Wednesday, 4 April 2012

A reinterpretation and remedy of Keynes’s liquidity preference theory


The dissension on the mechanism of determination of interest rate is always in the center of much confusion and many controversies of monetary economics. Keynes’s liquidity preference theory remains at the core of the center. This paper starts off with analyzing the inherent logic of liquidity preference theory and presents a new interpretation of the theory in a more logical and clear manner. The reinterpretation clearly indicates the necessity of introducing liquidity preference analysis into determination of interest rate, arguing that it is the liquidity preference analysis based on finance motive, rather than on transactions motive, that plays a more fundamental role in determining interest rate. The paper then points out a crucial and unsolved mistake in Keynes’s liquidity preference theory, i.e. interest rate is indeterminate, which is revealed by introducing finance motive into the theory. Further, the paper develops a logically consistent and integrated model of determination of interest rate on the basis of the liquidity preference analysis centered on finance motive. In this model, interest rate is not determined by the demand for and supply of money, but determined by the demand for and supply of idle money.

Keywords: Liquidity preference theory, Finance motive, IS-LM model, Determination of interest rate
JEL classifications: E12, E41, E43




1.   Introduction

The dissension on the mechanism of determination of interest rate is always in the center of much confusion and many controversies of monetary economics. Keynes’s liquidity preference theory remains at the core of the center. Liquidity preference was first introduced to determine interest rate by Keynes in his profoundly influential General Theory in 1936. Before that, the classical theory of interest argues that the level of interest rate is determined by two real factors: the demand for investment and supply of saving.
In The General Theory, Keynes (1936) criticizes the classical theory of interest and presents a brand-new theory of interest, namely liquidity preference theory. In Keynes’s opinion, interest rate is not determined by saving and investment, but by the demand for and supply of money. Demand for money, or broadly defined liquidity preference, is composed of transactions motive, precautionary motive and speculative motive. Among the three motives, transactions motive and precautionary motive mainly depend on the level of income; and speculative motive, or narrowly defined liquidity preference, mainly depends on the level of interest rate. The supply of money is the quantity of money determined by the monetary authority. Interest rate is a price, which makes the quantity of money the public would like to hold equal to the quantity of money in existence.
Keynes’s liquidity preference theory induced a lot of controversies soon after he brought it forward. Most curiously, The General Theory holds that the change of propensity to invest (namely, a shift of the investment demand curve or Keynes’s investment demand-schedule) only exerts an ex post influence on interest rate indirectly via the change of transactions motive after income changes. Moreover, Keynes didn’t explain why. Ohlin (1937) and Robertson (1937, 1940), the two most famous loanable funds theorists, attacked Keynes’s theory of interest effectively on this issue. Their criticism can be summarized as: if there is an increase in propensity to invest, according to Keynes, the multiplier effect can make the level of income rise, leading to investment equal to saving. However, in adjusting to the new equilibrium, desired investment and desired saving are not equal.
In his reply to Ohlin’s criticism, Keynes (1937B, 1937C, 1938) confessed his mistake and introduced a new and somewhat novel incentive for demanding money, namely the finance motive, in order to improve his liquidity preference theory. Keynes argues that, during the period between the date when entrepreneurs make their investment decisions and the date when they actually make their investment, there is a demand for finance. Keynes stresses that finance motive is an additional motive for demanding money and essentially a revolving fund, whilst an excess in demanding for finance resulting from the increase of propensity to invest may lead to a rise of interest rate.
