the essential properties of interest and money

The Essential Properties of Interest and MoneyAuthor(s): Abba P. LernerSource: The Quarterly Journal of Economics, Vol. 66, No. 2 (May, 1952), pp. 172-193Published by: Oxford University PressStable URL: http://www.jstor.org/stable/1882941 .

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THE ESSENTIAL PROPERTIES OF INTEREST AND MONEY

By ABBA P. LERNER

I. Concepts, 172. - II. Measurements, 173. - III. Equilibrium, 176. - IV. Commentary, 180. - V. Conclusion, 188.

Almost every tribute to the originality, brilliance, and impor- tance of Keynes's General Theory of Employment, Interest and Money during the fifteen years since its publication, has admitted that it is a badly written book. Of no part of the book is this more true than of Chapter 17, entitled, "The Essential Properties of Interest and Money." The present article is an attempt to analyze this chapter (from which it borrows its title), seeking to lay bare some confusions in presentation and terminology which have stumped most students, and to present in more easily understood language the arguments and conclusions at which Keynes seems to have been aiming.

I. CONCEPTS

The first thing is to distinguish clearly between the following concepts:

1. The rate of interest is the fee paid by a borrower to a lender. The money rate of interest is the fee paid when money is borrowed, but anything else might be borrowed in the same way. The wheat rate of interest is the fee paid if wheat is borrowed.

2. The marginal efficiency of holding any asset is the benefit to be derived, at the margin, from the possession of (an additional unit of) the asset. This benefit consists of the yield or output of services (q), minus any carrying cost involved in holding it (c), plus any liquidity (1) enjoyed by the holder. The marginal efficiency of holding is equal to the benefit (q - c + 1) per unit of the asset held.

3. The marginal efficiency of investing in any asset consists of the same benefits (q - c + 1), related to the cost of increasing the current output of it by one unit.' This cost, and therefore also the marginal efficiency of investment, is a function of the rate at which the asset is being produced, i.e., of the rate of investment in it.

1. This is what Keynes throughout his book calls the marginal efficiency of capital and frequently simply the marginal efficiency of an asset. In my "Capital, Investment and Interest," Proceedings of the Manchester Statistical Society, 1936- 37, pp. 26-31, in The Economics of Control (Macmillan, 1944), and elsewhere, I have called this the marginal efficiency of investment.

172



PROPERTIES OF INTEREST AND MONEY 173

4. The marginal productivity of capital (which is not discussed in the chapter we are examining but which seems worth adding to complete the picture) is the difference in the output of the economy as a whole which would result from the existence of an additional unit of capital stock in a stationary economy, all other inputs of factors of production being held constant. The marginal productivity of capital is a function not of the rate of investment but of the quantity of capital.2

II. MEASUREMENTS

Each of these four items is measured as a percentage per annum, and each can be expressed either in terms of the asset being loaned, held, or produced (and, in the case of the marginal productivity of capital, in terms of the capital goods in general existing in the economy), or in terms of money, or in terms of any other asset.

For example if a man who borrows ?100 has to pay back ?105 a year later, the rate of interest is 5 per cent per annum. More explicitly we would say that this is the money rate of interest expressed in money, or the own rate of interest on money.

The money rate of interest can also be expressed in terms of any other asset, say wheat. If we start with 100 quarters of wheat, sell them for ?100, lend the ?100 and get back ?105 a year later, and then use the proceeds to buy 98 quarters of wheat (which has meanwhile gone up in price to about ?1.07 a quarter), we see that the money rate of interest, while it is 5 per cent when expressed in money, is minus 2 per cent when expressed in terms of wheat.

The relationship between the two expressions of the money rate of interest is determined by the appreciation of one asset relative to the other. The money rate of interest is 7 percentage points less in terms of wheat than it is in terms of money because wheat appreciates that much in terms of money. (If we look at the whole set of transactions as they are expected to turn out, then we may say that the expected money rate of interest is minus 2 per cent in terms of wheat because that is the interest, in terms of wheat, that one would expect to earn; but the element of expectation could be removed by forward contracts, so that it is not really necessary for us to bring in the question of uncertainty or expectation.)

2. See Lerner, "Capital, Investment and Interest," op. cit.; and The Eco- nomics of Control, chapter 25. What is involved here is a comparison of stationary states, where net investment is equal to zero and the marginal efficiency of investment is equal to the marginal productivity of capital. It may be that this equality, together with the traditional concern with long-run stationary states that Keynes could not entirely escape, led him to use the word "capital" when he was clearly thinking of investment.



174 QUARTERLY JOURNAL OF ECONOMICS

FIGURE 1. MONEY RATE OF INTEREST

Units of Units of Money Wheat

End of 1951 100 100

End of 1952 105 98

The relationship between the two expressions of the money rate of interest, in money and in wheat respectively, is illustrated by Figure 1, where a horizontal arrow indicates a current exchange of wheat for money, or of money for wheat, while a vertical arrow shows a loan or exchange of money for money (or of wheat for wheat) over time. The numbers connected by the vertical arrow show the "own" rate of interest for money (the money rate of interest expressed in terms of itself, money) to be 5 per cent per annum. The same money rate of interest expressed in wheat is shown by the relationship between the numbers in the wheat column, which are connected only indirectly through the three arrows in the figure. The money rate of interest expressed in wheat is minus 2 per cent. It is emphasized that this is not a wheat rate of interest, since it is a measure of the fee for lending money, not for lending wheat. The vertical arrow indicates which is the item actually loaned and whose rate of interest is in question.

