A Treatise on Money (1930): Interest and Prices
As soon as TMR was published, Keynes was dissatisfied with the theory there presented. Work on what would become A Treatise on Money (hereafter TM, Keynes 1930 [1971]) began the following year.
The result was a scholarly work in two volumes following the traditional separation of the “pure theory” of money from “applied theory”. His original intention was to present his accumulated knowledge of the working of money and finance in the economy as a whole. The analysis was more far-reaching than that.Keynes still took the quantity theory as his starting point, but he states his intention to address the cardinal flaw acknowledged in TMR: “My object has been to find a method which is useful in describing, not merely the characteristics of static equilibrium, but also those of disequilibrium” (TM, Keynes 1930 [1971], I: xvii). The tempestuous seasons as well as the flat ocean should be the subject of analysis.
He was traditional also in taking Marshallian long-period normal profit and the consequent price level as his definition of equilibrium. Deviations from the equilibrium position were characterized as “windfall” profits or losses. The associated fluctuations in prices were analysed by an expanded version of the quantity theory which he called the “Fundamental Equations”. The link between money and prices was no longer simple and direct but involved three main elements: the level of money income relative to “efficiency” (that is, productivity), which determined factor costs, the expectations of holders of financial assets and, most importantly, disparities between voluntary savings and real investment, the latter measured in terms of cost of production.
The treatment of the saving-investment nexus marked a radical departure from the conventional wisdom, in which the two were brought into equilibrium by the rate of interest and analytically considered as Siamese twins.
In TM, saving and investment are undertaken by different people with different motives, and there is no specific “financial market” or single variable (such as a rate of interest) that coordinates these two separate activities. (This separation is also central to The General Theory.) At its simplest, an excess of investment over saving produces windfall profits and higher prices; an excess of saving produces losses and deflation. However, money is used not only in the “industrial circulation” but also in the “financial circulation”, where an increase in bearishness (pessimistic expectations) can result in money being withheld from the industrial circulation, causing a rise in the rate of interest and deflationary pressures on real investment. Bullishness (optimism) could have the opposite effect. This is a precursor of the “liquidity preference theory” fully unfolded in The General Theory. The rate of interest is mainly determined by expectations of participants in the financial circulation, and monetary fluctuations now affect the real economy: they were no longer neutral. Only when the money value of voluntary saving and investment are equal will normal profits and equilibrium prices prevail. The quantity theory holds in this equilibrium; but there are no automatic market mechanisms to bring it about.Besides this admixture of traditional and innovative theory, TM contains a wealth of institutional and historical detail and a thorough exploration of the theory of monetary policy. Keynes’s analysis showed that interest rate policy was not helpful in combating cost inflation but could be used to counteract or, preferably, ward off inflation or deflation caused by a misalignment of saving and investment. Monetary policy could stabilize the economy as a whole by bringing the market rate into line with the (Wicksellian) natural rate of interest.
A Treatise on Money was developed alongside Keynes’s work on the Macmillan Committee on Finance and Industry (1929-31), and his contribution there was based on its framework.
However, the Committee found it less than convincing, because it could not explain persistent unemployment, a crucial problem visible to all in interwar Britain and now intensified since the Wall Street crash of 1929. In TM, persistent unemployment could be seen as an imbalance between saving and investment in the context of an inappropriate exchange rate. The over-saving could not be eliminated by reducing the rate of interest, due to the fixed exchange rate and the predominance of bear speculators. Ingenious though TM was, the equilibrium level of output had been taken as given at full employment; all variation was perceived as a deviation from this level.Once again, as soon as TM was published, Keynes began to think his way to the next book: The General Theory. He brooded over it for six years, and it was his crowning theoretical achievement. Two of TMs conclusions will be overturned there, that a slump is due to lack of entrepreneurial optimism and that an increase in employment requires a fall in wages. And Keynes will at long last have put the quantity theory behind him.