The
dissension on the mechanism of determination of interest rate is always in the
center of much confusion and many controversies of monetary economics. Keynes’s
liquidity preference theory remains at the core of the center. This paper
starts off with analyzing the inherent logic of liquidity preference theory and
presents a new interpretation of the theory in a more logical and clear manner.
The reinterpretation clearly indicates the necessity of introducing liquidity
preference analysis into determination of interest rate, arguing that it is the
liquidity preference analysis based on finance motive, rather than on
transactions motive, that plays a more fundamental role in determining interest
rate. The paper then points out a crucial and unsolved mistake in Keynes’s
liquidity preference theory, i.e. interest rate is indeterminate, which is
revealed by introducing finance motive into the theory. Further, the paper
develops a logically consistent and integrated model of determination of
interest rate on the basis of the liquidity preference analysis centered on
finance motive. In this model, interest rate is not determined by
the demand for and supply of money, but determined by the demand for and supply
of idle money.
Keywords: Liquidity preference theory, Finance motive, IS-LM model, Determination
of interest rate
JEL classifications: E12, E41, E43
1.
Introduction
The dissension
on the mechanism of determination of interest rate is always in the center of
much confusion and many controversies of monetary economics. Keynes’s liquidity
preference theory remains at the core of the center. Liquidity preference was
first introduced to determine interest rate by Keynes in his profoundly
influential General Theory in 1936. Before that, the classical theory of
interest argues that the level of interest rate is determined by two real
factors: the demand for investment and supply of saving.
In The General Theory, Keynes (1936) criticizes the
classical theory of interest and presents a brand-new theory of interest,
namely liquidity preference theory. In Keynes’s opinion, interest rate is not
determined by saving and investment, but by the demand for and supply of money.
Demand for money, or broadly defined liquidity preference, is composed of transactions
motive, precautionary motive and speculative motive. Among the three motives,
transactions motive and precautionary motive mainly depend on the level of
income; and speculative motive, or narrowly defined liquidity preference,
mainly depends on the level of interest rate. The supply of money is the
quantity of money determined by the monetary authority. Interest rate is a
price, which makes the quantity of money the public would like to hold equal to
the quantity of money in existence.
Keynes’s liquidity preference theory induced a lot of
controversies soon after he brought it forward. Most curiously, The General
Theory holds that the change of propensity to invest (namely, a shift of
the investment demand curve or Keynes’s investment demand-schedule) only exerts
an ex post influence on interest rate indirectly via the change of transactions
motive after income changes. Moreover, Keynes didn’t explain why. Ohlin (1937)
and Robertson (1937, 1940), the two most famous loanable funds theorists,
attacked Keynes’s theory of interest effectively on this issue. Their criticism
can be summarized as: if there is an increase in propensity to invest, according
to Keynes, the multiplier effect can make the level of income rise, leading to investment
equal to saving. However, in adjusting to the new equilibrium, desired
investment and desired saving are not equal.
In his reply to Ohlin’s criticism, Keynes (1937B, 1937C,
1938) confessed his mistake and introduced a new and somewhat novel incentive
for demanding money, namely the finance motive, in order to improve his
liquidity preference theory. Keynes argues that, during the period between the
date when entrepreneurs make their investment decisions and the date when they
actually make their investment, there is a demand for finance. Keynes stresses
that finance motive is an additional motive for demanding money and essentially
a revolving fund, whilst an excess in demanding for finance resulting from the
increase of propensity to invest may lead to a rise of interest rate.
In his debate with loanable funds theorists, although Keynes
kept clarifying and improving his liquidity preference theory, the theory is
still known for its bizarrerie and difficulty to be understood, resulting in a
lot of controversies in interpreting it. Most strangely, finance motive
can hardly be found in the literatures after Keynes until Davidson (1965)
rediscovered finance motive. Among the various interpretations is IS-LM model of
NeoClassical Synthesis the most well-known.
