11.05. The Demand for Money

0:005. The Demand for Money a. Money in the E.R.E. and in the market It is true, as we have said, that the only use for money is in exchange. From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate. Indeed, the reason that a reservation demand for money exists and cash balances are kept is that the individual is keeping his money in reserve for future exchanges. That is the function of a cash balance, to wait for a propitious time to make an exchange.

0:46Exchange. Suppose the E.R.E. has been established. In such a world of certainty there would be no risk of loss in investment and no need to keep cash balances on hand in case an emergency for consumer spending should arise. Everyone would therefore allocate his money stock fully to the purchase of either present goods or future goods in accordance with his time preferences. No one would keep his money idle in a cash balance. Knowing that he will want to spend a certain amount of money on consumption in six months time, a man will lend his money out for that period to be returned at precisely the time it is to be spent.

1:35But if no one is willing to keep a cash balance longer than instantaneously, there will be no money held and no use for a money stock. Money in short would either be useless or very nearly so in the world of certainty. In the real world of uncertainty as contrasted to the ERE, even idle money kept in a cash Cash balance performs a use for its owner. Indeed, if it did not perform such a use, it would not be kept in his cash balance. Its uses are based precisely on the fact that the individual is not certain on what he will spend his money, or of the precise time that he will spend it in the future. Economists have attempted mechanically to reduce the the demand for money to various sources.

2:32There is no such mechanical determination however. Each individual decides for himself by his own standards, his whole demand for cash balances and we can only trace various influences which different catalactic events may have had on demand. B, speculative demand. One of the most obvious influences on the demand for money is expectation of future changes in the exchange value of money. Thus, suppose that at a certain point in the future the PPM of money is expected to drop rapidly. How the demand for money schedule now reacts depends on the number of people who hold this expectation and the strength with which they hold it.

3:25They Hold It. It also depends on the distance in the future at which the change is expected to take place. The further away in time any economic event, the more its impact will be discounted in the present by the interest rate. Whatever the degree of impact, however, an expected future fall in the PPM will tend to lower the PPM now. For an expected fall in the PPM means that present units of money are worth more than they will be in the future, in which case there will be a fall in the demand for money schedule as people tend to spend more money now than at the future date.

4:12A general expectation of an imminent fall in the PPM will lower the demand schedule for Money now and thus tend to bring about the fall at the present moment. Conversely, an expectation of a rise in the PPM in the near future will tend to raise the demand for money schedule as people decide to hoard, add money to their cash balance in expectation of a future rise in the exchange value of a unit of their money. The result will be a present rise in the PPM. An expected fall in the PPM in the future will therefore lower the PPM now, and an expected rise will lead to a rise now.

5:03The speculative demand for money functions in the same manner as the speculative demand for any good. An anticipation of a future point speeds the adjustment of the economy toward that future point. Just as the speculative demand for a good speeded adjustment to an equilibrium position, so the anticipation of a change in the PPM speeds the market adjustment toward that position. Just as in the case of any good, furthermore, errors in this speculative anticipation are Self-Correcting Many writers believe that in the case of money, there is no such self-correction.

5:48They assert that while there may be a real or underlying demand for goods, money is not consumed and therefore has no such underlying demand. The PPM and the demand for money, they declare, can be explained only as a perpetual and rather Another meaningless cat-and-mouse race in which everyone is simply trying to anticipate everyone else's anticipations. There is, however, a real or underlying demand for money. Money may not be physically consumed, but it is used, and therefore it has utility in a cash balance. Such utility amounts to more than speculation on a rise in the PPM.

6:39This is demonstrated by the fact that people do hold cash even when they anticipate a fall in the PPM. Such holdings may be reduced, but they still exist, and as we have seen, this must be so in an uncertain world. In fact, without willingness to hold cash, there could be no monetary exchange economy, whatever. The speculative demand therefore anticipates the underlying non-speculative demands, whatever their source or inspiration. Suppose then that there is a general anticipation of a rise in the PPM, a fall in prices, not Reflected in Underlying Supply and Demand. It is true that at first this general anticipation raises, Ceteris Paribus, the demand for money, and the PPM. But this situation does not last.

7:40For now that a pseudo-equilibrium has been reached, the speculative anticipators, who did not really have an increased demand for money, sell their money, buy goods, to reap C. Secular Influences on the Demand for Money Long-run influences on the demand for money Money in a progressing economy will tend to be manifold and in both directions.

8:27On the one hand, an advancing economy provides ever more occasions for new exchanges as more and more commodities are offered on the market and as the number of stages of production increases. These greater opportunities tend greatly to increase the demand for money schedule. If an economy deteriorates, fewer opportunities for exchange exist and the demand for money from this source will fall. The major long-run factor counteracting this tendency and tending toward a fall in the demand for money is the growth of the clearing system. Clearing is a device by which money is economized and performs the function of a medium of exchange without being physically present in the exchange.

