Friday, August 15, 2014

Paul Davidson on The Gross Substitution Axiom, Heart of Mainstream Economics

By Paul Davidson, [h/t] Lars P. Syll

The gross substitution axiom assumes that if the demand for good x goes up, its relative price will rise, inducing demand to spill over to the now relatively cheaper substitute good y. For an economist to deny this ‘universal truth’ of gross substitutability between objects of demand is revolutionary heresy – and as in the days of the Inquisition, the modern-day College of Cardinals of mainstream economics destroys all non-believers, if not by burning them at the stake, then by banishing them from the mainstream professional journals. Yet in Keynes’s (1936, ch. 17) analysis ‘The Essential Properties of Interest and Money’ require that:

1. The elasticity of production of liquid assets including money is approximately zero. This means that private entrepreneurs cannot produce more of these assets by hiring more workers if the demand for liquid assets increases. In other words, liquid assets are not producible by private entrepreneurs’ hiring of additional workers; this means that money (and other liquid assets) do not grow on trees.

2. The elasticity of substitution between all liquid assets, including money (which are not reproducible by labour in the private sector) and producibles (in the private sector), is zero or negligible. Accordingly, when the price of money increases, people will not substitute the purchase of the products of industry for their demand for money for liquidity (savings) purposes.

Read rest here.

2 comments:

  1. I'm not sure I understand the second point. I presume the relative price of producibles and money is basically the general price level. Is the demand for money then supposed to be the demand for nominal money balances or real money balances?

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  2. That's alright, but not nearly enough. As I am sure everyone here knows, being this one of the best blogs in the classical-keynesian tradition, the whole logical construction of neoclassical economics is based on the substitution principle. And it has been shown that this is logically flawed, so it does not add a lot to say that money is different from other assets. As a matter of fact, I believe that neoclassical economics fares way better when dealing with questions of strict financial decisions. After all, it was in this situation that Walras first designed his idea of general equilibrium...

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