FIGURE 2. WHEAT RATE OF INTEREST


End of 1951 100 -> 100

End of 1952 105 98

The wheat rate of interest comes into the picture only when it is wheat that is loaned, and this is illustrated in Figure 2. Here the numbers are the same; only the arrows are different. What is loaned is wheat, 100 quarters of wheat borrowed in 1951 being recompensed by the return of 98 quarters in 1952. The "own" rate of interest for wheat is minus 2 per cent. Expressed in terms of money, however, the wheat rate of interest is 5 per cent, since that is the measure of the money that can be gained by lending wheat for a year (or the money cost of borrowing wheat for a year), reflecting the appreciation of wheat in terms of money by about 7 per cent from 1951 to 1952.

In exactly the same way the marginal efficiency of holding any asset can be expressed either in terms of itself or in terms of any other asset. The same figures can be used too. The number above the vertical arrow would now represent the quantity of the asset held at the beginning of the year, while the number below the vertical arrow




would stand for the quantity at the end of the year including the yield minus the carrying cost plus an addition corresponding to the liquidity enjoyed by the holder. The horizontal arrows have the same meaning as before, namely the rate of exchange between the two kinds of assets at the dates indicated. Figure 1 would then show the marginal efficiency of holding money to be 5 per cent when expressed in terms of money - which might perhaps be called the "own" marginal efficiency of holding money - and minus 2 per cent when expressed in terms of wheat. Figure 2 would show the marginal efficiency of holding wheat to be minus 2 per cent in terms of itself (its "own" marginal efficiency of holding) and 5 per cent in terms of money.

The marginal efficiency of investment and the marginal productivity of capital can also be treated in the same manner and represented by similar figures. When representing the marginal efficiency of investment, Figure 2 would mean that, given the current rate of investment, the further investment of 100 units of wheat could increase next year's crop of wheat by 98 units; the marginal efficiency of investing wheat in the production of more wheat is minus 2 per cent. Expressed in terms of money, however, the marginal efficiency of investing wheat for the production of future wheat, is plus 5 per cent.

The marginal productivity of a capital asset is the increase in the annual output of the product that would be made possible by the existence of a larger stock to begin with. If the existence of an additional 100 tons of steel permitted the annual output of steel to be greater by 4 tons, then the marginal productivity of steel in the production of more steel is 4 per cent per annum. The additional stock of 100 tons of steel grows, as it were, to 104 tons in the course of the year, of which 4 tons can be consumed, leaving 100 tons to do the same the following year.' If the money price of steel is expected

3. The additional steel need not be devoted to increasing the future output of steel. It might be used to increase the output of wheat or of some mixture of different outputs. In such cases the marginal productivity can never be measured directly. We may take the steel equivalent, at next year's rates of exchange, of the additional stocks of the different goods that are made available. If the stock of additional goods is worth the same as 104 tons of steel, then the marginal productivity of capital is 4 per cent in terms of steel (though this is no longer an "own" marginal productivity). Alternatively we may take any other asset as a measuring rod, both the initial difference in the quantity of steel and the final difference in output at the end of the year being expressed in terms of this asset. The relationship between these two numbers will give us the marginal productivity of capital in terms of the asset we are using for our measuring rod, just as in the preceding paragraph where the marginal productivity of capital, which is 4 per cent in terms of steel, is 29 per cent in terms of another asset, i.e., money.

The complication dealt with in this footnote may just as well arise in any of the other three concepts under discussion. The repayment of a loan may be




to rise by 25 per cent, the 104 tons next year would be worth 129 per cent of the value of 100 tons this year, so that the marginal productivity of steel measured in terms of money would be 29 per cent.

Figure 2, applied to the marginal productivity of capital, would show the marginal productivity of capital to be 5 per cent in terms of money and minus 2 per cent in terms of wheat. This would mean that an additional 100 units of wheat in the capital stock would have the effect of making the annual crop of wheat 2 units less than it would otherwise be. The strangeness of this result reflects the strangeness of having a negative marginal productivity of capital. Such an oversaturation with capital is not inconceivable, and might even be worth suffering if the security provided by the larger stock against possible famines were considered a sufficient recompense for the smaller annual crop. But normally the existence of a larger stock of capital assets would permit the use of more productive methods so that the marginal efficiency of capital would be positive.

The essential difference between the marginal efficiency of investment and the marginal productivity of capital is that the former is concerned with the effects of decisions to increase the rate at which investment is carried on, while the latter is concerned with what would be the effects of a miraculous increase in the capital stock. As has been pointed out elsewhere,4 the marginal productivity of capital is a concept that can be used only for speculative comparisons of different stationary states of society. Capital considerations are never the basis of action. All the relevant practical matters fall under the heading of investment.

III. EQUILIBRIUM

The numbers in Figure 1 are the same as those in Figure 2, but this is not necessarily so. They have been made the same only for convenience of construction and in order to follow Keynes, who used the same numbers in his example in the chapter which we are still preparing ourselves to analyze.

Not all the similarities (or differences) in the numbers are funda- stipulated in terms of some other asset, so that there is no "own" rate of interest. The marginal efficiency of holding an asset may (and usually does) involve a yield or carrying cost in assets other than itself, so that there is no "own" marginal efficiency of holding, and similarly with the marginal efficiency of investment. In all cases except the lending of money, "own" measurements are artificially created by separating the phenomenon into an imaginary "own" transformation and an imaginary exchange of the "own" result for the product that is actually encountered.