9:21A simplified form of clearing may occur between two people. For example, A may buy a watch from B for three gold ounces. At the same time, B buys a pair of shoes from A for one gold ounce. Instead of two transfers of money being made and a total of four gold ounces changing hands, They decide to perform a clearing operation. A pays B two ounces of money and they exchange the watch and the shoes. Thus when a clearing is made and only the net amount of money is actually transferred, all parties can engage in the same transactions at the same prices but using far less cash. Their demand for cash tends to fall.

10:15There is obviously little scope for clearing, however, as long as all transactions are cash transactions. For then, people have to exchange one another's goods at the same time. But the scope for clearing is vastly increased when credit transactions come into play. These credits may be quite short-term. The Theory of Money and Credit

11:09The net debtor pays one lump sum to the net creditor. Once credit enters the picture, the clearing system can be extended to as many individuals as find it convenient. The more people engage in clearing operations, often in places called clearing houses, the more cancellations there will be, and the more money will be economized. At the end of the week, for example, there may be five people engaged in clearing and a may-o-b 10 ounces, b-o-c 10 ounces, c-o-d, etc., and finally e may-o-a 10 ounces. In such a case, 50 ounces worth of debt transactions and potential cash transactions are settled without a single ounce of cash being used.

12:06Clearing then is a process of reciprocal cancellations of money debts. It permits a huge quantity of monetary exchanges without actual possession and transfer of money, thereby greatly reducing the demand for money. Clearing however cannot be all-encompassing, for there must be some physical money which could be used to settle the transaction, and there must be physical money to settle when there is no 100% cancellation, which rarely occurs. D. Demand for money unlimited? A popular fallacy rejects the concept of demand for money because it is allegedly always unlimited.

12:57This idea misconceives the very nature of demand and confuses money with wealth or income. It is based on the notion that people want as much money as they can get. In the first place, this is true for all goods. People would like to have far more goods than they can procure now. But demand on the market does not refer to all possible entries on people's value scales. It refers to effective demand, to desires made effective by being demanded, that is, by the fact that something else is supplied for it, or else it is reservation demand, which takes the form of holding back the good from being sold. Clearly, effective demand for money is not and cannot be unlimited. It is limited by the appraised value of the goods a person can sell in exchange, and by the amount of that money which the individual wants to spend on goods, rather than keep in his cash balance. Furthermore, it is of course not money per se that he wants

14:14and demands, but money for its purchasing power, or real money, money in some way expressed in terms of what it will purchase. This purchasing power of money as we shall see cannot be measured. More money does him no good if its purchasing power for goods is correspondingly diluted. E. The PPM and the rate of interest. We have been discussing money and shall continue to do so in in the current section by comparing equilibrium positions, and not yet by tracing step by step how the change from one position to another comes about.

15:00We shall soon see that in the case of the price of money, as contrasted with all other prices, the very path toward equilibrium necessarily introduces changes that will change the equilibrium point. This will have important theoretical consequences. We may still talk, however, as if money is neutral, that is, does not lead to such changes, because this assumption is perfectly competent to deal with the problems analyzed so far. This is true, in essence, because we are able to use a general concept of the purchasing The Theory of Money and Credit

16:10In the determination of the interest rate, we must now modify our earlier discussion in Chapter 6 to take account of allocating one's money stock by adding to or subtracting from one's cash balance. A man may allocate his money to consumption, investment, or addition to his cash balance. His time preferences govern the proportion which an individual devotes to present and to future goods, that is, to consumption and to investment. Now suppose a man's demand for money schedule increases, and he therefore decides to allocate a proportion of his money income to increasing his cash balance.

17:02There is no reason to suppose that this increase affects the consumption investment proportion at all. It could, but if so, it would mean a change in his time preference schedule as well as in his demand for money. If the demand for money increases, there is no reason why a change in the demand for money Money should affect the interest rate one iota. There is no necessity at all for an increase in the demand for money to raise the interest rate or a decline to lower it, no more than the opposite. In fact, there is no causal connection between the two. One is determined by the valuations for money and the other by valuations for time preference.

17:56Let us return to the section in Chapter 6 on time preference and the individual's money stock. Did we not see there that an increase in an individual's money stock lowers the effective time preference rate along the time preference schedule and, conversely, that a decrease raises the time preference rate? Why does this not apply here? Because we were dealing with each individual's money stock, and assuming that the real exchange value of each unit of money remained the same. His time preference schedule relates to real monetary units, not simply to money itself.