The prototype of IS-LM model was first presented by Hicks
(1937) to elucidate the interrelationships between the theory of effective
demand and the liquidity preference theory. But it should be mainly owed to the
work of Hansen that IS-LM model becomes a popular model of determination of
interest rate. In his book A Guide to Keynes, Hansen (1953) points out
that interest rate is indeterminate in Keynes’s theory of interest. Hansen’s
criticism can be summarized as: interest rate is determined by the total demand
for and supply of money, and the transactions motive for demanding money is
determined by income; however, income is determined by the investment, and the
investment is determined by interest rate and marginal efficiency of capital.
Thus, interest rate and income are all indeterminate. Therefore, Hansen
develops IS-LM model to solve this problem by means of making the goods market
and the money market attain equilibrium simultaneously. Later, IS-LM model has
developed from a model of determination of interest rate to a dominant
macroeconomic model of NeoClassical Synthesis for many decades.
However,
IS-LM model has also been criticized by many economists. Among the various
criticisms, the most fundamental and common attack is that the approach with a
character of simultaneity doesn’t apply to Keynes’s theory, making IS-LM model
logically inconsistent. For example, Pasinetti (1974) has argued that Keynes’s
theory should not be analyzed simultaneously but sequentially. That is,
Keynes’s theory ought to be considered as a sequence of alternating decisions
in monetary sector and real sector. Davidson (1978) argues that the IS and LM
schedules are interdependent when finance motive is introduced. Chick (1982)
also attacks IS-LM model on the basis of its internal logic.
Which
one is correct, the mainstream interpretation of liquidity preference theory or
the criticism of it? Or neither of them is fully correct? Further, can
liquidity preference theory be correctly interpreted without finance motive? If
not, what kind of role should finance motive play in liquidity preference theory?
These questions inspire me to explore the essence of
liquidity preference theory. Section 2 starts off with analyzing the inherent
logic of liquidity preference theory and presents a new interpretation of the
theory in a manner I believe more logical and clear. Through bridging the gap
between the classical theory of interest and liquidity preference theory, the
reinterpretation clearly indicates the necessity of introducing liquidity
preference analysis into determination of interest rate. The reinterpretation
also suggests that it is the liquidity preference analysis based on finance
motive, rather than on transactions motive, that plays a more fundamental role
in determining interest rate. Section 3 then argues that Keynes makes a crucial
and yet unsolved mistake in his theory of interest, i.e. interest rate is
indeterminate, which is revealed by his introduction of finance motive into the
theory. Further, Section 4 develops a logically consistent and integrated model
of determination of interest rate on the basis of the liquidity preference
analysis that is centered on finance motive. In this model, interest rate is
not determined by the demand for and supply of money, but determined by the
demand for and supply of idle money. Section 5 discusses some other
controversies in respect of liquidity preference theory. Finally, Section 6
provides a brief conclusion.
2.
Reinterpretation of liquidity preference theory
After
analyzing the previous literatures on liquidity preference theory, I have found
that the research approach adopted by subsequent economists may be improper. It
seems that they limit themselves to Keynes’s literature, and even stick to the
sequence of Keynes’s presentation when they study the motives with respect to the
demand for money, i.e. analyzing transactions motive first and finance motive
last. This approach makes them very likely to ignore the inherent logic of
liquidity preference theory.
In my opinion, liquidity preference theory is not dreamed up
by Keynes without any foundation. It reveals the objective law of determination
of interest rate. Keynes does not create the law, but discover the law. The
researches that are confined to Keynes’s literature may be misled by Keynes’s
mistake. Accordingly, by focusing on the internal logic of liquidity preference
theory, I attempt to present a new interpretation of the theory to uncover its
essence.
It seems we can start from the problem of the classical
theory of interest since Keynes tried to develop a new theory of interest after
he was aware that there is something wrong with the classical theory. But when
criticizing the classical theory of interest in his General Theory,
Keynes makes chaos and conceals the essence of the problem by his unsuccessful
attack. Given that the problem of the classical theory is still not clear, I
feel the following quote from Keynes can be a more clear and reliable start:
[A]s I have
said above, the initial novelty lies in my maintaining that it is not the rate
of interest, but the level of incomes which ensures equality between saving and
investment. The arguments, which lead up to this initial conclusion, are
independent of my subsequent theory of the rate of interest, and in fact I
reached it before I had reached the latter theory. But the result of it was to
leave the rate of interest in the air. If the rate interest is not determined
by saving and investment in the same way in which price is determined by supply
and demand, how is it determined? (Keynes, 1937B, p.212)
It can be
clearly deduced from this quote that the initial divarication between the
classical theory of interest and Keynes is whether interest rate or income will
change along with the change of propensity to invest (no matter which of them
changes, saving would equate investment anyway). When propensity to invest
changes, the classical theory holds that interest rate will change and income will
not change, but Keynes thinks that it is not interest rate but income that will
change.