4. "Capital, Investment and Interest," and The Economics of Control, chapter 25.




mental. We can always make one number exactly 100 -say the top left-hand number - by simply varying all the numbers in proportion, merely changing the scale of all the transactions represented. This is very convenient because it fits in with our custom of reckoning interest and the other elements discussed, as ratios of this number, i.e., as percentages. We can then go on to make the top right-hand number exactly 100 by adjusting the arbitrary unit in which wheat is measured. Whatever the quantity of wheat that exchanges at the end of 1951 for 100 units of money, we can call one hundredth of that amount 1 unit, so that the quantity we started with is exactly 100 units. But having done this we can do no more tricks with the remaining two numbers, and these may be quite different in the two figures. Figure 2, for example, might be replaced by Figure 2a, while Figure 1 was unchanged. This would show the wheat rate of interest (which is shown in Figure 2a) to be different from the money rate of interest (which is shown in Figure 1), whether they are expressed in terms of money or whether they are expressed in terms of wheat or anything else. If we express the rates of interest in terms of money we find that the wheat rate of interest is 20 per cent (Figure 2a), while the money rate of interest is 5 per cent (Figure 1). If we express them in terms of wheat we find that the wheat rate of interest is 12 per cent (Figure 2a), while the money rate of interest is minus 2 per cent (Figure 1).

FIGURE 2a. WHEAT RATE OF INTEREST


End of 1951 100 - - 100

I End of 1952 120 '- 112

It should be noted that in this example the ratio of exchange between wheat and money is the same as in Figures 1 and 2, not only

1120 105\ in 1951 (when it is one to one), but also in 1952 = The

only thing different in Figure 2a is the wheat rate of interest. Whenever there is a difference between the money rate of interest

and the wheat rate of interest (when they are measured in terms of the same asset for the comparison), a profit can be made by borrowing one asset and lending the other. In our example a pure profit of ?15 (or 14 quarters of wheat) can be made by borrowing money and lending wheat, using no capital of one's own. One could borrow ?100,




promising to pay back ?105 next year, buy 100 quarters of wheat with the money, lend the wheat at the wheat rate of interest, getting back 112 quarters a year later. (The wheat might be pledged as security for the money loan.) The 112 quarters can then be exchanged for ?120. Repayment of the loan requires ?105, and ?15 is the net profit. Alternatively 98 quarters can be exchanged for ?105 to meet the loan, leaving 14 quarters of wheat as the net profit. And the larger the scale on which such operations were undertaken the greater would be the profit made.

Such a state of affairs, in which anyone could make very large profits by the arbitrage operations just described, would not persist very long. So many people would borrow money and lend wheat that the money rate of interest would be raised and the wheat rate of interest would be lowered until the difference between them was reduced to no more than the costs involved in further arbitrage transactions. There would thus come about an approximation' to equality between the different rates of interest such as is shown in Figures 1 and 2. It is stressed that this approximate equality is to be found only when equilibrium has been reached, and only to the degree that there is perfect competition in the four markets involved: the current and prospective markets where wheat is exchanged for money, the market where money is loaned, and the market where wheat is loaned. The wheat rate of interest and the money rate of interest are not automatically equal by definition: they are only brought into approximate equality in equilibrium by arbitrage in perfectly competitive markets.

In a perfectly competitive equilibrium, therefore, and only in such an equilibrium, if we disregard the approximate nature of the equaliza- tion and use the same asset throughout as the yardstick, we can say that there is a single rate of interest in the economy, the same for every asset that is loaned. This we may call the rate of interest in the economy, even though it may have as many measures as there are different assets that can be used as yardsticks.5

If each asset's rate of interest is measured in terms of itself (so that we compare "own" rates of interest), the rates will differ considerably even in equilibrium. They will differ in the same way and to approximately the same degree as the different measures (in terms of the various assets) of the rate of interest will differ from each other; namely by the (expected) appreciation of the various assets relatively to each other. An appreciation of any commodity is a benefit to the lender and therefore a substitute for interest payment. In equilibrium

5. See The Economics of Control, pp. 255-56.




the rate of interest in terms of the appreciating commodity is therefore less to that degree. In the example of Figures 1 and 2 wheat is appreciating (about) 7 per cent in terms of money, so that the rate of interest is 7 percentage points less in terms of wheat than in terms of money (minus 2 as compared with 5 per cent per annum).

In exactly the same way perfect competition would bring about equality between the rate of interest and the marginal efficiency of holding every asset in equilibrium. Any inequality would indicate either the profitability of borrowing in order to hold or the profitability of disposing of assets in order to lend. Everybody will adjust the amount he holds of every asset until he has brought the marginal efficiency of holding it into equality with the interest he loses (or pays) for holding it.

As long as the marginal cost of holding wheat is less than 2 per cent per annum in terms of wheat, it will be more advantageous to store wheat than to lend it or to sell it and lend the money. The equilibrium represented by Figures 1 and 2 is attainable only when the stocks of wheat are so great that marginal carrying costs are high enough to lover the marginal efficiency of holding wheat to the level of the rate of interest i.e., to minus 2 per cent in terms of wheat or to 5 per cent in terms of money.

While equilibrium is impossible as long as the marginal efficiency of holding wheat is greater than the rate of interest, it is not impossible for the marginal efficiency of holding wheat to be less in equilibrium than the rate of interest. In that case, however, nobody will be holding any stocks of wheat. Disregarding this extreme situation we can say that in competitive equilibrium the marginal efficiency of holding is equal to the rate of interest.

