5. The Demand for Money
a. Money in the E.R.E. and in the market
It is true, as we have said, that the only use for money is in exchange.
From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate.
Indeed, the reason that a reservation demand for money exists and cash balances are kept is that the individual is keeping his money in reserve for future exchanges.
That is the function of a cash balance, to wait for a propitious time to make an exchange.
Exchange. Suppose the E.R.E. has been established. In such a world of certainty there would be
no risk of loss in investment and no need to keep cash balances on hand in case an emergency
for consumer spending should arise. Everyone would therefore allocate his money stock fully
to the purchase of either present goods or future goods in accordance with his time preferences.
No one would keep his money idle in a cash balance.
Knowing that he will want to spend a certain amount of money on consumption in six months
time, a man will lend his money out for that period to be returned at precisely the time
it is to be spent.
But if no one is willing to keep a cash balance longer than instantaneously, there will be
no money held and no use for a money stock.
Money in short would either be useless or very nearly so in the world of certainty.
In the real world of uncertainty as contrasted to the ERE, even idle money kept in a cash
Cash balance performs a use for its owner. Indeed, if it did not perform such a use,
it would not be kept in his cash balance. Its uses are based precisely on the fact that
the individual is not certain on what he will spend his money, or of the precise time that
he will spend it in the future. Economists have attempted mechanically to reduce the
the demand for money to various sources.
There is no such mechanical determination however.
Each individual decides for himself by his own standards,
his whole demand for cash balances
and we can only trace various influences
which different catalactic events may have had on demand.
B, speculative demand.
One of the most obvious influences on the demand for money is expectation of future changes in the exchange value of money.
Thus, suppose that at a certain point in the future the PPM of money is expected to drop rapidly.
How the demand for money schedule now reacts depends on the number of people who hold this expectation and the strength with which they hold it.
They Hold It.
It also depends on the distance in the future at which the change is expected to take place.
The further away in time any economic event, the more its impact will be discounted in
the present by the interest rate.
Whatever the degree of impact, however, an expected future fall in the PPM will tend to
lower the PPM now.
For an expected fall in the PPM means that present units of money are worth more than
they will be in the future, in which case there will be a fall in the demand for money
schedule as people tend to spend more money now than at the future date.
A general expectation of an imminent fall in the PPM will lower the demand schedule
for Money now and thus tend to bring about the fall at the present moment.
Conversely, an expectation of a rise in the PPM in the near future will tend to raise
the demand for money schedule as people decide to hoard, add money to their cash balance
in expectation of a future rise in the exchange value of a unit of their money.
The result will be a present rise in the PPM.
An expected fall in the PPM in the future will therefore lower the PPM now, and an expected
rise will lead to a rise now.
The speculative demand for money functions in the same manner as the speculative demand
for any good.
An anticipation of a future point speeds the adjustment of the economy toward that future
point.
Just as the speculative demand for a good speeded adjustment to an equilibrium position,
so the anticipation of a change in the PPM speeds the market adjustment toward that position.
Just as in the case of any good, furthermore, errors in this speculative anticipation are
Self-Correcting Many writers believe that in the case of money,
there is no such self-correction.
They assert that while there may be a real or underlying demand for goods, money is not
consumed and therefore has no such underlying demand.
The PPM and the demand for money, they declare, can be explained only as a perpetual and rather
Another meaningless cat-and-mouse race in which everyone is simply trying to anticipate
everyone else's anticipations.
There is, however, a real or underlying demand for money.
Money may not be physically consumed, but it is used, and therefore it has utility in
a cash balance.
Such utility amounts to more than speculation on a rise in the PPM.
This is demonstrated by the fact that people do hold cash even when they anticipate a fall
in the PPM.
Such holdings may be reduced, but they still exist, and as we have seen, this must be so
in an uncertain world.
In fact, without willingness to hold cash, there could be no monetary exchange economy,
whatever.
The speculative demand therefore anticipates the underlying non-speculative demands, whatever
their source or inspiration.
Suppose then that there is a general anticipation of a rise in the PPM, a fall in prices, not
Reflected in Underlying Supply and Demand. It is true that at first this general anticipation
raises, Ceteris Paribus, the demand for money, and the PPM. But this situation does not last.
For now that a pseudo-equilibrium has been reached, the speculative anticipators, who
did not really have an increased demand for money, sell their money, buy goods, to reap
C. Secular Influences on the Demand for Money Long-run influences on the demand for money
Money in a progressing economy will tend to be manifold and in both directions.
On the one hand, an advancing economy provides ever more occasions for new exchanges as more
and more commodities are offered on the market and as the number of stages of production
increases.
These greater opportunities tend greatly to increase the demand for money schedule.
If an economy deteriorates, fewer opportunities for exchange exist and the demand for money
from this source will fall.
The major long-run factor counteracting this tendency and tending toward a fall in the
demand for money is the growth of the clearing system.
