WEBVTT NOTE 11.05. The Demand for Money 1 00:00:00.000 --> 00:00:04.000 5. The Demand for Money 2 00:00:04.000 --> 00:00:10.000 a. Money in the E.R.E. and in the market 3 00:00:10.000 --> 00:00:16.000 It is true, as we have said, that the only use for money is in exchange. 4 00:00:16.000 --> 00:00:25.000 From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate. 5 00:00:25.000 --> 00:00:39.000 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. 6 00:00:39.000 --> 00:00:46.000 That is the function of a cash balance, to wait for a propitious time to make an exchange. 7 00:00:46.000 --> 00:00:54.340 Exchange. Suppose the E.R.E. has been established. In such a world of certainty there would be 8 00:00:54.340 --> 00:01:02.360 no risk of loss in investment and no need to keep cash balances on hand in case an emergency 9 00:01:02.360 --> 00:01:09.820 for consumer spending should arise. Everyone would therefore allocate his money stock fully 10 00:01:09.820 --> 00:01:17.340 to the purchase of either present goods or future goods in accordance with his time preferences. 11 00:01:17.340 --> 00:01:21.740 No one would keep his money idle in a cash balance. 12 00:01:21.740 --> 00:01:27.540 Knowing that he will want to spend a certain amount of money on consumption in six months 13 00:01:27.540 --> 00:01:34.100 time, a man will lend his money out for that period to be returned at precisely the time 14 00:01:34.100 --> 00:01:35.940 it is to be spent. 15 00:01:35.940 --> 00:01:42.860 But if no one is willing to keep a cash balance longer than instantaneously, there will be 16 00:01:42.860 --> 00:01:47.960 no money held and no use for a money stock. 17 00:01:47.960 --> 00:01:54.940 Money in short would either be useless or very nearly so in the world of certainty. 18 00:01:54.940 --> 00:02:02.500 In the real world of uncertainty as contrasted to the ERE, even idle money kept in a cash 19 00:02:02.500 --> 00:02:09.100 Cash balance performs a use for its owner. Indeed, if it did not perform such a use, 20 00:02:09.100 --> 00:02:15.540 it would not be kept in his cash balance. Its uses are based precisely on the fact that 21 00:02:15.540 --> 00:02:22.380 the individual is not certain on what he will spend his money, or of the precise time that 22 00:02:22.380 --> 00:02:29.340 he will spend it in the future. Economists have attempted mechanically to reduce the 23 00:02:29.340 --> 00:02:32.580 the demand for money to various sources. 24 00:02:32.580 --> 00:02:36.380 There is no such mechanical determination however. 25 00:02:36.380 --> 00:02:40.900 Each individual decides for himself by his own standards, 26 00:02:40.900 --> 00:02:44.100 his whole demand for cash balances 27 00:02:44.100 --> 00:02:47.560 and we can only trace various influences 28 00:02:47.560 --> 00:02:52.180 which different catalactic events may have had on demand. 29 00:02:53.340 --> 00:02:56.300 B, speculative demand. 30 00:02:56.300 --> 00:03:06.300 One of the most obvious influences on the demand for money is expectation of future changes in the exchange value of money. 31 00:03:06.300 --> 00:03:14.300 Thus, suppose that at a certain point in the future the PPM of money is expected to drop rapidly. 32 00:03:14.300 --> 00:03:25.300 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. 33 00:03:25.300 --> 00:03:26.640 They Hold It. 34 00:03:26.640 --> 00:03:33.020 It also depends on the distance in the future at which the change is expected to take place. 35 00:03:33.020 --> 00:03:40.020 The further away in time any economic event, the more its impact will be discounted in 36 00:03:40.020 --> 00:03:42.980 the present by the interest rate. 37 00:03:42.980 --> 00:03:50.140 Whatever the degree of impact, however, an expected future fall in the PPM will tend to 38 00:03:50.140 --> 00:03:53.260 lower the PPM now. 39 00:03:53.260 --> 00:04:00.140 For an expected fall in the PPM means that present units of money are worth more than 40 00:04:00.140 --> 00:04:05.900 they will be in the future, in which case there will be a fall in the demand for money 41 00:04:05.900 --> 00:04:12.700 schedule as people tend to spend more money now than at the future date. 42 00:04:12.700 --> 00:04:19.300 A general expectation of an imminent fall in the PPM will lower the demand schedule 43 00:04:19.300 --> 00:04:25.900 for Money now and thus tend to bring about the fall at the present moment. 44 00:04:25.900 --> 00:04:32.700 Conversely, an expectation of a rise in the PPM in the near future will tend to raise 45 00:04:32.700 --> 00:04:40.240 the demand for money schedule as people decide to hoard, add money to their cash balance 46 00:04:40.240 --> 00:04:47.020 in expectation of a future rise in the exchange value of a unit of their money. 47 00:04:47.020 --> 00:04:52.540 The result will be a present rise in the PPM. 48 00:04:52.540 --> 00:05:00.220 An expected fall in the PPM in the future will therefore lower the PPM now, and an expected 49 00:05:00.220 --> 00:05:03.680 rise will lead to a rise now. 50 00:05:03.680 --> 00:05:09.420 The speculative demand for money functions in the same manner as the speculative demand 51 00:05:09.420 --> 00:05:11.220 for any good. 52 00:05:11.220 --> 00:05:17.960 An anticipation of a future point speeds the adjustment of the economy toward that future 53 00:05:17.960 --> 00:05:19.360 point. 54 00:05:19.360 --> 00:05:25.780 Just as the speculative demand for a good speeded adjustment to an equilibrium position, 55 00:05:25.780 --> 00:05:33.820 so the anticipation of a change in the PPM speeds the market adjustment toward that position. 56 00:05:33.820 --> 00:05:40.740 Just as in the case of any good, furthermore, errors in this speculative anticipation are 57 00:05:40.740 --> 00:05:46.020 Self-Correcting Many writers believe that in the case of money, 58 00:05:46.020 --> 00:05:48.900 there is no such self-correction. 59 00:05:48.900 --> 00:05:56.020 They assert that while there may be a real or underlying demand for goods, money is not 60 00:05:56.020 --> 00:06:01.260 consumed and therefore has no such underlying demand. 61 00:06:01.260 --> 00:06:08.740 The PPM and the demand for money, they declare, can be explained only as a perpetual and rather 62 00:06:08.740 --> 00:06:15.460 Another meaningless cat-and-mouse race in which everyone is simply trying to anticipate 63 00:06:15.460 --> 00:06:19.100 everyone else's anticipations. 64 00:06:19.100 --> 00:06:24.660 There is, however, a real or underlying demand for money. 65 00:06:24.660 --> 00:06:31.480 Money may not be physically consumed, but it is used, and therefore it has utility in 66 00:06:31.480 --> 00:06:33.340 a cash balance. 67 00:06:33.340 --> 00:06:39.180 Such utility amounts to more than speculation on a rise in the PPM. 68 00:06:39.180 --> 00:06:46.620 This is demonstrated by the fact that people do hold cash even when they anticipate a fall 69 00:06:46.620 --> 00:06:48.580 in the PPM. 70 00:06:48.580 --> 00:06:55.340 Such holdings may be reduced, but they still exist, and as we have seen, this must be so 71 00:06:55.340 --> 00:06:57.820 in an uncertain world. 72 00:06:57.820 --> 00:07:05.060 In fact, without willingness to hold cash, there could be no monetary exchange economy, 73 00:07:05.060 --> 00:07:06.460 whatever. 74 00:07:06.460 --> 00:07:13.680 The speculative demand therefore anticipates the underlying non-speculative demands, whatever 75 00:07:13.680 --> 00:07:16.980 their source or inspiration. 76 00:07:16.980 --> 00:07:24.820 Suppose then that there is a general anticipation of a rise in the PPM, a fall in prices, not 77 00:07:24.820 --> 00:07:32.660 Reflected in Underlying Supply and Demand. It is true that at first this general anticipation 78 00:07:32.660 --> 00:07:40.900 raises, Ceteris Paribus, the demand for money, and the PPM. But this situation does not last. 79 00:07:40.900 --> 00:07:46.980 For now that a pseudo-equilibrium has been reached, the speculative anticipators, who 80 00:07:46.980 --> 00:07:54.180 did not really have an increased demand for money, sell their money, buy goods, to reap 81 00:07:54.180 --> 00:08:21.100 C. Secular Influences on the Demand for Money Long-run influences on the demand for money 82 00:08:21.100 --> 00:08:27.320 Money in a progressing economy will tend to be manifold and in both directions. 83 00:08:27.320 --> 00:08:34.420 On the one hand, an advancing economy provides ever more occasions for new exchanges as more 84 00:08:34.420 --> 00:08:41.100 and more commodities are offered on the market and as the number of stages of production 85 00:08:41.100 --> 00:08:42.100 increases. 86 00:08:42.100 --> 00:08:47.900 These greater opportunities tend greatly to increase the demand for money schedule. 87 00:08:47.900 --> 00:08:54.860 If an economy deteriorates, fewer opportunities for exchange exist and the demand for money 88 00:08:54.860 --> 00:08:57.940 from this source will fall. 89 00:08:57.940 --> 00:09:04.180 The major long-run factor counteracting this tendency and tending toward a fall in the 90 00:09:04.180 --> 00:09:09.400 demand for money is the growth of the clearing system. 