ABSTRACT
The classical theory of efficient bond markets plays a crucial role in the out-of-equilibrium dynamics that ensure a return to full employment after a negative shock to demand. Classical theory has a flow equilibrium model in which the interest rate balances the flow of saving and investment at full-capacity income and output, a theory that assumes markets always clear in equilibrium. Efficient bond markets are an essential foundation of Say’s Law. Keynes presented a two-pronged attack on the classical theory of the role played by the bond market in the restoration of full employment. Keynes’s theory of the interest rate is compatible with periods of relative bond market stability, his main goal was to show why, in a world of uncertainty, and bond prices are inherently prone to occasional periods of high volatility and can exhibit destructive pro-cyclical disequilibrium dynamics.
