Keynes on

Money and
Speculation
LEC 22
 Expansionary Monetary
Policy
• Keynes also proposed expansionary monetary
policy as a cure for unemployment.
• This idea was based on a new theory of the
demand for money called liquidity preference.
 Motive for Holding
Money
• Keynes believed the community required some
minimum stock of money to lubricate the wheels of
commerce and to provide a reserve against
contingencies.
• These motives for holding money were thoroughly
compatible with neo-classical thinking.
• But Keynes insisted that there was also another
reason for holding cash - the speculative motive for
liquidity.
• This concept was essential to the opening of space
for the analytical innovations of the General Theory.
 Speculative Demand for
Money
• The classical theory of the demand for money
had said that people carry cash in their wallets
only because cash is needed for shopping
(that is, only for transactions purposes).
o After all, the classical economists argued, as cash does not earn
interest, you would be better off using your money to buy stocks and
bonds so that your wealth would grow.

• Keynes argued that people should carry cash

for the sensible management of their wealth as
well as for transactions purposes.
• Suppose you are convinced that the interest
rate on long-term bonds would soon go up.
• t would not be a good idea to use all of
your savings to buy bonds. You should hold
on to some cash.
o That way, when the interest rates do go up, you would have
some ready cash with which to buy those high interest bonds.

• Therefore, Keynes argued, sensible wealth

management required that people hang on
to some cash even if they don’t need it for
shopping.
 The Demand for Money
• Moreover, Keynes’s liquidity preference idea
implied that the demand for money would be
inversely related to the interest rate.
o If interest rates are currently very high, then it is likely that they will
soon fall.
o Therefore, it would not make sense to carry cash; it would be better
to spend all your savings to buy the bonds and lock in the current
high interest rates.
o On the other hand, if interest rates are currently low, then they
would be likely to rise soon.
o This gives people a good reason to hang on to cash and be ready
to snap up the bonds when interest rates rise.

• Therefore, the demand for money would be

high when interest rates are low.
• Why should anyone wish to hold money in excess of
the amounts required for transactions and
precautionary purposes when he sacrificed thereby
an income he might have gained as a lender?

• Keynes's reply rested on the inverse relationship

between interest rates and the capital values of
paper assets. The essentials of the point he had in
mind can most readily be conveyed through a
moment's consideration of the yield and market
price on a consol (a type of government debt issue
familiar in Britain, though not in the United States).
• As a negotiable perpetual bond the consol is
convenient for purposes of illustration because it
permits the general principle to be established
without the complications presented when debts
with differing maturity dates enter the picture.
 Example
• Let us assume that a 3 per cent consol has been
issued at a par value of £100; i.e. the holder is
assured of £3 per year.
• Let it further be assumed that, subsequently, the
rate of interest on new debt of comparable quality
rises to 6 per cent.
• The holder of the 3 per cent consol, should he wish
to sell, would be exposed to a considerable capital
loss.
• At interest rates now prevailing those seeking an
assured income of £3 per year could obtain it by
placing £50 and would not be prepared to pay
more for the consol originally valued at £100.
• Actual - as opposed to hypothetical - market
situations are, of course, less tidy because of
the variety of paper assets of widely differing
quality available as alternatives to holding
cash.
• Nevertheless, there will still be a tendency for
interest rates and capital values on interest-
bearing assets to move in opposite
directions.
• Rising interest rates will be associated with
capital losses to the holders of old issues,
while falling interest rates will bring windfall
gains.
• In the light of this relationship Keynes argued that
there might be circumstances in which it would be
prudent to hoard as a hedge against risks of capital
loss.
• Indeed the speculative motive for liquidity might be
forceful when the rate of interest was already low
(and the sacrifice of income through hoarding was
not great) and when it was thought that rates of
interest in the future would probably move up (and
expose the owners of debt instruments to
substantial capital losses).
 Role of Money
• When this consideration was taken into account,
money could no longer be interpreted exclusively as
a medium of exchange. Instead it also performed an
important function as a store of value. This insight
undercut the line of reasoning upon which Say's Law
had rested.
• Hoarding could no longer be ruled out by
assumption, nor treated as an irrational activity.
• Once this link in the neo-classical analytical chain
had been broken, confidence in the self adjusting
properties of the economy to a full-employment level
of equilibrium could no longer be sustained.
• On the contrary, an underemployed economy
might tend to get stuck at a level of income well
below its potential if part of its income stream
leaked into the build-up of idle hoards.
• In developing this view of money Keynes found
intellectual companions among mercantilist writers
of the seventeenth and eighteenth centuries. He
was prepared to argue that the mercantilist tradition
contained clearer insights into the nature of money
than those offered by the teachings of the classical
and neo-classical schools.
• In doing this he associated himself with doctrines
that had been viewed as heresy for more than a
century and a half.
 Monetary Expansion
• The equality of the supply and demand for money
then implied that a country’s central bank could
reduce interest rates by increasing the money
supply.
 Monetary Policy
• The neoclassical theory of investment had argued
that investment increases when interest rates fall
and vice versa.
• Therefore, if the central bank increased the money
supply by printing more money and lending it to
borrowers, the interest rate on borrowed money
would decrease.
• This in turn would increase investment spending by
businesses.
• This would increase the production of capital
equipment for businesses and, thereby, reduce
unemployment.
 Stabilization Policy
• Thus, we see that Keynes had proposed two
cures for unemployment:
o expansionary fiscal policy, and
o expansionary monetary policy.