91 00:09:09.400 --> 00:09:16.620 Clearing is a device by which money is economized and performs the function of a medium of exchange 92 00:09:16.620 --> 00:09:21.420 without being physically present in the exchange. 93 00:09:21.420 --> 00:09:25.900 A simplified form of clearing may occur between two people. 94 00:09:25.900 --> 00:09:31.660 For example, A may buy a watch from B for three gold ounces. 95 00:09:31.660 --> 00:09:37.980 At the same time, B buys a pair of shoes from A for one gold ounce. 96 00:09:37.980 --> 00:09:45.680 Instead of two transfers of money being made and a total of four gold ounces changing hands, 97 00:09:45.680 --> 00:09:53.960 They decide to perform a clearing operation. A pays B two ounces of money and they exchange 98 00:09:53.960 --> 00:10:01.360 the watch and the shoes. Thus when a clearing is made and only the net amount of money is 99 00:10:01.360 --> 00:10:08.400 actually transferred, all parties can engage in the same transactions at the same prices 100 00:10:08.400 --> 00:10:15.200 but using far less cash. Their demand for cash tends to fall. 101 00:10:15.200 --> 00:10:21.640 There is obviously little scope for clearing, however, as long as all transactions are cash 102 00:10:21.640 --> 00:10:23.520 transactions. 103 00:10:23.520 --> 00:10:29.560 For then, people have to exchange one another's goods at the same time. 104 00:10:29.560 --> 00:10:37.180 But the scope for clearing is vastly increased when credit transactions come into play. 105 00:10:37.180 --> 00:10:39.120 These credits may be quite short-term. 106 00:10:39.120 --> 00:10:44.120 The Theory of Money and Credit 107 00:11:09.120 --> 00:11:14.720 The net debtor pays one lump sum to the net creditor. 108 00:11:14.720 --> 00:11:20.520 Once credit enters the picture, the clearing system can be extended to as many individuals 109 00:11:20.520 --> 00:11:22.480 as find it convenient. 110 00:11:22.480 --> 00:11:29.160 The more people engage in clearing operations, often in places called clearing houses, the 111 00:11:29.160 --> 00:11:34.700 more cancellations there will be, and the more money will be economized. 112 00:11:34.700 --> 00:11:40.340 At the end of the week, for example, there may be five people engaged in clearing and 113 00:11:40.340 --> 00:11:52.980 a may-o-b 10 ounces, b-o-c 10 ounces, c-o-d, etc., and finally e may-o-a 10 ounces. 114 00:11:52.980 --> 00:12:01.340 In such a case, 50 ounces worth of debt transactions and potential cash transactions are settled 115 00:12:01.340 --> 00:12:06.700 without a single ounce of cash being used. 116 00:12:06.700 --> 00:12:12.120 Clearing then is a process of reciprocal cancellations of money debts. 117 00:12:12.120 --> 00:12:19.900 It permits a huge quantity of monetary exchanges without actual possession and transfer of 118 00:12:19.900 --> 00:12:24.820 money, thereby greatly reducing the demand for money. 119 00:12:24.820 --> 00:12:31.140 Clearing however cannot be all-encompassing, for there must be some physical money which 120 00:12:31.140 --> 00:12:37.620 could be used to settle the transaction, and there must be physical money to settle 121 00:12:37.620 --> 00:12:42.820 when there is no 100% cancellation, which rarely occurs. 122 00:12:44.340 --> 00:12:47.620 D. Demand for money unlimited? 123 00:12:48.660 --> 00:12:57.780 A popular fallacy rejects the concept of demand for money because it is allegedly always unlimited. 124 00:12:57.780 --> 00:13:06.100 This idea misconceives the very nature of demand and confuses money with wealth or income. 125 00:13:06.100 --> 00:13:11.220 It is based on the notion that people want as much money as they can get. 126 00:13:11.220 --> 00:13:17.700 In the first place, this is true for all goods. People would like to have far more goods than they 127 00:13:17.700 --> 00:13:26.180 can procure now. But demand on the market does not refer to all possible entries on people's value 128 00:13:26.180 --> 00:13:35.940 scales. It refers to effective demand, to desires made effective by being demanded, that is, by the 129 00:13:35.940 --> 00:13:44.180 fact that something else is supplied for it, or else it is reservation demand, which takes the form 130 00:13:44.180 --> 00:13:52.740 of holding back the good from being sold. Clearly, effective demand for money is not and cannot be 131 00:13:52.740 --> 00:14:00.180 unlimited. It is limited by the appraised value of the goods a person can sell in exchange, 132 00:14:00.180 --> 00:14:06.340 and by the amount of that money which the individual wants to spend on goods, rather 133 00:14:06.340 --> 00:14:14.500 than keep in his cash balance. Furthermore, it is of course not money per se that he wants 134 00:14:14.500 --> 00:14:22.700 and demands, but money for its purchasing power, or real money, money in some way expressed 135 00:14:22.700 --> 00:14:30.300 in terms of what it will purchase. This purchasing power of money as we shall see cannot be measured. 136 00:14:30.940 --> 00:14:37.420 More money does him no good if its purchasing power for goods is correspondingly diluted. 137 00:14:38.780 --> 00:14:47.900 E. The PPM and the rate of interest. We have been discussing money and shall continue to do so in 138 00:14:47.900 --> 00:14:55.100 in the current section by comparing equilibrium positions, and not yet by tracing step by 139 00:14:55.100 --> 00:15:00.780 step how the change from one position to another comes about. 140 00:15:00.780 --> 00:15:06.860 We shall soon see that in the case of the price of money, as contrasted with all other 141 00:15:06.860 --> 00:15:14.300 prices, the very path toward equilibrium necessarily introduces changes that will change 142 00:15:14.300 --> 00:15:16.540 the equilibrium point. 143 00:15:16.540 --> 00:15:20.160 This will have important theoretical consequences. 144 00:15:20.160 --> 00:15:27.780 We may still talk, however, as if money is neutral, that is, does not lead to such changes, 145 00:15:27.780 --> 00:15:34.160 because this assumption is perfectly competent to deal with the problems analyzed so far. 146 00:15:34.160 --> 00:15:40.520 This is true, in essence, because we are able to use a general concept of the purchasing 147 00:15:40.520 --> 00:15:42.520 The Theory of Money and Credit 148 00:16:10.520 --> 00:16:30.520 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. 149 00:16:30.520 --> 00:16:37.900 A man may allocate his money to consumption, investment, or addition to his cash balance. 150 00:16:37.900 --> 00:16:43.960 His time preferences govern the proportion which an individual devotes to present and 151 00:16:43.960 --> 00:16:49.580 to future goods, that is, to consumption and to investment. 152 00:16:49.580 --> 00:16:56.700 Now suppose a man's demand for money schedule increases, and he therefore decides to allocate 153 00:16:56.700 --> 00:17:02.120 a proportion of his money income to increasing his cash balance. 154 00:17:02.120 --> 00:17:09.420 There is no reason to suppose that this increase affects the consumption investment proportion 155 00:17:09.420 --> 00:17:10.740 at all. 156 00:17:10.740 --> 00:17:17.660 It could, but if so, it would mean a change in his time preference schedule as well as 157 00:17:17.660 --> 00:17:20.460 in his demand for money. 158 00:17:20.460 --> 00:17:26.500 If the demand for money increases, there is no reason why a change in the demand for money 159 00:17:26.500 --> 00:17:33.380 Money should affect the interest rate one iota. There is no necessity at all for an 160 00:17:33.380 --> 00:17:40.900 increase in the demand for money to raise the interest rate or a decline to lower it, 161 00:17:40.900 --> 00:17:47.860 no more than the opposite. In fact, there is no causal connection between the two. One 162 00:17:47.860 --> 00:17:56.380 is determined by the valuations for money and the other by valuations for time preference. 163 00:17:56.380 --> 00:18:02.820 Let us return to the section in Chapter 6 on time preference and the individual's money 164 00:18:02.820 --> 00:18:04.180 stock. 165 00:18:04.180 --> 00:18:10.740 Did we not see there that an increase in an individual's money stock lowers the effective 166 00:18:10.740 --> 00:18:17.780 time preference rate along the time preference schedule and, conversely, that a decrease 167 00:18:17.780 --> 00:18:20.660 raises the time preference rate? 168 00:18:20.660 --> 00:18:23.140 Why does this not apply here? 169 00:18:23.140 --> 00:18:30.340 Because we were dealing with each individual's money stock, and assuming that the real exchange 170 00:18:30.340 --> 00:18:34.820 value of each unit of money remained the same. 171 00:18:34.820 --> 00:18:43.260 His time preference schedule relates to real monetary units, not simply to money itself. 172 00:18:43.260 --> 00:18:49.620 If the social stock of money changes, or if the demand for money changes, the objective 173 00:18:49.620 --> 00:18:58.320 of Exchange Value of a Monetary Unit, the PPM will change also. If the PPM falls, then 174 00:18:58.320 --> 00:19:04.540 more money in the hands of an individual may not necessarily lower the time preference 175 00:19:04.540 --> 00:19:11.660 rate on his schedule, for the more money may only just compensate him for the fall in the 176 00:19:11.660 --> 00:19:34.940 An increased demand for money, then, tends to lower prices all around without changing 177 00:19:34.940 --> 00:19:38.660 time preference or the pure rate of interest. 