18:43If the social stock of money changes, or if the demand for money changes, the objective of Exchange Value of a Monetary Unit, the PPM will change also. If the PPM falls, then more money in the hands of an individual may not necessarily lower the time preference rate on his schedule, for the more money may only just compensate him for the fall in the An increased demand for money, then, tends to lower prices all around without changing time preference or the pure rate of interest.

19:38Thus suppose total social income is 100, with 70 allocated to investment and 30 to consumption. The demand for money increases, so that people decide to hoard a total of 20. Expenditure will now be 80 instead of 100, 20 being added to cash balances. Income in the next period will be only 80, since expenditures in one period result in the identical income to be allocated to the next period, since no one can receive a money income, unless someone else makes a money expenditure on his services. If time preferences remain the same, then the proportion of investment to consumption in the Society will remain roughly the same, that is, 56 invested and 24 consumed.

20:37Prices and nominal money values and incomes fall all along the line, and we are left with the same capital structure, the same real income, the same interest rate, etc. The only things that have changed are nominal prices, which have fallen, and the proportion The only other change is a lower proportion of cash balances to money income, which has increased. A decreased demand for money will have the reverse effect. Dishoarding will raise expenditure, raise prices, and, Ceteris Paribus, maintain the real income and capital structure intact. The only other change is a lower proportion of cash balances to money income.

21:26The only necessary result, then, of a change in the demand for money schedule is precisely a change in the same direction of the proportion of total cash balances to total money income and in the real value of cash balances. Given the stock of money, an increased scramble for cash will simply lower money incomes until Until the desired increase in real cash balances has been attained, if the demand for money falls, the reverse movement occurs. The desire to reduce cash balances causes an increase in money income. Total cash remains the same, but its proportion to incomes, as well as its real value, declines.

22:18Strictly the Ceteris Paribus condition will tend to be violated. An increased demand for money tends to lower money prices and will therefore lower money costs of gold mining. This will stimulate gold mining production until the interest return on mining is again the same as in other industries. Thus, the increased demand for money will also call forth new money to meet the demand. A decreased demand for money will raise money costs of gold mining and at least lower the rate of new production. It will not actually decrease the total money stock unless the new production rate falls below the wear and tear rate.

23:09F. Hoarding and the Keynesian System 1. Social Income, Expenditures and Unemployment To the great bulk of writers, hoarding, an increase in the demand for money, has appeared an unmitigated catastrophe. The very word hoarding is a most inappropriate one to use as in economics, since it is laden with connotations of vicious antisocial action. But there is nothing at all antisocial about either hoarding or dis-hoarding. Hoarding is simply an increase in the demand for money, and the result of this change in valuations is that people get what they desire, that is, an increase in the real value of The Theory of Money and Credit

24:30The Theory means that people want something, either an increase or a decrease in their real cash balances or in the real value of the monetary unit, and that they are able to obtain this result. What is wrong with that? We see here simply another manifestation of consumers or individuals' sovereignty on the free market. Furthermore, there is no theoretical way of defining hoarding beyond a simple addition to one's cash balance in a certain period of time. Yet most writers use the term in a normative fashion, implying that there is some vague standard below which a cash balance is legitimate, and above which it is antisocial and vicious.

25:20One of the two major pillars of the Keynesian system, now happily beginning to wane after sweeping the economic world in the 1930s and 1940s, is the proclamation that savings become equal to investment only through the terrible root of decline in social income. The term generally used is national income, however in a free market economy the nation will no more be an important economic boundary than the village or region.

26:05It is more convenient then to set aside regional problems for other analysis and to concentrate on Aggregate Social Income. This is especially true since regions do not present a problem to economic theory until their governments begin intervening in the free market. The implicit foundation of Keynesianism is the assertion that at a certain level of total social income, total social expenditures out of this income will be lower than income, The Keynesian consumption function plays its part in establishing an alleged law that there There exists a certain level of total income, say A, above which expenditures will be less than income, net hoarding, and below which expenditures will be greater than income, net dis-hoarding.

27:26But the basic Keynesian worry is hoarding, when total income must decline. We shall investigate the validity of this alleged law and the consumption function on which it rests, but suppose that we now grant the validity of such a law. The only comment can be an impertinent, so what? What if there is a fall in the national income? Since the fall need only be in money terms, and real income, real capital, etc. may remain In the same, why any alarm? The only change is that the hoarders have accomplished their objective of increasing their real cash balances and increasing the real value of the monetary unit.

28:16It is true that the picture is rather more complex for the transition process until equilibrium is reached, and this will be treated further, although our final conclusion will be the same. But the Keynesian system attempts to establish the perniciousness of the equilibrium position, and this it cannot do. Therefore, the elaborate attempts of the Keynesians to demonstrate that free market expenditures will be limited, that consumption is limited by the function, and investment by stagnation of Opportunities and Liquidity preference are futile, for even if they were correct, which they are not, the result would be pointless.