In his debate with loanable funds theorists, although Keynes kept clarifying and improving his liquidity preference theory, the theory is still known for its bizarrerie and difficulty to be understood, resulting in a lot of controversies in interpreting it. Most strangely, finance motive can hardly be found in the literatures after Keynes until Davidson (1965) rediscovered finance motive. Among the various interpretations is IS-LM model of NeoClassical Synthesis the most well-known.
The prototype of IS-LM model was first presented by Hicks (1937) to elucidate the interrelationships between the theory of effective demand and the liquidity preference theory. But it should be mainly owed to the work of Hansen that IS-LM model becomes a popular model of determination of interest rate. In his book A Guide to Keynes, Hansen (1953) points out that interest rate is indeterminate in Keynes’s theory of interest. Hansen’s criticism can be summarized as: interest rate is determined by the total demand for and supply of money, and the transactions motive for demanding money is determined by income; however, income is determined by the investment, and the investment is determined by interest rate and marginal efficiency of capital. Thus, interest rate and income are all indeterminate. Therefore, Hansen develops IS-LM model to solve this problem by means of making the goods market and the money market attain equilibrium simultaneously. Later, IS-LM model has developed from a model of determination of interest rate to a dominant macroeconomic model of NeoClassical Synthesis for many decades.
However, IS-LM model has also been criticized by many economists. Among the various criticisms, the most fundamental and common attack is that the approach with a character of simultaneity doesn’t apply to Keynes’s theory, making IS-LM model logically inconsistent. For example, Pasinetti (1974) has argued that Keynes’s theory should not be analyzed simultaneously but sequentially. That is, Keynes’s theory ought to be considered as a sequence of alternating decisions in monetary sector and real sector. Davidson (1978) argues that the IS and LM schedules are interdependent when finance motive is introduced. Chick (1982) also attacks IS-LM model on the basis of its internal logic.
Which one is correct, the mainstream interpretation of liquidity preference theory or the criticism of it? Or neither of them is fully correct? Further, can liquidity preference theory be correctly interpreted without finance motive? If not, what kind of role should finance motive play in liquidity preference theory?
These questions inspire me to explore the essence of liquidity preference theory. Section 2 starts off with analyzing the inherent logic of liquidity preference theory and presents a new interpretation of the theory in a manner I believe more logical and clear. Through bridging the gap between the classical theory of interest and liquidity preference theory, the reinterpretation clearly indicates the necessity of introducing liquidity preference analysis into determination of interest rate. The reinterpretation also suggests that it is the liquidity preference analysis based on finance motive, rather than on transactions motive, that plays a more fundamental role in determining interest rate. Section 3 then argues that Keynes makes a crucial and yet unsolved mistake in his theory of interest, i.e. interest rate is indeterminate, which is revealed by his introduction of finance motive into the theory. Further, Section 4 develops a logically consistent and integrated model of determination of interest rate on the basis of the liquidity preference analysis that is centered on finance motive. In this model, interest rate is not determined by the demand for and supply of money, but determined by the demand for and supply of idle money. Section 5 discusses some other controversies in respect of liquidity preference theory. Finally, Section 6 provides a brief conclusion.

