Thursday, July 28, 2011

More on the Gross Substitution Axiom

Post Keynesians reject the gross substitution axiom, an implicit assumption made by both Austrians and neoclassicals. In brief, money and financial assets have zero or near zero elasticity of substitution with producible commodities.

The operative concept is demand for liquidity. The most liquid asset is money, and, in varying degrees of liquidity, there follow various types of financial assets, which are nonproducible and held as a store of value:
“If the gross substitution axiom was universally applicable, however, any new savings that would increase the demand for nonproducibles would increase the price of nonproducibles (whose production supply curve is, by definition, perfectly inelastic). The resulting relative price rise in nonproducibles vis-a-vis producibles would, under the gross substitution axiom, induce savers to increase their demand for reproducible durables as a substitute for nonproducibles in their wealth holdings. Consequently nonproducibles could not be ultimate resting places for savings as they spilled over into a demand for producible goods ... Samuelson’s assumption that all demand curves are based on an ubiquitous gross substitution axiom implies that everything is a substitute for everything else. In Samuelson’s foundation for economic analysis, therefore, producibles must be good gross substitutes for any existing nonproducible liquid assets (including money) when the latter are used as stores of savings. Accordingly, Samuelson’s Foundation of Economic Analysis denies the logical possibility of involuntary unemployment as long as all prices are perfectly flexible.” (Davidson 2006: 189).
Neoclassical synthesis Keynesians and Post Keynesians part company on precisely this point: the gross substitution axiom is false, and even if all wages and prices were perfectly flexible, you would still have involuntary unemployment, for these reasons:
(1) with no truth in the gross substitution axiom, demand for liquid financial assets as a store of value, even when it raises the relative prices of nonproducible financial assets in relation to producible commodities will not necessarily spill over into demand for the latter;

(2) Say’s law does not hold in any economy where we face uncertainty, subjective expectations, and money and financial assets with a store of value function;

(3) Liquidity preference and the desire for increased liquidity apply not just to individuals but also to banks and other business institutions; indeed, in modern capitalist economies it is the liquidity preferences of banks that are particularly important.


Davidson, P. 2006. “Samuelson and the Keynes/Post Keynesian Revolution,” in M. Szenberg, L. Ramrattan, A. A. Gottesman (eds), Samuelsonian Economics and the Twenty-First Century, Oxford University Press, Oxford and New York. 178–196.


  1. Right, but the price stickiness ensures that Post Keynesians never have to put the rejection of gross substitution axiom to a real world test.

    In other words, you just keep saying that "even if all wages and prices were perfectly flexible", so you do assume price stickiness exists and therefore advise deficit spending preventatively, rather than after we wait and see if indeed people love paper money so much as you claim. I agree paper money looks nice, with all the holograms etc, but IMHO there are nicer things still.

    You must be really scared of the gross substitution to show up. My guess is, Post Keynesians have common sense enough to reject the absurd ideas of price stickness, especially nowadays what with all the global microsecond trading platforms etc. So the only defense left is to claim that people love fiat money's store of value function so much they would not buy a whole kingdom even at $1 dollar paper fiat money price. The ownership of a kingdom is supposed to be infinitely (zero elasticity) worse store of value than a kingdom. Wow. Did I hit your central assumption right LK?

  2. In fact, I always get the idea that involuntary employment is only the outcome of uncertainty and business expectations in an uncertain environment. The only way to assume that involuntary employment is a void concept is if we also assume both perfectly flexible wages and certainty.

    In fact, the whole concept of liquidity is tied to the concept of uncertainty. Liquidity would be equal for every good in a certain environment.