Notes
Keynes abstracted from both government expenditures and taxes as well as net exports that deal with this issue in chapters13-15.
This discussion assumes that corporate profits are zero or that all saving is done in the household sector.
See the diagram on page 180 of The General Theory.
Note that this exercise is an example of how classical financial markets are also efficient mechanisms that alter production priorities to reflect changes in time preference, risk preference, and technology. When the real sector signaled that investment was no longer as productive as before, financial markets efficiently raised the C/Y ratio and lowered the I/Y ratio. So financial markets not only kept the economy at its full-capacity equilibrium in the face of an exogenous shock, they also accomplished the appropriate transfer of resources between investment and consumption. Financial markets are our friends.
Keep in mind that the price of a bond and the interest rate on the bond are inversely related.
In The General Theory, Keynes separated the analysis of bond and stock markets. The stock market is treated in chapter 12 and the bond market in chapters 13-15. This was a change from the strategy he used in the Treatise on Money published in 1930, where he discussed the behavior of stocks and bonds together, referring to them collectively as security prices. "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, which I hope I have here avoided" (CW, pp. 173-174). This strategy creates a serious problem. It pictures investors as faced in chapters 13-15 with a choice of holding either "money" or long-term bonds. In fact, their choices are more complex and include the choice between stocks and bonds, which are potential substitutes in investors' portfolios.
We point out below that in the late 1920s stocks became more attractive than bonds because of the incredible stock market bubble in this period.Keynes defined "money" broadly to include not only zero-interest "cash," but also such short-term interest-bearing assets as savings accounts and Treasury bills that are relatively resistant to nominal capital loss. This raises the question as to whether he offered a theory of the long-term interest rate or of the long- short interest rate "spread." This issue is discussed in the Appendix.
Ideally, the model should take into account that the amount of financial wealth in the economy is changed by the flow of savings at every moment of model time. If the stationary probability distributions that correctly described future states were knowable, all risk could be hedged.
This point was emphasized by Hicks, as we note in Chapter 19.
Y is included in the function as a proxy for the transactions and precautionary motives to hold money.
As explained above, his theory of liquidity preference requires the assumption that agents are uncertain about the value of ret. If, for example, all investors knew with certainty that ret was lower than rt or that the future bond price was higher than the current bond price, no one would be willing to hold money and rt would be forced to rise until it equaled ret, at which point L2 would equal zero in equilibrium.
13 The same thing is also true about the LM curve. Endogenously generated changes in expectations and/or confidence in expectations keep the LM curve in perpetual motion.
14 While each individual investor might find comfort in the belief that he or she can quickly exit the stock or bond market when prices begin to fall, this cannot be true for all investors. When fear hits a market and everyone begins to sell, most investors will suffer large capital losses.
15 Brokers' loans more than doubled from the third quarter of 1927 through the third quarter of 1929. They then fell by more than 90 percent from the third quarter of 1929 to the fourth quarter of 1931 (Banking and Monetary Statistics: 1914-1941, Board of Governors of the Federal Reserve System, p. 494. Accessed at: http://fraser.stlouisfed.org/).
16 The relevance of the long-short "spread" is explained in the Appendix.
17 Data from "Interest Rates in the 1920s," Federal Reserve Bank of Cleveland, Economic Trends, No. 98-02, p. 7, 02.01, 1998.
18 Moody's (2018) and United States Bureau of Labor Statistics (2018).
19 Keynes argued that significant changes in monetary policy in response to problems in the real sector can actually aggravate the situation because they will increase uncertainty with respect to future central bank intervention: they "may also give rise to changed expectations concerning the future policy of the central bank" (CW 7, p. 198).
20 Non-specialist readers can skip this Appendix.
21 One resolution of the problem is to assume that the central bank can set or "anchor" the shortest-term interest rate, but in a model with Keynesian uncertainty, this creates an additional problem. In periods of instability, the central bank would be forced to keep changing its money supply target in an attempt to maintain a constant short-term interest rate, and this itself would add to the uncertainty confronting investors.
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