Abstract
One of the biggest controversies sparked by the General Theory concerned the determination of the rate of interest. Until the General Theory, the generally accepted view was that the rate of interest was determined in the capital market, defined in terms of the demand and supply of savings. The demand for savings was represented by the investment demand function, which depicted a negative relationship between investment and the rate of interest, while the supply of savings was represented by the savings function, which described a positive relationship between the interest rate and the amount saved out of income. The market was assumed to clear at the point where supply equals demand, thereby establishing investment, saving, and the market rate of interest.
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Notes
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There is nothing new in this discussion, for all of the points have been discussed by Fisher and others.
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Cf. the young man’s decision to build up a stock of 10 days of bread to build a house in the “Prologue.”
- 6.
See Keynes (1936, pp. 135–37).
- 7.
Cf. Cassell (1903).
- 8.
See Fisher (1930).
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Keynes (1937b).
- 10.
Readers are reminded once again that this concept of the natural rate of interest differs from the usual definition of the natural rate, which (per Wicksell) is the rate that equates investment and saving.
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Keynes (1936, pp. 223–24).
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See Keynes (1936, pp. 225–28).
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From the foregoing, it should be clear that the money rate of interest and the natural rate of interest (as defined here) bear no necessary relationship. Whether the two rates are equal in equilibrium is discussed in Chap. 6.
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In one of his 1937 Economic Journal articles, Keynes (1937b) added a fourth motive for holding money, the “finance” motive, which he defined as a holding of money that is built up by businesses in anticipation of financing new investment. In my view, Keynes’s discussion of the finance motive is especially insightful because it deals directly with monetization of the stock of fluid capital (although just for the purpose of financing investment in produced means of production). Except for the Post-Keynesians (see, especially, Davidson 1978), however, the finance motive has never received much attention. Meltzer (1988), for example, dismisses it as of no importance and avers that Keynes did not accord it much relevance either.
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The other way, obviously, is for banks to borrow from the central bank.
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Historically, money creation through business borrowing embodies what came to be known as the Banking School of Monetary Control (or equivalently as the Real Bills Doctrine). The premise of this school is simple and attractive. Banks are to make loans only for the purpose of financing current production, with the loans to be paid off by the proceeds from sale of the output, which is to say that the loans are self-liquidating. By restricting money creation to this form, the amount of money is carefully controlled – in essence, the value of current production providing an upper bound on the amount to be created – and risk (provided the bankers are adept at their jobs) is minimized (although obviously not eliminated altogether). For a discussion of the origins of the Banking School and the controversies, which surrounded it, see Schwartz (1987).
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The foregoing illustrates in yet another way the fact that the real value of the stock of money (viewed in terms of means of exchange) is bounded by the pool of fluid capital valued at current prices.
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Keynes saw bonds as the only alternative asset to money but this is obviously not the case. An individual’s portfolio decision is not just between money and bonds but between money and a wide range of assets, both financial and real. Economists who have modeled this portfolio decision in a general equilibrium framework include, among others, Tobin (1969) and Friedman (1974).
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The standard reference on the distinction between “inside” and “outside” money is Gurley and Shaw (1965).
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Consequently, for the point that he was wishing to make, Keynes would seem to have been not only justified but also logically correct in assuming bonds to be the only alternative asset to money.
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Cf. Fisher’s distinction between the nominal and real rates of interest, in which the nominal rate differs from the real rate by the expected rate of inflation.
- 25.
The foregoing suggests that the monetarist view that inflation always follows the creation of money is not true as a general proposition. Certainly, the monetarist conclusion is valid with respect to the creation of fiat money but not with respect to the creation of bank money. For with bank money, the money is created in anticipation of inflation, so that it is expected inflation, which determines how much money will be created. Bank money, once created, can (and usually will) ratify the inflation, but its creation is not the initial cause of the inflation.
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Travelers checks (which, with the advent of ATM machines, is no longer of much significance) and unutilized credit card lines will be ignored.
- 27.
At the time these words were first written, “e-business” on the Internet had already emerged as a major force in the way that firms do business with one another. Not only does the Internet allow firms to connect directly with customers but it also allows them to connect directly with vendors and suppliers on a real-time basis. Purchase orders can be executed more quickly and economically using the Internet and payment is more rapid. Periods of production are thereby reduced, resulting in a more rapid turnover of business bank loans and a slowing in the rate of growth of the primary money supply.
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A useful parallel can be drawn between the discussion in this section and Keynes’s discussion in Chap. 3 in the Treatise on Money of the three predominant types of bank deposits. The three types of deposits in question were referred to by Keynes as income, business, and savings deposits. The first two represent the transactions balances held by households and businesses, whereas savings deposits represent money held by households as an asset. At the time, Keynes’s orientation was still very much in the Cambridge tradition of the Quantity Theory so that his discussion is largely concerned with the volumes of deposits that are demanded in relation to volumes of transactions, with an eventual focus on the price levels relevant to each of the “circulations.”
- 30.
A good part of the post-Keynes fault for this can be attributed to Keynes himself because of his assumption in the General Theory that the money supply is controlled by the Monetary Authority. In one of his 1937 papers in the Economic Journal defending the General Theory, Keynes (1937b) clearly displayed understanding of the basic endogeneity of the money stock, but he restricted attention to what he called the “finance” motive for business holdings of money. He was very explicit in describing the money demand associated with this motive as constituting a revolving fund. He failed, however, to extend this reasoning to the whole of bank-created money.
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Or at least not until the financial meltdown of 2007–2008.
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It becomes de jure fiat money at the point when the central bank purchases the bonds in the open market in order to provide the banking system with more reserves.
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Even so, it is still almost certainly far from a perfect measure. Aggregate demand, as it has been defined in this book, represents the pool of purchasing power confronting the currently available supply of goods and services and will consist of money that is earmarked for financing current production and investment in produced means of production plus money earmarked for consumption in excess of income. Because a significant portion of currency in the hands of the public is outside of the country, and many travelers checks are held as precautionary reserves, M1 will in general probably overstate this pool of purchasing power.
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Taylor, L.D. (2010). Interest and Money. In: Capital, Accumulation, and Money. Springer, Boston, MA. https://doi.org/10.1007/978-0-387-98169-7_4
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