29:04There is nothing wrong with hoarding or dishording, or with low or high levels, whatever that may mean, of social money income. The Keynesian attempt to salvage meaning for their doctrine rests on one point and one point alone. The second major pillar of their system. This is the thesis that money, social income and level of employment are correlated, and that the latter is a function of the former. This assumes that a certain full employment level of social income exists below which there is correspondingly greater unemployment.

29:49The nub of the Keynesian critique of the free-market economy, then, rests on the involuntary unemployment allegedly caused by too low a level of social expenditures and income. But how can this be, since we have previously explained that there can be no involuntary unemployment in a free market? The answer has become evident, and is admitted in the most intelligent of the Keynesian writings. The Keynesian underemployment equilibrium occurs only if money wage rates are rigid downward. That is, if the supply of labor below full employment is infinitely elastic.

30:36Thus suppose there is a hoarding, an increased demand for money, and social income falls. The result is a fall in the monetary demand for labor factors, as well as in all other monetary demand. Since only money wage rates are being changed, while real wage rates, in terms of purchasing power, remain the same, there will be no shift in labor leisure preferences, and the total stock of labor offered on the market will remain constant. At any rate, certainly no involuntary unemployment will arise. How then can the Keynesian case arise? In only two ways.

31:22One, if people voluntarily agree with the unions, which insist that no one be employed at lower than the old money wage rate. Since selling prices are falling, maintaining the old money wage rate is equivalent to demanding Raising a Higher Real Wage Rate We have seen that the unions raising of real wage rates causes unemployment. But this unemployment is voluntary, since the workers acquiesce in the imposition of a higher minimum real wage rate, below which they will not undercut the union and accept employment. Chapter 2, Unions or Government Coercively Impose the Minimum Wage Rate, but this is an example of a hampered market, not the free market to which we are confining our analysis here.

32:20Kane's own exposition tended to run in terms of real, rather than money, magnitudes, real Real social income, real expenditures, etc. Such an analysis obscures dynamic considerations, since transactions take place, at least superficially, in monetary terms on the market. However, the essential conclusion of our analysis remains unchanged if we pursue it directly in real terms. Instead of falling, demand in real terms will now remain the same. This is true for the labor market as well. The sum and substance of the Keynesian Revolution was the thesis that there can be an unemployment equilibrium on the free market.

33:12As we have seen, the only sense in which this is true was known years before Keynes. That widespread union maintenance of excessively high wage rates will cause unemployment. Keynes believed that while other elements of the economic system, including prices, were set basically in real terms, workers bargained even ultimately, only in terms of money wages. That unions insisted on minimum money wage rates downward, but would passively accept falling real wages in the form of rising prices, money wage rates remaining the same. The Keynesian prescription for eliminating unemployment therefore rests specifically on the money illusion, that unions will impose minimum money wage rates, but are too stupid to Impose Minimum Real Wage Rates, Per Se.

34:15Unions, however, have learned about purchasing power problems and the distinction between money and real rates. Indeed, it hardly requires much reasoning ability to grasp this distinction. Ironically, Cain's advocacy of inflation based on the money illusion rested on the The historical experience that, during an inflation, selling prices rise faster than wage rates. Yet an economy in which unions impose minimum wage rates is precisely an economy in which unions will be alive to any losses in their real, as well as their money, wages. Inflation therefore cannot be used as a means of duping unions into relieving unemployment.

35:05Furthermore, inflation is, at best, an inefficient and distortive substitute for flexible wage rates, for inflation affects the entire economy and its prices, while particular wage rates will fall only to the extent necessary to clear the market for the particular labor factor. Thus freely flexible wage rates will fall only in those fields necessary to eliminate unemployment in those particular areas. Keynesianism has been touted as at least a practical system. Whatever its theoretical defects, it is alleged to be fit for the modern world of unionism.

35:51Yet it is precisely in the modern world that Keynes' doctrine is least appropriate or practical. The Keynesians object that to allow rigid money wage rates to become flexible downward would further lower monetary demand for goods and therefore monetary income. But this completely confuses wage rates with aggregate payroll or total income going to wages. That the former falls does not mean that the latter falls. On the contrary, total income is, as we have seen, determined by total expenditures in the previous period of time. Lower wage rates This will cause the hiring of those made unemployed by the old excessively high wage rates.

36:44The fact that labor is now cheaper relatively to land factors will cause investors to expend a greater proportion on labor vis-à-vis land than before. And the employment of unemployed labor increases production and therefore aggregate real income. Furthermore, even if payrolls also decline, prices and wage rates can adjust, but this will be taken up in the next section on liquidity preference. 2. Liquidity preference Those Keynesians who recognize the grave difficulties of their system fall back on one last string in their bow, liquidity preference.