178 00:19:38.660 --> 00:19:48.320 Thus suppose total social income is 100, with 70 allocated to investment and 30 to consumption. 179 00:19:48.320 --> 00:19:55.580 The demand for money increases, so that people decide to hoard a total of 20. 180 00:19:55.580 --> 00:20:03.060 Expenditure will now be 80 instead of 100, 20 being added to cash balances. 181 00:20:03.060 --> 00:20:09.220 Income in the next period will be only 80, since expenditures in one period result in 182 00:20:09.220 --> 00:20:16.020 the identical income to be allocated to the next period, since no one can receive a money 183 00:20:16.020 --> 00:20:22.900 income, unless someone else makes a money expenditure on his services. 184 00:20:22.900 --> 00:20:28.520 If time preferences remain the same, then the proportion of investment to consumption 185 00:20:28.520 --> 00:20:37.320 in the Society will remain roughly the same, that is, 56 invested and 24 consumed. 186 00:20:37.320 --> 00:20:44.200 Prices and nominal money values and incomes fall all along the line, and we are left with 187 00:20:44.200 --> 00:20:51.660 the same capital structure, the same real income, the same interest rate, etc. 188 00:20:51.660 --> 00:20:58.120 The only things that have changed are nominal prices, which have fallen, and the proportion 189 00:20:58.120 --> 00:21:04.120 The only other change is a lower proportion of cash balances to money income, which has increased. 190 00:21:04.120 --> 00:21:08.120 A decreased demand for money will have the reverse effect. 191 00:21:08.120 --> 00:21:12.120 Dishoarding will raise expenditure, raise prices, 192 00:21:12.120 --> 00:21:19.120 and, Ceteris Paribus, maintain the real income and capital structure intact. 193 00:21:19.120 --> 00:21:26.120 The only other change is a lower proportion of cash balances to money income. 194 00:21:26.120 --> 00:21:33.240 The only necessary result, then, of a change in the demand for money schedule is precisely 195 00:21:33.240 --> 00:21:41.760 a change in the same direction of the proportion of total cash balances to total money income 196 00:21:41.760 --> 00:21:45.440 and in the real value of cash balances. 197 00:21:45.440 --> 00:21:52.680 Given the stock of money, an increased scramble for cash will simply lower money incomes until 198 00:21:52.680 --> 00:22:00.120 Until the desired increase in real cash balances has been attained, if the demand for money 199 00:22:00.120 --> 00:22:03.400 falls, the reverse movement occurs. 200 00:22:03.400 --> 00:22:09.680 The desire to reduce cash balances causes an increase in money income. 201 00:22:09.680 --> 00:22:18.840 Total cash remains the same, but its proportion to incomes, as well as its real value, declines. 202 00:22:18.840 --> 00:22:23.520 Strictly the Ceteris Paribus condition will tend to be violated. 203 00:22:23.520 --> 00:22:30.040 An increased demand for money tends to lower money prices and will therefore lower money 204 00:22:30.040 --> 00:22:32.760 costs of gold mining. 205 00:22:32.760 --> 00:22:38.960 This will stimulate gold mining production until the interest return on mining is again 206 00:22:38.960 --> 00:22:41.680 the same as in other industries. 207 00:22:41.680 --> 00:22:49.120 Thus, the increased demand for money will also call forth new money to meet the demand. 208 00:22:49.120 --> 00:22:56.460 A decreased demand for money will raise money costs of gold mining and at least lower the 209 00:22:56.460 --> 00:22:58.740 rate of new production. 210 00:22:58.740 --> 00:23:05.760 It will not actually decrease the total money stock unless the new production rate falls 211 00:23:05.760 --> 00:23:09.240 below the wear and tear rate. 212 00:23:09.240 --> 00:23:13.740 F. Hoarding and the Keynesian System 213 00:23:13.740 --> 00:23:20.740 1. Social Income, Expenditures and Unemployment 214 00:23:20.740 --> 00:23:27.000 To the great bulk of writers, hoarding, an increase in the demand for money, has appeared 215 00:23:27.000 --> 00:23:34.160 an unmitigated catastrophe. The very word hoarding is a most inappropriate one to use 216 00:23:34.160 --> 00:23:40.840 as in economics, since it is laden with connotations of vicious antisocial action. 217 00:23:40.840 --> 00:23:47.080 But there is nothing at all antisocial about either hoarding or dis-hoarding. 218 00:23:47.080 --> 00:23:52.960 Hoarding is simply an increase in the demand for money, and the result of this change in 219 00:23:52.960 --> 00:24:00.040 valuations is that people get what they desire, that is, an increase in the real value of 220 00:24:00.040 --> 00:24:04.040 The Theory of Money and Credit 221 00:24:30.040 --> 00:24:35.280 The Theory means that people want something, either an increase or a decrease in their 222 00:24:35.280 --> 00:24:41.800 real cash balances or in the real value of the monetary unit, and that they are able 223 00:24:41.800 --> 00:24:44.440 to obtain this result. 224 00:24:44.440 --> 00:24:46.640 What is wrong with that? 225 00:24:46.640 --> 00:24:53.320 We see here simply another manifestation of consumers or individuals' sovereignty 226 00:24:53.320 --> 00:24:55.320 on the free market. 227 00:24:55.320 --> 00:25:06.320 Furthermore, there is no theoretical way of defining hoarding beyond a simple addition to one's cash balance in a certain period of time. 228 00:25:06.320 --> 00:25:20.320 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. 229 00:25:20.320 --> 00:25:36.920 One of the two major pillars of the Keynesian system, now happily beginning to wane after 230 00:25:36.920 --> 00:25:44.720 sweeping the economic world in the 1930s and 1940s, is the proclamation that savings become 231 00:25:44.720 --> 00:25:52.720 equal to investment only through the terrible root of decline in social income. 232 00:25:52.720 --> 00:26:00.040 The term generally used is national income, however in a free market economy the nation 233 00:26:00.040 --> 00:26:05.940 will no more be an important economic boundary than the village or region. 234 00:26:05.940 --> 00:26:12.840 It is more convenient then to set aside regional problems for other analysis and to concentrate 235 00:26:12.840 --> 00:26:15.720 on Aggregate Social Income. 236 00:26:15.720 --> 00:26:22.120 This is especially true since regions do not present a problem to economic theory until 237 00:26:22.120 --> 00:26:26.440 their governments begin intervening in the free market. 238 00:26:26.440 --> 00:26:32.920 The implicit foundation of Keynesianism is the assertion that at a certain level of total 239 00:26:32.920 --> 00:26:40.840 social income, total social expenditures out of this income will be lower than income, 240 00:26:40.840 --> 00:27:08.240 The Keynesian consumption function plays its part in establishing an alleged law that there 241 00:27:08.240 --> 00:27:16.500 There exists a certain level of total income, say A, above which expenditures will be less 242 00:27:16.500 --> 00:27:24.260 than income, net hoarding, and below which expenditures will be greater than income, 243 00:27:24.260 --> 00:27:26.100 net dis-hoarding. 244 00:27:26.100 --> 00:27:33.560 But the basic Keynesian worry is hoarding, when total income must decline. 245 00:27:33.560 --> 00:27:39.460 We shall investigate the validity of this alleged law and the consumption function on 246 00:27:39.460 --> 00:27:45.260 which it rests, but suppose that we now grant the validity of such a law. 247 00:27:45.260 --> 00:27:49.440 The only comment can be an impertinent, so what? 248 00:27:49.440 --> 00:27:52.940 What if there is a fall in the national income? 249 00:27:52.940 --> 00:28:01.040 Since the fall need only be in money terms, and real income, real capital, etc. may remain 250 00:28:01.040 --> 00:28:03.920 In the same, why any alarm? 251 00:28:03.920 --> 00:28:09.400 The only change is that the hoarders have accomplished their objective of increasing 252 00:28:09.400 --> 00:28:16.220 their real cash balances and increasing the real value of the monetary unit. 253 00:28:16.220 --> 00:28:23.440 It is true that the picture is rather more complex for the transition process until equilibrium 254 00:28:23.440 --> 00:28:29.440 is reached, and this will be treated further, although our final conclusion will be the 255 00:28:29.440 --> 00:28:30.520 same. 256 00:28:30.520 --> 00:28:36.940 But the Keynesian system attempts to establish the perniciousness of the equilibrium position, 257 00:28:36.940 --> 00:28:39.120 and this it cannot do. 258 00:28:39.120 --> 00:28:45.840 Therefore, the elaborate attempts of the Keynesians to demonstrate that free market expenditures 259 00:28:45.840 --> 00:28:53.800 will be limited, that consumption is limited by the function, and investment by stagnation 260 00:28:53.800 --> 00:29:00.980 of Opportunities and Liquidity preference are futile, for even if they were correct, which 261 00:29:00.980 --> 00:29:04.480 they are not, the result would be pointless. 