On a Difficult Passage in the General Theory

Keynes’s General Theory is not, in my estimation, an easy read. The terminology is often unfamiliar, and, so even after learning one of his definitions, I have trouble remembering what the term means the next time it’s used.. And his prose style, though powerful and very impressive, is not always clear, so you can spend a long time reading and rereading a sentence or a paragraph before you can figure out exactly what he is trying to say. I am not trying to be critical, just to point out that the General Theory is a very challenging book to read, which is one, but not the only, reason why it is subject to a lot of conflicting interpretations. And, as Harry Johnson once pointed out, there is an optimum level of difficulty for a book with revolutionary aspirations. If it’s too simple, it won’t be taken seriously. And if it’s too hard, no one will understand it. Optimally, a revolutionary book should be hard enough so that younger readers will be able to figure it out, and too difficult for the older guys to understand or to make the investment in effort to understand.

In this post, which is, in a certain sense, a follow-up to an earlier post about what, or who, determines the real rate of interest, I want to consider an especially perplexing passage in the General Theory about the Fisher equation. It is perplexing taken in isolation, and it is even more perplexing when compared to other passages in both the General Theory itself and in Keynes’s other writings. Here’s the passage that I am interested in.

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

The statement is problematic on just about every level, and one hardly knows where to begin in discussing it. But just for starters, it is amazing that Keynes seems (or, for rhetorical purposes, pretends) to be in doubt whether Fisher is talking about anticipated or unanticipated inflation, because Fisher himself explicitly distinguished between anticipated and unanticipated inflation, and Keynes could hardly have been unaware that Fisher was explicitly speaking about anticipated inflation. So the implication that the Fisher equation involves some confusion on Fisher’s part between anticipated and unanticipated inflation was both unwarranted and unseemly.

What’s even more puzzling is that in his Tract on Monetary Reform, Keynes expounded the covered interest arbitrage principle that the nominal-interest-rate-differential between two currencies corresponds to the difference between the spot and forward rates, which is simply an extension of Fisher’s uncovered interest arbitrage condition (alluded to by Keynes in referring to “Appreciation and Interest”). So when Keynes found Fisher’s distinction between the nominal and real rates of interest to be incoherent, did he really mean to exempt his own covered interest arbitrage condition from the charge?

But it gets worse, because if we flip some pages from chapter 11, where the above quotation is found, to chapter 17, we see on page 224, the following passage in which Keynes extends the idea of a commodity or “own rate of interest” to different currencies.

It may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys. . . .

If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion. If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a percent per annum in terms of money; the marginal efficiency of an asset, which is x percent in terms of money, will then be x – a percent in terms of wheat. Since the marginal efficiencies of all capital assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

So Keynes in chapter 17 explicitly allows for the nominal rate of interest to be adjusted to reflect changes in the expected value of the asset (whether a money or a commodity) in terms of which the interest rate is being calculated. Mr. Keynes, please meet Mr. Keynes.

I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen. But any change in inflation expectations, by definition, cannot have been foreseen, because to say that an expectation has changed means that the expectation is different from what it was before. Perhaps that is why Keynes tied himself into knots trying to figure out whether Fisher was talking about a change in the value of money that was foreseen or not foreseen. In any equilibrium, the change in the value of money is foreseen, but in the transition from one equilibrium to another, the change is not foreseen. When an unforeseen change occurs in expected inflation, leading to a once-and-for-all change in the value of money relative to other assets, the new equilibrium will be reestablished given the new value of money relative to other assets.

But I think that something else is also going on here, which is that Keynes was implicitly assuming that a change in inflation expectations would alter the real rate of interest. This is a point that Keynes makes in the paragraph following the one I quoted above.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relativevly to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)

Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.

Keynes comes back to this point at the end of chapter 17, making it more forcefully than he did the first time.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest – namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of of Wicksell’s “natural rate of interest,” which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus, it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. . . .

