In this chapter Keynes elaborates on the discussion of liquidity preference in Chapter 13. He starts with a brief consideration of how liquidity preference is related to the ‘income-velocity of money’. Liquidity preference, as we have seen, is about how much money units want to hold. Income-velocity is about how fast money travels around the economy on average during a period. Velocity is usually measured in terms of income (thus income-velocity): velocity equals income (in nominal terms, i.e. at current prices) divided by the quantity of money.
Liquidity preference is the inverse of income-velocity. Velocity is about how fast the average bit of money travels around the economy in a period; liquidity preference is about how much money is held idle in a period. Both concepts contain the same information; it’s really a question of which metaphor helps the intuition. Keynes prefers liquidity preference: “… the term ‘income-velocity of money’ carries with it the misleading suggestion of a presumption in favour of the demand for money as a whole being proportional, or having some determinate relation, to income, whereas this presumption should apply, as we shall see, only to a portion of the public’s cash holdings; with the result that it overlooks the part played by the rate of interest.” [p. 194]
Those parts of money held by units for other purposes than transactions will still show up in the velocity statistic – a rise in idle balances means a lower velocity of money as a whole. Keynes is right that the idea of velocity can be misleading. But so can the concept of ‘idle balances’ at the level of the economy as a whole, since we tend to use as money and near-money the liabilities of financial institutions, who are certainly not holding our funds idle. But since Keynes is discussing individual units’ decisions to hold money, it is better to look at it from the point of view of liquidity preference and idle balances, since individuals and firms decide how much liquidity to hold (though from inflows not of their own choosing!), and don’t have much control over the ‘velocity’ of those funds they send shooting off into the market.
Recall from Chapter 13 that Keynes split the motives for holding money into three categories: the transactions-motive, the precautionary-motive, and the speculative-motive. Now he splits the transactions-motive further, into the income-motive and the business-motive. This is basically a distinction between the transactions-motive for households and the transactions-motive for firms. Both depend on income and the normal periods between which money flows in and out of the units’ holdings. These periods are likely to be quite different for firms and households: though for the economy as a whole, business net expenditure is household net income (government excluded), there are a whole lot of transactions between businesses, which need to be included when you are thinking about the flow of money.
These two aspects of the transactions-motive and also the precautionary motive are clearly related to the interest rate, both as a gauge of how cheap money can be borrowed and how much is sacrificed in not lending it. These things work in opposite directions: a low interest rate means money is cheap to borrow when needed, so you don’t need to hold so much of it, but also means that not much is gained from not holding it.
So Keynes plays down the effect of monetary policy on the demand for money for these motives. Money demand for transactions and precautionary purposes mainly depends on the level of income and the structure of the payments system, and not so much on the interest rate. So the main impact of policy is through the speculative-motive. Effectively, the quantity of money demanded for other purposes can be subtracted from the total money supply, leaving the equilibrium interest rate to be determined by the rest of the money supply and the speculative-demand for money. Fortunately for money policy, the speculative-demand is continuously responsive to changes in the interest rate – there is a clear negative relationship between the interest rate and the speculative demand for money.
However, changes in the money supply by monetary authorities is not the only influence on the interest rate, because speculative expectations can change independently. In fact, changes in the money supply will affect interest rates not only directly, but also by affecting expectations of future rate changes.
When new money enters the economy, the effect on income and interest rates depends at first on how it enters. (No helicopters randomly scattering cash over the country here.) If it enters via the government’s deficit spending, it arrives as income. It will therefore have an affect on transactions and precautionary balances (which depend on income) as well as speculative balances. More money will be held to meet the needs of transactions and precautions, but not as much as the whole injection of money. Some of the injection will therefore find its way into the securities market, putting downward pressure on the interest rate – with the extent of the pressure dependent on the speculative demand for money. However, as the interest rate falls, investment will be stimulated to some extent, which will increase income further, and raise the transactions and precautionary demands for money again. There will be some equilibrium position where all demands will find balance with the money supply, and the end result of the whole business will probably be higher income and a lower interest rate.