Clearing is a device by which money is economized and performs the function of a medium of exchange
without being physically present in the exchange.
A simplified form of clearing may occur between two people.
For example, A may buy a watch from B for three gold ounces.
At the same time, B buys a pair of shoes from A for one gold ounce.
Instead of two transfers of money being made and a total of four gold ounces changing hands,
They decide to perform a clearing operation. A pays B two ounces of money and they exchange
the watch and the shoes. Thus when a clearing is made and only the net amount of money is
actually transferred, all parties can engage in the same transactions at the same prices
but using far less cash. Their demand for cash tends to fall.
There is obviously little scope for clearing, however, as long as all transactions are cash
transactions.
For then, people have to exchange one another's goods at the same time.
But the scope for clearing is vastly increased when credit transactions come into play.
These credits may be quite short-term.
The Theory of Money and Credit
The net debtor pays one lump sum to the net creditor.
Once credit enters the picture, the clearing system can be extended to as many individuals
as find it convenient.
The more people engage in clearing operations, often in places called clearing houses, the
more cancellations there will be, and the more money will be economized.
At the end of the week, for example, there may be five people engaged in clearing and
a may-o-b 10 ounces, b-o-c 10 ounces, c-o-d, etc., and finally e may-o-a 10 ounces.
In such a case, 50 ounces worth of debt transactions and potential cash transactions are settled
without a single ounce of cash being used.
Clearing then is a process of reciprocal cancellations of money debts.
It permits a huge quantity of monetary exchanges without actual possession and transfer of
money, thereby greatly reducing the demand for money.
Clearing however cannot be all-encompassing, for there must be some physical money which
could be used to settle the transaction, and there must be physical money to settle
when there is no 100% cancellation, which rarely occurs.
D. Demand for money unlimited?
A popular fallacy rejects the concept of demand for money because it is allegedly always unlimited.
This idea misconceives the very nature of demand and confuses money with wealth or income.
It is based on the notion that people want as much money as they can get.
In the first place, this is true for all goods. People would like to have far more goods than they
can procure now. But demand on the market does not refer to all possible entries on people's value
scales. It refers to effective demand, to desires made effective by being demanded, that is, by the
fact that something else is supplied for it, or else it is reservation demand, which takes the form
of holding back the good from being sold. Clearly, effective demand for money is not and cannot be
unlimited. It is limited by the appraised value of the goods a person can sell in exchange,
and by the amount of that money which the individual wants to spend on goods, rather
than keep in his cash balance. Furthermore, it is of course not money per se that he wants
and demands, but money for its purchasing power, or real money, money in some way expressed
in terms of what it will purchase. This purchasing power of money as we shall see cannot be measured.
More money does him no good if its purchasing power for goods is correspondingly diluted.
E. The PPM and the rate of interest. We have been discussing money and shall continue to do so in
in the current section by comparing equilibrium positions, and not yet by tracing step by
step how the change from one position to another comes about.
We shall soon see that in the case of the price of money, as contrasted with all other
prices, the very path toward equilibrium necessarily introduces changes that will change
the equilibrium point.
This will have important theoretical consequences.
We may still talk, however, as if money is neutral, that is, does not lead to such changes,
because this assumption is perfectly competent to deal with the problems analyzed so far.
This is true, in essence, because we are able to use a general concept of the purchasing
The Theory of Money and Credit
In the determination of the interest rate, we must now modify our earlier discussion in Chapter 6 to take account of allocating one's money stock by adding to or subtracting from one's cash balance.
A man may allocate his money to consumption, investment, or addition to his cash balance.
His time preferences govern the proportion which an individual devotes to present and
to future goods, that is, to consumption and to investment.
Now suppose a man's demand for money schedule increases, and he therefore decides to allocate
a proportion of his money income to increasing his cash balance.
There is no reason to suppose that this increase affects the consumption investment proportion
at all.
It could, but if so, it would mean a change in his time preference schedule as well as
in his demand for money.
If the demand for money increases, there is no reason why a change in the demand for money
Money should affect the interest rate one iota. There is no necessity at all for an
increase in the demand for money to raise the interest rate or a decline to lower it,
no more than the opposite. In fact, there is no causal connection between the two. One
is determined by the valuations for money and the other by valuations for time preference.
Let us return to the section in Chapter 6 on time preference and the individual's money
stock.
Did we not see there that an increase in an individual's money stock lowers the effective
time preference rate along the time preference schedule and, conversely, that a decrease
raises the time preference rate?
Why does this not apply here?
Because we were dealing with each individual's money stock, and assuming that the real exchange
value of each unit of money remained the same.
His time preference schedule relates to real monetary units, not simply to money itself.
If the social stock of money changes, or if the demand for money changes, the objective
of Exchange Value of a Monetary Unit, the PPM will change also. If the PPM falls, then
more money in the hands of an individual may not necessarily lower the time preference
rate on his schedule, for the more money may only just compensate him for the fall in the
An increased demand for money, then, tends to lower prices all around without changing
time preference or the pure rate of interest.
