Implications for the Role of Economic Theory:

Like the schedule for the marginal efficiency of capital, expectations about the future market rate of interest underlie the liquidity preference schedule. In Keynes' analysis, there are three factors which influence the level of output and employment in the economy in the short-run significantly. These are i) the quantity of money in circulation, ii) the money wage rate, and iii) certain fundamental psychological factors, the psychological attitude to liquidity and the psychological expectation of future yield from capital assets.

In analysing the determination of aggregate output, Keynes therefore takes the above factors including 'the psychology of the public' as given. For example, he takes marginal efficiency of capital and liquidity preference schedules as given. Changes in these factors are then studied separately in terms of their effect on output and employment.

Psychological factors do not necessarily denote random factors. These might depend (though not necessarily reasonably) on specific social and political circumstances. Two major implications follow from the fact that psychological factors are important in the determination of output. First, the level of output and employment and other relevant variables in the economy will not, in general, be predictable (in the form of an objective probability distribution) on the basis of historical data on a limited number of measurable factors alone. Second, changes in independent variables brought about as a measure of policy may also lead to changes in other determining factors, but not necessarily in a predictable manner. For example, Keynes recognises that monetary policy can have different effects on output depending on its impact on expectations about future monetary policy and therefore on the liquidity preference schedule. Similarly, there is recognition (Keynes, 1936, p.120) that a government programme of public works may "through its effect on 'confidence', increase liquidity-preference or diminish the marginal efficiency of capital, which, again, may retard other investment unless measures are taken to offset it."