The Role of Prices in the Establishment of Keynesian Short-run Equilibrium

Keynes does not directly discuss the behaviour of prices in the process of aggregate adjustment, and therefore the role of prices in this process remains unclear. However, we feel that Keynes does give us a few very important tools for analysing the role of prices in macroeconomic adjustment. These tools are summed up in the principal of the determination of effective demand based on the aggregate supply price and aggregate demand price curves. This formulation has a twofold interest. In connection with Say’s theory of markets, it shows that there is a unique equilibrium point and not an infinite number of possible points. The second important aspect — which is less often stressed — is connected to the quantity theory of money: the effective demand principle provides an explanation for the determination of the general price level which is also different from the ‘Classical’ explanation. Furthermore, Keynes’s explanation offers an answer to a hitherto unexplained phenomenon: the establishment of the general price level. Chapter 21 (‘The Theory of Prices’) in the General Theory opens with a discussion of this question. Keynes contrasts the usual analysis of market price determination (which he calls the theory of value) with the existence of a general price level determination which is totally independent of the first.