthinkable. Hence,ProfessorLeontiefsuggests (op. cit.,pp. 238-40) that Keynes should have writtenThe GeneralTheory n dynamic ratherthan comparative static form. Certainly,it would be exceedinglyhelpfulto have at hand a dynamited,general equilibriummodel encompassing all importanteconomic relationships. However, the dearthof dynamic economics, combined with data showingthe relatively arge numberof students in the fieldof economics, clearly indicate somethingmore than thederelictionof economists as the source of the difficulty.9. Cf. footnote6, p. 555 forthe Haberler version of otherKeynesian cases.



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COAMMENT 567fiscalpolicymustbe substituted ormonetarypolicy fequilibriumat fullemployments to be attained.

IVIt has been mypurposeto questionthe Leontief nterpretationof The General Theoryon the followinggrounds. First, Keynesrealizedthatrigidmoneywagesmust be taken intoaccountby thepracticing conomist. However,he did not postulatewage rigidity,for it is not essential to his theoretical tructure. Secondly,fullemploymentmay be attained throughmonetarypolicywhichdoes

notentaila rise n thepricesof commodities. Thirdly, mongotherreasons,we mayhave an unemploymentquilibrium ecause of thenatureof the demandformoney. Finally,I wishto reiterate hatwe were n equilibrium t less than full employmentn the liquiditytrapcase due to a rigidityn the rate of interest, ot because of arigiditynwages.1 Obviously, hewagerigidity lays suchan impor-tantrole ntheLeontief ersion fKeynesonlybecauseof heformer'sconception f iquiditypreferencend his denialof the liquidity rap.IRA 0. SCOTT, JR.

HARVARD UNIVERSITY

1. In The Keynesian Revolution, .89, Dr. Klein concludes: "In orderto showthat fullemployment s not automatic in a perfectworldsubject to the Keynesianconditions, t is necessary to assume nothingwhatsoever about rigidities n thesystem,but only to make plausible assumptions about the interest-elasticity fcertain basic relationships." In the case of the perfectly nelastic marginal effi-ciency of capital, no rigidity s involved. In the liquiditytrapcase, on the otherhand, there s a downwardrigidity n the rate of interest.

COMMENTMr. Scott's comments n the Keynesiantheoryof wagesbringtomy mindthe story bout thewomanwho whenaccusedofhavingreturned borrowed rock n damagedcondition efended erself yclaiming hat first f all she had not borrowed he crock; secondly,thecrockwas alreadybrokenwhenshe borrowedt; and thirdly,hatithas beenreturnedn perfect ondition. After dmitting,s Keynesdid himselfn his answerto my earlierreferenceo that particularpoint, that the "money illusion" plays a prominentpart in TheGeneral Theory f Employment,nd concedingthat without t thevery conceptof involuntaryunemployment ecomes meaningless,Scott denies that it constitutes n indispensableelement of theKeynesianargument. His referenceo Lawrence Klein's successin

professor leontief on lord keynes 1

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