My apologies for the lack of posting lately, school has been getting the better of me.
Keynes' focus in chapter XV deals with the incentives behind individuals choice for liquidity. The chapter is reminiscent of chapter's XIII and IX, which dealt with the factors which influence an individual's propensity to consume. As we will see, Keynes' logical flaws are the same here as they were on that topic. Keynes divides the incentives to liquidity into four categories:
(i) The income-motive: This motive is the need for cash to bridge the time between, "the receipt of income and its disbursement." This motive is dependent on the amount of income as well the "normal length of the interval" between receipt and disbursement. I'm not entirely sure how we can determine a normal length of time, but essentially this motive is the fact that when we receive cash in a transaction, we can't invest it in stock or deposit it in the bank immediately. This action takes time, and the amount of time is influenced by the amount of money trading hands.
(ii) The business-motive: This motive is the need for cash to bridge the time between, "incurring business costs and that of the receipt of the sale proceeds." The strength of this demand is dependent on the value of current output and the number of hands the product passes through. Keynes is not revealing anything new here, businesses need to acquire savings in order to pay for the factors of production needed to produce their good, which they will sell at a later date. This motive is a requirement 0f all businesses - without savings their can be no production - it is not necessarily a motive of liquidity.
(iii) The precautionary-motive: This motive is the need for money in your wallet, to serve the need for "sudden expenditures" or opportunities of "advantageous purchases." This makes sense, everyone needs to have money in order to pay for things like parking or a few beers at the bar. No one has all of their income tied up in savings or investments, their is a need for money to pay for short term demands.
(iv) The speculative-motive: Keynes devotes more time to this motive than the previous three because, "the demand for money to satisfy the former motives is generally irresponsive to any influence except the actual occurrence of a change in the general economic activity and the level of incomes." He continues explaining that the speculative-motive usually follows a continuous response to changes in the interest rate. If this were not true, open market operations would not be feasible, because, "in normal circumstances the banking system is in fact always able to purchase (or sell) bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount; and the larger the quantity of cash which they seek to create (or cancel) by purchasing (or selling) bonds and debts, the greater must be the fall (or rise) in the rate of interest."
I have no quarrel with Keynes on this point being factually correct, but rather that it is economically irresponsible. We have seen the government's ability to change the interest rate through their open market operations (i.e. QE1 and QE2) but what has that done to help the economy recover? Keynes' inability to see that simply driving interest rates to 0% will not magically make people start investing. It was the manipulation of the interest rates of the fed which caused the malinvestment that led to the ongoing recession. Entrepreneurs are not going to start investing in capital because the fed floods the market with fresh $100, as the saying goes, "fool me once shame on you, fool me twice shame on you."
Keynes then begins to analyze liquidity preference mathematically. The expression he comes up is as follows: M = M1 + M2 = L1(Y) + L2(r), where M1 is the cash needed to satisfy motives i-iii, M2 is the cash needed to satisfy motive iv, Y is the level of income, r the interest rate, and L1 and L2 are the corrosponding liquidity functions for their respective cash levels (M1 and M2). Based on this equation, Keynes argues their are three factors which require his investigation, "(i) the relation of changes in M to Y and r, (ii) what determines the shape of L1, (iii) what determines the shape of L2." We will look at these matters individually as he does.
(i) Suppose the government decides to print money, increasing M. This would cause Y to increase and conversely increase M1. He then makes the claim that this increase in Y is not large enough for the increase in M to be adequately absorbed by the increase in M1. It follows that M2 must then increase as well. This comes about by a fall in r. Keynes does not explain why M2 must also increase, but there is a bigger concern here. Why must M = M1 + M2? Could the total money supply not equal 7 different subsets instead of 2? By viewing economics as a mathematical science rather than a praxeological one, Keynes is able to deduce any equation that serves his purpose.
(ii) Keynes claims the shape of L1 is determined by the income velocity of money. This is essentially the frequency at which money changes hands during a time period. If there is $1 million dollars in an economy, and $4 million worth of transactions take place in a year, then the income velocity of money is $4/yr. Neglecting the fact that I am highly skeptical this figure can be calculated with a great deal of accuracy, Keynes argues that this figure can be assumed as constant for the short run. This is Keynes' "proof" that both M1 and M2 must change with a change in M. His equation for L1, L1(Y) = Y/V = M1 means that no matter how much Y increases with an increase in M, M1 can only increase by a factor dependent on V (income velocity of money.
(iii) Keynes then stretches his reasoning far beyond what I would expect. He writes there is no quantifiable relationship between changes in M2 and r, but that in this case that doesn't matter. What matters is, "the degree of its divergence from what is considered a fairly safe level of r." If Keynes is going to argue his case for liquidity from a quantitative perspective, I would at least expect him to stick to it throughout the course of his argument. What is a safe interest rate, and who gets to decide it?
Lastly, Keynes points out a few limitations to a monetary authorities ability to establish the rate of interest. One particular limitation is worth a comment, "here is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto."
This is one of the major problems with Keynes reasoning, simply because something has not happened to date does not mean it should be dismissed. The reckless policies of the Fed for nearly a century is leading up to a point when debt issued by the government will be seen as worthless. Even now, I would not buy a US Treasury security for the simple fact that I do not see the possibility of it being paid off. Once more and more people realize this, they will demand extremely high rates of return based on the risk of default. This will damage and possibly destroy the monetary authorities ability to manipulate the market at will.
Keynes' writings continue to get more and more confusing, both because he is a dismal writer and because his arguments contradict both what we are observing and what conventional wisdom leads one to believe.