262 00:29:04.480 --> 00:29:11.520 There is nothing wrong with hoarding or dishording, or with low or high levels, whatever that 263 00:29:11.520 --> 00:29:15.560 may mean, of social money income. 264 00:29:15.560 --> 00:29:21.720 The Keynesian attempt to salvage meaning for their doctrine rests on one point and one 265 00:29:21.720 --> 00:29:23.340 point alone. 266 00:29:23.340 --> 00:29:26.640 The second major pillar of their system. 267 00:29:26.640 --> 00:29:33.440 This is the thesis that money, social income and level of employment are correlated, and 268 00:29:33.440 --> 00:29:37.320 that the latter is a function of the former. 269 00:29:37.320 --> 00:29:44.280 This assumes that a certain full employment level of social income exists below which 270 00:29:44.280 --> 00:29:49.560 there is correspondingly greater unemployment. 271 00:29:49.560 --> 00:29:57.480 The nub of the Keynesian critique of the free-market economy, then, rests on the involuntary unemployment 272 00:29:57.480 --> 00:30:03.960 allegedly caused by too low a level of social expenditures and income. 273 00:30:03.960 --> 00:30:10.440 But how can this be, since we have previously explained that there can be no involuntary 274 00:30:10.440 --> 00:30:13.280 unemployment in a free market? 275 00:30:13.280 --> 00:30:19.480 The answer has become evident, and is admitted in the most intelligent of the Keynesian writings. 276 00:30:19.480 --> 00:30:28.440 The Keynesian underemployment equilibrium occurs only if money wage rates are rigid downward. 277 00:30:28.440 --> 00:30:35.240 That is, if the supply of labor below full employment is infinitely elastic. 278 00:30:36.040 --> 00:30:43.480 Thus suppose there is a hoarding, an increased demand for money, and social income falls. 279 00:30:43.480 --> 00:30:51.480 The result is a fall in the monetary demand for labor factors, as well as in all other monetary demand. 280 00:30:51.480 --> 00:31:00.480 Since only money wage rates are being changed, while real wage rates, in terms of purchasing power, remain the same, 281 00:31:00.480 --> 00:31:10.480 there will be no shift in labor leisure preferences, and the total stock of labor offered on the market will remain constant. 282 00:31:10.480 --> 00:31:17.160 At any rate, certainly no involuntary unemployment will arise. 283 00:31:17.160 --> 00:31:20.880 How then can the Keynesian case arise? 284 00:31:20.880 --> 00:31:22.640 In only two ways. 285 00:31:22.640 --> 00:31:29.680 One, if people voluntarily agree with the unions, which insist that no one be employed 286 00:31:29.680 --> 00:31:33.520 at lower than the old money wage rate. 287 00:31:33.520 --> 00:31:40.040 Since selling prices are falling, maintaining the old money wage rate is equivalent to demanding 288 00:31:40.040 --> 00:31:42.920 Raising a Higher Real Wage Rate 289 00:31:42.920 --> 00:31:48.920 We have seen that the unions raising of real wage rates causes unemployment. 290 00:31:48.920 --> 00:31:55.160 But this unemployment is voluntary, since the workers acquiesce in the imposition of 291 00:31:55.160 --> 00:32:03.040 a higher minimum real wage rate, below which they will not undercut the union and accept 292 00:32:03.040 --> 00:32:04.040 employment. 293 00:32:04.040 --> 00:32:11.240 Chapter 2, Unions or Government Coercively Impose the Minimum Wage Rate, but this is 294 00:32:11.240 --> 00:32:18.200 an example of a hampered market, not the free market to which we are confining our analysis 295 00:32:18.200 --> 00:32:20.200 here. 296 00:32:20.200 --> 00:32:27.640 Kane's own exposition tended to run in terms of real, rather than money, magnitudes, real 297 00:32:27.640 --> 00:32:32.520 Real social income, real expenditures, etc. 298 00:32:32.520 --> 00:32:40.520 Such an analysis obscures dynamic considerations, since transactions take place, at least superficially, 299 00:32:40.520 --> 00:32:43.240 in monetary terms on the market. 300 00:32:43.240 --> 00:32:50.060 However, the essential conclusion of our analysis remains unchanged if we pursue it directly 301 00:32:50.060 --> 00:32:52.520 in real terms. 302 00:32:52.520 --> 00:32:58.080 Instead of falling, demand in real terms will now remain the same. 303 00:32:58.080 --> 00:33:02.120 This is true for the labor market as well. 304 00:33:02.120 --> 00:33:09.380 The sum and substance of the Keynesian Revolution was the thesis that there can be an unemployment 305 00:33:09.380 --> 00:33:12.120 equilibrium on the free market. 306 00:33:12.120 --> 00:33:19.000 As we have seen, the only sense in which this is true was known years before Keynes. 307 00:33:19.000 --> 00:33:27.160 That widespread union maintenance of excessively high wage rates will cause unemployment. 308 00:33:27.160 --> 00:33:32.760 Keynes believed that while other elements of the economic system, including prices, were 309 00:33:32.760 --> 00:33:41.860 set basically in real terms, workers bargained even ultimately, only in terms of money wages. 310 00:33:41.860 --> 00:33:48.700 That unions insisted on minimum money wage rates downward, but would passively accept 311 00:33:48.700 --> 00:33:56.900 falling real wages in the form of rising prices, money wage rates remaining the same. 312 00:33:56.900 --> 00:34:02.820 The Keynesian prescription for eliminating unemployment therefore rests specifically 313 00:34:02.820 --> 00:34:10.600 on the money illusion, that unions will impose minimum money wage rates, but are too stupid 314 00:34:10.600 --> 00:34:15.040 to Impose Minimum Real Wage Rates, Per Se. 315 00:34:15.040 --> 00:34:20.780 Unions, however, have learned about purchasing power problems and the distinction between 316 00:34:20.780 --> 00:34:22.700 money and real rates. 317 00:34:22.700 --> 00:34:28.160 Indeed, it hardly requires much reasoning ability to grasp this distinction. 318 00:34:28.160 --> 00:34:34.740 Ironically, Cain's advocacy of inflation based on the money illusion rested on the 319 00:34:34.740 --> 00:34:41.180 The historical experience that, during an inflation, selling prices rise faster than 320 00:34:41.180 --> 00:34:42.820 wage rates. 321 00:34:42.820 --> 00:34:50.020 Yet an economy in which unions impose minimum wage rates is precisely an economy in which 322 00:34:50.020 --> 00:34:58.660 unions will be alive to any losses in their real, as well as their money, wages. 323 00:34:58.660 --> 00:35:05.860 Inflation therefore cannot be used as a means of duping unions into relieving unemployment. 324 00:35:05.860 --> 00:35:12.980 Furthermore, inflation is, at best, an inefficient and distortive substitute for flexible wage 325 00:35:12.980 --> 00:35:20.540 rates, for inflation affects the entire economy and its prices, while particular wage rates 326 00:35:20.540 --> 00:35:27.060 will fall only to the extent necessary to clear the market for the particular labor 327 00:35:27.060 --> 00:35:28.060 factor. 328 00:35:28.060 --> 00:35:39.060 Thus freely flexible wage rates will fall only in those fields necessary to eliminate unemployment in those particular areas. 329 00:35:39.060 --> 00:35:44.060 Keynesianism has been touted as at least a practical system. 330 00:35:44.060 --> 00:35:51.060 Whatever its theoretical defects, it is alleged to be fit for the modern world of unionism. 331 00:35:51.060 --> 00:35:58.340 Yet it is precisely in the modern world that Keynes' doctrine is least appropriate or practical. 332 00:35:59.780 --> 00:36:06.500 The Keynesians object that to allow rigid money wage rates to become flexible downward 333 00:36:06.500 --> 00:36:12.580 would further lower monetary demand for goods and therefore monetary income. 334 00:36:12.580 --> 00:36:20.980 But this completely confuses wage rates with aggregate payroll or total income going to wages. 335 00:36:21.540 --> 00:36:28.980 That the former falls does not mean that the latter falls. On the contrary, total income is, 336 00:36:28.980 --> 00:36:37.140 as we have seen, determined by total expenditures in the previous period of time. Lower wage rates 337 00:36:37.140 --> 00:36:44.860 This will cause the hiring of those made unemployed by the old excessively high wage rates. 338 00:36:44.860 --> 00:36:51.820 The fact that labor is now cheaper relatively to land factors will cause investors to expend 339 00:36:51.820 --> 00:36:57.420 a greater proportion on labor vis-à-vis land than before. 340 00:36:57.420 --> 00:37:04.940 And the employment of unemployed labor increases production and therefore aggregate real income. 341 00:37:04.940 --> 00:37:12.220 Furthermore, even if payrolls also decline, prices and wage rates can adjust, 342 00:37:12.220 --> 00:37:17.020 but this will be taken up in the next section on liquidity preference. 343 00:37:18.540 --> 00:37:21.180 2. Liquidity preference 344 00:37:22.300 --> 00:37:27.340 Those Keynesians who recognize the grave difficulties of their system 345 00:37:27.340 --> 00:37:32.780 fall back on one last string in their bow, liquidity preference. 346 00:37:32.780 --> 00:37:49.780 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. 