Thus suppose total social income is 100, with 70 allocated to investment and 30 to consumption.
The demand for money increases, so that people decide to hoard a total of 20.
Expenditure will now be 80 instead of 100, 20 being added to cash balances.
Income in the next period will be only 80, since expenditures in one period result in
the identical income to be allocated to the next period, since no one can receive a money
income, unless someone else makes a money expenditure on his services.
If time preferences remain the same, then the proportion of investment to consumption
in the Society will remain roughly the same, that is, 56 invested and 24 consumed.
Prices and nominal money values and incomes fall all along the line, and we are left with
the same capital structure, the same real income, the same interest rate, etc.
The only things that have changed are nominal prices, which have fallen, and the proportion
The only other change is a lower proportion of cash balances to money income, which has increased.
A decreased demand for money will have the reverse effect.
Dishoarding will raise expenditure, raise prices,
and, Ceteris Paribus, maintain the real income and capital structure intact.
The only other change is a lower proportion of cash balances to money income.
The only necessary result, then, of a change in the demand for money schedule is precisely
a change in the same direction of the proportion of total cash balances to total money income
and in the real value of cash balances.
Given the stock of money, an increased scramble for cash will simply lower money incomes until
Until the desired increase in real cash balances has been attained, if the demand for money
falls, the reverse movement occurs.
The desire to reduce cash balances causes an increase in money income.
Total cash remains the same, but its proportion to incomes, as well as its real value, declines.
Strictly the Ceteris Paribus condition will tend to be violated.
An increased demand for money tends to lower money prices and will therefore lower money
costs of gold mining.
This will stimulate gold mining production until the interest return on mining is again
the same as in other industries.
Thus, the increased demand for money will also call forth new money to meet the demand.
A decreased demand for money will raise money costs of gold mining and at least lower the
rate of new production.
It will not actually decrease the total money stock unless the new production rate falls
below the wear and tear rate.
F. Hoarding and the Keynesian System
1. Social Income, Expenditures and Unemployment
To the great bulk of writers, hoarding, an increase in the demand for money, has appeared
an unmitigated catastrophe. The very word hoarding is a most inappropriate one to use
as in economics, since it is laden with connotations of vicious antisocial action.
But there is nothing at all antisocial about either hoarding or dis-hoarding.
Hoarding is simply an increase in the demand for money, and the result of this change in
valuations is that people get what they desire, that is, an increase in the real value of
The Theory of Money and Credit
The Theory means that people want something, either an increase or a decrease in their
real cash balances or in the real value of the monetary unit, and that they are able
to obtain this result.
What is wrong with that?
We see here simply another manifestation of consumers or individuals' sovereignty
on the free market.
Furthermore, there is no theoretical way of defining hoarding beyond a simple addition to one's cash balance in a certain period of time.
Yet most writers use the term in a normative fashion, implying that there is some vague standard below which a cash balance is legitimate, and above which it is antisocial and vicious.
One of the two major pillars of the Keynesian system, now happily beginning to wane after
sweeping the economic world in the 1930s and 1940s, is the proclamation that savings become
equal to investment only through the terrible root of decline in social income.
The term generally used is national income, however in a free market economy the nation
will no more be an important economic boundary than the village or region.
It is more convenient then to set aside regional problems for other analysis and to concentrate
on Aggregate Social Income.
This is especially true since regions do not present a problem to economic theory until
their governments begin intervening in the free market.
The implicit foundation of Keynesianism is the assertion that at a certain level of total
social income, total social expenditures out of this income will be lower than income,
The Keynesian consumption function plays its part in establishing an alleged law that there
There exists a certain level of total income, say A, above which expenditures will be less
than income, net hoarding, and below which expenditures will be greater than income,
net dis-hoarding.
But the basic Keynesian worry is hoarding, when total income must decline.
We shall investigate the validity of this alleged law and the consumption function on
which it rests, but suppose that we now grant the validity of such a law.
The only comment can be an impertinent, so what?
What if there is a fall in the national income?
Since the fall need only be in money terms, and real income, real capital, etc. may remain
In the same, why any alarm?
The only change is that the hoarders have accomplished their objective of increasing
their real cash balances and increasing the real value of the monetary unit.
It is true that the picture is rather more complex for the transition process until equilibrium
is reached, and this will be treated further, although our final conclusion will be the
same.
But the Keynesian system attempts to establish the perniciousness of the equilibrium position,
and this it cannot do.
Therefore, the elaborate attempts of the Keynesians to demonstrate that free market expenditures
will be limited, that consumption is limited by the function, and investment by stagnation
of Opportunities and Liquidity preference are futile, for even if they were correct, which
they are not, the result would be pointless.
There is nothing wrong with hoarding or dishording, or with low or high levels, whatever that
may mean, of social money income.