2.        Reinterpretation of liquidity preference theory

After analyzing the previous literatures on liquidity preference theory, I have found that the research approach adopted by subsequent economists may be improper. It seems that they limit themselves to Keynes’s literature, and even stick to the sequence of Keynes’s presentation when they study the motives with respect to the demand for money, i.e. analyzing transactions motive first and finance motive last. This approach makes them very likely to ignore the inherent logic of liquidity preference theory.
In my opinion, liquidity preference theory is not dreamed up by Keynes without any foundation. It reveals the objective law of determination of interest rate. Keynes does not create the law, but discover the law. The researches that are confined to Keynes’s literature may be misled by Keynes’s mistake. Accordingly, by focusing on the internal logic of liquidity preference theory, I attempt to present a new interpretation of the theory to uncover its essence.
It seems we can start from the problem of the classical theory of interest since Keynes tried to develop a new theory of interest after he was aware that there is something wrong with the classical theory. But when criticizing the classical theory of interest in his General Theory, Keynes makes chaos and conceals the essence of the problem by his unsuccessful attack. Given that the problem of the classical theory is still not clear, I feel the following quote from Keynes can be a more clear and reliable start:

[A]s I have said above, the initial novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments, which lead up to this initial conclusion, are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory. But the result of it was to leave the rate of interest in the air. If the rate interest is not determined by saving and investment in the same way in which price is determined by supply and demand, how is it determined? (Keynes, 1937B, p.212)

It can be clearly deduced from this quote that the initial divarication between the classical theory of interest and Keynes is whether interest rate or income will change along with the change of propensity to invest (no matter which of them changes, saving would equate investment anyway). When propensity to invest changes, the classical theory holds that interest rate will change and income will not change, but Keynes thinks that it is not interest rate but income that will change.
To settle the divarication, we should analyze the ex ante situation first. If, for example, there is an increase of propensity to invest (namely, an outward shift of the investment demand curve or Keynes’s investment demand-schedule), desired investment will increase and exceed desired saving.
According to the classical theory, at the moment, a rise of interest rate will decrease desired investment and increase desired saving. The interest rate will continue to rise until desired investment equates desired saving. Therefore, ultimately interest rate changes and income maintains unchanged. Moreover, interest rate is directly determined by desired investment and desired saving.
But how can Keynes’s prediction that income will change be right? It is not difficult to see that income will change if the economy can draw idle money from somewhere to fill up the gap between desired investment and desired saving in the ex ante situation.
Thus, the debate on whether interest rate or income will change transforms to another equivalent debate: whether there exists idle money outside economic operation. If there doesn’t exist idle money, income won’t change, and the classical theory is right. If there exists idle money, income will change and interest rate cannot be determined by desired investment and desired saving.
Obviously, the idle money here is just Keynes’s “inactive balances” or “idle balances”. Why there exists idle money? Just as Keynes argues, the reason why the wealth-holders would like to hold money without gaining interest is the existence of speculative motive for demanding money. Accordingly, the concept of liquidity preference comes out naturally. Is there any cost to draw idle money into the economic operation? To make the wealth-holders give up holding money, according to Keynes, requires the rise of interest rate: the higher the demand for idle money, the more the rise of interest rate. In this way, liquidity preference analysis is logically introduced into determination of interest rate in the ex ante situation.
When there exists idle money, determination of interest rate is related not only to the difference between desired investment and desired saving, but also to the interest elasticity of liquidity preference. The higher the interest elasticity of liquidity preference, the lower the cost of drawing idle money, the less the rise of interest rate, the more the increase of income. Contrarily, the lower the interest elasticity of liquidity preference, the higher the cost of drawing idle money, the more the rise of interest rate, the less the increase of income.