347 00:37:49.780 --> 00:37:57.540 Neither Franco Modigliani nor Eric Lindahl, however, is thorough going enough in his critique 348 00:37:57.540 --> 00:38:04.740 of the Keynesian system, particularly of the liquidity preference doctrine. 349 00:38:04.740 --> 00:38:10.420 The Keynesian system, as is quite clear from the mathematical portrayals of it given it 350 00:38:10.420 --> 00:38:18.840 by its followers, suffers grievously from the mathematical economic sin of mutual determination. 351 00:38:18.840 --> 00:38:25.280 The use of mathematical functions, which are reversible at will, is appropriate in physics, 352 00:38:25.280 --> 00:38:29.320 where we do not know the causes of the observed movements. 353 00:38:29.320 --> 00:38:36.040 Since we do not know the causes, any mathematical law explaining or describing movements will 354 00:38:36.040 --> 00:38:42.600 be reversible, and, as far as we are concerned, any of the variables in the function is just 355 00:38:42.600 --> 00:38:45.720 as much cause as another. 356 00:38:45.720 --> 00:38:53.580 In praxeology, the science of human action, however, we know the original cause, motivated 357 00:38:53.580 --> 00:38:56.140 action by individuals. 358 00:38:56.140 --> 00:38:59.980 This knowledge provides us with true axioms. 359 00:38:59.980 --> 00:39:03.740 From these axioms, true laws are deduced. 360 00:39:03.740 --> 00:39:10.300 They are deduced step by step in a logical cause and effect relationship. 361 00:39:10.300 --> 00:39:16.100 Its first causes are known, their consequent effects are also known. 362 00:39:16.100 --> 00:39:23.760 Economics, therefore, traces unilinear cause and effect relations, not vague, mutually 363 00:39:23.760 --> 00:39:26.740 determining relations. 364 00:39:26.740 --> 00:39:33.100 This methodological reminder is singularly applicable to the Keynesian theory of interest. 365 00:39:33.100 --> 00:39:41.360 For the Keynesians consider the rate of interest, a, as determining investment, and b, as being 366 00:39:41.360 --> 00:39:50.260 determined by the demand for money to hold for speculative purposes, liquidity preference. 367 00:39:50.260 --> 00:39:56.860 In practice, however, they treat the latter not as determining the rate of interest, but 368 00:39:56.860 --> 00:39:59.980 as being determined by it. 369 00:39:59.980 --> 00:40:06.780 The methodology of mutual determination has completely obscured this sleight of hand. 370 00:40:06.780 --> 00:40:13.880 Keynesians might object that all demand and supply is mutually determined in its relation 371 00:40:13.880 --> 00:40:18.900 to price, but this facile assertion is not correct. 372 00:40:18.900 --> 00:40:25.500 Demand is determined by utility scales, and supply by speculation and the stock produced 373 00:40:25.500 --> 00:40:32.460 Interest by given labor and land factors, which is ultimately governed by time preferences. 374 00:40:32.460 --> 00:40:39.180 The Keynesians therefore treat the rate of interest not as they believe they do, as determined 375 00:40:39.180 --> 00:40:46.540 by liquidity preference, but rather as some sort of mysterious and unexplained force imposing 376 00:40:46.540 --> 00:40:50.140 itself on the other elements of the economic system. 377 00:40:50.140 --> 00:40:57.720 Thus, Keynesian discussion of liquidity preference centers around inducement to hold cash as 378 00:40:57.720 --> 00:41:01.580 the rate of interest rises or falls. 379 00:41:01.580 --> 00:41:07.060 According to the theory of liquidity preference, a fall in the rate of interest increases the 380 00:41:07.060 --> 00:41:14.380 quantity of cash demanded for speculative purposes, liquidity preferences, and a rise 381 00:41:14.380 --> 00:41:19.020 in the rate of interest lowers liquidity preference. 382 00:41:19.020 --> 00:41:25.520 The first error in this concept is the arbitrary separation of the demand for money into two 383 00:41:25.520 --> 00:41:33.720 separate parts, a transactions demand, supposedly determined by the size of social income, and 384 00:41:33.720 --> 00:41:38.160 a speculative demand, determined by the rate of interest. 385 00:41:38.160 --> 00:41:44.260 We have seen that all sorts of influences impinge themselves on the demand for money, 386 00:41:44.260 --> 00:41:50.820 But they are only influences, working through the value scales of individuals, and there 387 00:41:50.820 --> 00:41:59.180 is only one final demand for money, because each individual has only one value scale. 388 00:41:59.180 --> 00:42:05.300 There is no way by which we can split the demand up into two parts and speak of them 389 00:42:05.300 --> 00:42:07.300 as independent entities. 390 00:42:07.300 --> 00:42:12.700 Furthermore, there are far more than two influences on demand. 391 00:42:12.700 --> 00:42:19.920 In the final analysis, the demand for money, like all utilities, cannot be reduced to simple 392 00:42:19.920 --> 00:42:21.080 determinants. 393 00:42:21.080 --> 00:42:27.800 It is the outcome of free, independent decisions on individual value scales. 394 00:42:27.800 --> 00:42:35.360 There is, therefore, no transaction demand uniquely determined by the size of income. 395 00:42:35.360 --> 00:42:38.920 The speculative demand is mysterious indeed. 396 00:42:38.920 --> 00:42:44.160 Modigliani explains this liquidity preference as follows. 397 00:42:44.160 --> 00:42:49.880 We should expect that any fall in the rate of interest would induce a growing number 398 00:42:49.880 --> 00:42:57.020 of potential investors to keep their assets in the form of money, rather than securities. 399 00:42:57.020 --> 00:43:02.740 That is to say, we should expect a fall in the rate of interest to increase the demand 400 00:43:02.740 --> 00:43:05.840 for money as an asset. 401 00:43:05.840 --> 00:43:12.720 This is subject to the criticism, as we have seen, that the rate of interest is here determining 402 00:43:12.720 --> 00:43:17.360 and is not itself explained by any cause. 403 00:43:17.360 --> 00:43:20.200 Furthermore, what does this statement mean? 404 00:43:20.200 --> 00:43:25.880 A fall in the rate of interest, according to the Keynesians, means that less interest 405 00:43:25.880 --> 00:43:32.720 is being earned from bonds, and therefore there is a greater inducement to hold cash. 406 00:43:32.720 --> 00:43:38.280 This is correct, as long as we allow ourselves to think in terms of the interest rate as 407 00:43:38.280 --> 00:43:44.820 determining, instead of being determined, but highly inadequate. 408 00:43:44.820 --> 00:43:53.160 For if a lower interest rate induces greater cash holdings, it also induces greater consumption, 409 00:43:53.160 --> 00:43:57.000 since consumption also becomes more attractive. 410 00:43:57.000 --> 00:44:03.520 In fact, one of the grave defects of the liquidity preference approach is that the Keynesians 411 00:44:03.520 --> 00:44:09.420 never think in terms of three margins being decided at once. 412 00:44:09.420 --> 00:44:15.840 They think only in terms of two at a time, hence Modigliani. 413 00:44:15.840 --> 00:44:22.080 Having made his consumption-saving plan, the individual has to make decisions concerning 414 00:44:22.080 --> 00:44:24.660 the assets he owns. 415 00:44:24.660 --> 00:44:30.220 That is, he then allocates them between money and securities. 416 00:44:30.220 --> 00:44:36.960 In other words, people first decide between consumption and saving in the sense of not 417 00:44:36.960 --> 00:44:44.320 consuming, and then they decide between investing and hoarding these savings. 418 00:44:44.320 --> 00:44:48.360 But this is an absurdly artificial construction. 419 00:44:48.360 --> 00:44:55.560 People decide on all three of their alternatives, weighing one against each of the others. 420 00:44:55.560 --> 00:45:03.080 To say that people first decide between consuming and not consuming, and then choose between 421 00:45:03.080 --> 00:45:09.900 hoarding and investing, is just as misleading as to say that people first choose how much 422 00:45:09.900 --> 00:45:16.020 to hoard, and then decide between consumption and investment. 423 00:45:16.020 --> 00:45:22.420 People therefore allocate their money among consumption, investment and hoarding. 424 00:45:22.420 --> 00:45:30.260 The proportion between consumption and investment reflects individual time preferences. 425 00:45:30.260 --> 00:45:36.820 Consumption reflects desires for present goods, and investment reflects desires for future 426 00:45:36.820 --> 00:45:37.820 goods. 427 00:45:37.820 --> 00:45:44.620 An increase in the demand for money schedule does not affect the rate of interest if the 428 00:45:44.620 --> 00:45:52.840 The proportion between consumption and investment, that is, time preference, remains the same. 429 00:45:52.840 --> 00:45:59.720 The rate of interest, we must reiterate, is determined by time preferences, which also 430 00:45:59.720 --> 00:46:04.300 determine the proportions of consumption and investment. 