Posts Tagged 'Friedman'

Hicks on Keynes and the Theory of the Demand for Money

One of my favorite papers is one published by J. R. Hicks in 1935 “A Suggestion for Simplifying the Demand for Theory of Money.” The aim of that paper was to explain how to reconcile the concept of a demand for money into the theory of rational choice. Although Marshall had attempted to do so in his writings, his formulations of the idea were not fully satisfactory, and other Cambridge economists, notably Pigou, Lavington, Robertson, and Keynes, struggled to express the idea in a more satisfactory way than Marshall had done.

In Hicks’s introductory essay to volume II of his Collected Essays on Economic Theory in which his 1935 essay appears, Hicks recounts that Keynes told him after reading his essay that the essay was similar to the theory of liquidity preference, on which Keynes was then working.

To anyone who comes over from the theory of value to the theory of money, there are a number of things which are rather startling. Chief of these is the preoccupation of monetary theorists with a certain equation, which states that the price of goods multiplied by the quantity of goods equals the amount of money which is spent on them. The equation crops up again and again, and it has all sorts of ingenious little arithmetical tricks performed on it. Sometimes it comes out as MV = PT . . .

Now we, of the theory of value, are not unfamiliar with this equation, and there was a time when we used to attach as much importance to it as monetary theorists seem to do still. This was in the middle of the last century, when we used to talk about value being “a ratio between demand and supply.” Even now, we accept the equation, and work it, more or less implicitly, into our systems. But we are rather inclined to take it for granted, since it is rather tautologous, and since we have found that another equation, not alternative to the quantity equation, but complementary with it, is much more significant. This is the equation which states that the relative value of two commodities depends upon their relative marginal utility.

Now to an ingénue, who comes over to monetary theory, it is extremely trying to be deprived of this sheet-anchor. It was marginal utility that really made sense of the theory of value; and to come to a branch of economics which does without marginal utility altogether! No wonder there are such difficulties and such differences! What is wanted is a “marginal revolution!”

That is my suggestion. But I know that it will meet with apparently crushing objections. I shall be told that the suggestion has been tried out before. It was tried by Wicksell, and though it led to interesting results, it did not lead to a marginal utility theory of money. It was tried by Mises, and led to the conclusion that money is a ghost of gold – because, so it appeared, money as such has no marginal utility. The suggestion has a history, and its history is not encouraging.

This would be enough to frighten one off, were it not for two things. Both in the theory of value and in the theory of money there have been developments in the twenty of thirty years since Wicksell and Mises wrote. And these developments have considerably reduced the barriers that blocked their way.

In the theory of value, the work of Pareto, Wicksteed, and their successors, has broadened and deepened our whole conception of marginal utility. We now realize that the marginal utility analysis is nothing else than a general theory of choice, which is applicable whenever the choice is between alternatives that are capable of quantitative expression. Now money is obviously capable of quantitative expression, and therefore the objection that money has no marginal utility must be wrong. People do choose to have money rather than other things, and therefore, in the relevant sense, money must have a marginal utility.

But merely to call their marginal utility X, and then proceed to draw curves, would not be very helpful. Fortunately the developments in monetary theory to which I alluded come to our rescue.

Mr. Keynes’s Treatise, so far as I have been able to discover, contains at least three theories of money. One of them is the Savings and Investment theory, which . . . seems to me only a quantity theory much glorified. One of them is a Wicksellian natural rate theory. But the third is altogether more interesting. It emerges when Mr. Keynes begins to talk about the price-level of investment goods; when he shows that this price-level depends upon the relative preference of the investor – to hold bank-deposits or to hold securities. Here at last we have something which to a value theorist looks sensible and interesting! Here at last we have a choice at the margin! And Mr. Keynes goes on to put substance into our X, by his doctrine that the relative preference depends upon the “bearishness” or “bullishness” of the public, upon their relative desire for liquidity or profit.

My suggestion may, therefore, be reformulated. It seems to me that this third theory of Mr. Keynes really contains the most important of his theoretical contribution; that here, at last, we have something which, on the analogy (the approximate analogy) of value theory, does begin to offer a chance of making the whole thing easily intelligible; that it si form this point, not from velocity of circulation, or Saving and Investment, that we ought to start in constructing the theory of money. But in saying this I am being more Keynesian than Keynes [note to Blue Aurora this was written in 1934 and published in 1935].

The point of this extended quotation, in case it is not obvious to the reader, is that Hicks is here crediting Keynes in his Treatise on Money with a crucial conceptual advance in formulating a theory of the demand for money consistent with the marginalist theory of value. Hicks himself recognized that Keynes in the General Theory worked out a more comprehensive version of the theory than that which he presented in his essay, even though they were not entirely the same. So there was no excuse for Friedman to present a theory of the demand for money which he described “as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets,” without crediting Keynes for that theory, just because he rejected the idea of absolute liquidity preference.

Here is how Hicks summed up the relationship in his introductory essay referred to above.

Keynes’s Liquidity theory was so near to mine, and was put over in so much more effective a way than I could hope to achieve, that it seemed pointless, at first, to emphasize differences. Sometimes, indeed, he put his in such a way that there was hardly any difference. But, as time went on, what came to be regarded in many quarters, as Keynesian theory was something much more mechanical than he had probably intended. It was certainly more mechanical than I had intended. So in the end I had ot go back to “Simplifying,” and to insist that its message was a Declaration of Independence, not only from the “free market” school from which I was expressly liberating myself, but also from what came to pass as Keynesian economics.

Why Are Real Interest Rates So Low, and Will They Ever Bounce Back?

