The General Theory of Employment, Interest, and Money

Keynes explores how investors form long-term expectations about prospective returns on capital assets and why these expectations can be extremely fragile. Many economic decisions about future investment rely on a shaky foundation: No one can be certain about what conditions—consumer demands, market competition, or technological advancements—will prevail several years hence. Historically, investments were often undertaken by individual entrepreneurs fueled by optimism rather than precise calculation. In modern markets, however, the widespread ability to buy and sell shares daily—coupled with mass psychology—has introduced new volatility.

Keynes holds that “the state of confidence” (91), though difficult to measure rigorously, is central to investment decisions. Stock market prices, while appearing to provide continuous valuations, can be swayed by speculative behavior as investors anticipate short-term shifts in market sentiment rather than base their choices on a reasoned forecast of an asset’s long-run yield. This casino-like quality of modern exchanges can cause harmful cycles of booms and busts when enterprise is overshadowed by speculative fervor.

Despite this precariousness, certain mitigating factors exist, such as contractual guarantees in utility investments, or government-led projects where the social good is paramount over exact profitability. Keynes concludes by emphasizing that interest rates alone cannot ensure adequate, stable investment. He foresees a growing role for government in directly coordinating capital outlays to counteract the inevitable uncertainties of private long-term expectation.

Keynes defines the rate of interest as a reward for relinquishing liquidity rather than as a straightforward return to saving. He distinguishes between two psychological components of time-preference: the propensity to consume, which decides how much income is reserved for future use, and the preference for liquidity, which determines how people choose to hold that reserved portion—either in cash or in interest-bearing assets. According to Keynes, the rate of interest results from balancing the supply of money with the public’s overall desire for holding cash. If people prefer to keep their resources liquid, the rate of interest has to rise to make parting with money more attractive. Conversely, if liquidity-preference weakens, the interest rate falls. Changes in long-term interest rates thus depend not just on how much people want to save, but on how strong their desire is to remain liquid given uncertainties about future prices or rates. This nuance helps explain why an increase in money supply does not automatically lower interest rates—public confidence and expectations also play a critical role in determining how eagerly people exchange cash for assets offering returns.

Keynes critiques classical economic theory’s contention that the rate of interest equilibrates saving and investment. Under this view, interest is viewed as the price of investable resources, ensuring that the amount saved (supply) matches the amount invested (demand). Keynes points out that, despite being widespread, this notion fails to explain how interest is actually determined in a monetary economy.

He argues that saving and investment are merely outcomes that must equal each other once all decisions in the economy are made; they are not themselves the forces fixing the interest rate. Instead, the interest rate results from the interplay of people’s desire for liquidity—liquidity preference—and the available money supply. Classical analysis neglects the crucial fact that changes in aggregate income can alter both saving and investment, so one cannot treat the amount to be saved as fixed while shifting the demand for capital. This oversight leads to a flawed conclusion that the rate of interest automatically adjusts to any new balance of saving and investment. Keynes underscores that if the central bank or policy authority adjusts the money supply, it can influence the interest rate; by contrast, classical theory implies that money policy is largely irrelevant in establishing a “natural” market rate. Ultimately, Keynes’s criticism highlights that recognizing income fluctuations and liquidity-preference is indispensable to understanding why the rate of interest settles where it does.

Keynes refines his theory of liquidity preference by categorizing the motives behind why individuals and businesses hold cash. Beyond the immediate transactions motive (covering day-to-day income and business costs) and the precautionary motive (guarding against future uncertainties), he highlights a third, important factor: the speculative motive. According to Keynes, people hold money in anticipation that interest rates could shift, rendering bond holdings either profitable or risky. The combined desire for cash from these three motives interacts with the available money supply to shape the market rate of interest.