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (pp. 242-43)

So what Keynes is saying, I think, is this. Consider an economy with a given fixed marginal efficiency of capital (MEC) schedule. There is some interest rate that will induce sufficient investment expenditure to generate enough spending to generate full employment. That interest rate Keynes calls the “neutral” rate of interest. If the nominal rate of interest is more than the neutral rate, the amount of investment will be less than the amount necessary to generate full employment. In such a situation an expectation that the price level will rise will shift up the MEC schedule by the amount of the expected increase in inflation, thereby generating additional investment spending. However, because the MEC schedule is downward-sloping, the upward shift in the MEC schedule that induces increased investment spending will correspond to an increase in the rate of interest that is less than the increase in expected inflation, the upward shift in the MEC schedule being partially offset by the downward movement along the MEC schedule. In other words, the increase in expected inflation raises the nominal rate of interest by less than increase in expected inflation by inducing additional investment that is undertaken only because the real rate of interest has fallen.

However, for an economy already operating at full employment, an increase in expected inflation would not increase employment, so whether there was any effect on the real rate of interest would depend on the extent to which there was a shift from holding money to holding real capital assets in order to avoid the inflation tax.

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.

I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

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32 Responses to “On a Difficult Passage in the General Theory”


  1. 1 Frank Restly July 25, 2013 at 9:29 pm

    David,

    “The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule…”

    Or it increases the incentive to reduce the outstanding stock of capital.

    “and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital.”

    Or it increases the incentive to expand the outstanding stock of capital.

    “However, the increase in the value of real assets relative to money will increase the incentive to produce new assets.”

    Or it will it will increase the incentive to reduce money holdings relative to existing holdings of real assets (deleveraging).

  2. 2 Frank Restly July 25, 2013 at 10:47 pm

    David,

    “However, the increase in the value of real assets relative to money will increase the incentive to produce new assets.”

    Does a decrease in the the value of existing real assets relative to money increase the incentive to destroy those existing assets?

    http://en.wikipedia.org/wiki/Agricultural_Adjustment_Act

    “To accomplish its goal of parity (raising crop prices to where they were in the golden years of 1909-1914), the Act had to eliminate surplus production. It accomplished this by offering landowners acreage reduction contracts, by which they agreed not to grow cotton on a portion of their land.”

  3. 3 Gobanian (@Gobanian) July 26, 2013 at 12:15 am

    “Keynes could hardly have been aware that Fisher was explicitly speaking about anticipated inflation.” Is the word not missing?

  4. 4 Gobanian (@Gobanian) July 26, 2013 at 12:21 am

    “Keynes expounded the covered interest arbitrage principle that the nominal-interest-rate-differential between two currencies corresponds to the difference between the spot and forward rates.”
    I worked in FX markets for 15 years. The forward rate is DEFINED as the spot rate plus the interest rate differential.

  5. 5 worldofinterest July 26, 2013 at 2:36 am

    I think this is right. Suppose you have the following thought experiment:

    An (consumer) economy is divided into two groups “essentials” and “luxuries”, such that when a demand shock hits spending is exactly maintained on “essentials” and the fall is entirely in “luxuries”.

    Clearly the natural interest rate falls. In response you lower interest rates, and new investments are undertaken, which raises aggregate demand. However, when you return to “full demand”, because of the extra investment, there must be less spending on luxuries than there was before, at least in the short term, if you assume that at least some investments have multi year spending plans.

    Thus surely your natural interest rate should end up lower than it was before the demand shock, even after you have returned to full demand.

    I guess what I am trying to say could be stated more simply as this: If you use the interest rate as a policy lever to restore full employment, then you are expecting a demand shock to result in extra investment. Since you always do your best investments first, this means that following this, the stock of “undone” investments, must be less profitable than before the shock, so to return to the previous level of investment we must have a lower interest rate.

    Of course, the counter argument is that “new investment opportunities” are always being created, which will tend to raise the rate – but the point is that using the interest rate as a policy lever should reduce the real natural interest rate compared to the counter factual of using, say, monetary base expansion as a policy lever. I.e. you would prefer a policy lever which does not prefer investment over immediate consumption.