A similar approximate equality between the rate of interest and the marginal efficiency of investing in every asset takes somewhat longer to attain. For this we must suppose not merely the market equilibrium, which is reached as soon as the holders of the existing assets no longer want to swap with each other (which is all we have needed so far), but short period equilibrium, which is reached only when the rate of investment in every asset is extended to the point that reduces the marginal efficiency of investment to the rate of interest. We can say then that in perfectly competitive short period equilibrium the marginal efficiency of investment is (approximately) equal to the rate of interest.

We may complete the picture by bringing in the marginal productivity of capital. This is equal to the rate of interest (and therefore also to the marginal efficiency of holding and the marginal efficiency




of investment) only in the very long period equilibrium, when the quantity of capital has been completely adjusted to the rate of interest. There is then no further tendency for capital to be either increased or decreased, and we have reached the stationary state in which net investment is zero.

IV. COMMENTARY

We have now completed our preparation of concepts, measures, and equilibrium relationships. Armed with these we can begin the analysis, section by section, of Keynes's Chapter 17 on "The Essential Properties of Interest and Money."

Section I begins with a declaration of perplexity and asks why the rate of interest on money should be of special significance in deter- mining the level of employment since "for every capital-asset there must be an analogue of the rate of interest on money." (p. 222.) Keynes calls this, in the case of wheat, the wheat rate of interest and, more generally, for any asset its "own" rate of interest. But what he has in mind here is not at all what we have called the wheat (or "own") rate of interest but rather what we have called the money rate of interest as measured in terms of wheat.6

The different commodity rates of interest here are nothing but the different measures, in terms of the various commodities, of the single money rate of interest, the various commodity measures differing from the money measure of the money rate of interest (and from each other) by their expected appreciation relative to money (or relative to each other). When we see that we are concerned with different measures of the same rate of interest and not with different rates of interest at all, the perplexity at the supposed special impor- tance of the money measure of the money rate of interest gives way to a perplexity at Keynes's concern with such a question.

In this section Keynes seems to contradict our conclusion that in equilibrium there is a single rate of interest (or rather an approximate equality of interest rates) for all assets, when he says, "If there were some composite commodity which could be regarded strictly

6. "The exact relationship is as follows: Let us suppose that the spot price of wheat is ?100 per 100 quarters, that

the price of the 'future' contract for wheat for delivery a year hence is ?107 per 100 quarters, and that the money-rate of interest is 5 percent.; what is the wheat- rate of interest? ?100 spot will buy ?105 for forward delivery, and ?105 for

105 forward delivery will buy 107 . 100 (= 98) quarters for forward delivery. Al- ternatively ?100 spot will buy 100 quarters of wheat for spot delivery. Thus 100 quarters of wheat for spot delivery will buy 98 quarters for forward delivery. It follows that the wheat-rate of interest is minus 2 per cent. per annum." (p. 223.)




speaking as representative, we could regard [its] rate of interest ... as being, in some sense, uniquely the rate of interest . . ." (p. 225.) Since there is no such commodity, there would seem to be no unique rate of interest, but a different one for each commodity. But the contradiction is only apparent. In our terminology, where the rate of interest always refers to the commodity being loaned and not to the commodity in terms of which the rate of interest is being measured, it is only the measure that differs according to the commodity (or composite of commodities) that we choose as the measuring rod. It is still true that there is (approximate) equality between all the rates of interest in an economy in equilibrium, provided that they are all measured by the same yardstick. We therefore can speak of a single rate of interest in the economy, i.e., of the rate of interest.

Section II goes on to "consider what the various commodity- rates of interest are likely to be for different types of assets" (p. 225), but we find that Keynes is in fact no longer talking about the different measures of the rate of interest or even about the rate of interest at all. He is here talking about the marginal efficiency of holding the different assets. He states that "q - c + l is the own rate of interest of any commodity, where q, c and 1 are measured in terms of itself as a standard." (p. 226.) Taking houses, wheat, and money as representing three types of assets, for each of which only one of the three elements entering into the marginal efficiency of holding is significant, he declares that "ql is the house-rate of interest, -c2 is the wheat-rate of interest and 13 is the money rate of interest" (p. 227), and that if we want to measure the different "rates of interest" in terms of some single asset, we have to add the expected appreciation of the asset in question in terms of the asset that is to serve as the measuring rod. Thus if a is the expected appreciation of any asset in terms of, say, money, then the "rate of interest" in terms of money will be a + q -

c + 1. "The demand of wealth-owners will be directed to houses, to wheat or to money, according as . .. a, + q, or a2 - c2 or 13 is greatest. Thus in equilibrium the demand-prices of houses and wheat in terms of money will be such that there is nothing to choose in the way of advantage between the alternatives; - i.e., a, + qi, a2 -C2

and 13 will be equal." (p. 227-8.) There can be no doubt that in this section "the rate of interest" means nothing but the marginal efficiency of holding an asset, and the proposition made is that in (market) equilibrium the marginal efficiency of holding every asset will be the same.

Many students have found this part very difficult because they would not expect Keynes to be guilty of giving the same name to two




entities which are equal only in equilibrium. He was so emphatic in criticizing economists who identified the marginal efficiency of investment with the rate of interest, that one hesitates to charge him with so similar a confusion. But it does not seem that the charge can be avoided.