To settle the divarication, we should analyze the ex ante
situation first. If, for example, there is an increase of propensity to invest
(namely, an outward shift of the investment demand curve or Keynes’s investment
demand-schedule), desired investment will increase and exceed desired saving.
According to the classical theory, at the moment, a rise of interest
rate will decrease desired investment and increase desired saving. The interest
rate will continue to rise until desired investment equates desired saving.
Therefore, ultimately interest rate changes and income maintains unchanged.
Moreover, interest rate is directly determined by desired investment and
desired saving.
But how can
Keynes’s prediction that income will change be right? It is not difficult to
see that income will change if the economy can draw idle money from
somewhere to fill up the gap between desired investment and desired
saving in the ex ante situation.
Thus, the debate on whether interest rate or income will change
transforms to another equivalent debate: whether there exists idle money outside
economic operation. If there doesn’t exist idle money, income won’t change, and
the classical theory is right. If there exists idle money, income will change
and interest rate cannot be determined by desired investment and desired
saving.
Obviously, the idle money here is just Keynes’s “inactive
balances” or “idle balances”. Why there exists idle money? Just as Keynes
argues, the reason why the wealth-holders would like to hold money without
gaining interest is the existence of speculative motive for demanding money.
Accordingly, the concept of liquidity preference comes out naturally. Is there
any cost to draw idle money into the economic operation? To make the
wealth-holders give up holding money, according to Keynes, requires the rise of
interest rate: the higher the demand for idle money, the more the rise of
interest rate. In this way, liquidity preference analysis is logically
introduced into determination of interest rate in the ex ante situation.
When there exists idle money, determination of interest rate
is related not only to the difference between desired investment and desired
saving, but also to the interest elasticity of liquidity preference. The higher
the interest elasticity of liquidity preference, the lower the cost of drawing
idle money, the less the rise of interest rate, the more the increase of
income. Contrarily, the lower the interest elasticity of liquidity preference,
the higher the cost of drawing idle money, the more the rise of interest rate,
the less the increase of income.
Further, I would argue that the difference between desired
investment and desired saving as mentioned above is equivalent to what Keynes
(1937C) says an excess finance motive as a result of the increase of propensity
to invest. That is, finance motive will increase first when propensity to
invest increases. Only when the excess finance motive is satisfied by the idle
money, the excess investment can be realized and income can increase. After the
multiplier effect makes the level of income rise, the idle money will change to
revolving fund, which makes desired saving equal to desired investment if the
increase of propensity to invest lasts.
According to Keynes,
finance motive exists during what I call an investment-realization period,
the period between the date when entrepreneurs make their investment decisions
(at the same time, they arrange their finance) and the date when they actually
make their investment. Let’s see Figure 1, which tries to clarify the role of
finance motive in a simplified investment-realization period.
by entrepreneurs. If propensity to invest
increases, finance motive will increase simultaneously, drawing idle money from
inactive balances into economic operation and leading to the rise of interest
rate. Then the purchase contracts of investment goods will be signed between
entrepreneurs and producers. After that, producers will make production
decisions and seek more working capital for producing more investment goods.
Consequently, transactions motive will increase, drawing more idle money
from inactive balances into economic operation and leading to the rise of
interest rate once more. After the investment goods are delivered and payment is
made, the investment process is completed, and the investment is finally
realized. Moreover, if the increase of propensity to invest lasts, the increase
of finance motive and transactions motive will last in subsequent
investment-realization periods.
