Monday, January 10, 2011

Notes from General Theory - Chapter 13

After Chapter 3, I have jumped directly to note taking from Chapter 13. This is where the more interesting part of the book begins. I will take the notes of Chapter 4 to 12 later.

  • There are forces that cause the marginal efficiency of capital to be equal to the rate of interest, yet the marginal efficiency of capital is, in itself, a different thing than the ruling rate of interest. Marginal efficiency of capital governs the terms on which loanable funds are demanded for new investment. Rate of interest governs the terms on which funds are supplied. 
  • Historically, rate of interest has been thought to depend on the interaction of the schedule of marginal efficiency of capital with the psychological propensity to save. However, according to Keynes, merely knowing the demand for investment and the supply of savings is insufficient to determine the rate of interest. 
  • Any individual has two distinct set of decisions in his psychological time preference: a) Propensity to consume: how much of the income is consumed, and how much is saved. (b) Liquidity preference: in what form will he hold his savings. Historic theories are erroneous as they attempt to derive the rate of interest from the first of the psychological time preferences at the neglect of the second. 
  • Rate of interest is not a return to saving or waiting. If a man hoards his saving as cash, he will earn nothing. Rate of interest is the reward for parting with liquidity for a specified period. 
  • Rate of interest is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash. If rate of interest is lower, more people will be willing to hold saving as cash. If it is higher, there will be a surplus of cash which no one is willing to hold. Rate of interest is not the price which equilibrates saving and investment. 
  • So, it is the quantity of money, along with the liquidity preference, that determines the rate of interest. 
  • If r is the rate of interest, M the quantity of money, and L the function of liquidity preference, then M = L(r). This is where the quantity of money enters into the economic scheme
  • There are three drivers of liquidity preference: (a) Transactions motive: i.e. the need of cash for the current transaction of personal and business exchanges (b) Precautionary motive: i.e. the desire for security as to the future cash equivalent of a certain proportion of total resources, (c) Speculative motive, i.e. object of securing profit from knowing better than the market what the future will bring forth. 
  • The existence of an organized debt market creates a dilemma. In the absence of an organized market, liquidity preference due to precautionary motive would be greatly increased, however, the existence of an organized market might create wild swings in liquidity preference due to the speculative motive.
  • If there is negligible demand for cash from the speculative motive, an increase in quantity of money will have to lower the rate of interest, in whatever degree is necessary to raise employment and wage-unit to cause the additional cash to be absorbed by the transactions motive and the precautionary motive. This is what the Fed fought in 2009.