The Theory of Effective Demand Represents Keynes’s Attack on the Loan-Market Theory

 The pre-Keynesian analysis of fractional reserve banking can be illustrated with the loan market theory, the theory of multiple deposit creation, and the net present value. Together, these three theories support 100 percent reserve banking. But Keynes wrote to Irving Fisher, “on the matter of 100 per cent money I have, however, as you know, some considerable reservations.” So how can Keynes reject 100 percent reserves? He accepted the theory of multiple deposit creation, and he accepted the theory of DCF [discounted cash flow] analysis. Thus Keynes’s most obvious departure from the pre-Keynesians was his attack on the loan-market theory.

The Keynesian theory has three components: (1) the theory of effective demand, (2) the liquidity preference theory, and (3) the marginal efficiency of capital. The theory of effective demand represents Keynes’s attack on the loan-market theory. As noted, in the loan-market theory, the interest rate is the price that adjusts to balance saving and investment. However, Keynes explicitly rejected the theory. Instead, in his theory of effective demand, the level of income is the factor that adjusts to equalize saving and investment. If investment is greater (less) than saving, then income will rise (fall) until saving equals investment. In the Keynesian theory, income replaces the interest rate as the equilibrator of saving and investment.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 54.