37:32Intelligence Keynesians will concede that involuntary unemployment is a special or rare case, and Lindahl goes even further to say that it could be only a short-run and not a long-run equilibrium phenomenon. Neither Franco Modigliani nor Eric Lindahl, however, is thorough going enough in his critique of the Keynesian system, particularly of the liquidity preference doctrine. The Keynesian system, as is quite clear from the mathematical portrayals of it given it by its followers, suffers grievously from the mathematical economic sin of mutual determination.

38:18The use of mathematical functions, which are reversible at will, is appropriate in physics, where we do not know the causes of the observed movements. Since we do not know the causes, any mathematical law explaining or describing movements will be reversible, and, as far as we are concerned, any of the variables in the function is just as much cause as another. In praxeology, the science of human action, however, we know the original cause, motivated action by individuals. This knowledge provides us with true axioms. From these axioms, true laws are deduced. They are deduced step by step in a logical cause and effect relationship.

39:10Its first causes are known, their consequent effects are also known. Economics, therefore, traces unilinear cause and effect relations, not vague, mutually determining relations. This methodological reminder is singularly applicable to the Keynesian theory of interest. For the Keynesians consider the rate of interest, a, as determining investment, and b, as being determined by the demand for money to hold for speculative purposes, liquidity preference. In practice, however, they treat the latter not as determining the rate of interest, but as being determined by it.

39:59The methodology of mutual determination has completely obscured this sleight of hand. Keynesians might object that all demand and supply is mutually determined in its relation to price, but this facile assertion is not correct. Demand is determined by utility scales, and supply by speculation and the stock produced Interest by given labor and land factors, which is ultimately governed by time preferences. The Keynesians therefore treat the rate of interest not as they believe they do, as determined by liquidity preference, but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system.

40:50Thus, Keynesian discussion of liquidity preference centers around inducement to hold cash as the rate of interest rises or falls. According to the theory of liquidity preference, a fall in the rate of interest increases the quantity of cash demanded for speculative purposes, liquidity preferences, and a rise in the rate of interest lowers liquidity preference. The first error in this concept is the arbitrary separation of the demand for money into two separate parts, a transactions demand, supposedly determined by the size of social income, and a speculative demand, determined by the rate of interest.

41:38We have seen that all sorts of influences impinge themselves on the demand for money, But they are only influences, working through the value scales of individuals, and there is only one final demand for money, because each individual has only one value scale. There is no way by which we can split the demand up into two parts and speak of them as independent entities. Furthermore, there are far more than two influences on demand. In the final analysis, the demand for money, like all utilities, cannot be reduced to simple determinants. It is the outcome of free, independent decisions on individual value scales.

42:27There is, therefore, no transaction demand uniquely determined by the size of income. The speculative demand is mysterious indeed. Modigliani explains this liquidity preference as follows. We should expect that any fall in the rate of interest would induce a growing number of potential investors to keep their assets in the form of money, rather than securities. That is to say, we should expect a fall in the rate of interest to increase the demand for money as an asset. This is subject to the criticism, as we have seen, that the rate of interest is here determining and is not itself explained by any cause.

43:17Furthermore, what does this statement mean? A fall in the rate of interest, according to the Keynesians, means that less interest is being earned from bonds, and therefore there is a greater inducement to hold cash. This is correct, as long as we allow ourselves to think in terms of the interest rate as determining, instead of being determined, but highly inadequate. For if a lower interest rate induces greater cash holdings, it also induces greater consumption, since consumption also becomes more attractive. In fact, one of the grave defects of the liquidity preference approach is that the Keynesians never think in terms of three margins being decided at once.

44:09They think only in terms of two at a time, hence Modigliani. Having made his consumption-saving plan, the individual has to make decisions concerning the assets he owns. That is, he then allocates them between money and securities. In other words, people first decide between consumption and saving in the sense of not consuming, and then they decide between investing and hoarding these savings. But this is an absurdly artificial construction. People decide on all three of their alternatives, weighing one against each of the others.

44:55To say that people first decide between consuming and not consuming, and then choose between hoarding and investing, is just as misleading as to say that people first choose how much to hoard, and then decide between consumption and investment. People therefore allocate their money among consumption, investment and hoarding. The proportion between consumption and investment reflects individual time preferences. Consumption reflects desires for present goods, and investment reflects desires for future goods. An increase in the demand for money schedule does not affect the rate of interest if the The proportion between consumption and investment, that is, time preference, remains the same.

