In Prosperity for All, (PFA) I describe a theory of Keynesian economics, developed in my recent body of work, in which the transmission mechanism from demand to employment is through wealth, not through income. I call this, a theory of Keynesian economics without the consumption function.
I reject the Keynesian theory of aggregate demand, and I reject the theory of the multiplier that goes along with it. My reason is that the empirical evidence does not support a theory in which government expenditure multipliers work by increasing consumption, as they must if the Keynesian consumption theory is correct. As Valerie Ramey has shown, when government expenditure goes up; consumption goes down.
Here is how I describe my reluctance to embrace the traditional Keynesian approach to aggregate demand in Chapter 10 of PFA,
Keynesian economics has two parts: a theory of aggregate supply and a theory of aggregate demand. Traditionally, Keynesians have focused on the theory of aggregate demand. The central part of that theory is the consumption function, and an implication of the theory of the consumption function is that an increase in government expenditure will cause GDP to increase by a multiple of the initial increase in spending. That theory is wrong. Consumption depends on wealth, not on income. PFA, pages 177-178
If consumption depends on wealth, and not on income, we should be concerned that movements in wealth may lead to socially inefficient fluctuations in the unemployment rate. Those movements are not simply temporary movements away from a social planing optimum, they are permanent movements in the unemployment rate that can lead to decades of misery for those without jobs.
Quoting again from PFA,
Figure 1 illustrates the implications of a theory of Keynesian economics without the consumption function. The aggregate demand curve does not slope upward with income; it is a horizontal straight line. The position of this line depends on the beliefs of market participants about the value of their financial assets. As the value of financial assets fluctuate, driven by self-fulfilling beliefs, so the aggregate demand curve moves up and down between the solid horizontal line and the dashed horizontal line. As people feel more or less wealthy, they buy more or fewer goods. Firms hire more or fewer workers and real GDP fluctuates between point YA* and YB*. (PFA, page 178.)
But although, I reject the simple Keynesian version of Aggregate Demand, I do not reject Keynesian economics. The key idea in the General Theory is that high involuntary unemployment may persist as an equilibrium of a market economy. How can that be? In Prosperity for All,
I provide a foundation—Keynesian search theory—to the Keynesian theory of aggregate supply. This new theory is rooted firmly in the microeconomic theory of behavior. According to Keynesian search theory, everything demanded will be supplied and any unemployment rate can be an equilibrium unemployment rate. (PFA pages 178-9.)
The implications of these ideas, taken as a package, are profound. If demand works through wealth, the right policy to maintain full employment is an intervention in the asset markets, not in the goods markets.