The Keynesian attempt to salvage meaning for their doctrine rests on one point and one
point alone.
The second major pillar of their system.
This is the thesis that money, social income and level of employment are correlated, and
that the latter is a function of the former.
This assumes that a certain full employment level of social income exists below which
there is correspondingly greater unemployment.
The nub of the Keynesian critique of the free-market economy, then, rests on the involuntary unemployment
allegedly caused by too low a level of social expenditures and income.
But how can this be, since we have previously explained that there can be no involuntary
unemployment in a free market?
The answer has become evident, and is admitted in the most intelligent of the Keynesian writings.
The Keynesian underemployment equilibrium occurs only if money wage rates are rigid downward.
That is, if the supply of labor below full employment is infinitely elastic.
Thus suppose there is a hoarding, an increased demand for money, and social income falls.
The result is a fall in the monetary demand for labor factors, as well as in all other monetary demand.
Since only money wage rates are being changed, while real wage rates, in terms of purchasing power, remain the same,
there will be no shift in labor leisure preferences, and the total stock of labor offered on the market will remain constant.
At any rate, certainly no involuntary unemployment will arise.
How then can the Keynesian case arise?
In only two ways.
One, if people voluntarily agree with the unions, which insist that no one be employed
at lower than the old money wage rate.
Since selling prices are falling, maintaining the old money wage rate is equivalent to demanding
Raising a Higher Real Wage Rate
We have seen that the unions raising of real wage rates causes unemployment.
But this unemployment is voluntary, since the workers acquiesce in the imposition of
a higher minimum real wage rate, below which they will not undercut the union and accept
employment.
Chapter 2, Unions or Government Coercively Impose the Minimum Wage Rate, but this is
an example of a hampered market, not the free market to which we are confining our analysis
here.
Kane's own exposition tended to run in terms of real, rather than money, magnitudes, real
Real social income, real expenditures, etc.
Such an analysis obscures dynamic considerations, since transactions take place, at least superficially,
in monetary terms on the market.
However, the essential conclusion of our analysis remains unchanged if we pursue it directly
in real terms.
Instead of falling, demand in real terms will now remain the same.
This is true for the labor market as well.
The sum and substance of the Keynesian Revolution was the thesis that there can be an unemployment
equilibrium on the free market.
As we have seen, the only sense in which this is true was known years before Keynes.
That widespread union maintenance of excessively high wage rates will cause unemployment.
Keynes believed that while other elements of the economic system, including prices, were
set basically in real terms, workers bargained even ultimately, only in terms of money wages.
That unions insisted on minimum money wage rates downward, but would passively accept
falling real wages in the form of rising prices, money wage rates remaining the same.
The Keynesian prescription for eliminating unemployment therefore rests specifically
on the money illusion, that unions will impose minimum money wage rates, but are too stupid
to Impose Minimum Real Wage Rates, Per Se.
Unions, however, have learned about purchasing power problems and the distinction between
money and real rates.
Indeed, it hardly requires much reasoning ability to grasp this distinction.
Ironically, Cain's advocacy of inflation based on the money illusion rested on the
The historical experience that, during an inflation, selling prices rise faster than
wage rates.
Yet an economy in which unions impose minimum wage rates is precisely an economy in which
unions will be alive to any losses in their real, as well as their money, wages.
Inflation therefore cannot be used as a means of duping unions into relieving unemployment.
Furthermore, inflation is, at best, an inefficient and distortive substitute for flexible wage
rates, for inflation affects the entire economy and its prices, while particular wage rates
will fall only to the extent necessary to clear the market for the particular labor
factor.
Thus freely flexible wage rates will fall only in those fields necessary to eliminate unemployment in those particular areas.
Keynesianism has been touted as at least a practical system.
Whatever its theoretical defects, it is alleged to be fit for the modern world of unionism.
Yet it is precisely in the modern world that Keynes' doctrine is least appropriate or practical.
The Keynesians object that to allow rigid money wage rates to become flexible downward
would further lower monetary demand for goods and therefore monetary income.
But this completely confuses wage rates with aggregate payroll or total income going to wages.
That the former falls does not mean that the latter falls. On the contrary, total income is,
as we have seen, determined by total expenditures in the previous period of time. Lower wage rates
This will cause the hiring of those made unemployed by the old excessively high wage rates.
The fact that labor is now cheaper relatively to land factors will cause investors to expend
a greater proportion on labor vis-à-vis land than before.
And the employment of unemployed labor increases production and therefore aggregate real income.
Furthermore, even if payrolls also decline, prices and wage rates can adjust,
but this will be taken up in the next section on liquidity preference.
2. Liquidity preference
Those Keynesians who recognize the grave difficulties of their system
fall back on one last string in their bow, liquidity preference.
Intelligence Keynesians will concede that involuntary unemployment is a special or rare case, and Lindahl goes even further to say that it could be only a short-run and not a long-run equilibrium phenomenon.
