John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 165–174.
The General Theory of the rate of interest
Chapter 11 deals with the marginal efficiency of capital (MEC); here, Keynes will explain his unique approach to the theory of interest: the liquidity preference theory. To put the two concepts in relation to each other, Keynes harks back to supply and demand. The MEC is what decides the demand for loanable funds, while interest is what decides the supply of loanable funds. Traditionally, interest is said to be a function of the relationship between the MEC and time preference, but Keynes doesn’t believe this to be true.
Keynes essentially divides the concept of time preference into two ancillary ideas: (i) the propensity to consume; and, (ii) liquidity preference: “in what form he will hold the command over future consumption which he has reserved” (p. 166). Does the person want to retain some high degree of immediate command — like cash — or is he willing to part with command for some amount of time? It’s the concept of liquidity preference that traditional theories of interest neglect.
Why can’t the rate of interest be a return on waiting or saving? Let’s suppose two forms of savings are available: holding cash and a time deposit. The latter pays interest, while the former does not. Yet, an individual might choose to increase his demand for money, rather than store it in a time deposit, and earn no interest. Rather, the rate of interest is the price of “parting with liquidity;” specifically, it’s the inverse proportion between a stock of money and “what can be obtained for parting with control over the money in exchange for debt for a stated period of time” (p. 167).
Therefore, the rate of interest measures how unwilling those with cash are to part with control over it. So, rather than equilibrating the supply of and demand for loanable funds, it equilibrates demand for money with the supply of money. Given this, we can say that the rate of interest is determined by liquidity preference and the quantity of money. Or, where M is money, L is liquidity preference, and r the rate of interest: M = Lr.
While most of this concern will be answered in chapter 15, what determines liquidity preference? Why might someone prefer liquid command over interest payments? Keynes’ answer, “[U]ncertainty as to the future of the rate of interest.” In other words, if there is uncertainty as to the interest that investment into a long-term bond will pay, such that there may be a loss, an individual may refer to simply hold cash. As such, the decision to part with liquidity is made when the expected gain is higher than the expected gain of holding money, meaning that when there is high uncertainty the rate of interest will have to increase. Now, knowing that expectations will diverge, we can say that interest will balance at the equilibrium point between “bears” (hold cash; sell bonds) and “bulls” (buy bonds).
- The Transaction Motive: the need for cash to fulfill current transactions during personal and business exchanges;
- The Precautionary Motive: the desire for security;
- The Speculative Motive: The objective of securing profit by “knowing better than the market” (p. 170).
As with earlier chapters, he mentions that organized markets suffer the burden of destabilization at the hands of speculators. Let’s say that liquidity preference due to the transaction and precautionary motives leads to demand for cash y, such that total cash x – y is equal to the amount of cash available to satisfy the speculative motive (z). The rate of interest and price of bonds have to be set where liquidity preference due to the speculative motive is equal to z. Suppose the quantity of money increases, then the price of bonds has to rise to the point where it persuades the marginal speculators to become bearish, and thus sell their bonds in exchange for holding cash. As a matter of simple arithmetic: X = Y + Z; assuming Y remains the same, ↑M must lead to ↑Z. Alternatively, if Z is negligible, then an ↑M will cause a ↓r (↑Y).
Why, though, can we generally assume a liquidity preference schedule such that ↑M leads to ↓r? Keynes gives two reasons,
- The more r falls, usually the more money will be held due to the transaction motive. If a fall in r leads to an increase in income, money held due to the transaction motive will rise proportionally with the increase in income;
- A fall in r may change the amount of cash held due to the speculative motive.
There maybe a time when increases in the quantity of money may not reduce the rate of interest further (or “will exert a comparatively small influence” [p. 172]). It occurs when an increase in M causes high uncertainty with regards to the future state of r. Liquidity preference will rise due to stimulation of the precautionary motive and it may lead a “mass movement” (p. 172) to cash. Here Keynes make the great observation that for changes in the money stock to change the rate of interest, there has to exist some degree of variation in expectations. The more heterogeneous expectations are, the more stable the cash–bond market.
Keynes sees this relationship between the stock of money (and changes in this stock), bond prices, and the rate of interest as the main artery by which money exerts its influence over the economy. For example, while we may expect an ↑M to cause a ↓r, this may not occur if ↑L>↑M. Similarly, while a ↓r may be expected to cause a ↑I, this may not occur if there is a simultaneous ↓MEC greater than the ↓r. Just the same, a ↑I will not lead to higher employment if there is a ↓MPC. Finally, to maintain r in the face of ↑money wages and ↑O, there will have to be a ↑L.
This is a minor note, relating this chapter and liquidity preference to what Keynes called “the state of bearishness” in his Treatise on Money. The difference is that the “state of bearishness” is a functional relationship between the “price of assets and debts, taken together, and the quantity of money” (pp. 173–174). The error there is a confusion between the results of a change in the rate of interest and a change in the MEC.
Liquidity preference is not just hoarding in the sense of cash holdings; the decision to hoard is taken into consideration along with “the advantages” of parting with liquidity. No less, equating hoarding with only the demand for money is meaningless if we consider that all money has to be held by someone. So, while the public doesn’t choose how much to hoard, since the public doesn’t choose the quantity of money, the public does “choose” the rate of interest, in the sense that interest is set where “the aggregate desire to hoard becomes equal to the available cash” (p. 174). As Keynes eloquently states,
The habit of overlooking the relation of the rate of interest to hoarding may be a part of the explanation why interest has been usually regarded as the reward of not-spending, whereas in fact it is the reward of not-hoarding.
— p. 174.