The above analysis demonstrates two points:
First, finance motive doesn’t merely exist when
investment increases, but exists at any time. When the economic operation is
constant, finance motive is a constant revolving fund, the amount of which
equates to the amount of the desired investment or desired saving during an
investment-realization period. When all the other conditions are the same,
the amount of finance motive depends on the length of the
investment-realization period: the longer the investment-realization period,
the more the finance motive for demanding money. In this way, finance motive
transforms the flow demand for funds into the stock demand for money.
Second, finance motive and transactions motive are different
demands for money and play different roles in economic operation. They
simultaneously exist in economic operation and change at different time in
expansion or contraction of economy. Therefore, finance motive cannot be just a
subcategory or addendum of transactions motive. Furthermore, I would like to
argue that in determining interest rate, the liquidity preference
analysis based on finance motive plays a more fundamental role than does the
liquidity preference analysis based on transactions motive, because: 1) finance
motive bridges the classical theory of interest and liquidity preference theory,
thereby illuminating the necessity of introducing liquidity preference analysis
into determination of interest rate; and 2) finance motive is the start point
of liquidity preference analysis since finance motive changes first when
propensity to invest changes.
Hereto, we arrive at a new interpretation of liquidity
preference theory. Without finance motive, liquidity preference theory
is terribly half-baked, or even false. However, it is very strange that finance
motive can hardly be found in the literatures after Keynes, e.g. IS-LM model
and most other interpretations of liquidity preference theory all overlook
finance motive.
In my opinion, Keynes’s mistake of initially overlooking
finance motive in The General Theory mainly contributes to this strange
phenomenon. Although Keynes later added finance motive to correct this mistake,
the strong first impressions of The General Theory make most economists
still consider his initial mistake the innovation and elite of the theory. This
misunderstanding results in that they think that transactions motive plays a
fundamental role in liquidity preference theory and finance motive is
dispensable. Thus, the inherent logic and essence of liquidity preference theory
are covered up, leading to much confusion and many misinterpretations. If
Keynes had firstly introduced finance motive with its ex ante effect on
interest rate, then brought forward transactions motive with its succedent
effect on interest rate, liquidity preference theory would have become more
logical and clear, and all the misunderstandings and controversies would have been
cleared up naturally.
3.
Keynes’s crucial and unsolved mistake in his theory of
interest
After
introducing finance motive, Keynes summarized his liquidity preference theory
in Mr Keynes ‘Finance’:
[T]he rate of interest is
determined by the total demand and total supply of cash or liquid resources.
The total demand falls into two parts: the inactive demand due to the state of
confidence and expectation on the part of the owners of wealth, and the active
demand due to the level of activity established by the decisions of the
entrepreneurs. The active demand in its turn falls into two parts: the demand
due to the time lag between the inception and the execution of the
entrepreneurs’ decisions, and the part due to the time lags between the receipt
and the disposal of income by the public and also between the receipt by
entrepreneurs of their sale proceeds and the payment by them of wages, etc. An
increase in activity raises the demand for cash, first of all to provide for
the first of these time lags in circulation, and then to provide for the second
of them. (Keynes, 1938, p.230)
Keynes may
not be aware that a new problem comes out after he adds finance motive: interest
rate becomes indeterminate. Here, interest rate is determined by the total
demand for and supply of money, and the finance motive for demanding money is
determined by desired investment. However, as desired investment is
determined by interest rate and marginal efficiency of capital, interest rate
and desired investment have to be determined simultaneously. Thus, there is a
circular logic in his theory of interest.
Here I must stress that, from the appearance, I have arrived
at a conclusion similar to Hansen’s, i.e. interest rate is indeterminate in
Keynes’s theory of interest, but the bases of our reasoning are totally
different. My reasoning is established on what I calls the comprehensive
liquidity preference theory, namely, Keynes’s theory of interest that
includes both finance motive and transactions motive; whereas the reasoning of
Hansen is established on what I calls the half-baked liquidity preference
theory, namely, Keynes’s theory of interest in The General Theory
that merely includes transactions motive.