• However, of these two cures, Keynes

preferred expansionary fiscal policy and
had doubts about the effectiveness of
monetary policy.
 Doubts about Monetary
Policy
• First, Keynes argued that at especially low
interest rates a liquidity trap may appear.
o That is, the demand for money may become infinitely elastic and,
therefore, it may no longer be possible to reduce interest rates by
printing more money.

• Second, even if you reduce interest rates,

investment spending by businesses may not
increase.
o Business investment is determined basically by expectations—
optimistic or pessimistic “animal spirits”—and only slightly by the
interest rate.
o Therefore, when the economy is in trouble, even if the central
bank succeeds in reducing interest rates, the businesses may be
so pessimistic that they may not boost investment spending. And
if that happens, no new jobs would get created.
 Keynes and the Quantity
Theory of Money
• There are three versions of the Quantity Theory.
• Irving Fischer’s equation of exchange provides a
widely-cited version of the theory, as follows: MV=PT (i)
• The second version is the income quantity theory of
money, as follows: MV=PY (ii)
• Third version of the quantity theory of money is the
Cambridge Cash Balance equation:
M= kd PY (iii)
• It can be seen that V (whether it is regarded as the
velocity of circulation of money as in equation 1, or
the income velocity of circulation of money as in
equation 2) or kd must be constant for the quantity
theory of money to work, as must T (in equation 1)
or Y (in equations 2 and 3).
• Keynes correctly argued that neither kd nor Y is constant.
• Pre-Keynesians assumed that Y was constant because
of their foolish belief that a free market economy was
nearly always in, or moving towards, equilibrium (i.e., full
employment and full use of resources).
• By contrast, Keynes, in his criticism of equation 3, argued
that in the absence of full employment, Y will not be
constant. Thus the theory breaks down, especially in a
recession, depression or even in periods of expansions in
the business cycle where full employment is not
reached.
• The neoclassicals also assumed that V was constant
because they only accepted the transactions demand
for money.
• Keynes, however, showed that there are three motives
for holding money: (1) the transactions motive, (2) the
speculative motive, and the (3) precautionary motive.
• Keynes thus rejected the idea that there is a direct
and proportional relationship between the money
supply and the price level.
• Instead, Keynes argued that the money supply
influences the price level indirectly through its
effects on the interest rate, income, output,
employment and investment.
• Moreover, prices are also influenced by the costs of
production. It is only when there is full employment
and full use of resources that money supply
increases could then increase the price level in the
way the quantity theory predicts.