431 00:46:04.300 --> 00:46:11.980 To think of the rate of interest as inducing more or less saving or hoarding is to misunderstand 432 00:46:11.980 --> 00:46:21.980 Admitting, then, that time preference determines the proportions of consumption and investment, 433 00:46:21.980 --> 00:46:28.100 and that the demand for money determines the proportion of income hoarded, does the demand 434 00:46:28.100 --> 00:46:32.660 for money play a role in determining the interest rate? 435 00:46:32.660 --> 00:46:38.660 The Keynesians assert that there is a relation between the rate of interest and a speculative 436 00:46:38.660 --> 00:46:40.820 of Demand for Cash. 437 00:46:40.820 --> 00:46:46.100 Should the schedule of the latter rise, the former rises also. 438 00:46:46.100 --> 00:46:48.620 But this is not necessarily true. 439 00:46:48.620 --> 00:46:51.540 A greater proportion of funds hoarded 440 00:46:51.540 --> 00:46:55.460 can be drawn from three alternative sources. 441 00:46:55.460 --> 00:46:59.620 A, from funds that formerly went into consumption, 442 00:46:59.620 --> 00:47:02.980 B, from funds that went into investment, 443 00:47:02.980 --> 00:47:06.260 and C, from a mixture of both that 444 00:47:06.260 --> 00:47:11.260 leaves the old consumption investment proportion unchanged. 445 00:47:11.620 --> 00:47:16.100 Condition A will bring about a fall in the rate of interest. 446 00:47:16.100 --> 00:47:19.640 Condition B, a rise in the rate of interest. 447 00:47:19.640 --> 00:47:24.100 And condition C will leave the rate of interest unchanged. 448 00:47:24.100 --> 00:47:28.700 Thus hoarding may reflect either a rise, a fall, 449 00:47:28.700 --> 00:47:31.900 or no change in the rate of interest, 450 00:47:31.900 --> 00:47:35.080 depending on whether time preferences 451 00:47:35.080 --> 00:47:50.080 The Keynesians contend that the speculative demand for cash depends upon and determines the rate of interest in this way. 452 00:47:50.080 --> 00:48:00.080 If people expect that the rate of interest will rise in the near future, then their liquidity preference increases to await this rise. 453 00:48:00.080 --> 00:48:09.080 This, however, can hardly be a part of a long-run equilibrium theory such as Keynes is trying to establish. 454 00:48:09.080 --> 00:48:19.080 Speculation by its very nature disappears in the ERE and hence no fundamental causal theory can be based upon it. 455 00:48:19.080 --> 00:48:22.080 Furthermore, what is an interest rate? 456 00:48:22.080 --> 00:48:37.080 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. 457 00:48:37.080 --> 00:48:42.080 The former, as we have seen, is only the reflection of the latter. 458 00:48:42.080 --> 00:48:54.080 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. 459 00:48:54.080 --> 00:49:05.080 A fall in prices means that entrepreneurs generally expect that factor prices will fall further in the near future than their selling prices. 460 00:49:05.080 --> 00:49:10.080 But it requires no Keynesian labyrinth to explain this phenomenon. 461 00:49:10.080 --> 00:49:11.080 phenomenon. 462 00:49:11.080 --> 00:49:16.880 All we are confronted with is a situation in which entrepreneurs, expecting that factor 463 00:49:16.880 --> 00:49:24.120 prices will soon fall, cease investing and wait for this happy event, so that their return 464 00:49:24.120 --> 00:49:25.760 will be greater. 465 00:49:25.760 --> 00:49:31.840 This is not liquidity preference, but speculation on price changes. 466 00:49:31.840 --> 00:49:37.680 It involves a modification of our previous discussion of the relation between prices 467 00:49:37.680 --> 00:49:44.440 and the demand for money, caused by a fact that we shall explore soon in detail, namely 468 00:49:44.440 --> 00:49:50.020 that prices do not change equally and proportionately. 469 00:49:50.020 --> 00:49:56.840 The expectation of falling factor prices speeds up the movement toward equilibrium, and hence 470 00:49:56.840 --> 00:50:02.240 toward the pure interest relation as determined by time preference. 471 00:50:02.240 --> 00:50:11.200 W. H. Hutt concludes that equilibrium is secured when all services and products are so priced 472 00:50:11.200 --> 00:50:17.640 that they are, one, brought within the reach of people's pockets, that is, so that they 473 00:50:17.640 --> 00:50:25.640 are purchasable by existing money incomes, or, two, brought into such a relation to predicted 474 00:50:25.640 --> 00:50:31.360 prices that no postponement of expenditure on them is induced. 475 00:50:31.360 --> 00:50:37.560 For instance, the products and services used in the manufacture of investment goods must 476 00:50:37.560 --> 00:50:45.120 be so priced that anticipated future money incomes will be able to buy the services and 477 00:50:45.120 --> 00:50:50.000 depreciation of new equipment or replacement. 478 00:50:50.000 --> 00:50:57.840 If for example, unions keep wage rates artificially high, hoarding will increase, as unions keep 479 00:50:57.840 --> 00:51:26.480 Postponements in purchases arise because it is judged that a cut in costs or other prices 480 00:51:26.480 --> 00:51:33.680 is less than will eventually have to take place, or because the rate of fall of costs 481 00:51:33.680 --> 00:51:36.760 is insufficiently rapid. 482 00:51:36.760 --> 00:51:43.440 The final Keynesian bogey is that people may acquire an unlimited demand for money, so 483 00:51:43.440 --> 00:51:47.300 that hoards will indefinitely increase. 484 00:51:47.300 --> 00:51:54.760 This is termed an infinite liquidity preference, and this is the only case in which neo-Keynesians 485 00:51:54.760 --> 00:52:02.040 Experts such as Modigliani believe that involuntary unemployment can be compatible with price 486 00:52:02.040 --> 00:52:03.920 and wage freedom. 487 00:52:03.920 --> 00:52:10.600 The Keynesian worry is that people will hoard instead of buying bonds, for fear of a fall 488 00:52:10.600 --> 00:52:12.840 in the price of securities. 489 00:52:12.840 --> 00:52:19.680 Translating this into more important natural terms, this would mean, as we have stated, 490 00:52:19.680 --> 00:52:26.080 investing because of expectation of imminent increases in the natural interest rate. 491 00:52:26.080 --> 00:52:33.280 Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. 492 00:52:33.280 --> 00:52:40.400 Furthermore, the demand for money could not be infinite, since people must always continue 493 00:52:40.400 --> 00:52:47.280 consuming whatever their expectations. Of necessity, therefore, the demand for money 494 00:52:47.280 --> 00:52:54.320 could never be infinite. The existing level of consumption, in turn, will require a certain 495 00:52:54.320 --> 00:53:00.960 level of investment. As long as productive activities are continuing, there is no need 496 00:53:00.960 --> 00:53:06.480 or possibility of lasting unemployment, regardless of the degree of hoarding. 497 00:53:07.280 --> 00:53:14.480 As Hutt points out, if we can conceive of a situation of infinitely elastic liquidity preference, 498 00:53:14.480 --> 00:53:22.080 and no such situation has ever existed, then we can conceive of prices falling rapidly, 499 00:53:22.080 --> 00:53:29.760 keeping pace with expectations of price changes, but never reaching zero, with full utilization 500 00:53:29.760 --> 00:53:38.640 of resources persisting all the way. A demand for money to hold stems from the general uncertainty 501 00:53:38.640 --> 00:53:46.320 of the Market. Keynesians, however, attribute liquidity preference not to general uncertainty 502 00:53:46.320 --> 00:53:53.520 but to the specific uncertainty of future bond prices. Surely this is a highly superficial 503 00:53:53.520 --> 00:54:00.720 and limiting view. In the first place, this cause of liquidity preference could occur 504 00:54:00.720 --> 00:54:07.680 only on a highly imperfect securities market. As Ludwig Lachmann pointed out years ago in 505 00:54:07.680 --> 00:54:15.280 In a neglected article, Kane's causal pattern, bearishness causing liquidity preference, demand 506 00:54:15.280 --> 00:54:22.460 for cash, and high interest rates, could take place only in the absence of an organized 507 00:54:22.460 --> 00:54:27.300 forward or futures market for securities. 508 00:54:27.300 --> 00:54:34.680 If such a market existed, both bears and bulls on the bond market could express their expectations 509 00:54:34.680 --> 00:54:36.680 by Forward Transactions 510 00:54:36.680 --> 00:54:39.680 which do not require any cash. 511 00:54:39.680 --> 00:54:43.680 Where the market for securities is fully organized over time, 512 00:54:43.680 --> 00:54:49.680 the owner of 4% bonds who fears a rise in the rate of interest 513 00:54:49.680 --> 00:54:52.680 has no incentive to exchange them for cash, 514 00:54:52.680 --> 00:54:57.680 for he can always hedge by selling them forward. 515 00:54:57.680 --> 00:55:02.680 Bearishness would cause a fall in forward bond prices, 516 00:55:02.680 --> 00:55:06.680 followed immediately by a fall in spot prices. 517 00:55:06.680 --> 00:55:14.680 Thus, speculative bearishness would, of course, cause at least a temporary rise in the rate of interest, 518 00:55:14.680 --> 00:55:18.680 but accompanied by no increase in the demand for cash. 519 00:55:18.680 --> 00:55:29.680 Hence, any attempted connection between liquidity preference, or demand for cash, and the rate of interest, falls to the ground. 