Neither Franco Modigliani nor Eric Lindahl, however, is thorough going enough in his critique
of the Keynesian system, particularly of the liquidity preference doctrine.
The Keynesian system, as is quite clear from the mathematical portrayals of it given it
by its followers, suffers grievously from the mathematical economic sin of mutual determination.
The use of mathematical functions, which are reversible at will, is appropriate in physics,
where we do not know the causes of the observed movements.
Since we do not know the causes, any mathematical law explaining or describing movements will
be reversible, and, as far as we are concerned, any of the variables in the function is just
as much cause as another.
In praxeology, the science of human action, however, we know the original cause, motivated
action by individuals.
This knowledge provides us with true axioms.
From these axioms, true laws are deduced.
They are deduced step by step in a logical cause and effect relationship.
Its first causes are known, their consequent effects are also known.
Economics, therefore, traces unilinear cause and effect relations, not vague, mutually
determining relations.
This methodological reminder is singularly applicable to the Keynesian theory of interest.
For the Keynesians consider the rate of interest, a, as determining investment, and b, as being
determined by the demand for money to hold for speculative purposes, liquidity preference.
In practice, however, they treat the latter not as determining the rate of interest, but
as being determined by it.
The methodology of mutual determination has completely obscured this sleight of hand.
Keynesians might object that all demand and supply is mutually determined in its relation
to price, but this facile assertion is not correct.
Demand is determined by utility scales, and supply by speculation and the stock produced
Interest by given labor and land factors, which is ultimately governed by time preferences.
The Keynesians therefore treat the rate of interest not as they believe they do, as determined
by liquidity preference, but rather as some sort of mysterious and unexplained force imposing
itself on the other elements of the economic system.
Thus, Keynesian discussion of liquidity preference centers around inducement to hold cash as
the rate of interest rises or falls.
According to the theory of liquidity preference, a fall in the rate of interest increases the
quantity of cash demanded for speculative purposes, liquidity preferences, and a rise
in the rate of interest lowers liquidity preference.
The first error in this concept is the arbitrary separation of the demand for money into two
separate parts, a transactions demand, supposedly determined by the size of social income, and
a speculative demand, determined by the rate of interest.
We have seen that all sorts of influences impinge themselves on the demand for money,
But they are only influences, working through the value scales of individuals, and there
is only one final demand for money, because each individual has only one value scale.
There is no way by which we can split the demand up into two parts and speak of them
as independent entities.
Furthermore, there are far more than two influences on demand.
In the final analysis, the demand for money, like all utilities, cannot be reduced to simple
determinants.
It is the outcome of free, independent decisions on individual value scales.
There is, therefore, no transaction demand uniquely determined by the size of income.
The speculative demand is mysterious indeed.
Modigliani explains this liquidity preference as follows.
We should expect that any fall in the rate of interest would induce a growing number
of potential investors to keep their assets in the form of money, rather than securities.
That is to say, we should expect a fall in the rate of interest to increase the demand
for money as an asset.
This is subject to the criticism, as we have seen, that the rate of interest is here determining
and is not itself explained by any cause.
Furthermore, what does this statement mean?
A fall in the rate of interest, according to the Keynesians, means that less interest
is being earned from bonds, and therefore there is a greater inducement to hold cash.
This is correct, as long as we allow ourselves to think in terms of the interest rate as
determining, instead of being determined, but highly inadequate.
For if a lower interest rate induces greater cash holdings, it also induces greater consumption,
since consumption also becomes more attractive.
In fact, one of the grave defects of the liquidity preference approach is that the Keynesians
never think in terms of three margins being decided at once.
They think only in terms of two at a time, hence Modigliani.
Having made his consumption-saving plan, the individual has to make decisions concerning
the assets he owns.
That is, he then allocates them between money and securities.
In other words, people first decide between consumption and saving in the sense of not
consuming, and then they decide between investing and hoarding these savings.
But this is an absurdly artificial construction.
People decide on all three of their alternatives, weighing one against each of the others.
To say that people first decide between consuming and not consuming, and then choose between
hoarding and investing, is just as misleading as to say that people first choose how much
to hoard, and then decide between consumption and investment.
People therefore allocate their money among consumption, investment and hoarding.
The proportion between consumption and investment reflects individual time preferences.
Consumption reflects desires for present goods, and investment reflects desires for future
goods.
An increase in the demand for money schedule does not affect the rate of interest if the
The proportion between consumption and investment, that is, time preference, remains the same.
The rate of interest, we must reiterate, is determined by time preferences, which also
determine the proportions of consumption and investment.
To think of the rate of interest as inducing more or less saving or hoarding is to misunderstand
Admitting, then, that time preference determines the proportions of consumption and investment,
and that the demand for money determines the proportion of income hoarded, does the demand
for money play a role in determining the interest rate?
The Keynesians assert that there is a relation between the rate of interest and a speculative
of Demand for Cash.
Should the schedule of the latter rise, the former rises also.