Moreover, contrary to Hansen, I would argue that interest
rate is determinate in the half-baked liquidity preference theory. In The
General Theory, two incomes are different from each other: the income that
affects transactions motive, demand for money, and then interest rate; and the
income determined by investment and then by interest rate and marginal
efficiency of capital. The first income, or the ex ante income, is realized
before the investment is carried out. The second income, or the ex post income,
is realized after the investment is carried out. In The General Theory,
although Keynes didn’t elucidate explicitly, he implied that the change of
propensity to invest doesn’t directly exert an ex ante influence on interest
rate. Therefore, the ex ante interest rate is just determined by the supply of
money and the demand for money, the latter being determined by the ex ante
income. This ex ante interest rate and marginal efficiency of capital will then
collectively determine investment and the ex post income. Accordingly, interest
rate and income are not determined simultaneously, but
sequentially. That means, Pasinetti is right in interpreting the half-baked
liquidity preference theory.
There doesn’t
exist a circular logic in the half-baked liquidity preference theory. The
sequentiality of the half-baked liquidity preference theory makes the
simultaneous IS-LM model logically inconsistent. It is the introduction of
finance motive that makes interest rate and desired investment have to be
determined simultaneously, and then results in the circular logic of the
comprehensive liquidity preference theory. This is a crucial mistake in
Keynes’s theory of interest, but unfortunately he is never aware of it.
On the basis of above
analysis, it is not difficult to see that Hansen makes two mistakes: 1) that he
overlooks finance motive and does research on the half-baked liquidity
preference theory; 2) he makes an incorrect interpretation of the half-baked
liquidity preference theory. But very accidentally, Hansen based on his
successional mistakes arrives at a correct conclusion: interest rate is
indeterminate in Keynes’s liquidity preference theory.
4.
Remedy of liquidity preference theory
In order to
correct the mistake in Keynes’s theory of interest, I will develop a new
integrated model of determination of interest rate on the basis of the
liquidity preference analysis centered on finance motive.
If we regard the difference between
desired investment and desired saving in an investment-realization
period as the demand for idle money, the demand for idle money will
increase along with the fall of interest rate. When interest rate falls,
desired investment will rise and desired saving will fall, so the difference
will increase.
If we regard the
difference between the idle balance and the narrowly defined liquidity
preference as the supply of idle money, the supply of idle money will increase
along with the rise of interest rate. When interest rate rises, liquidity
preference will decrease, i.e. the money that the wealth-holders would like to
hold will decrease; thereby, the supply of idle money will increase.
In this way, we arrive at a new model of determination of
interest rate, or an integrated liquidity preference theory. In this model, interest
rate is determined by the demand for and supply of idle money. The main
features of the analysis can be illustrated in Figure 2.
In Figure 2,
y-axis denotes interest rate, and x-axis denotes the quantity of the demand for
and supply of idle money. When propensity to invest increases, the increase in
finance motive will make the demand for idle money curve move rightwards,
leading to the rise of interest rate from a to b. Later, when the
producers make production decisions, the increase of transactions motive will
make the supply of idle money curve move leftwards, leading to the rise of
interest rate higher from b to c, since the increase of
transactions motive decreases the idle balance. This model is established on
the relationship between finance motive and liquidity preference, namely, the
liquidity preference analysis based on finance motive; and then the influence
of transactions motive is added to the model.
Compared with IS-LM model, the new model is a logically
consistent and stable model of determination of interest rate because interest
rate and the quantity of (demand for and supply of) idle money are determined
simultaneously.
5.
Some other controversies related to liquidity
preference theory
In addition
to the controversies discussed in the above sections, there are some other
common controversies related to liquidity preference theory that I would like
to discuss so we can better elucidate the essence of liquidity preference
theory. Given their importance and complexity, I would like to leave to
separate papers the discussion of the well-known Liquidity Preference –
Loanable Funds controversy and the discussion of the relationship between
endogenous money supply and liquidity preference theory.
5.1.