  6. 6 worldofinterest July 26, 2013 at 2:37 am

    PS: I have a large monitor, and the sight of forty pictures of Hawtrey staring out at me is quite disconcerting……

  7. 7 Rob Rawlings July 26, 2013 at 7:13 am

    Very stimulating article.

    I can’t quite understand this though: “the increase in the value of real assets relative to money will increase the incentive to produce new assets.”

    If prices are expected to double I can plan to sell any asset I produce at double what I could in the past, but as this additional revenue just buys the same amount of other goods, why will I be motivated to produce more ?

  8. 8 JP Koning July 26, 2013 at 7:32 am

    David, is this sentence complete?

    “Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises.”

  9. 9 David Glasner July 26, 2013 at 7:55 am

    Gobanian, Thanks. I meant to write “unaware” not “aware.” I made the change in the text.

  10. 10 David Glasner July 26, 2013 at 7:56 am

    JP, I left out “the MEC schedule” at the end of the sentence. I have added it to the text. Thanks for catching that.

  11. 11 Frank Restly July 26, 2013 at 9:42 am

    Rob,

    “I can’t quite understand this though: the increase in the value of real assets relative to money will increase the incentive to produce new assets.”

    “If prices are expected to double I can plan to sell any asset I produce at double what I could in the past, but as this additional revenue just buys the same amount of other goods, why will I be motivated to produce more?”

    You might be motivated to produce more if:
    1. You are able to exploit a relative cost change between an input good (capital, labor, raw material, etc.) and the price at which you sell your produced good.

    2. You are able to exploit a supply constraint on the good you produce or you have a monopoly on the production of that good.

    3. You increase the amount of outstanding liabilities (debt and equity) against future production of that good. That is a bit of self motivation rather than expectations driven motivation.

  12. 12 Rob Rawlings July 26, 2013 at 10:31 am

    Frank,

    If the inflation was unexpected (at least to some people) then I can see that output might get boosted for a while. But if everyone equally has perfectly correct and aligned expectations of inflation I can’t see why this would be the case..

  13. 13 David Glasner July 26, 2013 at 11:03 am

    Rob, The point is that the expectation of inflation causes a shift from holding money to holding real physical assets, that was Keynes’s argument against the Fisher equation. So the expectation of inflation necessarily causes a relative price change, physical assets appreciating relative to the value of their services. So the MECs of physical assets rise in response to the expectation of inflation.

  14. 14 Rob Rawlings July 26, 2013 at 11:55 am

    Ok, so in expectation of inflation people want to hold less cash, but as they don’t want to consume more they buy assets (rather than the output of those assets). As assets have then increased in price more than other goods there is more incentive to produce them so their MEC increases.

    Is that it ?

  15. 16 Frank Restly July 26, 2013 at 8:07 pm

    Rob,

    “But if everyone equally has perfectly correct and aligned expectations of inflation I can’t see why this would be the case..”

    “Ok, so in expectation of inflation people want to hold less cash, but as they don’t want to consume more they buy assets (rather than the output of those assets).”

    It would also depend on marginal propensity to consume. Just because the price of a certain good goes up does not automatically mean all people are going to run out and buy more of that good. People may substitute other goods, income constrained people may simply forgo consumption of that good when they can. And highly levered people may simply choose to reduce liabilities rather than purchase more goods.

    David,

    “The point is that the expectation of inflation causes a shift from holding money to holding real physical assets, that was Keynes’s argument against the Fisher equation.”

    The only problem with the Fisher equation is that it looks at relative price changes (cost of debt versus cost of goods) without looking at the supply and demand for debt versus goods. If the incentive to reduce debt is higher than the incentive to buy goods at higher prices, then more debt will be reduced and fewer goods will be bought at those higher prices.

