Keynes in his arguments dropped the microeconomic principles of the supply and demand as they did not apply at the nation level. In national level, Keynes said, the consumption of the nation will also affect their income. He formulated his analysis for the closed economy with no government, but the theory could be extended.
So all income is either spent or saved. Y=C+S, whereas the income of the nation will be the investment expenditure + consumption. Y=C+I, it follows that the country is in equilibrium if S=I, but this is just stating an identity. In practice the time lags are involved and C+S comes from the previous time period, whereas C+I forms the income for the next period.
It is the nature of people not to spend all their extra income, the proportion spent is the Marginal Propensity to Consume. At very low levels of income people actually dissave (live from previous stocks or borrow). By diagram:
Only at point A will the level of expenditure that the economy wishes to spend equal to the level of output. We assume investment is exogenously given. The rate of interest is also given. When economy is in a point below Y1 firms have to run down stocks and people are forced to save, so actual savings and investment are still equal. Planned savings and investment are brought into equilibrium by the national income Y, because firms soon discover that they must invest more and this shifts the C+I line up. Equilibrium can also be looked at the point where S=I. If the average propensity to save arises, national income will fall according to that theory.
So Keynes suggested in the case when full employment level was above Y1 government intervention to increase I and ultimately C+I, so the level of national income would rise. Friedeman called early Keynesians fiscalists. But the general theory does not mention fiscal policy, Keynes only mentions monetary policy.
Keynes took over the quantity theorists assumption about Ms=exogenous. The demand for money is Md=kPY according to the Cambridge approach. Keynes accepted that but told this is not the complete picture. The Md should also include interest rate. So Md could be split to 3:
1. transactionary - like monetarists defined it, it is interest inelastic and depends on how often one is paid the wage.
2. precautionary - for rainy days, much the same as 1.
3. asset demand for money - liquidity preference L(r). This is interest elastic. So Keynes reformulated the Cambridge formulae: Md=kPY + L(r). Liquidity preference showed the difference between how many bonds or money you like to hold. If you have higher liquidity preference you hold more money. Amount of money does not matter, aggregate demand can be anything with given amount of money, the velocity of circulation can be whatever, if people do not want to spend, then extra money will be held in accounts.
The supply of money was given by the government.
Interest was determined in the money market. The rate of interest was purely a monetary phenomenon.
The attraction to hold money is its liquidity. It can be exchanged to other goods with minimum goods. There are also bonds, that are illiquid. They pay a rate of interest - they yield income.
If people want to hold more money:
They cant hold more as Ms is given. So the price of bonds drops and they become more profitable.
Classical writers said the amount of investment will rise and rate of interest (r) will fall, so investment will rise as interest rate falls, which is a good thing:
Keynes on the other hand showed that for a given monetary situation there is a unique interest rate. Let s assume that the interest rate falls (e.g. because of the increase in supply of money or decline in demand):
So the investment would by classical theory crowd itself out as the savings will rise.
If monetary authorities like to influence aggregate demand (e.g. stimulate it to eliminate unemployment). So they do open market operations(sell 90 day maturing Treasury Bills):
This assumes that the authorities can actually bid down the interest. This is very hard and the effect can be very small. So monetary authorities can increase Ms but the increase in expectations is not certain.
When interest rate does fall, the investment will rise (as decisions are made by marginal efficiency of investment which is downward sloping because of the diminishing return). If investment rises so does Y. This will cause an increase in Md and interest rate will rise causing some private investment to be crowded out. But as Md is elastic crowding out is never 100%.
Keynesian monetary transmissions mechanisms were that big increase in money supply (perfectly inelastic, because state controls) causes relatively small decrease in interest rates, causes relatively small increase in investment, causes income and expenditure to rise a bit (thus finally a rise in aggregate demand). Note that the link between money S and aggregate demand is indirect (through I). Keynesians thought demand for money is interest elastic, thus the quantity of money supply increase is absorbed and the interest rate will change insignificantly compared to expectations. Investment is inelastic, thus increases a little only. Both the demands for money and investment are likely to be highly volatile because of expectations. Thus Keynesians do not think rising of money S helps and believe in fiscal policy. Also the Banks have liquid reserves, thus the money supply increase is shielded.
Saving and finance are now clearly distinguished (though perhaps surprisingly this is a fairly recent development). Finance refers to monetary transactions securing the means of payment for purchases in excess of current cash flow or funding the holding of assets. Problems of finance exist for individuals or fires, not for economies as a whole except in relation to other country"; accordingly, the analysis of finance is macroeconomics in character. Saying is income not consumed. In contrast to finance it is both an action undertaken by individuals and an outcome for the economy as a whole. In the context of today's financial institutions, individual saving largely consists of money-flow" to those institutions, though saving can take 'rear form as well (e.g. the purchase of houses or works of art).
(This essay was bloody lot better before my computer crashed erasing last 1h)