Appendix20
There has been some confusion in the literature on Keynes's theory of interest rate determination in The General Theory created by his definition of the term "money."
[W]e can draw the line between "money" and "debts" [or "bonds"] at whatever point is most convenient for handling a particular problem.
For example, we can treat as money any command over purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for "three months" one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such bills as (e.g.) treasury bills.(CW 7, p. 167, emphasis in original)
These short-term interest-bearing assets should dominate zero-interest cash as a safe haven when bond prices are expected to decline.
Moreover:
In general discussion, as distinct from specific problems where the period of the debt is expressly specified, it is convenient to mean by the rate of interest the complex of the various rates of interest current for different periods of time, i.e. for debts of different maturities.
(CW 7, p. 167)
In this case, the theory of liquidity preference would be about the determination of the term structure of interest rates rather than the long-term bond rate alone, or, in a simpler two-maturity debt model, about the spread between the interest rate on risky long-term bonds and the normally much lower rate of interest on very-short-term debts that are almost invulnerable to nominal capital loss. If investors began to expect that bond prices are likely to decline, they would sell some bonds and hold the cash they received in the sale in the form of savings accounts or short-term Treasury bills.
These transactions would raise the long rate and lower the short rate, increasing the spread.This is a bit awkward for the interpreter of Keynes's theory of liquidity preference: is it a theory of the long-term interest rate or a theory of the term structure of interest rates - the "spread" between a long-term and short-term interest rate? Indeed, if only the spread is determined in the model, the level of the long-term interest rate is missing an "anchor" and its equilibrium value is undetermined.21
Fortunately, this "anchor" issue is not of primary importance for the main purpose of this chapter. We are concerned here primarily with the dynamic response of the long-term interest rate to a substantial decline in AD, especially, as in the early 1930s, in a situation of financial fragility and with the endogenously induced dynamics associated with financial market cycles and not with some hypothetical static-equilibrium value of the long-term interest rate in the depth of the Great Depression. We have shown that in the financial meltdown of the early 1930s investors sought capital protection by dramatically shifting from long-term bonds to the short-term interest-bearing assets included in Keynes's broad definition of "money," a process that caused the long-short spread to skyrocket as long rates rose dramatically while short rates fell.