  16. 17 Frank Restly July 26, 2013 at 8:37 pm

    Starting with the equation of exchange:

    M * V = P * Q

    Replace M (Money) with D (Debt)

    D * V = P * Q = Income * ( 1 – Liquidity Preference ) + dD/dt

    Total income is income from goods sold plus capital income (interest payments)

    Income = P * Q + D * INT = D * ( V + INT )

    D * V = D * ( V + INT ) + dD/dt

    Now we let the total debt outstanding be a function of time:

    D = exp ( f(t) )
    dD / dt = f'(t) * exp ( f(t) )

    Dividing the equation above by exp ( f(t) ) and we can solve for the velocity of money:

    V = ( V + INT ) * ( 1 – LP ) + f'(t)

    V = [ INT * ( 1 – LP ) + f'(t) ] / LP

    To arrive at the real interest rate we must introduce productivity:

    D * V = P * Q = Real GDP * ( 1 + Inflation Rate )

    Productivity = Real GDP / Debt = Velocity / ( 1 + Inflation Rate)

    Solving for velocity again:

    V = PROD * ( 1 + INF )

    PROD * ( 1 + INF ) = [ INT * ( 1 – LP ) + f'(t) ] / LP

    Solving for the inflation rate:

    INF = [ INT * ( 1 – LP ) + f'(t) ] / [ LP * PROD ] – 1

    We treat the inflation rate here as an exogenous variable (same as Fisher). What Fisher did not do was factor in liquidity preference, credit demand, and productivity to determine how the inflation rate is arrived at.

    From the equation above it should be apparent that a drop in liquidity preference combined with a drop in credit demand may reduce the inflation rate – not raise it!!

    The real interest rate is simply:

    Real Interest Rate = INT – INF = INT – [ INT * ( 1 – LP ) + f'(t) ] / [ LP * PROD ] + 1

  17. 18 Jon S. July 28, 2013 at 2:18 pm

    I start getting confused about halfway through your post.

    MEC should incorporate or be compared with the real rate of interest. If both expected inflation and expected nominal rates rise in tandem then any increase in the real present value of real assets squeezes the relative risk premium of holding real versus nominal assets. In other words they should offset each other.

    Then you go on to say something which appears to be an indirect claim about the effects of inflation on real wages at less than full employment, but since it is presented indirectly whether it is expansionary or contractionary seems less than established.

    Still turning it over…

  18. 19 greghill1000 July 28, 2013 at 5:08 pm

    David,

    Very challenging post (that’s a good thing). It’s important to bear in mind, as I’m sure you do, that Keynes’ main point in this discussion is that MEC refers to the prospective, not merely the current, yield of capital (see p.141, just before the passage you cite). And although Keynes’ refers to an investment demand “schedule,” the path of this “schedule” over time can look rather more like a leaf blowing in the wind than a line that “holds still” on a graph, whether it’s ISLM or not.

    p.s. On your title, have you seen Victoria Chick’s paper, “The General Theory is Difficult: Whose Fault is That?”

  19. 20 Blue Aurora July 28, 2013 at 8:54 pm

    Is it just me, or am I right to have the feeling that a lot of people have a tendency of reading things into The General Theory that aren’t actually there?

    Of course, J.M. Keynes’s intellectual thought evolved over the course of his inter-war trilogy (A Tract on Monetary Reform [1923], A Treatise on Money [1930], and The General Theory of Employment, Interest, and Money [1936]), but that doesn’t mean he contradicts himself.

    IIRC, the Marginal Efficiency of Capital and the State of Long-Term Expectation are actually very similar parts that in turn, are part of the whole octopus.

  20. 21 David Glasner July 29, 2013 at 9:46 am

    Frank, Why does an expectation that money will lose value increase the incentive to reduce the stock of capital? If money is losing value relative to real assets wouldn’t you want to increase your holding of capital?

    You ask:

    “Does a decrease in the value of existing real assets relative to money increase the incentive to destroy those existing assets?”

    I didn’t say anything about destroying real assets, but you would have an incentive to sell the asset for money if you could find someone willing to buy it at its current price.

    Gobanian, Defined by whom?

    worldofinterest, I am not sure that all demand shocks are created equal, so I would prefer not to talk about a demand shock in the abstract, but to talk about a specific kind of demand shock. Sorry about all those pictures of Hawtrey staring at you. Have you considered narrowing the window through which you view the site?

