"alternative approaches to money and interest rates": a comment

"Alternative Approaches to Money and Interest Rates": A CommentAuthor(s): Jane KnodellSource: Journal of Economic Issues, Vol. 29, No. 1 (Mar., 1995), pp. 266-273Published by: Association for Evolutionary EconomicsStable URL: http://www.jstor.org/stable/4226929 .

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266 Notes and Communications

_ Collected Writings, Vol. 6: The General Theory and After, Part 2. London: Macmillan, 1971.

. Collected Writings, Vol 14: The General Theory and After, Part 2. London: Macmillan, 1973.

Minsky, Hyman P. "Central Banking and Money Market Changes." Quarterly Journal of Economics 11, no. 2 (May 1957): 171.

Modigliani, Franco. "Liquidity Preference and the Theory of Interest and Money." Econometrica 12 (1944): 45-88.

Moore, Basil J. Horizontalists and Verticalists: The Macroeconomics of Credit Money. New York: Cambridge University Press, 1988.

Wray, L. Randall. "Alternative Approaches to Money and Interest Rates." Journal of Economic Issues 26, no. 4 (December 1992).

"Alternative Approaches to Money and Interest Rates": A Comment

In an article in this journal, L. Randall Wray criticizes Basil Moore's work on credit money for ignoring liquidity preference and offers an alternative that combines the endogenous-money "flow" approach with the liquidity-preference "stock" approach [Wray 1992a]. In my view, Wray's model moves Post Keynesian monetary analysis in the right direction. However, I will argue in this comment that in some respects Wray's model loses sight of some of the first principles of Keynes's theory of liquidity preference and that, as a consequence, it shares some of the shortcomings of the "pure" endogenous-money approach.

These shortcomings refer specifically to three claims made in endogenous-money theories: that there is always a money supply response to changes in money demand; that it is impossible to think of money supply and money demand as independent schedules; and that flow adjustments are far more important than stock adjustments in financing capitalist expansion in the short run.

Does Money Supply Accommodate Money Demand?

Keynes's theory of liquidity preference in The General Theory advances certain basic principles about the nature of the relationship between the money supply and money demand [Keynes 1964]. There, the money supply is perfectly interest-inelastic, and the liquidity preference (money demand) schedule is inversely related to the interest rate and the income



Notes and Communications 267

velocity of money and directly related to the expected future level of long- term interest rates and the level of aggregate income.1 In Wray's terms, this is a pure "stock" theory of money demand. This simple model makes two points about the relationship between money supply and money demand:

1. Shifts in the money demand schedule give rise not to a change in the quantity of money supplied, but to a change in the interest rate.

2. There is a money demand function that is independent of the money supply. The converse also holds.

The first point follows from the intrinsic nature of the medium of exchange. Leland Yeager explained it this way:

Because money is traded on all markets and on none specifically its own, and because it has no single price of its own to come under specific pressure, an imbalance between its supply and demand has far-reaching consequences . . . [to] get money, the individual need only curtail his spending or lending relative to his inflow of income and other receipts ... [Yeager 1969, 56; emphasis added].2

Hence, in Keynes's model, an increase in liquidity preference, that is, a desire among wealthholders to have more liquid portfolios, is not met through an increase in the quantity of money supplied, but with lower asset prices (higher interest rates), as wealthholders satisfy their need for more liquidity by selling financial assets or curtailing their lending.3

Some Post Keynesians have criticized The General Theory's model as an exogenous-money-supply model [Foster 1986].4 Basil Moore and other proponents of the "endogenous-money" approach have proposed in its place a perfectly interest-elastic money supply that fully accommodates any and all shifts out in money demand without any increase in interest rates. Money demand is broadened to include the finance motive, or the demand for money to finance an increase in the level of spending (also referred to as the "flow demand for money"). Such a demand for money is satisfied when a loan request is granted.