But this is not necessarily true.
A greater proportion of funds hoarded
can be drawn from three alternative sources.
A, from funds that formerly went into consumption,
B, from funds that went into investment,
and C, from a mixture of both that
leaves the old consumption investment proportion unchanged.
Condition A will bring about a fall in the rate of interest.
Condition B, a rise in the rate of interest.
And condition C will leave the rate of interest unchanged.
Thus hoarding may reflect either a rise, a fall,
or no change in the rate of interest,
depending on whether time preferences
The Keynesians contend that the speculative demand for cash depends upon and determines the rate of interest in this way.
If people expect that the rate of interest will rise in the near future, then their liquidity preference increases to await this rise.
This, however, can hardly be a part of a long-run equilibrium theory such as Keynes is trying to establish.
Speculation by its very nature disappears in the ERE and hence no fundamental causal theory can be based upon it.
Furthermore, what is an interest rate?
One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production.
The former, as we have seen, is only the reflection of the latter.
A strong expectation of a rapid rise in interest rate means a strong expectation of an increase in the price spreads or rate of net return.
A fall in prices means that entrepreneurs generally expect that factor prices will fall further in the near future than their selling prices.
But it requires no Keynesian labyrinth to explain this phenomenon.
phenomenon.
All we are confronted with is a situation in which entrepreneurs, expecting that factor
prices will soon fall, cease investing and wait for this happy event, so that their return
will be greater.
This is not liquidity preference, but speculation on price changes.
It involves a modification of our previous discussion of the relation between prices
and the demand for money, caused by a fact that we shall explore soon in detail, namely
that prices do not change equally and proportionately.
The expectation of falling factor prices speeds up the movement toward equilibrium, and hence
toward the pure interest relation as determined by time preference.
W. H. Hutt concludes that equilibrium is secured when all services and products are so priced
that they are, one, brought within the reach of people's pockets, that is, so that they
are purchasable by existing money incomes, or, two, brought into such a relation to predicted
prices that no postponement of expenditure on them is induced.
For instance, the products and services used in the manufacture of investment goods must
be so priced that anticipated future money incomes will be able to buy the services and
depreciation of new equipment or replacement.
If for example, unions keep wage rates artificially high, hoarding will increase, as unions keep
Postponements in purchases arise because it is judged that a cut in costs or other prices
is less than will eventually have to take place, or because the rate of fall of costs
is insufficiently rapid.
The final Keynesian bogey is that people may acquire an unlimited demand for money, so
that hoards will indefinitely increase.
This is termed an infinite liquidity preference, and this is the only case in which neo-Keynesians
Experts such as Modigliani believe that involuntary unemployment can be compatible with price
and wage freedom.
The Keynesian worry is that people will hoard instead of buying bonds, for fear of a fall
in the price of securities.
Translating this into more important natural terms, this would mean, as we have stated,
investing because of expectation of imminent increases in the natural interest rate.
Rather than act as a blockade, however, this expectation speeds the ensuing adjustment.
Furthermore, the demand for money could not be infinite, since people must always continue
consuming whatever their expectations. Of necessity, therefore, the demand for money
could never be infinite. The existing level of consumption, in turn, will require a certain
level of investment. As long as productive activities are continuing, there is no need
or possibility of lasting unemployment, regardless of the degree of hoarding.
As Hutt points out, if we can conceive of a situation of infinitely elastic liquidity preference,
and no such situation has ever existed, then we can conceive of prices falling rapidly,
keeping pace with expectations of price changes, but never reaching zero, with full utilization
of resources persisting all the way. A demand for money to hold stems from the general uncertainty
of the Market. Keynesians, however, attribute liquidity preference not to general uncertainty
but to the specific uncertainty of future bond prices. Surely this is a highly superficial
and limiting view. In the first place, this cause of liquidity preference could occur
only on a highly imperfect securities market. As Ludwig Lachmann pointed out years ago in
In a neglected article, Kane's causal pattern, bearishness causing liquidity preference, demand
for cash, and high interest rates, could take place only in the absence of an organized
forward or futures market for securities.
If such a market existed, both bears and bulls on the bond market could express their expectations
by Forward Transactions
which do not require any cash.
Where the market for securities is fully organized over time,
the owner of 4% bonds who fears a rise in the rate of interest
has no incentive to exchange them for cash,
for he can always hedge by selling them forward.
Bearishness would cause a fall in forward bond prices,
followed immediately by a fall in spot prices.
Thus, speculative bearishness would, of course, cause at least a temporary rise in the rate of interest,
but accompanied by no increase in the demand for cash.
Hence, any attempted connection between liquidity preference, or demand for cash, and the rate of interest, falls to the ground.
The fact that such a securities market has not been organized indicates that traders are not
nearly as worried about rising interest rates as Keynes believes. If they were,
and this fear loomed as an important phenomenon, then surely a futures market would have developed
in securities. Furthermore, as we have seen, interest rates on loans are merely a reflection
of Price Spreads, so that a prediction of higher interest rates really means the expectation
of lower prices, and especially lower costs, resulting in a greater demand for money.
