Expectation formation and Keynes’s theory of effective demand

Victoria Chick highlighted a critical gap in Keynes's General Theory: the absence of a formal theory of expectations formation, despite the central role it plays in Keynes's principle of effective demand (PED). This paper addresses that omission by reconstructing Keynes's implicit expectations framework. Keynes's theory of effective demand, in which production is undertaken in accordance with market expectations, applies at the levels of firm, industry and the macroeconomy. Expectations that entrepreneurs form at each level must therefore be consistent with the determination of effective demand for that level. An important aspect of the proposed layered approach is that the expectations formed at a lower level will partly depend on those formed at a higher level. For example, a small competitive firm's expectations regarding its own effective demand will require as input expectations of market clearing prices formed at the industry level. The paper formalizes how expectations formed in the indicated manner influence price-setting, employment and production at the different levels. The proposed theory's hierarchical expectation formation indicates "reverse reductionism". This reinforces Keynes's open-system methodology and its stress on macroeconomic resolutions, while promoting a more robust alternative to reductionist macroeconomic models.