Keynes goes on to show that it would be profitable to produce assets whose "marginal efficiency would be greater . . . than the rate of interest . . . As the stock of [such] assets . . . is increased, their marginal efficiency . . . tends to fall." (p. 228.) It is clear that here "marginal efficiency" stands for "marginal efficiency of capital" or what we have called the marginal efficiency of investment. It is not very clear to what degree the equilibrium is brought about by the increase in the size of the stock of the asset and to what degree it is brought about by the increase in the marginal cost (or supply price) of the asset as the rate at which it is being produced (the rate of investment) rises; that is to say, whether it is a question of quantity of capital or of the rate of investment. It is not at all clear whether "rate of interest" here means rate of interest or whether it means marginal efficiency of holding assets. This, however, does not matter too much since we are concerned only with market equilibrium, in which they are equal.

Keynes then says that as (the schedule of) the marginal efficiency (of investment) declines, investment will diminish, and ultimately cease, unless "the rate of interest" falls pari pass; and that if there is any asset (e.g., money) whose "rate of interest" refuses to fall enough, we will find ourselves without the investment on which prosperity depends.7 In this sentence the first "rate of interest" means rate of interest, and the second "rate of interest" means marginal efficiency of holding. The "rate of interest" that is reluctant to decline is said to "rule the roost" (p. 223), or "set the pace" (p. 235), for all the other commodity-rates of interest. The confusion between the commodity measures of the money rate of interest, the different commodity "own" rates of interest, and the marginal efficiencies of holding the different commodities - all called "own-rates of interest" - make the argument very difficult to follow.

7. This is the meaning of the last paragraph on p. 228. Keynes puts the argument in terms of the relation which must hold in equilibrium between the "own-rates of interest" in the sense of marginal efficiencies of holding the different assets. The declining yield (q) and increasing carrying costs (c) of other assets must be offset by an increase in their expected appreciation (a) if the marginal efficiency of holding them should remain equal to the marginal efficiency of holding money (as it must in equilibrium). Unless the expected future price of an asset rises, this must mean that its present price falls -until it is no longer profitable to invest in producing it.




At one point it is suggested that the trouble is caused by an asset having an "own rate of interest" that is higher than that of any other asset: "it may be the greatest of the own-rates of interest . . . which rules the roost." (p. 223.) At another point the trouble seems to be caused by an asset whose "own-rate of interest" is rising relative to that of all other assets. (p. 228.) Since the equilibrium conditions are assumed to hold ("a1 + qi, a2 - c2 and 13 are necessarily [sic] equal" - p. 228), the relationship is reflected in the expected appreciation of the other assets relative to the disturbing one.

Taking this very strictly we arrive at some surprising conclusions. If the misbehaving asset is money and its "rate of interest" is the highest, this would mean that every "a" is positive; every commodity in the assumed equilibrium is expected to appreciate relatively to money; every single price is expected to fall!

If, on the other hand, we say that the misbehaving asset is one whose "own-rate of interest" is rising relatively to all other "own" rates of interest, this means that every "a" is increasing; that is to say the price of every asset is falling relative to its expected future price. Keynes assumes that it is normal for the expected future price to be held stable (by expected future cost of production), so that the present price keeps falling until current production is unprofitable and the required investment disappears. It seems no less plausible to suppose that the present price is kept up by present cost of production, so that the increasing "a" means that the expectation of the future price is rising. This would tend to have the effect of raising the present price and stimulating investment!

Neither of these arguments, however, has any cogency because they essentially assume the operation of tendencies to equilibrium at the same time as they assume that the equilibrium conditions have already been reached. These troubles can be avoided by using the language developed earlier in this paper and saying simply that if there is any asset whose marginal efficiency of holding stays high, all the other marginal efficiencies and all the rates of interest must be equally high because they must be equal in equilibrium - all being measured on the same commodity-yardstick.

At this point Keynes insists that it is not the habit of keeping accounts in terms of money that can cause depressions, but rather the existence of any asset (so far supposed to be money) whose obstinately high marginal efficiency of holding keeps up the rate of interest (and the marginal efficiency of holding). "It may be for example, that gold will continue to fill this role in a country which has gone over to an inconvertible paper standard." (p. 229.)




Section III considers three reasons why money may be the culprit. The marginal efficiency of holding money refuses to fall because:

i) Its elasticity of production is negligible, i.e., it cannot be "grown like a crop or manufactured like a motor car." (p. 230.) This has two consequences. In the first place there is no direct increase in investment when there is an increase in demand for money, and in the second place there are no increases in its stock to lower the marginal efficiency of holding it.

Money is not the only asset that is thus fixed in supply (apart from government action), but it is further distinguished in that:

ii) Its elasticity of substitution is negligible, i.e., "as the exchange value of money rises there is no tendency to substitute some other factor for it. . . . This follows from the peculiarity of money that its utility is solely derived from its exchange value so that the two rise and fall pari passu." (p. 231.) In the case of any other asset in fixed supply, an increase in the demand raises its price. This means a reduction in the ratio of yield to price, i.e., a reduction in the marginal efficiency of holding the asset, and a shift to other assets whose marginal efficiency of holding has not fallen. Since a rise in the price of money (i.e., its purchasing power) is at the same time a proportional increase in the amount of liquidity yielded by a unit of it, the marginal efficiency of holding money is unaffected, and there is no tendency for the shift to holding other assets.

In spite of this the marginal efficiency of holding money might fall because "as money-values fall the stock of money will bear a higher proportion to the total wealth of the community." (p. 232.) This is in fact a recognition that the very same reason that makes negligible the elasticity of substitution of other assets for money also tends to negate the second consequence of the first trouble - see i) above. The fact that when the value of money rises the utility of a unit of money rises pari passu, keeping constant the marginal efficiency of holding a unit of money (for a given stock of money), also means that when the value of money rises the effectiveness of the total stock of money also increases in the same way. In fact the unit of money is most inappropriate for measuring the stock of money because to use this, apparently natural, measure amounts to ignoring the effect of the rise in the value of money on the real effectiveness of the total stock of money. A more appropriate measure is a unit of purchasing power or of liquidity.