If new money enters the economy without being part of somebody’s income, it will have its initial effect on the interest rate, but still increase income to some extent as the lower rate induces investment. How is it possible for money to enter the economy without being someone’s income? Through a financial transaction where a financial asset is purchased from outside the system. Keynes gives the example of a bank relaxing its credit standards and buying bonds with a self-created deposit. (Does this not complicate the story with regard to Keynes’ general assumption that the government controls the money supply?) But it might be easier to think about in terms of open market operations by the central bank: the central bank buys bonds, thus injecting money into the economy but into wealth portfolios rather than income.
At any rate, any increase in the money supply lowers interest rates (all else being equal), and a new equilibrium is reached partly by inducing greater holdings of money for speculative purposes, and partly by raising incomes and thereby increasing the need for money for transactions and precautionary purposes. Keynes is not entirely clear whether it makes a difference to the final equilibrium income and interest rate outcome if the money enters the system via income or not.
Keynes then gives his own definition of the income-velocity of money. For him it is related only to that part of the money supply which is held for transactions and precautionary purposes. This is clearly not a statistically functional definition, since there is no way to separate these balances from speculative balances. But, for what it’s worth, Keynes argues that income-velocity is constant, at least in the short-run, and the interest rate has no direct effect on it.
So (again) the equilibrium point between the rest of the money supply and the interest rate depends on the speculative demand for money. There is no constant relationship where a given rate is always in equilibrium with a given amount of money. That’s because “what matters is not the absolute level of [the interest rate] but the degree of its divergence from what is considered a fairly safe level of [the interest rate], having regard to those calculations of probability which are being relied upon.” [p. 201] As we saw in Chapter 13, the speculative demand for money depends on diverse assessments of where interest rates are going to go next, or at least in the medium term. But generally, a fall in the interest rate will be associated with an increase in the speculative demand for money, as more speculators will expect a rise in the future. (The considerations are actually a little more complex than this, also involving what is sacrificed in forgoing interest while wealth is held as money.)
Unless, that is, the fall in rates is associated with a fall in the general expectation of the ‘normal’ rate. Because in that case not so many speculators will expect a rise.
It is evident, then, that the rate of interest is a highly psychological phenomenon. We shall find, indeed, in Book V. that it cannot be in equilibrium at a level belowthe rate which corresponds to full employment; because at such a level a state of true inflation will be produced, with the result that [the transactions and precautionary demand for money] will absorb ever-increasing quantities of cash. But at a level above the rate which corresponds to full employment, the long-term market-rate of interest will depend, not only on the current policy of the monetary authority, but also on market expectations concerning its future policy. [p. 202]
The first part of that is very interesting, confirming again that Keynes converges with the classicals if full employment is assumed. The difference is that the classicals assume full employment.
Keynes now discusses the spread of interest rates rather than treated them as a homogeneous rate. Monetary authorities have much more influence over short-term rates than long-term rates precisely because they are expected to not aim at the same rate forever. Thus speculators can be reasonably sure that policymakers will maintain the rate in the short term. But because conditions will change over a longer horizon, policymakers are likely to change rates at some point, and this likelihood means they have less control over long-term rates in the present. This is especially so if speculators see the rate aimed at by policy as unsustainable, say, because it is lower that that prevailing overseas.
Of course, it is long-term rates that are more important in their effect on investment. So this is interesting – Keynes is implying that monetary authorities do not have the power to set rates as they please. If a broad spectrum of speculators thinks interest rates are going to rise in the long run, demand for money will rise to a high point “almost without limit” so absorbing whatever quantity of money authorities inject into the system in their attempt to lower rates. [p. 203]
It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal. [p. 203]
There is no reason why that conventional rate should be the rate consistent with full employment, even in the long run – “… particularly if it is the prevailing opinion that the rate of interest is self-adjusting, so that the level established by convention is thought to be rooted in objective grounds much stronger than convention, the failure of employment to attain an optimum level being in no way associated, in the minds either of the public or of authority, with the prevalence of an inappropriate rate of interest.” [p. 204]
This means that keeping effective demand at full-employment level is very difficult, especially since the marginal efficiency of capital is also unstable. But Keynes is optimistic that because the rate is malleable, so too can be long-run expectations about the rate, and so authorities might be able to cajole speculators step by step to a more appropriate rate if they are persistent enough.