Keynesian Animal Spirits

Keynes used animal spirits to describe the spontaneous confidence or urge that leads businesses to act despite an uncertain future. The concept explains why investment decisions cannot be derived entirely from available facts, probability calculations, or current financial conditions.

Why calculation alone is insufficient

Investment requires firms to compare present costs with returns expected over many future years. Because future demand, prices and profits cannot be known with certainty, estimates of prospective yield depend partly on the firm's state of confidence and expectations about the business environment.

How animal spirits influence investment

In Keynes's framework, confidence affects prospective returns and therefore the marginal efficiency of capital, while the interest rate represents the financing or opportunity cost of investment.

• When optimism strengthens, firms may expect higher returns and undertake more capital expenditure, even if present conditions have changed little.
• When pessimism spreads, firms may postpone or cancel projects despite low interest rates or available finance.
• Changes in business confidence can therefore produce sharp investment fluctuations and amplify expansions or contractions in aggregate demand.

Relation to economic fundamentals

Animal spirits do not imply that firms ignore costs, demand, technology or interest rates. Rather, they explain how decisions are completed when these fundamentals do not provide a certain forecast: the same observable conditions can generate different investment outcomes because firms hold different long-term expectations.

• A reduction in interest rates may not revive investment if expected profitability and confidence remain weak.
• Conversely, strong expectations can make firms invest despite relatively less favourable financing conditions.