Further, I would argue that the difference between desired investment and desired saving as mentioned above is equivalent to what Keynes (1937C) says an excess finance motive as a result of the increase of propensity to invest. That is, finance motive will increase first when propensity to invest increases. Only when the excess finance motive is satisfied by the idle money, the excess investment can be realized and income can increase. After the multiplier effect makes the level of income rise, the idle money will change to revolving fund, which makes desired saving equal to desired investment if the increase of propensity to invest lasts.
According to Keynes, finance motive exists during what I call an investment-realization period, the period between the date when entrepreneurs make their investment decisions (at the same time, they arrange their finance) and the date when they actually make their investment. Let’s see Figure 1, which tries to clarify the role of finance motive in a simplified investment-realization period.
 by entrepreneurs. If propensity to invest increases, finance motive will increase simultaneously, drawing idle money from inactive balances into economic operation and leading to the rise of interest rate. Then the purchase contracts of investment goods will be signed between entrepreneurs and producers. After that, producers will make production decisions and seek more working capital for producing more investment goods. Consequently, transactions motive will increase, drawing more idle money from inactive balances into economic operation and leading to the rise of interest rate once more. After the investment goods are delivered and payment is made, the investment process is completed, and the investment is finally realized. Moreover, if the increase of propensity to invest lasts, the increase of finance motive and transactions motive will last in subsequent investment-realization periods.
The above analysis demonstrates two points:
First, finance motive doesn’t merely exist when investment increases, but exists at any time. When the economic operation is constant, finance motive is a constant revolving fund, the amount of which equates to the amount of the desired investment or desired saving during an investment-realization period. When all the other conditions are the same, the amount of finance motive depends on the length of the investment-realization period: the longer the investment-realization period, the more the finance motive for demanding money. In this way, finance motive transforms the flow demand for funds into the stock demand for money.
Second, finance motive and transactions motive are different demands for money and play different roles in economic operation. They simultaneously exist in economic operation and change at different time in expansion or contraction of economy. Therefore, finance motive cannot be just a subcategory or addendum of transactions motive. Furthermore, I would like to argue that in determining interest rate, the liquidity preference analysis based on finance motive plays a more fundamental role than does the liquidity preference analysis based on transactions motive, because: 1) finance motive bridges the classical theory of interest and liquidity preference theory, thereby illuminating the necessity of introducing liquidity preference analysis into determination of interest rate; and 2) finance motive is the start point of liquidity preference analysis since finance motive changes first when propensity to invest changes.
Hereto, we arrive at a new interpretation of liquidity preference theory. Without finance motive, liquidity preference theory is terribly half-baked, or even false. However, it is very strange that finance motive can hardly be found in the literatures after Keynes, e.g. IS-LM model and most other interpretations of liquidity preference theory all overlook finance motive.
In my opinion, Keynes’s mistake of initially overlooking finance motive in The General Theory mainly contributes to this strange phenomenon. Although Keynes later added finance motive to correct this mistake, the strong first impressions of The General Theory make most economists still consider his initial mistake the innovation and elite of the theory. This misunderstanding results in that they think that transactions motive plays a fundamental role in liquidity preference theory and finance motive is dispensable. Thus, the inherent logic and essence of liquidity preference theory are covered up, leading to much confusion and many misinterpretations. If Keynes had firstly introduced finance motive with its ex ante effect on interest rate, then brought forward transactions motive with its succedent effect on interest rate, liquidity preference theory would have become more logical and clear, and all the misunderstandings and controversies would have been cleared up naturally.

