Keynes - The General Theory - Chapter XIII

Using some of the conclusions he made in the previous chapters, Keynes attempts to explain his interest theory.

Section I: Keynes begins by stating that the rate of interest depends on the schedule of the marginal efficiency of capital and the psychological propensity to save. He continues that it is wrong to conclude that, "the rate of interest is the balancing factor which brings the demand for saving in the shape of new investment forthcoming at a given rate of interest into equality with the supply of saving which results at that rate of interest from the community’s psychological propensity to save." Essentially, there is some other factor - that has been glossed over by other economists - that properly explains interest theory.

Section II: Here Keynes introduces us to this other factor, liquidity-preference. Keynes argues that when an individual decides how much of his income to consume now rather than later we are dealing with the propensity to consume. After this decision, an individual must decide what to do with this income for future consumption. Liquidity-preference is the schedule that shows how much of that income should be held as money, and what should be invested. Keynes continues that the rate of interest is not the "price" which brings into equilibrium the "demand for resources to invest with the readiness to abstain from present consumption." Rather, it is the reward for parting with liquidity.

Here Keynes makes the mistake of assuming that humans are incapable of thinking in terms of three margins. Why must a person decide between consumption and saving, and then after determine what to do with the savings? It is much more likely that people decide to consume, invest, and hoard at the same time. Thus, liquidity-preference has no real value in economic analysis. We once again conclude that interest rates are determined by individual time preferences, no more, no less.

Liquidity-preference does have its uses to Keynes, because from his conclusion Keynes deduces that the other factor affecting the interest rate must be the money supply. For if the rate of interest is lowered significantly, the amount of cash the public wishes to hold would exceed the available supply of money. To prove this point, Keynes turns to his trusted mathematical equations. Keynes writes, "Liquidity-preference fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L(r)."

Here again, Keynes' analysis fails a thorough examination. As any student of Austrian Economics - or even someone familiar with their theories - knows, Economics is an a priori science. Disregarding this fact, Keynes uses mutual determination to deduce the influence of the money supply on interest rates. When originally discussing liquidity-preference Keynes wrote that the mistake of accepted interest theories lies in their attempts to deduce the rate of interest while neglecting liquidity-preference. Then, as I quoted above, he writes how changes in the interest rate change a person's desire to hold cash, or simply change their liquidity preference. The interest rate can not both be determining and determined by liquidity preference. That completely contradicts the idea that Economics follows cause-and-effect relationships.

Keynes end this section with a gem worth quoting. "Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ." Interpreted: Ideally, we should be able to predict the future, but since we cannot we should control the money supply to drive the economy. If that fails, blame everyone for having the same opinions.

Section III: This section is essentially the fine print for his interest theory. For example, Keynes writes, "an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money." He then follows this same formula for several different scenarios.

Section IV: A simple disclaimer that liquidity-preference as mentioned in this text is not the same thing as the "state of bearishness" in his Treatise on Money. Since I have not read that text, nor do I have any interest in reading it, I will withhold comment.

Section V: Keynes finishes this chapter by introducing us to hoarding. He does not say much on the subject for now, with his main point being the rate of interest is not the reward for not-spending, but not-hoarding. The fallacy of this conclusion has already been demonstrated above.