    Frank, The Fisher equation, as Keynes’s own versions of it make clear, is a property of asset market equilibrium. As an equilibrium condition, it doesn’t provide a theory of why interest rates are what they are or why inflation expectations are what they are just that in equilibrium interest rates, nominal and real, will be related to each other in a certain manner that eliminates the possibility of traders reaping profits.

    John, The Fisher equation does not assert that expected inflation and nominal interest rates rise in tandem. It is asserts that the change in nominal rates will equal the sum of the change in real rate plus the change in expected inflation. There is an implicit assumption that inflation does not affect the real rate, but that is true only under some, not necessarily all, conditions.

    Greg, Yes, I do agree that Keynes believed that the MEC was a very subjective magnitude and could be subject to unstable fluctuations. No I haven’t seen that paper. Thanks for bringing it to my attention.

    Blue Aurora, No I don’t think it’s just you, but “reading things that aren’t there” is a pretty general complaint. I’m not sure what you have in mind. I gave a very specific example of (at least apparent) self-contradiction. If you think that I am mistaken in thinking that he contradicted himself in his criticism of the Fisher equation and his exposition of own rates in the General Theory, please explain to me how to reconcile the passages.

  21. 22 Frank Restly July 29, 2013 at 1:21 pm

    David,

    “Frank, Why does an expectation that money will lose value increase the incentive to reduce the stock of capital?”

    I can maximize utility in one of two ways – I can maximize my asset to liability ratio or I can maximize my assets net of my liabilities.

    I have direct control of the cost of my liabilities. I do not have direct control of the market price of my assets.

    And so if I have spare liquidity and wanted to maximize utility I could buy assets and hope that market prices hold or I can reduce liabilities and not worry about market prices.

    “It makes no sense to worry about things you have no control over because there’s nothing you can do about them, and why worry about things you do control?” – Mickey Rivers

  22. 23 andrew lainton August 2, 2013 at 12:54 am

    David, sorry didnt get a chance to respond earlier.
    I dont think this passage is so difficult when you consider two assumptions of Keynes, firstly that he is dealing with such a short run that the supply of money is essentially fixed – a stock only, secondly that, as you rightly suggest, he believed that the demand for money curve was essentially vertical and that liquidity preference solely determined the interest rate. In IS-LM terms with a vertical LM curve and real interest rights on the vertical axis the marginal schedule of investment is the area under the IS curve to the vertical intersection between the risk free rate R and the real interest rate r. I show this in two diagrams in a recent paper on IS-LM (critical) here http://andrewlainton.wordpress.com/2013/07/26/a-simple-post-keynesian-alternative-to-is-lm/ see figures 4 and 12 – what Keynes seems to be assuming is a combination of both. Then any change in expected inflation has no impact whatsover on interest rates and investment, It can only come on the supply side on the schedule of supply of money. Hence Keynes phrase
    ‘The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital’
    Of course this assumes a fixed stock of money. Of you relax that – as Freidman did in his 1990 comment on Japan, that the monetary authority should signal that monetary expansion should be signalled as permanent – then the demand for money curve will slope and expecations will have an impact. indeed as Randall Wray has showed any inclusion of flow variables within an ISLM curve will undermine the vertical LM curve assumption.
    I should state that I do not hold the ISLM model because of its loanable funds assumption and have been building an alternative using endogneous money, this reproduces some nice empirical features such as a shortage of credit even after deleveraging – as in Japan, and a Hawtrian Credit Deadlock as well as a liquidity trap.

  23. 24 David Glasner August 4, 2013 at 7:35 am

    Frank, Generally, economists assume that people do not derive utility from the composition of the their asset and liability portfolio except insofar as they are risk averse and therefore have to be compensated for higher risk with a higher expected yield. So I don’t know what you mean by saying that there are two ways to maximize utility, maximizing the asset to liability ratio or the value of assets net of liabilities. You want to maximize the value of your net worth, adjusted for your willingness to bear risk.

    Andrew, You said:

    “as you rightly suggest, [Keynes] believed that the demand for money curve was essentially vertical and that liquidity preference solely determined the interest rate.”

