From Hawtrey to Keynes
Between 1917 and 1930, the Cambridge School contributed to the evolution of the quantity theory. Alfred Marshall, Arthur Cecil Pigou and John Maynard Keynes, in A Tract on Monetary Reform (1923 [1971]), developed the analysis of incentives for the demand for cash balances.
The general price level was then determined, corresponding to a given level of transactions, by the supply and demand for money. These authors wanted to integrate money into the theory of choice. But their analysis of the demand for money had to free itself of Karl Helfferich’s criticism (Das Geld, 1903) that we are arguing in a circle if we admit that money has an indirect utility that depends on its exchange value, because the former will vary with the latter. This means that the latter cannot be determined by the utility of money. Consequently, it is necessary to introduce the demand for money in real terms.The demand for real money is first explained by a transaction motive that depends on long-term evolutions, such as the size of the real payments to be made and the degree of synchronisation between receipts and payments. There is also a precautionary motive, because of uncertainty concerning this possibility of synchronisation. Moreover, Marshall in Money, Credit and Commerce (1923) and Pigou in “The value of money” (1917) began to build tools for studying portfolio choices, which would later be refined. They considered the demand for money to be a function of the interest rate on financial assets, a function of the return gained from the ownership of physical capital and the utility resulting from the consumption of goods.
Hawtrey’s cycle theory, developed in Currency and Credit (1919), is founded on the importance this author attributed to traders. Their activity is very elastic with respect to the short-term interest rate, because it is the cost at which they borrow to finance their stocks.
At the macroeconomic level, traders will adjust their stocks in proportion to their expectations regarding demand for goods. However, if the bank interest rate is raised, traders will reduce their stocks and their demand to entrepreneurs. They contribute to a decrease in credit, income and demand, which will determine the cumulative decrease in output and prices. These reductions will cease, and a new expansion will begin once banks have replenished the reserves in their coffers and are again able to reduce their rate of interest.Furthermore, Hawtrey also introduced the market for money in line with the Cambridge tradition, influencing Keynes’s theory. The difference between consumers’ income and spending is their “unspent margin”. It is a demand for money for transactions (goods and assets, as in Marshall and Pigou). Traders and entrepreneurs also have a demand for money for transactions. The total cash balance of the two kinds of agents is compared to the total supply of cash balances.
According to Keynes in the Treatise on Money (1930), the role of the banking system is important. The demand for money is a demand for bank money. Keynes makes a distinction between “income deposits” (for the transaction motive) and “saving deposits”, which are a kind of liquid asset. The interest rate is determined firstly but indirectly by the “bullishness” or “bearishness” of agents as regards the price of securities, and secondly by the behaviour of the banking system, depending on its money supply. As a result of their expectations regarding the price of securities, agents will choose to hold securities or to hold money. The decision of firms to buy new investment goods depends on their expected return compared with the interest rate, the latter not being determined by saving, but by decisions on portfolio composition of assets and by the “banking system policy”.
That is why the Treatise on Money integrates the investment and liquidity preference theories to be found (but reformulated) in The General Theory of Employment, Interest and Money (1936).
In the latter, Keynes wanted to separate the determination of the rate of return on investment from the price of debts or the interest rate. The prospective yields and the supply price of investment determine the marginal efficiency of capital goods. Liquidity preference only determines the rate of interest, and investment is the result of a comparison between these two variables.Whilst liquidity-preference due to the speculative-motive corresponds to what in my Treatise on Money, I called “the state of bearishness”, it is by no means the same thing. For “bearishness” is there defined as the functional relationship, not between the rate of interest (or price of debts) and the quantity of money, but between the price of assets and debts, taken together, and the quantity of money. This treatment, however, involved a confusion between results due to a change in the rate of interest and those due to a change in the schedule of the marginal efficiency of capital. (Keynes 1936 [1973]: 173)
In Keynes (1930), the central bank creates liquidity by lending to banks on the money market and through open market operations. It can influence the ability of banks to create liquidity. Banks supply liquid “saving deposits” and buy securities on the financial market. Therefore, banks take financial risks based on their own liquidity preference and their own “bullishness” or “bearishness”. Three markets are taken into account: the money market, the market for money (income and saving deposits), and the financial market. In Keynes (1936 [1973]), the banking system is seen as a whole and the central bank intervenes with respect to the overall money supply. The market for money is the place where there is a confrontation between this money supply and the overall demand for money, first for the transaction and precautionary motives (related to income and which are not different from those of the Cambridge School) and secondly for the speculative motive (related to the interest rate), which stems from a choice between bonds and money with respect to the composition of all agents’ financial portfolios. In The General Theory, liquidity preference is presented as a demand for money that determines the long-term interest rate, the most important variable for the investment function.
The importance of the role of banks and of the money market is reduced in this analysis. However, Keynes was primarily concerned with the impact of monetary policy on the financial market interest rate owing to the behaviour of banks, which may refuse to follow the central bank’s lending policy and refuse to take risks by buying securities. In this case, fiscal policy must be introduced. This was to be described after Keynes in IS- LM models, through IS shifts.