520 00:55:29.680 --> 00:55:36.640 The fact that such a securities market has not been organized indicates that traders are not 521 00:55:36.640 --> 00:55:42.800 nearly as worried about rising interest rates as Keynes believes. If they were, 522 00:55:42.800 --> 00:55:49.520 and this fear loomed as an important phenomenon, then surely a futures market would have developed 523 00:55:49.520 --> 00:55:57.280 in securities. Furthermore, as we have seen, interest rates on loans are merely a reflection 524 00:55:57.280 --> 00:56:04.360 of Price Spreads, so that a prediction of higher interest rates really means the expectation 525 00:56:04.360 --> 00:56:12.800 of lower prices, and especially lower costs, resulting in a greater demand for money. 526 00:56:12.800 --> 00:56:19.240 And all speculation on the free market is self-correcting and speeds adjustment, rather 527 00:56:19.240 --> 00:56:22.480 than a cause of economic trouble. 528 00:56:22.480 --> 00:56:30.480 G. The purchasing power and terms of trade components in the rate of interest. 529 00:56:30.480 --> 00:56:36.480 Many economists beginning with Irving Fisher have asserted that the market rate of interest, 530 00:56:36.480 --> 00:56:44.480 in addition to containing specific entrepreneurial components superimposed on the pure rate of interest, 531 00:56:44.480 --> 00:56:49.480 also contains a price or a purchasing power component. 532 00:56:49.480 --> 00:56:59.480 When the purchasing power of money is generally expected to rise, the theory asserts that the market rate of interest falls correspondingly. 533 00:56:59.480 --> 00:57:07.480 When the PPM is expected to fall, the theory declares that the market rate of interest rises correspondingly. 534 00:57:07.480 --> 00:57:17.480 These economists erred by concentrating on the loan rate, rather than on the natural rate, the rate of return. 535 00:57:17.480 --> 00:57:33.480 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. 536 00:57:33.480 --> 00:57:44.480 Suppose that 100 gold ounces exchange for 105 gold ounces a year from now, that is, that the rate of interest is 5%. 537 00:57:44.480 --> 00:57:52.640 Now, suddenly, let there be a general expectation that the purchasing power of money will increase. 538 00:57:52.640 --> 00:58:01.800 In that case, a lower amount to be returned, say 102 ounces, may yield 5% real interest 539 00:58:01.800 --> 00:58:04.360 in terms of purchasing power. 540 00:58:04.360 --> 00:58:10.960 A general expectation of a rise in purchasing power, therefore, will lower the market rate 541 00:58:10.960 --> 00:58:18.840 of Interest at present, while a general expectation of a fall in purchasing power will raise the 542 00:58:18.840 --> 00:58:20.140 rate. 543 00:58:20.140 --> 00:58:25.800 There is a fatal defect in this generally accepted line of reasoning. 544 00:58:25.800 --> 00:58:33.160 Suppose for example that prices are generally expected to fall by 50% in the next year. 545 00:58:33.160 --> 00:58:40.540 Would someone lend 100 gold ounces to exchange for 53 ounces one year from now? 546 00:58:40.540 --> 00:58:41.740 Why not? 547 00:58:41.740 --> 00:58:46.700 This would certainly preserve the real interest rate at 5%. 548 00:58:46.700 --> 00:58:53.500 But then why should the would-be lenders not simply hold on to their money and double their 549 00:58:53.500 --> 00:58:57.300 real assets as a result of the price fall? 550 00:58:57.300 --> 00:59:00.180 And that is precisely what they would do. 551 00:59:00.180 --> 00:59:05.800 They certainly would not give money away, even though their real assets would be greater 552 00:59:05.800 --> 00:59:07.220 than before. 553 00:59:07.220 --> 00:59:13.140 Fisher simply shrugged off this point by saying that the purchasing power premium could never 554 00:59:13.140 --> 00:59:20.040 make the interest rate negative, but this flaw vitiates the entire theory. 555 00:59:20.040 --> 00:59:25.700 The root of the difficulty consists in ignoring the natural rate of interest. 556 00:59:25.700 --> 00:59:29.620 Let us consider the interest rate in those terms. 557 00:59:29.620 --> 00:59:36.900 Then suppose 100 ounces are paid for factors that will be transformed in one year into 558 00:59:36.900 --> 00:59:44.900 to a product that sells for 105 gold ounces, for an interest gain of 5 and an interest 559 00:59:44.900 --> 00:59:47.460 return of 5%. 560 00:59:47.460 --> 00:59:55.060 Now a general expectation arises of a general having of prices one year from now. 561 00:59:55.060 --> 01:00:00.620 The selling price of the product will be 53 ounces in a year's time. 562 01:00:00.620 --> 01:00:02.080 What happens now? 563 01:00:02.080 --> 01:00:09.520 Will entrepreneurs buy factors for $100 and sell at $53 merely because their real interest 564 01:00:09.520 --> 01:00:11.680 rate is preserved? 565 01:00:11.680 --> 01:00:12.680 Certainly not. 566 01:00:12.680 --> 01:00:19.600 They will do so only if they do not at all anticipate the change in purchasing power. 567 01:00:19.600 --> 01:00:26.760 But to the extent that it is anticipated, they will hold money rather than buy factors. 568 01:00:26.760 --> 01:00:34.720 This will immediately lower factor prices to their expected future levels, say from 100 569 01:00:34.720 --> 01:00:36.420 to 50. 570 01:00:36.420 --> 01:00:41.160 What happens to the loan rate is analytically quite trivial. 571 01:00:41.160 --> 01:00:47.700 It is simply a reflection of the natural rate, and depends on how the expectations and judgment 572 01:00:47.700 --> 01:00:53.880 of the people on the loan market compare with those on the stock and other markets. 573 01:00:53.880 --> 01:00:59.840 For the free economy, there is no point in separately analyzing the loan market. 574 01:00:59.840 --> 01:01:06.020 Analysis of the Fisher problem, the relation of the interest rate to price changes, should 575 01:01:06.020 --> 01:01:10.640 concentrate on the natural rate of interest. 576 01:01:10.640 --> 01:01:15.920 Discussion of the relation between price movements and the natural rate of interest should be 577 01:01:15.920 --> 01:01:18.320 divided into two parts. 578 01:01:18.320 --> 01:01:25.760 First, assuming neutral money, that all prices change equally and at the same time. 579 01:01:25.760 --> 01:01:32.520 And second, analyzing conditions where factor and product change at different rates. 580 01:01:32.520 --> 01:01:38.940 And these changes should first be analyzed without considering that they had been anticipated 581 01:01:38.940 --> 01:01:41.680 by people on the market. 582 01:01:41.680 --> 01:01:47.720 Suppose first that all prices change equally and at the same time. 583 01:01:47.720 --> 01:01:53.600 Instead of thinking in terms of 100 ounces borrowed on the loan market, let us consider 584 01:01:53.600 --> 01:01:55.280 the natural rate. 585 01:01:55.280 --> 01:02:02.680 An investor buys factors in period 1 and then sells the product, say, in period 3. 586 01:02:02.680 --> 01:02:08.000 Time, as we have seen, is the essence of the production structure. 587 01:02:08.000 --> 01:02:15.040 All the processes take time, and capitalists pay money to owners of factors in advance 588 01:02:15.040 --> 01:02:17.560 of production and sale. 589 01:02:17.560 --> 01:02:24.080 Since factors are bought before products are sold, what is the effect of a period of rising 590 01:02:24.080 --> 01:02:28.840 general prices, that is, falling PPM? 591 01:02:28.840 --> 01:02:34.120 The result is that the entrepreneur reaps an apparent extra profit. 592 01:02:34.120 --> 01:02:47.620 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. 593 01:02:47.620 --> 01:03:02.120 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. 594 01:03:02.120 --> 01:03:09.000 Then, just because of the passage of time, an entrepreneur who purchases factors for 595 01:03:09.000 --> 01:03:15.280 100 now will sell for 240 ounces in two years' time. 596 01:03:15.280 --> 01:03:25.160 Instead of a net return of 20 ounces, or 10% per annum, he reaps 140 ounces, or 70% per 597 01:03:25.160 --> 01:03:26.880 annum. 598 01:03:26.880 --> 01:03:33.920 It would seem that a rise in prices creates an inherent tendency for large-scale profits 599 01:03:33.920 --> 01:03:39.240 that are not simply individual rewards for more accurate forecasting. 600 01:03:39.240 --> 01:03:45.760 However, more careful analysis reveals that this is not an extra profit at all, for the 601 01:03:45.760 --> 01:03:54.560 240 ounces two years from now is roughly equivalent in terms of purchasing power to 120 ounces 602 01:03:54.560 --> 01:03:55.700 now. 603 01:03:55.700 --> 01:04:03.100 The real rate of net return, based on money services, is the same 10% as it has always 604 01:04:03.100 --> 01:04:04.100 been. 605 01:04:04.100 --> 01:04:10.580 It is clear that any lower net return would amount to a decline in real return. 606 01:04:10.580 --> 01:04:18.620 A return of a mere 120 ounces, for example, would amount to a drastic negative real return, 607 01:04:18.620 --> 01:04:26.220 For 100 ounces would then be invested for the equivalent gross return of only 60 ounces. 