    Did I suggest that? That’s strange I thought it was the classicals who believed (or were supposed to have believed] that that the demand for money is interest-inelastic. I am confused. I will try to have a look at the very interesting links that you have provided. Perhaps I will be less confused after I look at them.

  24. 25 Frank Restly August 5, 2013 at 7:45 pm

    David,

    “Frank, Generally, economists ASS U ME…”

    “You want to maximize the value of your net worth, adjusted for your willingness to bear risk.”

    Um, no I do not, simply because I cannot accurately measure all of the risk that exists. There is a difference between risk adversity (willingness / unwillingness to take on risk) and risk uncertainty (ability / inability to accurately measure the risk being taken on).

    It’s the difference between knowing you have a 50/50 shot of winning and knowing that you have somewhere between a 10% and 90% chance of winning.

  25. 26 robert waldmann August 7, 2013 at 1:54 am

    I think I’ve got it ! I will comment before I think again and realise I am confused. I think the whole passage says that expected inflation and changes in expected inflation do not create arbitrage opportunities. It doesn’t say that changes in expected inflation are impossible or that they don’t have real effects.

    First my confusion. I had thought that “the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized,” was presented as a proof that expected inflation is impossible in equilibrium. This would obviously contradict the discussion in chapter 17.as you note. But now I think it just means that neither expected inflation nor a change in expected inflation creates arbitrage opportunities.

    Note the conclusion “the advantages of holding money and of holding goods are again equalized” is just saying “no arbitrage opportunity is created”. Here in chapter 11, Keynes doesn’t explain how they are equalized. In particular, he does not assert (as he seems to assert) that the real interest rate must be zero, nor that it must be constant. Now one of his eccentricities was in denying that the distinction between fixed capital and other goods was fundamental. The existing goods might be say a factory and “holding goods” might mean buying the factory or a share of the factory or a share of the firm that owns the factory.

    There is no discussion of the advantages of producing new “goods” including new factories, that is of NIPA fixed capital investment. I think the passage amounts to the claim that inflation does not create an arbitrage opportunity to profit by borrowing nominal and buying stock or a commodity and storing it. Again in chapter 17 Keynes stresses that the way that expected inflation affects NIPA fixed capital investment is by affecting the value of the newly built capital and not by affecting the return on the purely financial strategy of buying already existing capital. The two passages taken together hint at the Q theory of investment and, in modern terms Keynes is saying Q is equal to 1 plus marginal investment costs. It varies, for example if the nominal interest rate is constant and expected inflation varies, but r- Qdot/Q equals the marginal product of capital so there are no arbitrage opportunities.

  26. 27 Kevin Donoghue (@Paddy_Solemn) August 9, 2013 at 8:28 am

    David, when Keynes refers to “Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another”, do you know what comment of Pigou’s he has in mind? The puzzle might go away if Pigou, like Keynes, saw some difficulty with Fisher’s theory. It may be that he spelled out the problem more carefully than Keynes did.

    Absent some clue of that sort, my best guess is that Keynes is simply trying to say that the Fisher relation can be read as an equation which determines current prices when the nominal interest rate is slow to adjust — spot prices are discounted futures prices. But as Allin Cottrell shows, Fisher was well aware of that so, the puzzle remains. It’s not as if Keynes thought Fisher was dim, he certainly didn’t.


  1. 1 Links for 07-26-2013 | Symposium Magazine Trackback on July 26, 2013 at 12:27 am
  2. 2 TheMoneyIllusion » Glasner, Keynes, and the Fisher effect Trackback on July 28, 2013 at 8:49 am
  3. 3 My Milton Friedman Problem | Uneasy Money Trackback on August 1, 2013 at 3:21 pm
  4. 4 Keynes on the Fisher Equation and Real Interest Rates | Uneasy Money Trackback on September 2, 2013 at 7:41 pm
  5. 5 A New Version of my Paper (with Paul Zimmerman) on the Hayek-Sraffa Debate Is Available on SSRN | Uneasy Money Trackback on July 7, 2014 at 7:16 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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