3.        Keynes’s crucial and unsolved mistake in his theory of interest

After introducing finance motive, Keynes summarized his liquidity preference theory in Mr Keynes ‘Finance’:

[T]he rate of interest is determined by the total demand and total supply of cash or liquid resources. The total demand falls into two parts: the inactive demand due to the state of confidence and expectation on the part of the owners of wealth, and the active demand due to the level of activity established by the decisions of the entrepreneurs. The active demand in its turn falls into two parts: the demand due to the time lag between the inception and the execution of the entrepreneurs’ decisions, and the part due to the time lags between the receipt and the disposal of income by the public and also between the receipt by entrepreneurs of their sale proceeds and the payment by them of wages, etc. An increase in activity raises the demand for cash, first of all to provide for the first of these time lags in circulation, and then to provide for the second of them. (Keynes, 1938, p.230)

Keynes may not be aware that a new problem comes out after he adds finance motive: interest rate becomes indeterminate. Here, interest rate is determined by the total demand for and supply of money, and the finance motive for demanding money is determined by desired investment. However, as desired investment is determined by interest rate and marginal efficiency of capital, interest rate and desired investment have to be determined simultaneously. Thus, there is a circular logic in his theory of interest.
Here I must stress that, from the appearance, I have arrived at a conclusion similar to Hansen’s, i.e. interest rate is indeterminate in Keynes’s theory of interest, but the bases of our reasoning are totally different. My reasoning is established on what I calls the comprehensive liquidity preference theory, namely, Keynes’s theory of interest that includes both finance motive and transactions motive; whereas the reasoning of Hansen is established on what I calls the half-baked liquidity preference theory, namely, Keynes’s theory of interest in The General Theory that merely includes transactions motive.
Moreover, contrary to Hansen, I would argue that interest rate is determinate in the half-baked liquidity preference theory. In The General Theory, two incomes are different from each other: the income that affects transactions motive, demand for money, and then interest rate; and the income determined by investment and then by interest rate and marginal efficiency of capital. The first income, or the ex ante income, is realized before the investment is carried out. The second income, or the ex post income, is realized after the investment is carried out. In The General Theory, although Keynes didn’t elucidate explicitly, he implied that the change of propensity to invest doesn’t directly exert an ex ante influence on interest rate. Therefore, the ex ante interest rate is just determined by the supply of money and the demand for money, the latter being determined by the ex ante income. This ex ante interest rate and marginal efficiency of capital will then collectively determine investment and the ex post income. Accordingly, interest rate and income are not determined simultaneously, but sequentially. That means, Pasinetti is right in interpreting the half-baked liquidity preference theory.
There doesn’t exist a circular logic in the half-baked liquidity preference theory. The sequentiality of the half-baked liquidity preference theory makes the simultaneous IS-LM model logically inconsistent. It is the introduction of finance motive that makes interest rate and desired investment have to be determined simultaneously, and then results in the circular logic of the comprehensive liquidity preference theory. This is a crucial mistake in Keynes’s theory of interest, but unfortunately he is never aware of it.
On the basis of above analysis, it is not difficult to see that Hansen makes two mistakes: 1) that he overlooks finance motive and does research on the half-baked liquidity preference theory; 2) he makes an incorrect interpretation of the half-baked liquidity preference theory. But very accidentally, Hansen based on his successional mistakes arrives at a correct conclusion: interest rate is indeterminate in Keynes’s liquidity preference theory.

4.        Remedy of liquidity preference theory

In order to correct the mistake in Keynes’s theory of interest, I will develop a new integrated model of determination of interest rate on the basis of the liquidity preference analysis centered on finance motive.
If we regard the difference between desired investment and desired saving in an investment-realization period as the demand for idle money, the demand for idle money will increase along with the fall of interest rate. When interest rate falls, desired investment will rise and desired saving will fall, so the difference will increase.
If we regard the difference between the idle balance and the narrowly defined liquidity preference as the supply of idle money, the supply of idle money will increase along with the rise of interest rate. When interest rate rises, liquidity preference will decrease, i.e. the money that the wealth-holders would like to hold will decrease; thereby, the supply of idle money will increase.
In this way, we arrive at a new model of determination of interest rate, or an integrated liquidity preference theory. In this model, interest rate is determined by the demand for and supply of idle money. The main features of the analysis can be illustrated in Figure 2.
In Figure 2, y-axis denotes interest rate, and x-axis denotes the quantity of the demand for and supply of idle money. When propensity to invest increases, the increase in finance motive will make the demand for idle money curve move rightwards, leading to the rise of interest rate from a to b. Later, when the producers make production decisions, the increase of transactions motive will make the supply of idle money curve move leftwards, leading to the rise of interest rate higher from b to c, since the increase of transactions motive decreases the idle balance. This model is established on the relationship between finance motive and liquidity preference, namely, the liquidity preference analysis based on finance motive; and then the influence of transactions motive is added to the model.
Compared with IS-LM model, the new model is a logically consistent and stable model of determination of interest rate because interest rate and the quantity of (demand for and supply of) idle money are determined simultaneously.

5.        Some other controversies related to liquidity preference theory

In addition to the controversies discussed in the above sections, there are some other common controversies related to liquidity preference theory that I would like to discuss so we can better elucidate the essence of liquidity preference theory. Given their importance and complexity, I would like to leave to separate papers the discussion of the well-known Liquidity Preference – Loanable Funds controversy and the discussion of the relationship between endogenous money supply and liquidity preference theory.