Keynes emphasizes that, while money demanded for transactions and precautionary purposes is relatively stable (closely linked to income and business volume), the speculative demand is more elastic and strongly influences monetary policy effectiveness. Central banks, through open-market operations, can lower or raise bond prices and thus interest rates—but only up to a point. If investors collectively fear a rise in rates or deem rates too low, they may hold onto cash despite attempts to flood the market with liquidity. Consequently, the interest rate becomes a phenomenon sustained by collective expectations. Whether rates drop enough to stimulate new investments depends not just on policy, but also on whether the public believes in the durability of low rates, underscoring the psychological and social underpinnings of Keynes’s liquidity preference framework.

Keynes discusses how individual acts of saving do not necessarily spur equivalent demand for future goods. Unlike a direct order for delayed consumption, general saving simply withdraws current spending from the economy without creating a guaranteed offsetting demand for future consumption. This can lower overall effective demand, thereby curbing both consumption-related industries and new investment if it also depresses the marginal efficiency of capital.

Keynes explains that capital’s value stems from its scarcity—if it becomes overly abundant, its marginal efficiency can drop to zero. Normally, interest rates adjust to balance saving and investment, but institutional and psychological factors often prevent rates from declining sufficiently. In such cases, forced saving can accumulate wealth to a point that undermines full employment. He envisions a scenario where, with proper monetary and social policies, the marginal efficiency of capital gradually falls toward zero, turning capitalist economies quasi-stationary and eliminating the rentier class whose income derives largely from accumulated wealth rather than productive work. However, uncertainties about future yields and the existence of risk premiums mean there can still be returns on specific investments, ensuring that some entrepreneurial activity and speculative behavior remains.

Keynes explores why the money-rate of interest exerts a uniquely powerful influence on economic activity, contrasting it with other “own-rates” of interest (e.g. the wheat-rate of interest). Any durable asset can be measured in terms of its own-rate, defined by its expected yield, minus carrying costs, plus a liquidity-premium. Yet money, unlike other commodities, usually has: 1) almost no carrying costs and 2) a high liquidity-premium, making its effective rate of interest comparatively unresponsive to supply increases.

Keynes argues that money’s inelasticity of production prevents entrepreneurs from easily manufacturing additional money if its value (and hence its interest) rises. Further, its zero (or near-zero) elasticity of substitution means that as its price climbs, few stand ready to switch into another asset. These features allow money to become a bottomless sink of purchasing power. Because of this, a rise in the money-rate of interest halts new investment in more easily produced goods (e.g., houses, wheat) but does not stimulate output of money itself. Consequently, the money-rate often sets an upper bound for growth, since the marginal efficiency of newly produced capital must exceed that money-rate to be profitable.

He extends this notion by showing that if another commodity, such as wheat, were to become the standard of value, the same problem would arise if wheat also could be produced or substituted easily. Ultimately, classical notions of a unique “natural” rate of interest, set by saving and investment alone, ignore the fact that every level of employment and output can have a different natural rate. Instead, modern economies remain anchored by a money whose rate of interest tends to stick above what’s needed for full employment. Government monetary policies can mitigate this, but must contend with people’s strong desire to hold money, given its unrivaled liquidity and negligible costs.

Keynes restates his main argument regarding employment determination. He outlines how certain factors—like existing technology, labor supply, consumer habits, and social structures—remain relatively fixed, while three independent variables guide economic outcomes: the propensity to consume, the marginal efficiency of capital, and the interest rate. These variables shape investment, which, through the multiplier effect, dictates levels of employment and aggregate income. In equilibrium, new capital investment will proceed up to the point where its marginal efficiency matches the prevailing interest rate, after which additional output and jobs no longer appear profitable. Keynes further emphasizes the role of stability conditions—such as a moderately sized multiplier, elasticity in capital production, and “sticky” wages—in preventing the economy from spiraling into extreme booms or collapses. Yet these conditions also allow chronic underemployment to persist, as neither automatic market forces nor flexible wages necessarily drive output up to full employment. Hence, the chapter stresses that the system, while often resting in a stable, suboptimal position, is not bound by any immutable law. Policymakers can influence fundamental psychological and institutional factors—particularly through monetary and fiscal actions—to shift employment and income toward more satisfactory outcomes.