Keynesian Analysis of the Monetary Sector: The Hard-Drawn Keynesian View

1. ISLM Analysis Part II: The Monetary Sector (The Hard-Drawn Keynesian View) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010

2. Keynes had once considered himself to be a “classical” economist. With Marshall, he believed that 1. the interest rate is determined in the loanable-funds market and 2. money is to be analyzed in terms of the equation of exchange. He later concluded that the interest rate wasn’t doing its job—because saving was not affected by the interest rate and investment was governed exclusively (or, at least, primarily) by psychological factors. He also concluded that the equation of exchange should be jettisoned (or, at least, should have greatly diminished significance)—because it stood in the way of our recognizing the impact that monetary disturbances can have on the economy’s real sector.

3. Keynes had once considered himself to be a “classical” economist. With Marshall, he believed that 1. the interest rate is determined in the loanable-funds market and 2. money is to be analyzed in terms of the equation of exchange. Keynes was left with two puzzles: 1. What job is the interest rate actually doing? and 2. What replaces the equation of exchange? Keynes then had a Road-to-Damascus conversion: There is a single answer to both questions: The supply and demand for money are brought into balance by adjustments in the interest rate!

4. According to Keynes, the interest rate has little or no influence on people’s willingness to save. But it has a great influence, he claims, on the preferred form of saving. Do people put their savings at interest (e.g. by buying bonds) or do they keep their savings liquid (by holding money)? KEYNES’S LIQUIDITY-PREFERENCE THEORY OF INTEREST Income alone determines consumption behavior. Then, the interest rate (or rather, the expected direction of movement in the interest rate) affects the relative attractiveness of money and bonds. C = a + bY Y B (if the interest rate is expected to fall) S = -a + (1-b)Y M (if the interest rate is expected to rise)

5. Suppose that a Railroad issues a 6%, 30 year, $1,000 bond in 1872. The bond, which sells for about $1,000, has 60 coupons attached. These coupons are redeemable for $30 each at six-month intervals. $1,000 paid at maturity. What is a bond? When the last coupon is redeemed, the $1,000 is returned to the bond holder. The buyer pays about $1,000 in 1872. He gets back $1,000 in 1902. And he gets $30 biannually for 30 years. He can sell the bond any time he wants. But the selling price might be less than, more than, or equal to $1,000. How so?

6. Suppose that a few years after you bought this bond, market rates of interest are significantly higher than 6%. At that point, someone might be able to buy a 9% bond or a 12% bond. These $1,000 bonds would have a coupon value of $45 and $60, respectively. You could still sell your 6% bond, but you would have to offer it at a price considerably less than $1,000. Suppose that a few years after you bought this bond, market rates of interest are significantly lower than 6%. At that point, the $1,000-bond rate might be as low as 4% or 3%. These bonds would have a six-month coupon value of $20 or $15, respectively. You could easily sell your 6% bond, and you would be able to sell it at a price considerably higher than $1,000. From a 1993 OECD OUTLOOK: In the United States, long-term railroad-bond yields fell gradually from about 5 per cent in 1880 to 4 per cent at the turn of the century then rose slightly.

7. Keynes portrayed each saver as facing a choice between holding his savings liquid or holding long-term bonds. The savers’ preferences in this regard determine both the demand for money (liquidity) and the demand for earning assets (bonds). i The choices (between money and bonds) hinge critically on beliefs about future movements in the interest rate. In this connection, the demand for money is a speculative demand (MSPEC) whose magnitude is related, though widely-held views about the “normal” rate of interest, to the current rate of interest. MSPEC

8. If a high current rate of interest implies that rates are likely to fall and a low current rate implies that they are likely to rise, then we get a downward-sloping demand for speculative money holdings. Keynes believed that the demand for money holdings, i.e., for liquidity, is fairly interest-rate elastic—especially at low rates of interest. i If the current rate is sufficiently high, savers will lock themselves into a high long-term bond rate, and the quantity of money holdings demanded will be zero. MSPEC If the current rate is sufficiently low, savers will abstain from buying bonds and will hold all their savings liquid. The elasticity of money demand becomes infinite.

9. The speculative demand for money is unique to Keynesian macroeconomics and, according to some, is the sine qua non of Keynesianism. CLASSICAL REGION This special demand curve is non-linear and has three identifiable regions: i INTERMEDIATE REGION At rates of interest so high that virtually no one believes they are likely to go still higher, the speculative demand for money is perfectly inelastic and is co-incident with the vertical axis. This is the “classical region,” so named because in the classical theory, there is no speculative demand for money. At rates of interest so low that virtually no one believes they are likely to go still lower, the speculative demand for money becomes perfectly elastic. In this “extreme Keynesian region,” all additions to the money supply are simply hoarded. In the “intermediate region,” the quantity of money holdings demanded varies inversely with the rate of interest. EXTREME KEYNESIAN REGION MSPEC

