THE RE-INTERPRETATION OF THE RATE OF INTEREST

Both the Keynesian model and the aggregative strand of the neo-classical system manipulated the same variables: income, saving, investment, money, and the rate of interest. These pieces of analytical furniture, however, occupied quite different places on the stage.

It is already apparent that Keynes gave a different twist to one of the variables - money. His view of money, in turn, opened up a new perspective on the rate of interest. He described the problem in the following manner: 'The habit of overlooking the relation of the rate of interest to hoarding may be part of the explanation why interest has been usually

regarded as the reward of not-spending, whereas in fact it is the reward of not- hoarding'.7

But how was the level of the rate of interest determined? As Keynes saw the matter, the rate of interest was governed - not by the supply of and demand for loanable funds (as neo-classical writers had maintained) - but by the supply of and demand for money. The supply of money (consisting of currency and coin issued by governments and bank money held in the form of checking accounts) could, of course, be regulated by the government and the central bank. The demand for money, on the other hand, was established by the preferences of the community. At any moment, of course, all of the money in existence would be held by someone. But it did not necessarily follow that those who held money would wish to continue to do so. At the earliest opportunity they might prefer to exchange money for goods or for income-yielding assets. The explanation of the determination of an equilibrium between the supply and demand for money called for an answer to the question: what factors would induce the public to hold the available stock of money?

In working out a solution to this puzzle, Keynes built further on the foundation laid by his revisionist interpretation of the motives for holding money.

An example may be helpful in conveying the Keynesian argument on the mechanics of this process. Let us suppose that the monetary authorities increase the supply of money (say by buying government securities held by the banks or by the public and thus increasing the money balances of those who formerly held these securities). How would a new equilibrium position be reached? In the absence of a change in national income there would be no reason to expect a change in the amount of money the public would be prepared to hold for transactions and precautionary purposes. Presumably, many of those who received increased money balances in exchange for government securities would prefer to hold income-yielding assets. As they acquired them, however, the market price of these assets would be bid up; simultaneously, the effective rate of interest would be depressed. Lower rates of interest would reduce the reward for parting with liquidity. This adjustment, in turn, would increase the willingness of the community to hold an enlarged quantity of money.

This interpretation of the determination of interest rates completely scuttled the orthodox neo-classical view that interest rates were established by the interaction of the demand for and supply of loanable funds. The Keynesian argument held that the rate of interest was primarily a monetary phenomenon - and one, moreover, detached from the real factors of thrift and the productivity of capital to which the neo-classical mind had linked it. This position further implied that the rate of interest could no longer be invoked as the delicate mechanism for equilibrating intended saving and intended investment. These relationships played no part in the determination of the rate of interest itself. Saving and investment might respond to changes in the rate of interest but they were not its primary determinants.

In addition this analysis implied that the ability of the monetary authorities to influence interest rates might, in periods of depression, be severely restricted. The Central Bank could continue to expand the money supply. But if the increment simply swelled idle balances, no reduction in interest rates would ensue. The economic system would find itself locked into what Keynes described as a 'liquidity trap'. This situation might arise for institutional reasons quite independent of the intentions of the parties directly involved. Banks, for example, do not exist to hold idle balances; on the contrary, they seek to augment their earnings by lending at interest. In the circumstances of a deep depression, however, their ability to lend is curtailed because the pool of eligible borrowers largely dries up. Involuntarily banks may thus find themselves holding idle balances in substantial volume as excess reserves. While it is still possible for bankers to acquire earning assets (such as government securities) with idle reserves, this course may not be desirable if the market prices of fixed-interest assets are already high and interest rates low. Financial institutions, no less than the public at large, may choose to protect themselves against capital losses by hoarding for speculative reasons.

5.