If the total stock in units of money is unchanged but prices fall (i.e., the value of money rises), the total stock of liquidity by that same




token increases. It is not quite true that the desire for more liquidity is like a "desire for the moon." (p. 235.) Unlike the desire for the moon, which has no effect on that satellite, the desire for more liquidity, by raising the value of money, increases its supply. In terms of liquidity, or purchasing power units, therefore, the total amount of liquidity yielded by a given stock of money increases in the same proportion as the value or purchasing power of each unit. The elasticity of supply of liquidity is not zero but unity!

At this point Keynes asserts that: iii) "There are, however, several reasons . . . why . . . it is very

probable that the money-rate of interest will often prove reluctant to decline adequately." (p. 232.) The low carrying cost of holding money makes the demand for liquidity very elastic so that a very large fall in the price level (a very large increase in the amount of money or in liquidity in real terms) would be needed to reduce sufficiently the marginal efficiency of holding money; the stickiness of wages and costs (Keynes here says "stable" when he should say "sticky') prevents prices from falling very rapidly; and the slowness of wage, cost, and price reductions establishes expectations of still further price reductions. Such expectations make things worse: "the reaction on the marginal efficiency of capital may offset the decline in the rate of interest." (p. 232.) To this may be added the increase in the marginal efficiency of holding money from the expectation that the value of money will increase as a result of the expected fall in prices.

All this argument shows why money can be the cause of depression if the monetary authorities do not create enough of it and why one cannot rely on the automatic working of the market to bring about the adjustment that may be needed to induce the investment required for full employment. But Keynes puts the conclusion in more general terms, deliberately not mentioning money. "No further increase in the rate of investment is possible . .. [even] before full employment is reached, if there exists some asset, having zero (or relatively small) elasticities of production and substitution, whose rate of interest declines more slowly, as output increases, than the marginal efficiencies of capital-assets measured in terms of it." (p. 236.)

Section IV asks whether some other aspect of money may not make it the asset whose recalcitrant marginal efficiency of holding prevents the rate of interest from falling. Keynes considers the contribution to the liquidity yield of money from "the convenience of holding assets in the same standard as that in which future liabilities may fall due and in a standard in terms of which the future cost of




living is expected to be stable," (p. 237), but argues that "whilst the fact of contracts and wages being fixed in terms of money considerably enhances the significance of the money-rate of interest, this circum- stance is, nevertheless, probably insufficient by itself to produce the observed characteristics of the money-rate of interest." (p. 237.) This is because the marginal efficiency of holding an asset cannot resist the downward pressure from an increase in the demand for it unless its carrying cost is very low. Otherwise an increase in the amount held would sharply raise the carrying cost and thereby push down the marginal efficiency of holding it.

The next question is "What, then, would the position be if wages were expected to be more sticky (i.e., more stable) in terms of some one or more commodities other than money, than in terms of money itself?" (p. 237.) And the answer is again that the trouble we are discussing would be brought about only if the asset also had the other characteristics of money, and that this combination of the characteristics of money is not accidental: "the expectation of a relative stickiness of wages in terms of money is a corollary of the excess of liquidity-premium over carrying cost being greater for money than for any other asset." (p. 238.)

This section ends with an attack on economists who "have been accustomed to assume that there is a presumption in favor of real wages being more stable than money-wages," (p. 238), culminating in the remarkable statement that "the attribution of relative stability to real wages is not merely a mistake in fact and experience. It is also a mistake in logic, if we are supposing that the system in view is stable." (p. 239.)

It must be presumed that Keynes did not really mean to deny the proposition that real wages have changed less, historically, than money wages. The trouble here seems to lie in a confusion between stability and stickiness. The stickiness of a price is the degree to which it resists a given force trying to change it. The stability of a price is the degree to which it stays the same over time - possibly because there is no force trying to change it. What Keynes must mean is that it would be unwise to remove the stickiness of money wages and to try to hold real wages constant by adjusting money wages whenever prices changed: "if indeed some attempt were made to stabilize real wages by fixing wages in terms of wage-goods, the effect could only be to cause a violent oscillation of money-prices." (p. 239.) But the sentence which reads: "That money-wages should be more stable than real wages is a condition of the system possessing inherent stability" (p. 239), merely means that the system will be




more stable if money-wages are sticky than if they are easily changed in attempts to stabilize real wages by compensating for any changes in the price level. The truth of this is unaffected by the stickiness of money wages being insufficient to prevent them from moving more over time than do real wages. That is a matter of stability, not of stickiness.

Section V begins with the interesting recognition of a "non- monetary" economy as one "in which there is no asset for which the liquidity-premium is always in excess of the carrying-costs" (p. 239), and discusses some secondary meanings of "liquidity" which would come to the fore in such an economy. The section then goes on to what is perhaps the most challenging and memorable part of the chapter. This is the assertion that there may "have been occasions in history in which the desire to hold land has played the same role in keeping up the rate of interest at too high a level which money has played in recent times." (p. 241.)