608 01:04:26.220 --> 01:04:32.380 It has often been shown that a period of rising prices misleads businessmen into thinking 609 01:04:32.380 --> 01:04:39.740 that their increased money profits are also real gains, whereas they only maintain real 610 01:04:39.740 --> 01:04:42.060 rates of return. 611 01:04:42.060 --> 01:04:47.720 Consider for example replacement costs, the prices which the businessmen will now have 612 01:04:47.720 --> 01:05:03.720 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. 613 01:05:03.720 --> 01:05:15.720 Businessmen who, under such circumstances, treat their monetary profits as real profits and consume them, soon find that they are really consuming their capital. 614 01:05:15.720 --> 01:05:17.280 Capital 615 01:05:17.280 --> 01:05:21.200 The converse occurs in the case of falling prices. 616 01:05:21.200 --> 01:05:27.900 The capitalist buys factors in period one and sells the product in period three, when 617 01:05:27.900 --> 01:05:30.820 all-around prices are lower. 618 01:05:30.820 --> 01:05:37.340 If prices are to fall by a half in two years, an investment of one hundred, followed by 619 01:05:37.340 --> 01:05:44.160 a sale at sixty, does not really involve the terrific loss that it appears to be. 620 01:05:44.160 --> 01:05:51.260 For the 60, return is equivalent in real terms, both in generalized purchasing power and in 621 01:05:51.260 --> 01:05:56.740 replacement of factors, to 120 previous ounces. 622 01:05:56.740 --> 01:06:00.520 His real rate of return remains the same. 623 01:06:00.520 --> 01:06:06.880 The consequence is that businessmen will be likely to overstate their losses in a period 624 01:06:06.880 --> 01:06:09.020 of price contraction. 625 01:06:09.020 --> 01:06:14.860 Perhaps this is one of the major reasons for the deep-seated belief of most businessmen 626 01:06:14.860 --> 01:06:21.740 that they always gain during a general price expansion and lose during a period of general 627 01:06:21.740 --> 01:06:23.280 contraction. 628 01:06:23.280 --> 01:06:26.960 This belief is purely illusory. 629 01:06:26.960 --> 01:06:33.500 In these examples, the natural interest rate on the market has contained a purchasing power 630 01:06:33.500 --> 01:06:40.220 Component, which corrects for real rates, positively in money terms during a general 631 01:06:40.220 --> 01:06:45.260 expansion and negatively during a general contraction. 632 01:06:45.260 --> 01:06:50.900 The loan rate will be simply a reflection of what has been happening in the natural 633 01:06:50.900 --> 01:06:51.900 rate. 634 01:06:51.900 --> 01:06:58.380 So far, the discussion is similar to Fisher's, except that these are the effects of actual, 635 01:06:58.380 --> 01:07:04.880 not anticipated changes, and the Fisher thesis cannot take account of the negative interest 636 01:07:04.880 --> 01:07:06.300 rate case. 637 01:07:06.300 --> 01:07:12.460 We have seen that rather than take a monetary loss, even though their real return will be 638 01:07:12.460 --> 01:07:19.900 the same, entrepreneurs will hold back their purchases of factors until factor prices fall 639 01:07:19.900 --> 01:07:23.180 immediately to their future low level. 640 01:07:23.180 --> 01:07:30.020 But this process of anticipatory price movement does not occur only in the extreme case of 641 01:07:30.020 --> 01:07:33.280 a prospective negative return. 642 01:07:33.280 --> 01:07:38.020 It happens whenever a price change is anticipated. 643 01:07:38.020 --> 01:07:44.340 Thus, suppose all entrepreneurs generally anticipate that prices will double in two 644 01:07:44.340 --> 01:07:45.420 years. 645 01:07:45.420 --> 01:07:52.160 The fact of an anticipated rise will lead to an increase in the price level now and 646 01:07:52.160 --> 01:08:16.160 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. 647 01:08:16.160 --> 01:08:24.120 The purchasing power component, then, is not the reflection, as has been thought, of expectations 648 01:08:24.120 --> 01:08:26.840 of changes in purchasing power. 649 01:08:26.840 --> 01:08:29.920 It is the reflection of the change itself. 650 01:08:29.920 --> 01:08:37.960 Indeed, if the change were completely anticipated, the purchasing power would change immediately, 651 01:08:37.960 --> 01:08:43.780 and there would be no room for a purchasing power component in the rate of interest. 652 01:08:43.780 --> 01:08:52.460 As it is, partial anticipations speed up the adjustment of the PPM to the changed conditions. 653 01:08:52.460 --> 01:08:59.140 So far we have distinguished three components of the natural rate of interest, all reflected 654 01:08:59.140 --> 01:09:01.820 in the loan rate of interest. 655 01:09:01.820 --> 01:09:08.900 One is the pure rate of interest, the result of individual time preferences tending to 656 01:09:08.900 --> 01:09:12.380 be uniform throughout the economy. 657 01:09:12.380 --> 01:09:16.540 are the specific entrepreneurial rates of interest. 658 01:09:16.540 --> 01:09:20.940 These differ from firm to firm and so are not uniform. 659 01:09:20.940 --> 01:09:26.900 They are anticipated in advance and they are the rates that an investor will have to anticipate 660 01:09:26.900 --> 01:09:30.060 receiving before he enters the field. 661 01:09:30.060 --> 01:09:36.660 A particularly risky venture, if successful at all, will therefore tend to earn more in 662 01:09:36.660 --> 01:09:49.100 The third component of the natural rate of interest is the purchasing power component, 663 01:09:49.100 --> 01:09:56.340 correcting for general PPM changes because of the inevitable time lags in production. 664 01:09:56.340 --> 01:10:03.280 This will be positive in an expansion and negative in a contraction, but will be ephemeral. 665 01:10:03.280 --> 01:10:10.040 The more the changes in the PPM are anticipated, the less important will be the purchasing 666 01:10:10.040 --> 01:10:17.480 power component, and the more rapid will be the adjustment in the PPM itself. 667 01:10:17.480 --> 01:10:22.160 There is still a fourth component in the natural rate of interest. 668 01:10:22.160 --> 01:10:28.760 This exists to the extent that money changes are not neutral, and they never are. 669 01:10:28.760 --> 01:10:34.200 Sometimes product prices rise and fall faster than factor prices. 670 01:10:34.200 --> 01:10:37.320 Sometimes they rise and fall more slowly. 671 01:10:37.320 --> 01:10:43.600 And sometimes their behavior is mixed, with some factor prices and some product prices 672 01:10:43.600 --> 01:10:45.960 rising more rapidly. 673 01:10:45.960 --> 01:10:52.400 Whenever there is a general divergence in rates of movement between the prices of the 674 01:10:52.400 --> 01:11:00.400 and of Original Factors, a Terms of Trade component emerges in the natural rate of interest. 675 01:11:00.400 --> 01:11:12.400 Historically, it has often been the case that product prices rise more rapidly and fall more rapidly than the prices of original factors. 676 01:11:12.400 --> 01:11:19.180 In the former case, there is, during the period of transition, a favorable change in the terms 677 01:11:19.180 --> 01:11:23.340 of trade to the general run of capitalists. 678 01:11:23.340 --> 01:11:30.220 For-selling prices are increasing faster than the buying prices of original factors. 679 01:11:30.220 --> 01:11:36.640 This will increase the general rate of return and constitute a general positive terms of 680 01:11:36.640 --> 01:11:40.820 trade component in the natural rate of interest. 681 01:11:40.820 --> 01:11:46.240 This of course will also tend to be reflected in the loan rate of interest. 682 01:11:46.240 --> 01:11:53.020 In the case of a contraction, a more sluggish fall in the prices of factors creates a general 683 01:11:53.020 --> 01:11:57.500 negative terms of trade component in the interest rate. 684 01:11:57.500 --> 01:12:04.900 The components are precisely the reverse whenever factor prices change more rapidly than product 685 01:12:04.900 --> 01:12:06.420 prices. 686 01:12:06.420 --> 01:12:13.140 However there is no general change in the terms of trade to capitalist entrepreneurs, 687 01:12:13.140 --> 01:12:18.900 no terms of trade component will appear in the interest rate. 688 01:12:18.900 --> 01:12:24.960 Changes in terms of trade discussed here are only those resulting purely from differences 689 01:12:24.960 --> 01:12:29.160 in the speed of reaction to changing conditions. 690 01:12:29.160 --> 01:12:41.160 They do not include basic changes in the terms of trade resulting from changes in time preferences, such as we have discussed previously. 691 01:12:41.160 --> 01:12:55.160 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. 692 01:12:55.160 --> 01:13:01.880 None of these components would exist in the ERE, and therefore the market interest rate 693 01:13:01.880 --> 01:13:08.920 in the ERE would equal the pure rate determined by time preferences alone. 694 01:13:08.920 --> 01:13:16.940 In the ERE, the only net incomes would be a uniform pure interest return, and wages 695 01:13:16.940 --> 01:13:23.300 to Labor, Ground Land Rents being capitalized into an interest return.