The brunt of Keynes’s attack on the classical quantity theory of money was aimed at its conclusions that (a) velocity is constant and (b) full employment is the natural state of a market economy.
Early classical economists believed that money balances are held only for transactions purposes and that the transactions anyone engages in are roughly proportional to that individual’s nominal income. Thus, planned money balances were assumed roughly proportional to nominal income. “Why,” they asked, “would people want to hold money unless they intend to spend it? Virtually any other asset yields a positive rate of return—and money holdings do not. No one holds more money than they need for transactions. They hold income-earning assets instead of money whenever possible.” Keynes responded by adding the precautionary and asset (speculative) motives to the transactions motive for holding money.
Remember that people adjust their money balances until what they demand equals what they have. If you have more money than you demand, you spend or invest more, reducing your money balances. If you demand more money than you presently hold, you acquire more by cutting back on your spending out of income, liquidating some of your assets, or selling more of your time. Keynes emphasized financial investments (stocks or bonds) as the major way to reduce one’s money holdings.
The Asset Demand for Money
One major difference between the classical model and Keynes’ model is that classical economists view the world as a reasonably certain place, while Keynesian reasoning emphasizes uncertainty and describes how our expectations about uncertain futures might affect the economy. Rising uncertainty is a major reason for growth of the asset demand for money.
Suppose you are working on an assembly line when the economy nose-dives. Many of your co-workers are laid off. You would probably start saving more because you could be the next one to find a pink slip in your pay envelope. As your savings mount, assets in the form of money balances grow. What happens to the velocity of money? Velocity falls as saving increases. Why not convert these funds into a stock or bond that pays interest or some positive rate of return? You must be kidding! The economy is in a tailspin—a recession may be under way. The crucial point here is that when people expect hard times, the velocity of money falls as people convert money from transactions balances to precautionary or asset balances. Conversely, money balances are increasingly held for transactions purposes when prosperity seems just around the corner. This causes velocity to rise.
Let us see what all this means within the context of the equation of exchange. Because the percentage changes in the money supply plus velocity are equal to the percentage changes in the price level plus the real level of output, a 5% decline in velocity (money supply assumed constant) will cause nominal GDP to fall by 5%. If prices do not fall fairly rapidly, output and employment will decline by about 5%. (One economic law seems to be that if circumstances change and prices do not adjust, quantities will.) The economy may settle in equilibrium at less than full employment.
Keynes and his followers assumed that price adjustments are sticky (slow), especially on the down side, and that people’s expectations are volatile. This implies that the velocity of money may vary considerably over time and that the real economy may adjust only slowly, if at all, to these variations.
• The Liquidity Trap
Classical economists viewed the interest rate as an incentive for saving: you are rewarded for postponing consumption. Keynes’s rebuttal was that interest is a reward for sacrificing liquidity. According to Keynes, how much you save is determined by your income and will be affected very little by interest rates. However, interest rates are important in deciding the form your saving takes. You will hold money unless offered some incentive to hold a less-liquid asset. Interest is such an inducement. Higher interest rates will induce you to relinquish money and hold more of your wealth in the form of illiquid assets.
Keynes believed that very high interest rates cause people to hold little, if any, money in asset balances; the demand for money consists almost exclusively of transactions and precautionary balances. But low interest rates result in large asset balances of money. Just as we horizontally sum individual demands for goods to arrive at market demands, we can sum the transactions, precautionary, and asset demands for money to obtain the total demand for money. This demand curve for money is shown in Figure 8.
Note that at a very low interest rate, the demand for money becomes flat. This part of the demand curve for money is called the liquidity trap.
A liquidity trap occurs if people will absorb any extra money into idle balances because they are extremely pessimistic or risk averse, view transaction costs as prohibitive, or expect the prices of nonmonetary assets to fall in the near future.
It implies that if the money supply grew (say, from Ms0 to Ms1), any extra money you received would not be spent, but hoarded, that is, absorbed into idle cash balances. Monetary growth would increase Aggregate Spending very little, if at all. Expectations about economic conditions might become so pessimistic that people would hoard every cent they could “for a rainy day,” an instance of the liquidity trap. Alternatively, historically low interest rates might persuade nearly everyone that interest rates will soon rise. You would not want to hold bonds because rising interest rates would reduce bond prices and you would suffer a capital loss; you and many other investors would hold money while waiting for interest rates to rise and bond prices to fall.
Even though Keynes was writing during the Depression, he suggested that no economy had ever been in a perfect liquidity trap. At the trough of the Great Depression, however, the nominal interest rate hovered around 1.5% and there may have been a “near-liquidity” trap. Severe depressions may cause near-liquidity traps because (a) banks pile up huge excess reserves when nominal interest rates are very low because the returns from lending are small; (b) bankers fear that all loans are very risky, even those that normally would pose no problem of repayment; and (c) private individuals hoard their own funds, fearing that bank failures are probable and that neither their job prospects nor investment opportunities are very bright.
Keynes rejected classical theory in his thinking about the demand for money, broadening the earlier perspective to consider precautionary and asset demands for money. Keynes thought that interest rates are determined solely by the demand and supply of money. His classical predecessors viewed interest rates as being determined in the market for capital goods. Thus, Keynesian and classical economists differ sharply in their perceptions of investment.