The relationship between liquidity preference theory
and the classical theory of interest
In The
General Theory, Keynes attacks the classical theory of interest on its
assumption that income is constant and argues that interest rate is
indeterminate. However, Keynes fails to present the reason why income will
change, making his criticism unsuccessful. In my opinion, the classical theory
impliedly supposes that there is no idle money or the interest elasticity of liquidity
preference is zero. If Keynes wants to criticize the classical theory
effectively, he should attack the classical theory not on the change of income
in the ex post situation, but on the existence of idle money in the ex ante
situation. The change of income is merely the consequence of the existence of
idle money. In this way, he can uncover the essence of the problem of the
classical theory of interest.
Accordingly,
liquidity preference theory and the classical theory of interest are not
incompatible. The liquidity preference analysis centered on finance motive
bridges these two theories: liquidity preference theory is a general theory
of interest, whereas the classical theory is just a special case of the theory.
5.2.
The exact meaning of liquidity preference
Understanding
Keynes’s liquidity preference theory is made difficult by his inconsistent use
of the term liquidity preference. In The General Theory, liquidity
preference sometimes means the total demand for money and sometimes means the
speculative motive for demanding money.
In my opinion,
for the purpose of making liquidity preference theory clear, liquidity
preference should only refer to the speculative motive for demanding money. The
narrowly defined liquidity preference clearly indicates the role of monetary
factor in determining of interest rate. On the contrary, the broadly
defined liquidity preference involves not only monetary factor but also real
factors, so it means nothing but confusion.
5.3.
Is liquidity preference theory a pure monetary theory
of interest
There has
always been a viewpoint that liquidity preference theory is a pure monetary
theory of interest since The General Theory was published. The
economists holding this view argue that interest rate is purely a monetary
phenomenon and concentrate their attention on Chapter 17 of The General
Theory to study the own interest rate of money.
However, in
my opinion, this view distorts Keynes’s intension. In The General Theory,
Keynes first presents the liquidity preference theory, which is a general model
of determination of interest rate including both real and monetary factors, as
the basis for further analysis: the introduction of liquidity preference
analysis makes it possible to analyze the roles of real factors and monetary
factors separately in determination of interest rate. Then he tries to
demonstrate in Chapter 17 that the interest elasticity of liquidity preference
is very high. Thus, he arrives at the conclusion that interest rate is mainly a
monetary phenomenon, i.e. the real factors only exert little influence on interest
rate. Therefore, liquidity preference theory is not a pure monetary theory of
interest and interest rate mainly as a monetary phenomenon is merely an
inference of liquidity preference theory.
6.
Conclusion
With his profound and keen
insight, Keynes creatively introduces liquidity preference analysis into
determination of interest rate. However, he makes two mistakes in developing an
integrated liquidity preference theory: 1) he initially overlooks finance
motive, and 2) he wrongly insists that interest rate is determined by the
demand for and supply of money.
The first mistake leads to that Keynes initially just
presented the liquidity preference analysis based solely on transactions
motive. Although he later added finance motive to correct this mistake, the strong
first impressions of The General Theory make this mistake exert a
far-reaching influence on subsequent researches: most economists mistakenly
consider his initial mistake the innovation and elite of the theory. This huge
misunderstanding results in that they think that transactions motive plays a
fundamental role in liquidity preference theory and finance motive is
dispensable. Thus, the inherent logic and essence of liquidity preference
theory are covered up, leading to much confusion and many misinterpretations.
The second mistake leads to indetermination of interest rate
or circular logic of Keynes’s theory of interest. This mistake and its
consequence are made apparent by the introduction of finance motive into the
theory. Unfortunately, Keynes is never aware of it. Hansen seems right to argue
that Keynes’s theory of interest is indeterminate, but the basis of his
reasoning is wrong.
In this paper, I firstly clarify the lasting misunderstanding
resulting from Keynes’s first mistake through analyzing the internal logic of
liquidity preference theory, arguing that the liquidity preference analysis
based on finance motive plays a more fundamental role in determining interest
rate. Then I point out Keynes’s second mistake and reveal why IS-LM model is
logically inconsistent. Further, I develop a logically consistent and
integrated model of determination of interest rate on the basis of the
liquidity preference analysis that is centered on finance motive. In this
model, interest rate is not determined by the demand for and supply of
money, but determined by the demand for and supply of idle money.
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