45:52The rate of interest, we must reiterate, is determined by time preferences, which also determine the proportions of consumption and investment. To think of the rate of interest as inducing more or less saving or hoarding is to misunderstand Admitting, then, that time preference determines the proportions of consumption and investment, and that the demand for money determines the proportion of income hoarded, does the demand for money play a role in determining the interest rate? The Keynesians assert that there is a relation between the rate of interest and a speculative of Demand for Cash.

46:40Should the schedule of the latter rise, the former rises also. But this is not necessarily true. A greater proportion of funds hoarded can be drawn from three alternative sources. A, from funds that formerly went into consumption, B, from funds that went into investment, and C, from a mixture of both that leaves the old consumption investment proportion unchanged. Condition A will bring about a fall in the rate of interest. Condition B, a rise in the rate of interest. And condition C will leave the rate of interest unchanged. Thus hoarding may reflect either a rise, a fall, or no change in the rate of interest, depending on whether time preferences The Keynesians contend that the speculative demand for cash depends upon and determines the rate of interest in this way.

47:50If people expect that the rate of interest will rise in the near future, then their liquidity preference increases to await this rise. This, however, can hardly be a part of a long-run equilibrium theory such as Keynes is trying to establish. Speculation by its very nature disappears in the ERE and hence no fundamental causal theory can be based upon it. Furthermore, what is an interest rate? One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production.

48:37The former, as we have seen, is only the reflection of the latter. A strong expectation of a rapid rise in interest rate means a strong expectation of an increase in the price spreads or rate of net return. A fall in prices means that entrepreneurs generally expect that factor prices will fall further in the near future than their selling prices. But it requires no Keynesian labyrinth to explain this phenomenon. phenomenon. All we are confronted with is a situation in which entrepreneurs, expecting that factor prices will soon fall, cease investing and wait for this happy event, so that their return will be greater.

49:25This is not liquidity preference, but speculation on price changes. It involves a modification of our previous discussion of the relation between prices and the demand for money, caused by a fact that we shall explore soon in detail, namely that prices do not change equally and proportionately. The expectation of falling factor prices speeds up the movement toward equilibrium, and hence toward the pure interest relation as determined by time preference. W. H. Hutt concludes that equilibrium is secured when all services and products are so priced that they are, one, brought within the reach of people's pockets, that is, so that they are purchasable by existing money incomes, or, two, brought into such a relation to predicted prices that no postponement of expenditure on them is induced.

50:31For instance, the products and services used in the manufacture of investment goods must be so priced that anticipated future money incomes will be able to buy the services and depreciation of new equipment or replacement. If for example, unions keep wage rates artificially high, hoarding will increase, as unions keep Postponements in purchases arise because it is judged that a cut in costs or other prices is less than will eventually have to take place, or because the rate of fall of costs is insufficiently rapid.

51:36The final Keynesian bogey is that people may acquire an unlimited demand for money, so that hoards will indefinitely increase. This is termed an infinite liquidity preference, and this is the only case in which neo-Keynesians Experts such as Modigliani believe that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds, for fear of a fall in the price of securities. Translating this into more important natural terms, this would mean, as we have stated, investing because of expectation of imminent increases in the natural interest rate.

52:26Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite, since people must always continue consuming whatever their expectations. Of necessity, therefore, the demand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding. As Hutt points out, if we can conceive of a situation of infinitely elastic liquidity preference, and no such situation has ever existed, then we can conceive of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way. A demand for money to hold stems from the general uncertainty of the Market. Keynesians, however, attribute liquidity preference not to general uncertainty but to the specific uncertainty of future bond prices. Surely this is a highly superficial and limiting view. In the first place, this cause of liquidity preference could occur

54:00only on a highly imperfect securities market. As Ludwig Lachmann pointed out years ago in In a neglected article, Kane's causal pattern, bearishness causing liquidity preference, demand for cash, and high interest rates, could take place only in the absence of an organized forward or futures market for securities. If such a market existed, both bears and bulls on the bond market could express their expectations by Forward Transactions which do not require any cash. Where the market for securities is fully organized over time, the owner of 4% bonds who fears a rise in the rate of interest has no incentive to exchange them for cash, for he can always hedge by selling them forward.

54:57Bearishness would cause a fall in forward bond prices, followed immediately by a fall in spot prices. Thus, speculative bearishness would, of course, cause at least a temporary rise in the rate of interest, but accompanied by no increase in the demand for cash. Hence, any attempted connection between liquidity preference, or demand for cash, and the rate of interest, falls to the ground. The fact that such a securities market has not been organized indicates that traders are not nearly as worried about rising interest rates as Keynes believes. If they were, and this fear loomed as an important phenomenon, then surely a futures market would have developed in securities. Furthermore, as we have seen, interest rates on loans are merely a reflection of Price Spreads, so that a prediction of higher interest rates really means the expectation of lower prices, and especially lower costs, resulting in a greater demand for money.