"In certain historic environments the possession of land has been characterized by a high liquidity-premium in the minds of the owners of wealth." (p. 241.) The elasticity of production of land is clearly very low. To the degree that land is held for prestige purposes rather than for the sake of rents earned, an increase in its value brings with it a proportional increase of yield in prestige-liquidity so that, just as in the case of money, this may not cause the marginal efficiency of holding it to fall. Consequently there is a certain plausibility in Keynes's assertion that the present poverty of the world "after several millennia of steady saving . . . is to be explained . . . by the high liquidity-premiums formerly attaching to the ownership of land and now attaching to money." (p. 242.)

This intriguing speculation seems, however, to fall to the ground because of the lack of one essential condition. This is the one rather modestly arranged above8 as the second of the three items under (iii), commenting on Keynes's Section III, p. 232, par. (b). Wages and costs are not sticky in terms of land. There is nothing to stop the value of land from rising rapidly, the way money-wage stickiness stops the value of money from rising rapidly.

Any conceivable desire for holding wealth in the form of land can therefore be fulfilled until it overflows into the demand for other forms of wealth that can be produced. There is no brake checking the rise in the value of land, as there is in the case of money, that would establish long-lasting expectations of further rises and thereby provide an additional reason for keeping up the marginal efficiency of holding

8. P. 185.




land (and therefore, in equilibrium, the rate of interest). Nor would such an expectation of a rising value of land reduce the marginal efficiency of investment as would be the case if it were money that was expected to increase in real value, i.e., if prices were expected to fall. In other parts of the chapter Keynes shows very clearly and emphatically how the different qualities of money depend on each other and even more than in general on the stickiness of money- wages, costs, and prices. The failure to remember this at this point must be attributed to the fascination of the grand historical speculation.

Section VI, the last section in the chapter, is concerned with the concept of the natural rate of interest which is really another topic.

V. CONCLUSION

The central proposition that emerges from Keynes's Chapter 17 is that stickiness of wages, and therefore also of costs and of prices, is an essential property of money.

The money rate of interest, it turns out, does not play any special part in the determination of the level of employment and of unemployment. Although most loans are made in terms of money it is not just the money rate but the or the general rate of interest that may be too high. In the equilibrium analysis on which the theory of employment is based, the rate of interest on money is no greater than any other rate of interest when they are both measured in terms of any common asset-yardstick - as they must be for any valid comparison. But it is true that an essential part in the unemployment problem is played by the marginal efficiency of holding money. Because of some peculiarities about the liquidity yielded by the holding of money, the marginal efficiency of holding it may obstinately remain very high. When this happens, the other elements which must be equal in equilibrium to the marginal efficiency of holding money will also be very high.

The marginal efficiency of holding other assets is kept up by the attempts of wealth-owners to shift into holding money as long as the marginal efficiency of holding money is greater than the marginal efficiency of holding other assets. This shifting from other assets to money lowers the prices of the other assets to the point where the ratio of their yield (minus carrying cost) to their price, is (approximately) as great as the marginal efficiency of holding money. This means that every asset has (approximately) the same marginal efficiency of holding, equal to the (high) marginal efficiency of holding




money. We may call this the marginal efficiency of holding assets in the economy.

The money rate of interest must be as high as the marginal efficiency of holding money, because at lower rates of interest lenders would prefer to hold their money rather than to lend it, and borrowers would want to borrow money in order to hold it for the sake of the high marginal (liquidity) yield. The rate of interest for any other asset will be brought up to (approximately) the same level by arbitrage operations. The (approximately) identical rate of interest on all assets we may call the rate of interest in the economy.

The marginal efficiency of investing in every kind of asset is brought into equality with the rate of interest by the adjustment of the rate of investment in short period equilibrium. When investment in each kind of asset is cut back to this point there may be too little investment in the economy to provide a satisfactory level of employment. The (approximately) identical marginal efficiency of investment for every kind of asset we may call the marginal efficiency of investment in the economy.

The marginal productivity of capital will also tend to approach the rate of interest, but we need not concern ourselves with this if for no other reason than that this equality would be approached only in the very long period needed to bring about a total adjustment of the quantity of capital. This period is far longer than that appropriate for our fundamental assumption of a given supply of money.

The situation we have just been describing, in which the marginal efficiency of holding, the rate of interest, and the marginal efficiency of investment are all too high (so that the level of employment is too low) would be of no interest if there were some way in which the economic system automatically relieved the very high marginal efficiency of holding money that seems to start the whole trouble.

One over-simplified version of the Keynesian analysis seems to argue that there is no tendency for any automatic correction whatever. The level of employment is determined by the volume of effective demand. The volume of effective demand is determined by the rate of investment and the propensity to consume. The rate of investment is determined by (the schedule of) the marginal efficiency of investment and the rate of interest. The rate of interest is determined by the stock of money and the liquidity preference of the

community./ The system is closed. The obvious lever for doing anything about the situation is in the hands of the authorities who determine the volume of money and can influence the other determi-




nants of the volume of employment. Apart from conscious policy for curing the trouble by increasing the amount of money or changing the other determinants, there seems no way out of the impasse, unless one counts waiting for the various determinants - the propensity to consume, the schedule of the marginal efficiency of investment, and the liquidity preference - to change, and to change in the proper direction.

Some economists reacted to this oversimplification by concentrat- ing their emphasis on the price reduction caused by unemployment when it forces money wages down. Such a price reduction, by increasing the value of the stocks of money, would enable the same stock of money to satisfy more fully the desire for liquidity, lower the rate of interest, and thus increase the rate of investment. At the same time the reduction in prices would increase the real wealth of all the owners of the existing stock of money, so that they would not have such a strong desire to add to their wealth by saving out of current income, i.e., there would be an increase in their propensity to consume. These two forces together would automatically cure any excessive unemployment. The only trouble is that there are resistances to the natural reduction of money wages which would occur in a freely working price system whenever there was excessive unemployment. The so-called "Keynesian Revolution" was nothing but the discovery that the automatic free market mechanism would not work if a vital part of the machinery was jammed by downward wage and price rigidities.