In Moore's model, if money demand still includes the speculative, transactions, and precautionary motives, an increase in any of these com- ponents of demand would have to be met by borrowing money.5 But one may ask whether it makes sense to acquire more precautionary or transactions balances by borrowing them; an individual agent better achieves her ultimate goal (becoming more liquid) by reducing her flow of spending or lending. If Moore's money demand schedule does not include any com-




ponent other than the finance demand, then his theory is behaviorally consistent, but it is also open to Goodhart's charge that it has mislaid some of the demand for money, namely, the demand for the outstanding stock of money (as opposed to the demand for increments to the stock of money) [Goodhart 1991].6

Wray's model, which he describes as "endogenous money plus liquidity preference," does not mislay the stock demand for money, but it is also somewhat confused about whether the supply of money accommodates the demand for it in all instances. According to Wray:

... when liquidity preference is high and expectations are low, the flow demand for money will fall as planned spending declines. At the same time, the stock demand for money rises. However, banks are unlikely to meet the stock demand for money since it is unlikely that their expectations and preference for liquid positions would move in a direction opposite to those of the general public [Wray 1992a, 1163].

The implication is that if banks' expectations were moving in a direction opposite to those of the general public, banks would meet the increased stock demand for money with increased supply. This runs counter to be- havioral rationality (why borrow if the purpose is to become more liquid) and to first principles as elucidated in Keynes's pure stock model.

The point is that when it comes to the relationship between money supply and money demand, not all motives for holding money are created equally. Changes in the stock demand for money, arising out of a desire for more liquid balance sheets, are not met with endogenous changes in the nominal quantity of money supplied, as Keynes argued.7 But changes in the so-called flow demand for money may be met, in whole or in part, with endogenous changes in the quantity of money supplied.

Are the Supply and Demand for Money Independent of Each Other?

In a debate with C. A. E. Goodhart, Moore argued that the inde- pendence of money supply and money demand breaks down with an endogenous (or "credit") money supply. According to Moore, there is no supply of money independent of the demand for money, hence, no possibility of an excess supply of, or excess demand for, money:

Credit money is supplied in response to loan contracts administered by the sellers (banks). . . for all goods produced to contract, the supply depends on contractual orders . . . For such goods, it is impossible to envisage a quantity supplied independent of the demand for




the good . . . the quantity supplied is necessarily always demand- determined [Moore 1991b, 125-126; emphasis added].

In the first part of this quote, Moore points to a feature of the flow supply of financial assets that makes them different than produced commodities: while produced commodities can be placed in inventory if they are not sold, a financial asset cannot be created in the absence of an effective demand for that asset. However, this intrinsic feature of the flow supply of financial assets does not imply that the flow supply of financial assets fully accommodates the demand for financial assets. As Wray's model (correctly, in my view) demonstrates, liquidity preference and lenders' risk can and does render the supply of credit independent of the demand for credit.

Stock and Flow Adjustments in Financing Aggregate Expansion

There are two interconnected hypotheses associated with the "pure" endogenous-money approach that bear on the role of financial flows (credit creation) and stocks (rising velocity) in economic expansion: (1) the supply of credit money is perfectly interest-elastic at going interest rates; and (2) all growth in spending manifests itself as growth in the demand for credit money. Each of these hypotheses is flawed because it ignores the stock demand for money. Wray's model, which marries endogenous money with liquidity preference, seems to retain the second of these hypotheses.

Wray rejects the pure endogenous-money view that the supply of bank credit is perfectly elastic at going interest rates. He applies the idea of liquidity preference to the supply of bank credit and postulates that banks will engage in "joint price and quantity rationing" to manage uncertainty and risk [Wray 1992a, 1162]. Hence, for Wray, as noted above, the supply of credit plays a role clearly independent from demand in determining the volume of credit.8

Furthermore, Wray, citing Keynes, recognizes the role that the stock demand for money plays in setting the price of bank credit, short- and long-term:

... the prices of new issues of both long-term and short-term debt are influenced by the prices of existing debt. This means that the price of new credit instruments must continually compete with the prices of existing assets [Wray 1992a, 1164].

However, Wray overplays the causal role of new flows of bank credit in the determination of the level of interest rates:




. . even if new flows are relatively small, they can play a large role in affecting the prices of existing assets by affecting expectations and by the leadership role played by the central bank and by large ("money center") banks. That is, those who operate in secondary markets will pay close attention to wholesale and retail rates an- nounced by the central bank and commercial banks [Wray 1992a, 1164].

While the pricing of new flows of bank credit may have some influence on the capital market's interest rate expectations, surely the lines of influence run both ways. And as long as these new flows are very small in comparison with the stock of financial assets, shifts in demand within the stock of financial assets will swamp any factors operating within new flows of financial asset formation.