In his recent post commenting on the op-ed piece in the Wall Street Journal by Michael Woodford and Frederic Mishkin on nominal GDP level targeting (hereinafter NGDPLT), Scott Sumner made the following observation.

I would add that Woodford’s preferred interest rate policy instrument is also obsolete.  In the next recession, and probably the one after that, interest rates will again fall to zero.  Indeed the only real suspense is whether they’ll be able to rise significantly above zero before the next recession hits.  In the US in 1937, Japan in 2001, and the eurozone in 2011, rates had barely nudged above zero before the next recession hit. Ryan Avent has an excellent post discussing this issue.

Perhaps I am misinterpreting him, but Scott seems to think that the decline in real interest rates reflects some fundamental change in the economy since approximately the start of the 21st century. Current low real rates, below zero on US Treasuries well up the yield curve. The real rate is unobservable, but it is related to (but not identical with) the yield on TIPS which are now negative up to 10-year maturities. The fall in real rates partly reflects the cyclical tendency for the expected rate of return on new investment to fall in recessions, but real interest rates were falling even before the downturn started in 2007.

In this post, at any rate, Scott doesn’t explain why the real rate of return on investment is falling. In the General Theory, Keynes speculated about the possibility that after the great industrialization of the 19th and early 20th centuries, new opportunities for investment were becoming exhausted. Alvin Hansen, an early American convert to Keynesianism, developed this idea into what he called the secular-stagnation hypothesis, a hypothesis suggesting that, after World War II, even with very low interest rates, the US economy was likely to relapse into depression. The postwar boom seemed to disprove Hansen’s idea, which became a kind of historical curiosity, if not an embarrassment. I wonder if Scott thinks that Keynes and Hansen were just about a half-century ahead of their time, or does he have some other reason in mind for why he thinks that real interest rates are destined to be very low?

One possibility, which, in a sense, is the optimistic take on our current predicament, is that low real interest rates are the result of bad monetary policy, the obstacle to an economic expansion that, in the usual course of events, would raise real interest rates back to more “normal” levels. There are two problems with this interpretation. First, the decline in real interest rates began in the last decade well before the 2007-09 downturn. Second, why does Scott, evidently accepting Ryan Avent’s pessimistic assessment of the life-expectancy of the current recovery notwithstanding rapidly increasing support for NGDPLT, anticipate a relapse into recession before the recovery raises real interest rates above their current near-zero levels? Whatever the explanation, I look forward to hearing more from Scott about all this.

But in the meantime, here are some thoughts of my own about our low real interest rates.

First, it can’t be emphasized too strongly that low real interest rates are not caused by Fed “intervention” in the market. The Fed can buy up all the Treasuries it wants to, but doing so could not force down interest rates if those low interest rates were inconsistent with expected rates of return on investment and the marginal rate of time preference of households. Despite low real interest rates, consumers are not rushing to borrow money at low rates to increase present consumption, nor are businesses rushing to take advantage of low real interest rates to undertake shiny new investment projects. Current low interest rates are a reflection of the expectations of the public about their opportunities for trade-offs between current and future consumption and between current and future production and their expectations about future price levels and interest rates. It is not the Fed that is punishing savers, as the editorial page of the Wall Street Journal constantly alleges. Rather, it is the distilled wisdom of market participants that is determining how much any individual should be rewarded for the act of abstaining from current consumption. Unfortunately, there is so little demand for resources to be used to increase future output, the act of abstaining from current consumption contributes essentially nothing, at the margin, to the increase of future output, which is why the market is now offering next to no reward for a marginal abstention from current consumption.

Second, interest rates reflect the expectations of businesses and investors about the profitability of investing in new capital, and the expectations of households about their future incomes (largely dependent on expectations about future employment). These expectations – about profitability and about future incomes — are distinct, but they are clearly interdependent. If businesses are optimistic about the profitability of future investment, households are likely to be optimistic about future incomes. If households are pessimistic about future incomes, businesses are unlikely to expect investments in new capital to be profitable. If real interest rates are stuck at zero, it suggests that businesses and households are stuck in a mutually reinforcing cycle of pessimistic expectations — households about future income and employment and businesses about the profitability of investing in new capital. Expectations, as I have said before, are fundamental. Low interest rates and secular stagnation need not be the result of an inevitable drying up of investment opportunities; they may be the result of a vicious cycle of mutually reinforcing pessimism by households and businesses.

The simple Keynesian model — at least the Keynesian-cross version of intro textbooks or even the IS-LM version of intermediate textbooks – generally holds expectations constant. But in fact, it is through the adjustment of expectations that full-employment equilibrium is reached. For fiscal or monetary policy to work, they must alter expectations. Conventional calculations of spending or tax multipliers, which implicitly hold expectations constant, miss the point, which is to alter expectations.

Similarly, as I have tried to suggest in my previous two posts, what Friedman called the natural rate of unemployment may itself depend on expectations. A change in monetary policy may alter expectations in a manner that reduces the natural rate. A straightforward application of the natural-rate model leads some to dismiss a reduction in unemployment associated with a small increase in the rate of inflation as inefficient, because the increase in employment results from workers being misled into accepting jobs that will turn out to pay workers a lower real wage than they had expected. But even if that is so, the increase in employment may still be welfare-increasing, because the employment of each worker improves the chances that another worker will become employed. The social benefit of employment may be greater than the private benefit. In that case, the apparent anomaly (from the standpoint of the natural-rate hypothesis) that measurements of social well-being seem to be greatest when employment is maximized actually make perfectly good sense.

In an upcoming post, I hope to explore some other possible explanations for low real interest rates.


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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