Hidden in Chapter 17 of The General Theory is the essential answer to this debate.

It is certainly not true that wage and price reductions have no effect whatever, no matter how tempting it is to make such a simplify- ing assumption. This assumption is defensible only as a device for isolating the effects of wage and price reductions for more careful study later in the analysis. At least as unsatisfactory as the assumption that wage and price reductions would have no effect is the assumption that they would suffice to restore full employment equilibrium. We cannot say what would be the effects of wage flexibility until we say somewhat more specifically what we mean by it.

A mild form of downward wage flexibility, in which unemployment made wages fall slowly and unevenly, as successive resistances to the reductions were overcome, would almost certainly do more harm than good. It would establish expectations of further wage and price reductions, and these expectations would lower the marginal




efficiency of investment and increase the marginal efficiency of holding money. The depression would be very much aggravated for a long time even if the continuing fall in prices would tend to a longer run equilibrium with sufficient liquidity to provide adequate employment. It does not seem likely that the political system, on which is built the general economic framework assumed in the analysis, would endure such a strain.

If instead of this mild flexibility we assume a thoroughgoing wage and price flexibility, so that there could be a rapid movement to the position where adequate liquidity has been produced by the wage and price declines, we find ourselves in a strange world in which we can no longer make use of money for its normal purposes.

The essential superiority of a monetary economy over a barter economy is the saving of mental effort made possible by money. In a monetary economy it is not necessary to think of all the rates of exchange of every commodity for every other commodity in which one might be interested. It is sufficient to know the money price of a commodity and to use this price as a representative of all the other things that one might have instead. But this service can be rendered by money only if there is a sufficient stability in its purchasing power. In hyperinflations money ceases to be able to perform this service, and the economy reverts to barter until some other monetary unit is established. It seems not unreasonable to suppose, in the absence of actual experience, that in this matter hyperdeflations would destroy the usefulness of money as effectively as hyperinflations have.

During severe inflations calculation is made easier by the development of roundabout methods of evading the effects of the rising prices. Index numbers of various kinds are used to deflate the prices and permit some approximation to rational comparisons. The money price is divided by some factor, given by the index number or by the price of a foreign currency or of some staple commodity. No doubt similar developments would occur during a hyperdeflation, when each price and each monetary unit would have to be multiplied by some number so as to make possible comparisons based on past experience. The citizen would then restore some order by telling himself repeatedly throughout the day that ?1 really is ?2 or ?10 or ?100, the factor being different every day. In Indonesia, not so long ago, an excessive money supply was treated by cutting each note in two and declaring that only one of the halves was valid (for half a unit), the other half being destroyed. In a hyperdeflation (where there is a shortage of money) this could be done in reverse,




the note being cut into a number of pieces and each piece declared a whole unit, since each piece will have the purchasing power that the whole piece of paper once had.

It will of course hardly have escaped the reader's notice that these devices for mitigating the evils of hyperdeflation are merely backhanded ways of increasing the amount of money, and would be adequate only if the deflation consisted of a uniform decline in all prices. But that is exactly what it is not reasonable to assume. Unless we are to suppose away the whole universe we will have different arrangements in different cases for making the appropriate abrogations of contracts. We will have different degrees of the influence of custom in different parts of the economy. Some prices will therefore fall much more than others, and some incomes will fall much more than others. There will be injustice and chaos of a kind that cannot be avoided by the publication of index numbers. Every- thing will be in disorder and nothing predictable - except perhaps one thing: that the public would not stand for a continuation of such disturbance and injustice. No matter what else they retain in their social order they will certainly not retain the monetary unit. It will have been rendered quite unfit to do its main job.

This is the essential lesson of the chapter. The usefulness of money depends intimately on a certain degree of stability in its purchasing power. This stability encourages the making of contracts and the development of other institutions that help to establish a rigidity of the general price level. The rigidity in turn gives further stability to the purchasing power of money so that its position in the economy reinforces itself in the mould of custom.

One effect of the rigidity is that the automatic adjustment to a change in the demand for liquidity is not socially satisfactory. The automatic response to an increase in the desire for liquidity is a higher rate of interest, a lower rate of investment, and a lower volume of employment. Similarly if there is a change in any of the other determinants of output which would require a larger supply of liquidity to maintain a satisfactory level of employment, there is no automatic increase in the supply of liquidity but instead an equilibrium in which the rate of interest and the marginal efficiency of investment are too high and employment too low. Because of the absence of any automatic achievement of a satisfactory level of employment, monetary and fiscal measures must be harnessed to an employment policy.

Economists naturally tend to resent the intrusion of this political element into the middle of the economic system. They would very much like to replace it by an automatic mechanism, and the removal



PROPERTIES OF INTEREST ANI) MONEY 193

of the price rigidities seems to some to open up a tempting path. What is not immediately seen, and what Keynes's Chapter 17 in a confused and nebulous way tried to warn against in advance, is that price rigidity is not an appendage that can be removed without harm. Wage and price rigidity is an essential property of money and the most successful of operations to remove it would mean the death of the patient so transformed. Any money which was completely cured of wage and price rigidity would not be able to survive as money.

ABBA P. LERNER.

ROOSEVELT COLLEGE

CHICAGO



the essential properties of interest and money

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