And all speculation on the free market is self-correcting and speeds adjustment, rather
than a cause of economic trouble.
G. The purchasing power and terms of trade components in the rate of interest.
Many economists beginning with Irving Fisher have asserted that the market rate of interest,
in addition to containing specific entrepreneurial components superimposed on the pure rate of interest,
also contains a price or a purchasing power component.
When the purchasing power of money is generally expected to rise, the theory asserts that the market rate of interest falls correspondingly.
When the PPM is expected to fall, the theory declares that the market rate of interest rises correspondingly.
These economists erred by concentrating on the loan rate, rather than on the natural rate, the rate of return.
The reasoning behind this theory was as follows. If the purchasing power of money is expected to change, then the pure rate of interest determined by time preference will no longer be the same in real terms.
Suppose that 100 gold ounces exchange for 105 gold ounces a year from now, that is, that the rate of interest is 5%.
Now, suddenly, let there be a general expectation that the purchasing power of money will increase.
In that case, a lower amount to be returned, say 102 ounces, may yield 5% real interest
in terms of purchasing power.
A general expectation of a rise in purchasing power, therefore, will lower the market rate
of Interest at present, while a general expectation of a fall in purchasing power will raise the
rate.
There is a fatal defect in this generally accepted line of reasoning.
Suppose for example that prices are generally expected to fall by 50% in the next year.
Would someone lend 100 gold ounces to exchange for 53 ounces one year from now?
Why not?
This would certainly preserve the real interest rate at 5%.
But then why should the would-be lenders not simply hold on to their money and double their
real assets as a result of the price fall?
And that is precisely what they would do.
They certainly would not give money away, even though their real assets would be greater
than before.
Fisher simply shrugged off this point by saying that the purchasing power premium could never
make the interest rate negative, but this flaw vitiates the entire theory.
The root of the difficulty consists in ignoring the natural rate of interest.
Let us consider the interest rate in those terms.
Then suppose 100 ounces are paid for factors that will be transformed in one year into
to a product that sells for 105 gold ounces, for an interest gain of 5 and an interest
return of 5%.
Now a general expectation arises of a general having of prices one year from now.
The selling price of the product will be 53 ounces in a year's time.
What happens now?
Will entrepreneurs buy factors for $100 and sell at $53 merely because their real interest
rate is preserved?
Certainly not.
They will do so only if they do not at all anticipate the change in purchasing power.
But to the extent that it is anticipated, they will hold money rather than buy factors.
This will immediately lower factor prices to their expected future levels, say from 100
to 50.
What happens to the loan rate is analytically quite trivial.
It is simply a reflection of the natural rate, and depends on how the expectations and judgment
of the people on the loan market compare with those on the stock and other markets.
For the free economy, there is no point in separately analyzing the loan market.
Analysis of the Fisher problem, the relation of the interest rate to price changes, should
concentrate on the natural rate of interest.
Discussion of the relation between price movements and the natural rate of interest should be
divided into two parts.
First, assuming neutral money, that all prices change equally and at the same time.
And second, analyzing conditions where factor and product change at different rates.
And these changes should first be analyzed without considering that they had been anticipated
by people on the market.
Suppose first that all prices change equally and at the same time.
Instead of thinking in terms of 100 ounces borrowed on the loan market, let us consider
the natural rate.
An investor buys factors in period 1 and then sells the product, say, in period 3.
Time, as we have seen, is the essence of the production structure.
All the processes take time, and capitalists pay money to owners of factors in advance
of production and sale.
Since factors are bought before products are sold, what is the effect of a period of rising
general prices, that is, falling PPM?
The result is that the entrepreneur reaps an apparent extra profit.
Suppose that he normally purchases original factors for 100, and then sells the product for 120 ounces two years later, for an interest return of 10% per annum.
Now suppose that a decrease in the demand for money, or an increase of money stock, propels a general upward movement in prices, and that all prices double in two years' time.
Then, just because of the passage of time, an entrepreneur who purchases factors for
100 now will sell for 240 ounces in two years' time.
Instead of a net return of 20 ounces, or 10% per annum, he reaps 140 ounces, or 70% per
annum.
It would seem that a rise in prices creates an inherent tendency for large-scale profits
that are not simply individual rewards for more accurate forecasting.
However, more careful analysis reveals that this is not an extra profit at all, for the
240 ounces two years from now is roughly equivalent in terms of purchasing power to 120 ounces
now.
The real rate of net return, based on money services, is the same 10% as it has always
been.
It is clear that any lower net return would amount to a decline in real return.
A return of a mere 120 ounces, for example, would amount to a drastic negative real return,
For 100 ounces would then be invested for the equivalent gross return of only 60 ounces.