5.1.       The relationship between liquidity preference theory and the classical theory of interest
In The General Theory, Keynes attacks the classical theory of interest on its assumption that income is constant and argues that interest rate is indeterminate. However, Keynes fails to present the reason why income will change, making his criticism unsuccessful. In my opinion, the classical theory impliedly supposes that there is no idle money or the interest elasticity of liquidity preference is zero. If Keynes wants to criticize the classical theory effectively, he should attack the classical theory not on the change of income in the ex post situation, but on the existence of idle money in the ex ante situation. The change of income is merely the consequence of the existence of idle money. In this way, he can uncover the essence of the problem of the classical theory of interest.
Accordingly, liquidity preference theory and the classical theory of interest are not incompatible. The liquidity preference analysis centered on finance motive bridges these two theories: liquidity preference theory is a general theory of interest, whereas the classical theory is just a special case of the theory.

5.2.       The exact meaning of liquidity preference
Understanding Keynes’s liquidity preference theory is made difficult by his inconsistent use of the term liquidity preference. In The General Theory, liquidity preference sometimes means the total demand for money and sometimes means the speculative motive for demanding money.
In my opinion, for the purpose of making liquidity preference theory clear, liquidity preference should only refer to the speculative motive for demanding money. The narrowly defined liquidity preference clearly indicates the role of monetary factor in determining of interest rate. On the contrary, the broadly defined liquidity preference involves not only monetary factor but also real factors, so it means nothing but confusion.

5.3.       Is liquidity preference theory a pure monetary theory of interest
There has always been a viewpoint that liquidity preference theory is a pure monetary theory of interest since The General Theory was published. The economists holding this view argue that interest rate is purely a monetary phenomenon and concentrate their attention on Chapter 17 of The General Theory to study the own interest rate of money.
However, in my opinion, this view distorts Keynes’s intension. In The General Theory, Keynes first presents the liquidity preference theory, which is a general model of determination of interest rate including both real and monetary factors, as the basis for further analysis: the introduction of liquidity preference analysis makes it possible to analyze the roles of real factors and monetary factors separately in determination of interest rate. Then he tries to demonstrate in Chapter 17 that the interest elasticity of liquidity preference is very high. Thus, he arrives at the conclusion that interest rate is mainly a monetary phenomenon, i.e. the real factors only exert little influence on interest rate. Therefore, liquidity preference theory is not a pure monetary theory of interest and interest rate mainly as a monetary phenomenon is merely an inference of liquidity preference theory.

6.        Conclusion

With his profound and keen insight, Keynes creatively introduces liquidity preference analysis into determination of interest rate. However, he makes two mistakes in developing an integrated liquidity preference theory: 1) he initially overlooks finance motive, and 2) he wrongly insists that interest rate is determined by the demand for and supply of money.
The first mistake leads to that Keynes initially just presented the liquidity preference analysis based solely on transactions motive. Although he later added finance motive to correct this mistake, the strong first impressions of The General Theory make this mistake exert a far-reaching influence on subsequent researches: most economists mistakenly consider his initial mistake the innovation and elite of the theory. This huge misunderstanding results in that they think that transactions motive plays a fundamental role in liquidity preference theory and finance motive is dispensable. Thus, the inherent logic and essence of liquidity preference theory are covered up, leading to much confusion and many misinterpretations.
The second mistake leads to indetermination of interest rate or circular logic of Keynes’s theory of interest. This mistake and its consequence are made apparent by the introduction of finance motive into the theory. Unfortunately, Keynes is never aware of it. Hansen seems right to argue that Keynes’s theory of interest is indeterminate, but the basis of his reasoning is wrong.
In this paper, I firstly clarify the lasting misunderstanding resulting from Keynes’s first mistake through analyzing the internal logic of liquidity preference theory, arguing that the liquidity preference analysis based on finance motive plays a more fundamental role in determining interest rate. Then I point out Keynes’s second mistake and reveal why IS-LM model is logically inconsistent. Further, I develop a logically consistent and integrated model of determination of interest rate on the basis of the liquidity preference analysis that is centered on finance motive. In this model, interest rate is not determined by the demand for and supply of money, but determined by the demand for and supply of idle money.

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