The Keynesian View of Investment
The capital stock consists of all improvements that make natural resources more productive than they are in their raw states: equipment, buildings, inventories, and so forth. Net economic investment is the growth of the capital stock during a given period. Classical and Keynesian theories differ about how variations in the money supply affect investment. Over a business cycle, investment fluctuates proportionally more than either consumption or government purchases. Inventory accumulation is especially unstable.
Keynesians focus on investors’ volatile moods: optimistic expectations of large returns generate high levels of investment, while pessimism stifles it. Both Keynesian and classical writers agree that greater investment eventually leads to lower rates of return. Keynesian analysis takes the position that the interest rate, which is the major opportunity cost of investment, is only one aspect of investment planning and is not the overwhelming influence posited by classical economists. This perspective emphasizes changes in investors’ expectations as far more important in explaining changes in investment. Figure 9 shows why.
Suppose the initial investment curve is r0 and that equilibrium investment is $70 billion (point a) at an 8% interest rate. Note that the rate of return curves are relatively steep in this Keynesian view of the world. A drop in the interest rate to 7.5% moves the equilibrium from point a to point b, causing investment to grow only slightly, from $70 billion to $80 billion.
Now suppose that investors become skeptical about future economic conditions so that the expected rate of return schedule shifts leftward from r0 to r1. Equilibrium shifts from point b to point c, and investment falls sharply to $50 billion. If investors’ herdlike mentality (Keynes described them as possessed of “animal spirits”) then caused them to begin bubbling with optimism, the schedule would shift rightward, moving equilibrium from c back to b, so that investment rises back to $80 billion. Keynesians argue that investment is not very responsive to small changes in interest rates but investment demand responds strongly to changing expectations.
To summarize, both Keynesian and classical economists agree that equilibrium investment requires the expected rate of return on investment to equal the rate of interest. However, Keynesians attribute cyclical swings of investment to changes in investors’ expectations of future returns. They believe that investment is less influenced by changes in interest rates than it is by the unpredictable expectations of investors. Classical economists perceive investors’ expectations about returns as quite stable and explain large variations in investment as responses to small changes in interest rates.
Keynesian Monetary Transmission
The demand and supply of money determine the nominal rate of interest in financial markets, as shown in Panel A of Figure 10. Keynesian theory suggests that during recessions, changes in the interest rate (Panel A) may cause small changes in the level of investment (Panel B), and thus in National Income (Panel C). However, the demand for money is thought to be especially sensitive to interest rate movements during economic downturns. Hence, interest rates may not decrease (or increase) very much as the money supply is increased (or decreased). Even if expansionary monetary policies do reduce interest rates a bit, Keynesians believe that investment is relatively insensitive to the interest rate, and so income is affected little, if at all, by monetary policies.
Keynesians argue that changes in the money supply do not affect consumer spending directly, but only indirectly through a money Æ interest rate Æ investment Æ income sequence. Even then, the effects of monetary policy are thought to be slight and erratic, because the linkages are perceived to be weak. This view of the chain of events emanating from a change in the money supply is called the Keynesian monetary transmission mechanism. If the money supply is increased from $800 billion to $1,000 billion (a 25% increase) in Panel A of Figure 10, the interest rate falls from 8% to 7% and investment grows slightly from $200 billion to $220 billion (a 10% increase). Total output grows via the multiplier effect from $6 trillion to $6.06 trillion (only a 1% increase). This suggests that monetary policy will be weak compared to fiscal policy. Note that Panel D reflects the Keynesian view of a slack economy (Aggregate Supply is horizontal up to the full employment level of output); monetary expansion induces only quantity adjustments, and the price level is unaffected.
Keynesian Analysis of Depressions and Inflations
Classical and Keynesian predictions differ most during a depression. Classical economists advocate laissez-faire policies because they believe the natural long-run state of the economy to be a full employment equilibrium. If pressed, however, most would assert that expansionary monetary policies increase Aggregate Spending enough to rapidly cure any depression. Classical reasoning also suggests that restrictive monetary policies are the only lasting remedy for inflation.
Most Keynesians agree that monetary restraint dampens inflationary pressures but disagree with the view that monetary expansion is powerful in curing a depression. During a depression, pessimism reigns and interest rates tend to plummet. Consequently, Keynesians suggest that an economy in recession will not recover quickly in response to expansionary monetary policies, because any extra money people receive is seldom spent but is hoarded. This is another way of saying that the velocity of money falls to offset monetary growth. Keynesians compare money to a string—you can pull on it to restrain inflation, but trying to push the economy out of the doldrums through expansionary monetary policy is like “pushing on a string.” Expansionary monetary policy is viewed as stringlike both because banks may not lend out their reserves if their view of the economic horizon is pessimistic and because people may simply hoard rather than spend most of any extra money that comes their way.
Early Keynesians recommended massive government spending and tax cuts to cure recessions quickly. They emphasized fiscal policy because of a widespread (though mistaken) belief that central banks throughout the world attempted to push their respective nations out of the Great Depression with expansionary monetary policies. Only long after the depression did researchers discover that although the U.S. monetary base rose slightly between 1929 and 1933, the money multiplier shrank and the money supply fell sharply. Remember that good information is costly; the economic data of the time were awful.