It has often been shown that a period of rising prices misleads businessmen into thinking
that their increased money profits are also real gains, whereas they only maintain real
rates of return.
Consider for example replacement costs, the prices which the businessmen will now have
The Capitalist who earns 240 ounces on a 100 ounce investment neglects to his sorrow the fact that his factor bundle now costs 200 ounces instead of 100.
Businessmen who, under such circumstances, treat their monetary profits as real profits and consume them, soon find that they are really consuming their capital.
Capital
The converse occurs in the case of falling prices.
The capitalist buys factors in period one and sells the product in period three, when
all-around prices are lower.
If prices are to fall by a half in two years, an investment of one hundred, followed by
a sale at sixty, does not really involve the terrific loss that it appears to be.
For the 60, return is equivalent in real terms, both in generalized purchasing power and in
replacement of factors, to 120 previous ounces.
His real rate of return remains the same.
The consequence is that businessmen will be likely to overstate their losses in a period
of price contraction.
Perhaps this is one of the major reasons for the deep-seated belief of most businessmen
that they always gain during a general price expansion and lose during a period of general
contraction.
This belief is purely illusory.
In these examples, the natural interest rate on the market has contained a purchasing power
Component, which corrects for real rates, positively in money terms during a general
expansion and negatively during a general contraction.
The loan rate will be simply a reflection of what has been happening in the natural
rate.
So far, the discussion is similar to Fisher's, except that these are the effects of actual,
not anticipated changes, and the Fisher thesis cannot take account of the negative interest
rate case.
We have seen that rather than take a monetary loss, even though their real return will be
the same, entrepreneurs will hold back their purchases of factors until factor prices fall
immediately to their future low level.
But this process of anticipatory price movement does not occur only in the extreme case of
a prospective negative return.
It happens whenever a price change is anticipated.
Thus, suppose all entrepreneurs generally anticipate that prices will double in two
years.
The fact of an anticipated rise will lead to an increase in the price level now and
An anticipated fall will lead to an immediate fall in factor prices. If all changes were anticipated by everyone, there would be no room for a purchasing power component to develop. Prices would simply fall immediately to their future level.
The purchasing power component, then, is not the reflection, as has been thought, of expectations
of changes in purchasing power.
It is the reflection of the change itself.
Indeed, if the change were completely anticipated, the purchasing power would change immediately,
and there would be no room for a purchasing power component in the rate of interest.
As it is, partial anticipations speed up the adjustment of the PPM to the changed conditions.
So far we have distinguished three components of the natural rate of interest, all reflected
in the loan rate of interest.
One is the pure rate of interest, the result of individual time preferences tending to
be uniform throughout the economy.
are the specific entrepreneurial rates of interest.
These differ from firm to firm and so are not uniform.
They are anticipated in advance and they are the rates that an investor will have to anticipate
receiving before he enters the field.
A particularly risky venture, if successful at all, will therefore tend to earn more in
The third component of the natural rate of interest is the purchasing power component,
correcting for general PPM changes because of the inevitable time lags in production.
This will be positive in an expansion and negative in a contraction, but will be ephemeral.
The more the changes in the PPM are anticipated, the less important will be the purchasing
power component, and the more rapid will be the adjustment in the PPM itself.
There is still a fourth component in the natural rate of interest.
This exists to the extent that money changes are not neutral, and they never are.
Sometimes product prices rise and fall faster than factor prices.
Sometimes they rise and fall more slowly.
And sometimes their behavior is mixed, with some factor prices and some product prices
rising more rapidly.
Whenever there is a general divergence in rates of movement between the prices of the
and of Original Factors, a Terms of Trade component emerges in the natural rate of interest.
Historically, it has often been the case that product prices rise more rapidly and fall more rapidly than the prices of original factors.
In the former case, there is, during the period of transition, a favorable change in the terms
of trade to the general run of capitalists.
For-selling prices are increasing faster than the buying prices of original factors.
This will increase the general rate of return and constitute a general positive terms of
trade component in the natural rate of interest.
This of course will also tend to be reflected in the loan rate of interest.
In the case of a contraction, a more sluggish fall in the prices of factors creates a general
negative terms of trade component in the interest rate.
The components are precisely the reverse whenever factor prices change more rapidly than product
prices.
However there is no general change in the terms of trade to capitalist entrepreneurs,
no terms of trade component will appear in the interest rate.
Changes in terms of trade discussed here are only those resulting purely from differences
in the speed of reaction to changing conditions.
They do not include basic changes in the terms of trade resulting from changes in time preferences, such as we have discussed previously.
It is clear that all the interest rate components aside from the pure rate, entrepreneurial, purchasing power and terms of trade, are dynamic and the result of uncertainty.
None of these components would exist in the ERE, and therefore the market interest rate
in the ERE would equal the pure rate determined by time preferences alone.
In the ERE, the only net incomes would be a uniform pure interest return, and wages
to Labor, Ground Land Rents being capitalized into an interest return.