Wray's overemphasis on the flow supply of and demand for money in interest rate determination carries over into his view of the role of bank credit creation in financing the deficit spending characteristic of periods of economic growth. Wray appears to accept the second hypothesis listed above:

Growth of income requires growth of spending, and spending during this period can exceed the spending of last period only through deficits and credit creation. . . . In the ISLM framework, it is possible to analyze the effects of an increase in spending while holding the money supply constant, or vice versa. This dichotomy is rejected by the endogenous money approach . . . [Wray 1992a, 1156; emphasis added].9

In Keynes's model of the General Theory, it is clearly possible to increase spending without increasing the money supply schedule (in fact, to do otherwise would be analytically incorrect). In Keynes's model, income growth is financed through a stock adjustment: interest rates rise (by an amount depending on the elasticity of the asset demand for money), and money balances are transferred from speculative use to transactions use. Keynes's model assumes that capital markets have an abundant capacity to mobilize existing money balances to meet the financing needs of spending units, while admittedly ruling out the possibility that the increased demand for transactions balances was ultimately satisfied, wholly or in part, by credit money creation.

In contrast, the models offered by Moore and Wray assume that expen- diture growth is fully financed by credit creation. The empirical basis for this assumption is questionable in light of the highly developed nature of the secondary markets, the expansion of secondary markets into more and




more segments of finance, and the shifting role of banks in the financing process as their share of the flow of funds declines over time.

Clearly, either extreme position is incorrect; the finance demand for money is met with both stock and flow supply-side adjustments, the relative shares of which vary over the cycle and as institutions change over the long run.10 But regardless of their relative importance at any particular time and place, monetary theory needs to better understand the links between capital markets and the banking system in the financing process. Wray's work, here and elsewhere, points us in this direction.11

Jane Knodell

The author is Associate Professor of Economics, University of Vermont.

Notes

1. The exposition here follows the General Theory in that there is no finance motive to hold money in anticipation of an increase in the level of spending.

2. When Yeager refers to an individual's effort to "get more money," he is referring to an increase in the ratio of money to other assets and commodities.

3. The conclusion that there is no change in the quantity of money supplied requires 'money" to be defined either very narrowly or very broadly. Suppose that money were defined very narrowly as currency. Then an increase in liquidity preference reduces the supply of broader monetary aggregates because it reduces the multi- plier on broader monetary aggregates, but it does not change the quantity of currency supplied to the economy. Now suppose that "money" were defined broadly as all monetary liabilities of banks, where "banks" are defined as those financial intermediaries that are empowered (either by law or by social practice) to monetize debt. Then a shift into money and out of nonmonetary financial assets (bonds) would reduce asset prices and redist- ribute the stock of money toward those parties desiring to become more liquid, but it would not change the stock of money. (It should be noted, however, that the ratio of money to the stock of aggregate financial assets would rise as asset prices fell.) Finally, suppose that money were defined as Ml. Then an increase in liquidity preference in the form of a shift out of less liquid bank liabilities (such as certifi- cates of deposit) and into transactions deposits would increase the Ml money multi- plier and increase the quantity of "money" supplied. However, a shift into Ml and out of nonmonetary financial assets would have the same results as the broad- definition case discussed above.

4. However, a vertical money-supply world is not necessarily a commodity-money world; to the contrary, Keynes's model is fully consistent with a credit-money world where the volume of credit money (defined broadly as all monetary liabilities of banks) depends on the volume of bank lending (and the currency-deposit ratio). None of the four shift factors of Keynes's money demand schedule necessarily imply a change in the volume of bank lending; hence, it would be incorrect, in a credit- money world, for changes in any of these factors to be met with changes in the quantity of credit money supplied to the economy.

5. According to Wray:




. . . Moore's theory . . . implies that not only do banks fully accommodate the "finance motive," but they fully accommodate the other motives that make up liquidity preference: the transactions motive, the speculative motive, and the precautionary motive. When liquidity preference rises, interest rates do not rise in Moore's model (as they do in Keynes's) since anyone who wants more cash can simply go to the bank and borrow it at a fixed interest rate [Wray 1992a, 1160]. Wray is not altogether consistent in his characterization of Moore's treatment of money demand; Wray also says that "in Moore's model, money demand represents planned spending-which may well be a function of current income and current interest rates but must also be a function of . .. expectations about the future" (but none of the other motives to hold money).

