Wednesday, May 22, 2013

Liquidity preference and effective demand

Reading The Battle of Bretton Woods, by Benn Steil, an interesting book with some problems associated to its conventional economics analysis, I was struck by the following phrase: "Keynes had struggled for years ... to induce a compelling theoretical cause for his burning belief that investment could, even under flexible prices, fail to harmonize savings in a way that would maximize aggregate income. ... It was the concept of ´liquidity preference,' or the idea that people might choose to hoard inert cash rather than consume or invest the fruits of their labor."

It is improtant to remember how Keynes himself suggested he developed Liquidity Preference, to put Steil's argument in perspective. Keynes says in his "Alternative Theories of the Rate of Interest" (1937, p. 250; subscription required) that:
"the initial novelty [in his General Theory] lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory."
In other words, the central idea of the GT is effective demand (investment determines savings through the multiplier) and liquidity preference is more or less an afterthought, developed to deal with the fact that by eliminating the Loanable Funds Theory he had left "the rate of interest in the air" (ibid.). Further, note that the situation in which "people might hoard cash," corresponds to the so-called Liquidity Trap.

In other words, when everybody expects that in the future the rate of interest will increase, and prices of bonds will collapse, and hence there would be windfall losses, there might be an absolute demand for liquidity [in spite of Krugman, not the case now]. What did Keynes have to say about the liquidity trap? In chapter 15 Keynes tells us ‘after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute … [b]ut … I know of no example of it hitherto’ (Keynes, 1936, p. 207). In other words, a downward rigidity of the rate of interest, while possible in theory, was not in practice the cause of unemployment for him, and certainly it was not the "compelling theoretical cause for his burning belief that investment could fail to harmonize savings in a way that would maximize aggregate income."

There are several other issues with the book, which I'll discuss in other posts.

6 comments:

  1. Keynes plagiarized and bastardized Douglas. Douglas's theories and A + B theorem are transformational and downsizing to Banks and the Financial system. I wonder why they might tend to reject and ridicule it?

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    1. Douglas was actually a member of the Old Chicago School, that preceded Friedman and colleagues, which was more ecclectic and a mix of marginalism with institutional ideas, of which Henry Simon was the most prominent figure. And Douglas was for counter cyclical policies, and was a progressive New Dealer in general. But I think it's a bit of a stretch to suggest that Keynes popularized Douglas's ideas. On him, it's worth reading the biography by Roger Biles "Crusading Liberal: Paul H. Douglas of Illinois."

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    2. And I should add he is famous for the Cobb-Douglas production function too.

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  2. It is interpreted that Keynes said in the paper you quote, and in a letter he wrote to Harrod (quoted by Garegnani) that he thought of the liquidity preference after he thought of the effective demand principle. I think that by the liquidity preference theory he was referring to the own-rates of interest part, Chapter 17, and that part was developed after Sraffa's critique of Hayek. However, in the Treatise on Money there's the "state of bearishness". And it's almost exactly the same as the liquidity preference. There are no own rates of interest in the TM, but there is liquidity preference, it was not invented after the principle of effective demand. In my reading of the TM and the GT, the sole substantive difference is that there is no natural rate of interest in the latter. This point is mentioned by Kregel in another article. Saludos.

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    1. The quote makes it clear that Keynes thought of Liquidity Preference as the alternative to Loanable Funds, and, hence, as his theory of interest, which involves the demand for money function. Chapter 17 is a huge mistake. Sraffa, who developed the idea that was the basis for what Keynes wrote in that chapter, had a terrible view of chapter 17 and Liquidity Preference, not without reason, as noted by Heinz Kurz here http://pendientedemigracion.ucm.es/info/nomadas/MA_sraffa/heinzkurz.pdf

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  3. Matias Vernengo,

    I've been looking to learn more about Post-Keynesianism, and so far I've seen some of Keen's work, like effective demand = income + change in debt and his debt deflation dynamics.

    However, I wonder if you can suggest me something regarding MMT, since I wonder if MMTers define effective demand as being equal to income, or something different.

    Hope my question doesn't come as excessively dumb, thanks in advance.

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