Keynes' General Theory

Summary

Assumptions

3 characteristics of money

  1. High liquidity premium and low carrying costs
  2. Negligible or zero elasticity of production - i.e. higher demand --> higher production
  3. Negligible elasticity of substitution.

Total net-return of an asset can be divided into 3 elements where r_nt=r_mt+r_pt-r_at

  1. Pecuniary returns r_mt - interest/dividends
  2. Non-pecuniary service flow r_pt - liquidity premium of sorts
  3. Convenience costs r_at

Typical assets have r_mt>r_at and negligible r_pt. Money has r_pt>r_at and in the case of cash zero r_mt

Motives for holding money - three divisions of liquidity preference 

  1. Transactions motive
    • Saw-tooth diagram of money balances where the longer time periods between payments the higher the average money balances
  2. Precautionary motive
    • Like the transactions motive but for unexpected expenditures
  3. Speculative motive
    • Portfolio of risky but +ve rate of return bonds versus riskless but zero return money.
    • Future price of bonds are inversely related to the future interest rate. If the interest rate is expected to fall relative to present, the future price of bonds will be higher than current, there would be an excess demand for bonds and an excess supply of money. 
    • Thus demand for money depends upon expectations of the future rate of interest
    • Keynes assumed that market expectations were based on the assumption of reversion to 'normal' and thus if interest rates are higher than normal they can be expected to fall in the future. Lower future r--> higher future price of bonds --> excess demand for bonds , excess supply of money, less demand for money. 

Model/Theory

M=M1+M2 = L_1(Y)+L_2(r)

  • Where L's are two liquidity functions & transactions-precautionary (M1)  motive depends mainly on level of income and from the speculative motive (M2) we find that demand for money varies inversely with the rate of interest (and future expectations).

Liquidity preference theory

  • Unlike classical theory where rate of interest is a real eq between foregoing current consumption versus future return, Keynes asked how would individuals like to store their forgone consumption - money or bonds? Which depends upon liquidity preference - interest is a reward for parting with liquidity not consumption.

General Theory

  • Classical theory argues that saving --> investment (axiom of parallels) depends upon acceptance of the classical theory of the rate of interest.
  • Keynes argues investment --> savings. Where liquidity preference --> (determined in money market) rate of interest --> investment --> savings. Thus liquidity preference may keep interest rates too high for the full employment level of investment to be generated.

Predictions

  • Money --> unemployment because three characteristics incentivise the holding of money which means a reduction in labour effort required and real supply can (at least temporarily) exceed real demand.
  • In disequilibrium the loanable funds theory and liquidity preference theory differ, Ohler arguing the price of securities is determined by the demand & supply of securities, Keynes in D&S of money
  • Liquidity trap prevents interest rates falling much below zero because individuals will hold money instead because when interest rates are so low (and therefore expected to rise) that all preferences for holding money (and not bonds) align. Thus monetary policy becomes ineffective.

Evidence

Evaluation

  • Money isn't the only non-reproducible asset e.g. land, however Keynes argues it is unique in the fact that he doesn't have any substitutes.
  • Each individual speculator has a critical rate where they switch their entire portfolio from bonds to money or vice versa, it is only the diversity in opinions which smooths out this step function at an aggregate level.
  • Liquidity preference theory differs from loanable funds theory 1. money market eq interest rate rather than bond market. 2. liquidity is a stock of money balances theory whereas loanable funds is based on flows of funds. However it can be shown eq in one market implies eq in the other and that flows and stocks are equivalent.
  • Keynes was against cutting real wages arguing that workers react to nominal wages (sticky wages) and also depend upon the price level. 
  • Hick's IS-LM model synthesises classical and Keynesian views.