10. Complicating matters, the demand for money holdings, like the demand for investment funds, is unstable. While investment is governed by “animal spirits,” money hoarding is rooted in the “fetish of liquidity.” Expectations about which direction the interest rate is likely to move can become unanchored. The shifting and drifting expectational winds can send the demand for money holdings right and left or up and down. Just as “animal spirits” dominate the demand for loanable funds, the demonized miser dominates the demand for speculative money holdings. i MSPEC

11. If the demand for money holdings stays put for the time being, we can note the inverse relationship between the interest rate and the demand for money holdings. To determine the particular rate of interest that actually prevails, we take into account the money supply, which is set by the central bank. i MS ieq The rate of interest adjusts to its equilibrium value (ieq), where the preferred level of money holdings is equal to the money supply. MSPEC This the hard-drawn Keynesian view, where “forces of a different kind” (and not the loanable-funds market) determine the market-clearing rate of interest.

12. If the demand for money holdings stays put for the time being, we can note the inverse relationship between the interest rate and the demand for money holdings. Robertson on Keynes’s theory of interest: “The interest rate is what it is because it is expected to be other than what it is. If it isn’t expected to be other than what it is, there is nothing to tell us why it is what it is. The organ that secretes it has been amputated and yet somehow it still exists, the grin without the cat.” To determine the particular rate of interest that actually prevails, we take into account the money supply, which is set by the central bank. i MS ieq The rate of interest adjusts to its equilibrium value (ieq), where the preferred level of money holdings is equal to the money supply. MSPEC Dennis Robertson (1890−1963) This the hard-drawn Keynesian view, where “forces of a different kind” (and not the loanable-funds market) determine the market-clearing rate of interest.

13. Suppose that people’s propensity to hoard strengthens—meaning that their demand for money to hold increases. Note that the increased demand is not automatically accommodated by an increase in the money supply. Instead, the rate of interest rises until people are content to hold the existing money supply. i MS i’eq ieq However, if the central bank wants to re-establish the pre-existing rate of interest, it can increase the money supply, moving the money holders along their money-demand curves. MSPEC

14. With an economy performing at full-employment without inflation, Keynes argued that changes in money demand should be accommodated by corresponding changes in the money supply. He did not want increased money demand to be choked off by an increase in the rate of interest. i MS MS If the central bank could synchronize movements in the money supply with movements in money demand, the interest rate would not need to change. ieq MSPEC Note that successful synchronization effectively transforms a perfectly inelastic money supply into a perfectly elastic money supply.

15. So, why does it matter that the interest rate increases with a strengthening of hoarding propensities? S S Seq W S Y I D i i i MS Suppose the economy is in an income-expenditure equilibrium and is performing at full employment without inflation. That is, labor demand is just strong enough to clear the labor market at the going wage. 1 (1 – b) N ΔI ΔY= i’eq ieq ieq IS ΔY ΔI MSPEC Yeq Y Ieq I It matters because a change in the interest rate has an impact on the real sector of the economy. An increase in money demand raises the rate of interest and takes this fully-employed economy into recession. An accommodating increase in the money supply undoes the damage.

16. S S Seq Y I i i i MS MS ieq ieq IS MSPEC Yeq Y Ieq I People behave fetishistically toward money, sometimes wanting to hoard it. If the central bank matches their hoarding propensities by supplying additional quantities of money, the economy will be spared from spiraling into depression. By continuously manipulating the money supply so as to keep the interest rate from changing, the central bank can nip in the bud any recession (or inflation) that would otherwise be associated with the unstable demand for money.

17. S S Seq W S Y I D i i i MS N ieq ieq IS MSPEC Yeq Y Ieq I We begin again with the economy in an income-expenditure equilibrium and performing at full employment without inflation. We assume away the problem of hoarding and show how monetary policy can counter a waning of animal spirits.

18. Suppose the animal spirits are on the wane, causing investors to cut back on their borrowing of investment funds. S S Seq S'eq W W S S Y I D D i i i MS N N ΔY ΔI 1 (1 – b) ΔY= ΔI ieq ieq ieq IS MSPEC Y'eq Yeq Y I'eq Ieq I With the change in investment behavior, the IS curve shifts to the left. The magnitude of the shift in the IS curve is a multiple of the magnitude of the shift in the demand for investment funds. Here, the simple Keynesian multiplier is in play. In the absence of any fiscal-policy levers, the recession can be countered by monetary policy. Though strictly limited by the shape of the demand for money, an increase in the money supply can lower the rate of interest and move the economy down along the IS curve. Finally, note that the decrease in income reflects a corresponding decrease in the demand for labor. And with the going wage rate persisting, the labor market is experiencing a persistent (Marshallian) disequilibrium. Keynes would call it “unemployment equilibrium.” The economy has experienced a downturn in which lower levels of income, investment, and saving are established. And note that with an unchanged rate of interest, the equilibrium level of income also changes in accordance with the simple Keynesian multiplier. Note that the interest rate, which continues to match the money supply to the speculative demand for money, remains unchanged.

19. ISLM Analysis Part II: The Monetary Sector (The Hard-Drawn Keynesian View) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010