13: The General Theory of the Rate of Interest

Keynes argues that it is impossible to determine the rate of interest with reference to only the demand for savings and the propensity to save, though he leaves a detailed look at the classical theory of interest to the next chapter.

The gap comes from the fact that the form in which people save matters. To what extent are savings held in money and money-like assets that can be spent at any time, and to what extent in assets which cannot be converted back into a set amount of purchasing power immediately? This can be conceived in terms of liquidity preference – a high preference for liquidity means most savings held as money; a low liquidity preference means people are more prepared to hold bonds, etc.

The interest rate is the reward for parting with liquidity, i.e., with money, not for saving as such. In a footnote Keynes gives a pragmatic definition of money, which it is important to understand. It is not defined as ‘cash’ or ‘cash plus current accounts’. It is defined in terms of how quickly its holder can turn it into purchasing power, and the line can be drawn in different places depending on the context:

… we can draw the line between ‘money’ and ‘debts’ at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for ‘three months’ one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. [p. 167]

However, as a rule, in this book he is treating as ‘money’ bank deposits. The second thing to note is that ‘money’ and ‘debt’ exist on a scale; they are not binary opposites.

One more definitional thing: Keynes uses the word ‘interest’ to stand in for “the complex of the various rates of interest current for different periods of time, i.e. for debts of different maturities.” The spread between them is treated as constant, or not considered important, and there is an assumption that rate differentials reflect differences in maturity, and not, say, risk.

So the interest rate equlibrates the desire to hold money with the available quantity of money, not the supply of savings with the demand for savings. Here we have another parallel with Marx, because Marx was also clear in opposition to doctrines that determined the interest rate with reference to the ‘real’ economy. For both Keynes and Marx the interest rate cannot be determined without reference to money. For Marx, the rate reflects supply and demand for ‘loanable funds’.

Finally, Keynes treats the supply of money as a fixed quantity, independent of demand. This is dubious in a world where private bank liabilities are money. Opinions differ on whether Keynes was using this as a simplifying assumption, or genuinely considered the money supply to be under the control of the state. Though this was no different from the majority of the (neo)classical economists of Keynes’ time, it was not universal, and apparently Keynes did not rely on this assumption in his earlier Treatise on Money. But he was certainly attacked for using this assumption in the General Theory, for example by Schumpeter in his History of Economic Analysis.

Anyway, treating the money supply in this way certainly makes things less complicated. We get an equation stating that the amount of money supplied equals the amount of money demanded. The supply is fixed, so demand must adjust. The interest rate moves to equalise the amount of money people want to hold with the amount there is to hold.

The only question, then, is what determines the relationship between the interest rate and the amount of money people want to hold, i.e., liquidity preference. First, Keynes upholds the “ancient distinction” between the demand for money to carry out transactions and the demand for money as a store of wealth. [p. 168] Obviously it is convenient to hold a certain amount of money between payment inflows to cover expenses. You don’t want to have to phone your broker to sell bonds every time you need to get some milk. But the amount held as money for transactions will be influenced by the interest rate, because at a higher rate it is worthwhile to sacrifice convenience to get a higher reward by holding bonds. So transactions demand for money is inversely related to the interest rate, and this is pretty obvious. (Note that there is an assumption that current accounts do not pay interest, or at least not much relative to bonds. Also, interest-paying term deposits are assumed to be equivalent to bonds.)

The demand for money as a store of wealth is more complex. If it were not for the fact that interest rates vary in unpredictable ways, there would seem little point in holding as money more than is needed for transactions. (Though I am sure I am far from alone in not caring enough to bother moving what spare money I have out of a current account.) But since we can’t predict when the rate will change, we could easily lose money by holding a bond – either relative to what we could have got with different decisions, or even in absolute terms.

Remember that in Keynes’ world, the only alternative to holding non-interest-paying money is buying a bond. The price of a bond changes in inverse proportion to the rate of interest. If the interest rate rises, existing bonds paying the old interest rate will fall in value because new bonds are available paying a higher rate. Therefore holding bonds carries some risk of capital loss. Therefore, there is an additional motive for holding some wealth in money rather than bonds. This is the precautionary motive for holding money.

Furthermore, some people will try to second-guess changes in interest rates. If they expect interest rates to rise, it makes sense to sell bonds now and hold money until they do, then buy the new bonds. If they expect interest rates to fall, it makes sense to borrow short-term to buy bonds, then sell them for capital gains when rates do fall. Because different market participants have different expectations, “the market price will be fixed at the point at which the sales of the ‘bears’ and the purchases of the ‘bulls’ are balanced.” [p. 170] This is the speculative motive for holding money

Remember that it is the aggregate demand and supply of bonds that determines the interest rate (though Keynes neglects the supply), so a general expectation of higher rates will lead to a sell-off of bonds, which will lower their price and thereby raise the rates – a self-fulfilling prophecy. But there are other independent influences on the rate – most importantly, the money supply.

So we have three motives for holding money: transactions, precautionary and speculative. Now we come to another paradox of the development of capital markets: deeper capital markets make it easier for individuals to sell (liquidate) their assets, so reduce the need for precautionary money balances, but open the possibility of speculation and cause fluctuations in liquidity preference because of the speculative motive. Keynes believes the interest rate will have more effect on money holdings via the speculative motive than via the transactions and precautionary motives. It is the balance between bull and bears on the bond market, then, that determines the interest rate for a given supply of money.

However, individual speculators are not bears and bulls permanently, but relative to the price pertaining presently in the market. As the rate rises, the number of people expecting it to rise further declines – some bears cross to the bull camp, or at least to a more neutral position. And vice versa. High interest rates tend to mean more people expecting them to fall, and vice versa.

Overall, we can imagine a schedule of liquidity preference, a smooth curve, such that as the money supply increases, the interest rate falls, and, again, vice versa. Keynes lists a couple of paths to equilibrium after an increase in the money supply leads to lower rates.

(1) As the interest rate falls, it is likely to cause increased investment, and therefore increased income, and therefore more money required for transactions. Thus some of the extra supply of money is absorbed.

(2) At the same time, the demand for money for speculative reasons will also rise, because a growing proportion of speculators expect the interest rate to rise again.

However, we can also think of circumstances in which things will not work so neatly. For example, suppose a small fall in the interest rate leads a large number of speculators to increase their expectation of a future rise, and the increased demand for money for speculative purposes is larger than the expansion of the money supply. Stability requires, then, a variety of opinions about the future.

Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ. Thus this method of control is more precarious in the United States, where everyone tends to hold the same opinion at the same time, than in England where differences of opinion are more usual. [p. 172]

Ooooh! No wonder they hated him at Bretton Woods.

Keynes cautions the reader against thinking that this analysis means that the quantity of money moves the whole system. This is because the analysis above assumes stable parameters: in the real world, liquidity preference, the marginal efficiency of capital, expectations, etc. will all be moving at the same time, so state control of the money supply alone will not be an all-powerful lever.

Keynes’ theory of the interest rate basically boils down to this: the entire money supply must be held by somebody; the interest rate adjusts to bring the demand for money balances in line with this supply.

Published in: on 22 October, 2007 at 4:17 pm  Leave a Comment  

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