56:12And all speculation on the free market is self-correcting and speeds adjustment, rather than a cause of economic trouble. G. The purchasing power and terms of trade components in the rate of interest. Many economists beginning with Irving Fisher have asserted that the market rate of interest, in addition to containing specific entrepreneurial components superimposed on the pure rate of interest, also contains a price or a purchasing power component. When the purchasing power of money is generally expected to rise, the theory asserts that the market rate of interest falls correspondingly.

56:59When the PPM is expected to fall, the theory declares that the market rate of interest rises correspondingly. These economists erred by concentrating on the loan rate, rather than on the natural rate, the rate of return. The reasoning behind this theory was as follows. If the purchasing power of money is expected to change, then the pure rate of interest determined by time preference will no longer be the same in real terms. Suppose that 100 gold ounces exchange for 105 gold ounces a year from now, that is, that the rate of interest is 5%.

57:44Now, suddenly, let there be a general expectation that the purchasing power of money will increase. In that case, a lower amount to be returned, say 102 ounces, may yield 5% real interest in terms of purchasing power. A general expectation of a rise in purchasing power, therefore, will lower the market rate of Interest at present, while a general expectation of a fall in purchasing power will raise the rate. There is a fatal defect in this generally accepted line of reasoning. Suppose for example that prices are generally expected to fall by 50% in the next year.

58:33Would someone lend 100 gold ounces to exchange for 53 ounces one year from now? Why not? This would certainly preserve the real interest rate at 5%. But then why should the would-be lenders not simply hold on to their money and double their real assets as a result of the price fall? And that is precisely what they would do. They certainly would not give money away, even though their real assets would be greater than before. Fisher simply shrugged off this point by saying that the purchasing power premium could never make the interest rate negative, but this flaw vitiates the entire theory.

59:20The root of the difficulty consists in ignoring the natural rate of interest. Let us consider the interest rate in those terms. Then suppose 100 ounces are paid for factors that will be transformed in one year into to a product that sells for 105 gold ounces, for an interest gain of 5 and an interest return of 5%. Now a general expectation arises of a general having of prices one year from now. The selling price of the product will be 53 ounces in a year's time. What happens now? Will entrepreneurs buy factors for $100 and sell at $53 merely because their real interest rate is preserved?

1:00:11Certainly not. They will do so only if they do not at all anticipate the change in purchasing power. But to the extent that it is anticipated, they will hold money rather than buy factors. This will immediately lower factor prices to their expected future levels, say from 100 to 50. What happens to the loan rate is analytically quite trivial. It is simply a reflection of the natural rate, and depends on how the expectations and judgment of the people on the loan market compare with those on the stock and other markets. For the free economy, there is no point in separately analyzing the loan market.

1:00:59Analysis of the Fisher problem, the relation of the interest rate to price changes, should concentrate on the natural rate of interest. Discussion of the relation between price movements and the natural rate of interest should be divided into two parts. First, assuming neutral money, that all prices change equally and at the same time. And second, analyzing conditions where factor and product change at different rates. And these changes should first be analyzed without considering that they had been anticipated by people on the market. Suppose first that all prices change equally and at the same time.

1:01:47Instead of thinking in terms of 100 ounces borrowed on the loan market, let us consider the natural rate. An investor buys factors in period 1 and then sells the product, say, in period 3. Time, as we have seen, is the essence of the production structure. All the processes take time, and capitalists pay money to owners of factors in advance of production and sale. Since factors are bought before products are sold, what is the effect of a period of rising general prices, that is, falling PPM? The result is that the entrepreneur reaps an apparent extra profit.

1:02:34Suppose that he normally purchases original factors for 100, and then sells the product for 120 ounces two years later, for an interest return of 10% per annum. Now suppose that a decrease in the demand for money, or an increase of money stock, propels a general upward movement in prices, and that all prices double in two years' time. Then, just because of the passage of time, an entrepreneur who purchases factors for 100 now will sell for 240 ounces in two years' time. Instead of a net return of 20 ounces, or 10% per annum, he reaps 140 ounces, or 70% per annum.

1:03:26It would seem that a rise in prices creates an inherent tendency for large-scale profits that are not simply individual rewards for more accurate forecasting. However, more careful analysis reveals that this is not an extra profit at all, for the 240 ounces two years from now is roughly equivalent in terms of purchasing power to 120 ounces now. The real rate of net return, based on money services, is the same 10% as it has always been. It is clear that any lower net return would amount to a decline in real return. A return of a mere 120 ounces, for example, would amount to a drastic negative real return, For 100 ounces would then be invested for the equivalent gross return of only 60 ounces.