6. According to Moore, "Goodhart still envisions economic units as having a demand in 'ultimate equilibrium' to hold some proportion of their total wealth portfolios in money balances, the proportion depending on wealthowner tastes, expenditures, income, asset characteristics, and returns." Moore takes issue with both the idea of an ultimate equilbrium in application to "nondeterministic, nonergodic" real-world economic processes and the idea that there could ever be more or less credit money supplied than credit money demanded because "credit money is produced to contract" [Moore 1991b, 127, 128, 132]. Would Moore argue, then, that when investment banking firms seek to reduce the proportion of their assets in stocks and bonds, and to increase the proportion in credit money broadly defined, that this does not create an excess demand for credit money at the initial level of interest rates?

7. However, in Tsiang [1943, 292], when "bearishness" among speculators in stocks and bonds increases, speculators sell securities and use the proceeds to repay mar- gin loans with banks, not to increase speculative holdings of money. In this case, speculators' balance sheets become more liquid, but there is no change in the stock demand for money, and the supply of bank money endogenously contracts as some portion of outstanding brokers' loans are repaid.

8. Hence, Wray's theory of the supply of credit amounts to an implicit rejection of Moore's position on the impossibility of conceiving independent credit supply and credit money demand schedules.

9. In this statement, Wray comes close to asserting the interdependence of the (flow) supply and demand for money, since planned spending here is equivalent to the flow demand for money.

10. In an article that has received relatively little attention from Post Keynesian monetary economists, S. C. Tsiang offers a dynamic model that views the money market, and more specifically the demand for short-term loans to finance security portfolios, as the link between the long-term capital market and the industrial cir- culation. Tsiang's model would predict that the "stock" supply-side adjustment to changes in the finance demand for money are the more important source of money at times in the cycle when short-term interest rates have reached their institution- ally set minimum, and that the "flow" adjustment (bank credit creation) is the more important source at other points of the cycle. The supply of bank credit is normally very elastic, except at the top of the boom [Tsiang 1943].

11. See in particular Wray [1992b].

References

Foster, Gladys P. "The Endogeneity of Money and Keynes's General Theory." Journal of Economic Issues 20, no. 4 (December 1986): 953-968.




Goodhart, C. A. E. "Is the Concept of an Equilibrium Demand for Money Meaningful? A Reply to 'Has the Demand for Money Been Mislaid'?" Journal of Post Keynesian Economics 14, no. 1 (Fall 1991): 134-136.

Keynes, J. M. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace & World, 1964.

Moore, B. J. "Money Supply Endogeneity: 'Reserve Price Setting' or 'Reserve Quantity Setting'?" Journal of Post Keynesian Economics 13, no. 3 (Spring 1991a): 404413.

. "Has the Demand for Money Been Mislaid? A Reply to 'Has Moore Become Too Horizontal?"' Journal of Post Keynesian Economics 14, no. 1 (Fall 1991b): 125-133.

Tsiang, S. C. "A Note on Speculation and Income Stability." Economica (November 1943): 286-296.

Wray, L. R. "Alternative Approaches to Money and Interest Rates." Journal of Economic Issues 26, no. 4 (December 1992a): 1145- 1178.

_ . "Alternative Theories of the Rate of Interest." Cambridge Journal of Economics 16, no. 1 (1992b): 69-89.

Yeager, L. B. "Essential Properties of the Medium of Exchange." In Monetary Theory, edited by R.W. Clower, 37-60. London: Penguin Books, 1969.

Keynesian Monetary Theory: Liquidity Preference or Black Box Horizontalism?

Professor Moore begins with comments on the taxonomy presented in my article and has some disagreement with my characterization of neoclassical theory as an "exogenous interest rate-exogenous money supply" approach and with my four model classification of ISLM analysis. To some extent, his disagreement reflects some misunderstanding of my ar- guments, but it also reflects divergence and lack of rigor in various or- thodox expositions. However, there is no reason to devote space in clarification of these relatively minor points. Moore then goes on to give his version of Keynes's exposition in the General Theory and of the trans- formation of Keynes's thought after 1936. I will leave it up to readers to decide whether Moore's presentation of Keynes is more appealing than was my interpretation.1 This will allow me to devote more space to what I think is the fundamental point of disagreement: whether the "money supply curve" should be taken as horizontal, with the interest rate determined "exogenously" by the central bank, or whether liquidity preference provides a better theory of money and interest rates. I will argue that horizontalism can only offer a "black box" theory of money and interest rates, while the Keynesian liquidity preference approach is rich in institu- tional detail.



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