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Keynes became interested in monetary theory. As his studies continued, Keynes became increasingly skeptical of the conclusions of classical economic theory and of the classical dichotomy.  His research in monetary theory convinced him that finance could affect the real side of the economy.  Keynes thus set out to explain the Great Depression using this line of thinking. In 1936, he publishedThe General Theory of Employment, Interest, and Money, concisely known as The General Theory, which arguably became one of the most influential writings of modern economic theory.

The General Theory focuses on refuting the classical conclusions that employment is determined by the price of labour, and proposes that employment is actually determined by spending, or aggregate demand. Keynes argues that under-full employment equilibria exist, unlike the classical claim that if the economy is not at full employment, it will reach full employment eventually. Keynes argues that investment need not equal savings, since investment is a function of the expected rate of return as well as the interest rate.  An increase in saving may lower the interest rate and provide an incentive for investment to rise, but if the expected rate of return is low investment will not rise in proportion to saving.  Consequently, the level of aggregate demand will fall, and the insufficient demand will cause an equilibrium with less than full employment.

Keynes’ “propensity to consume” (or MPC) plays an important role in his theory. Given the propensity to consume and level of employment, Keynes argues an equilibrium exists where aggregate demand equals aggregate supply. Consumption is largely dependent on income, because as income increases people are willing and able to consume more. Furthermore, increased investment leads to increased income. He introduces the concept of an “expenditure multiplier” to explain this phenomenon. Keynes argues that consumption will always be less than income, but never be negative. Consumption and income will always move in the same direction, and a change in income will create a change in consumption and investment where 1/(1-mpc)= k. An increase in investment results in an increase in income; because of people’s propensity to consume, they will not save all their money. Instead they will spend some fraction of it, putting part of the increased income back into the economy. In this way a small increase in investment has a larger  cumulative effect on income. The increased income leads to more consumption, which will raise GDP. Overall, Keynes argues that changes in spending (investment and/or consumption) cause more than proportionate changes in GDP.  This Keynesian multiplier effect is 1/(1-mpc) in the simplest models.

Keynes says that the interest rate does not change an individual’s propensity to consume, but rather makes it more expensive for individuals to borrow. The Classicals said that interest was determined through the interaction between the supply and demand of saving, but Keynes refuted this saying that interest rates are determined by the supply and demand for money. He argued that savings and investment were much more inelastic than originally hypothesized by the classicals. The interest rate, Keynes says, is determined by people‘s money demand, or “liquidity preference.”  It is a measure of the willingness of individuals to part with their liquid assets. Money, he argued, was much more responsive to periods of excessive saving, and would allow faster changes in the interest rate. Because of substitution and income effects on saving, and long-term expectations on investment, the supply and demand of saving, Keynes argued, were not an accurate explanation for how the interest rate adjusts. The interest rate has an obvious effect on the economy because as the interest rate increases, it becomes more expensive to borrow. Individuals will borrow less, resulting in decreased consumption and decreased overall income. As the interest rate rises, Keynes argues that consumer spending and investment will also fall. For these reasons, Keynes opposed a laissez-faire approach to regulating the macro-economy, and supported federal stimulus in times of recession.

The Keynesian view of the world was articulated by Sir John Hicks in the IS-LM model, which became the macroeconomic model used by policy makers for the next few decades. The IS curve represents all combinations of interest rates and GDP where total spending equals total output (or GDP). The LM curve represents equilibria in the money market–all combinations of interest rates and real income where money supply equals money demand.  If the government increases its spending, the IS curve will shift to the right. This increases GDP as well as interest rates. Keynes believes that, assuming the economy is operating at less than full employment, increased government spending is good for the economy because it encourages private investment through the accelerator effect.  The accelerator effect says that an increase in GDP leads to an increase in investment, which leads to a further increase in GDP.

The Classicals said that increased saving would decrease consumption, but interest rates would also decrease and investment would adjust so that the total aggregate spending would be the same.  Keynes said that spending does affect GDP.  Increased spending leads to increased production, which increases aggregate demand, which affects GDP. He says that people are pessimistic about the future and hold on to their money; as a result it does not flow into financial markets. Because hoarding exists, the interest rate does not affect investment enough to offset consumer saving, therefore aggregate demand can fall and GDP is not always at full potential.

Keynes argues that in order to revert back to full employment the government must use expansionary monetary and fiscal policy in order to stimulate the economy and increase employment, because it won’t happen by the private sector. The government needs to spend money to jump start the economy. Keynesian and modern revisions of Keynesian thought continue to influence macro-economic policy today.