1:04:26It has often been shown that a period of rising prices misleads businessmen into thinking that their increased money profits are also real gains, whereas they only maintain real rates of return. Consider for example replacement costs, the prices which the businessmen will now have The Capitalist who earns 240 ounces on a 100 ounce investment neglects to his sorrow the fact that his factor bundle now costs 200 ounces instead of 100. Businessmen who, under such circumstances, treat their monetary profits as real profits and consume them, soon find that they are really consuming their capital.

1:05:15Capital The converse occurs in the case of falling prices. The capitalist buys factors in period one and sells the product in period three, when all-around prices are lower. If prices are to fall by a half in two years, an investment of one hundred, followed by a sale at sixty, does not really involve the terrific loss that it appears to be. For the 60, return is equivalent in real terms, both in generalized purchasing power and in replacement of factors, to 120 previous ounces. His real rate of return remains the same. The consequence is that businessmen will be likely to overstate their losses in a period of price contraction.

1:06:09Perhaps this is one of the major reasons for the deep-seated belief of most businessmen that they always gain during a general price expansion and lose during a period of general contraction. This belief is purely illusory. In these examples, the natural interest rate on the market has contained a purchasing power Component, which corrects for real rates, positively in money terms during a general expansion and negatively during a general contraction. The loan rate will be simply a reflection of what has been happening in the natural rate. So far, the discussion is similar to Fisher's, except that these are the effects of actual, not anticipated changes, and the Fisher thesis cannot take account of the negative interest rate case.

1:07:06We have seen that rather than take a monetary loss, even though their real return will be the same, entrepreneurs will hold back their purchases of factors until factor prices fall immediately to their future low level. But this process of anticipatory price movement does not occur only in the extreme case of a prospective negative return. It happens whenever a price change is anticipated. Thus, suppose all entrepreneurs generally anticipate that prices will double in two years. The fact of an anticipated rise will lead to an increase in the price level now and An anticipated fall will lead to an immediate fall in factor prices. If all changes were anticipated by everyone, there would be no room for a purchasing power component to develop. Prices would simply fall immediately to their future level.

1:08:16The purchasing power component, then, is not the reflection, as has been thought, of expectations of changes in purchasing power. It is the reflection of the change itself. Indeed, if the change were completely anticipated, the purchasing power would change immediately, and there would be no room for a purchasing power component in the rate of interest. As it is, partial anticipations speed up the adjustment of the PPM to the changed conditions. So far we have distinguished three components of the natural rate of interest, all reflected in the loan rate of interest.

1:09:01One is the pure rate of interest, the result of individual time preferences tending to be uniform throughout the economy. are the specific entrepreneurial rates of interest. These differ from firm to firm and so are not uniform. They are anticipated in advance and they are the rates that an investor will have to anticipate receiving before he enters the field. A particularly risky venture, if successful at all, will therefore tend to earn more in The third component of the natural rate of interest is the purchasing power component, correcting for general PPM changes because of the inevitable time lags in production.

1:09:56This will be positive in an expansion and negative in a contraction, but will be ephemeral. The more the changes in the PPM are anticipated, the less important will be the purchasing power component, and the more rapid will be the adjustment in the PPM itself. There is still a fourth component in the natural rate of interest. This exists to the extent that money changes are not neutral, and they never are. Sometimes product prices rise and fall faster than factor prices. Sometimes they rise and fall more slowly. And sometimes their behavior is mixed, with some factor prices and some product prices rising more rapidly.

1:10:45Whenever there is a general divergence in rates of movement between the prices of the and of Original Factors, a Terms of Trade component emerges in the natural rate of interest. Historically, it has often been the case that product prices rise more rapidly and fall more rapidly than the prices of original factors. In the former case, there is, during the period of transition, a favorable change in the terms of trade to the general run of capitalists. For-selling prices are increasing faster than the buying prices of original factors. This will increase the general rate of return and constitute a general positive terms of trade component in the natural rate of interest.

1:11:40This of course will also tend to be reflected in the loan rate of interest. In the case of a contraction, a more sluggish fall in the prices of factors creates a general negative terms of trade component in the interest rate. The components are precisely the reverse whenever factor prices change more rapidly than product prices. However there is no general change in the terms of trade to capitalist entrepreneurs, no terms of trade component will appear in the interest rate. Changes in terms of trade discussed here are only those resulting purely from differences in the speed of reaction to changing conditions.

1:12:29They do not include basic changes in the terms of trade resulting from changes in time preferences, such as we have discussed previously. It is clear that all the interest rate components aside from the pure rate, entrepreneurial, purchasing power and terms of trade, are dynamic and the result of uncertainty. None of these components would exist in the ERE, and therefore the market interest rate in the ERE would equal the pure rate determined by time preferences alone. In the ERE, the only net incomes would be a uniform pure interest return, and wages to Labor, Ground Land Rents being capitalized into an interest return.