Query: Whether a national bank would not at once secure our properties, put an end to usury, facilitate commerce and supply the want of coin, and produce ready payments in all parts of the kingdom? The Querist

In a closed economy in any relevant period the number of available monetary units multiplied by the velocity of their circulation must at the end of the period equal the total of monetary transactions multiplied by the average price at which each transaction took place. This is generally expressed in the form of an equation MV=PT which is a self evident identity.

The object of monetary manipulation is to bring about by an increase of M such an increase of T as will leave P (the general level of prices) unaffected. This is possible In theory in certain circumstances, but as four variables are concerned and only one (M) Is readily controllable by monetary manipulation in most circumstances it is difficult to predict what the final result will be.

If M has been increased but at the end of the relevant period no change has taken place in P or T then the increase of M must have been neutralised by a decrease of V. Such a decrease would be the result of a multitude of individual human judgements in the economy.

People in general must have been willing to hold additional amounts of money in the form of idle cash balances. There are three main reasons for holding money in the form of cash or cheque operated deposits -- the transactions motive, the precautionary motive, and the speculative motive. The amount of money held for the first two purposes is largely determined by the price level, the distribution of income, and the habits of individuals. Any change in velocity is likely to be reflected mainly in money held for speculative purposes though perhaps to a certain extent in money held for the precautionary motive.

If the period of reference is 12 months and the total amount of money remains inactive on the average for 2 months then V=6 and we can write the equation 6M=PT. If owing to an injection of new money people hold idle balances on the average for 3 months then the equation becomes 4M=PT. In such a case V would have diminished in the ratio of 6 to 4 and this is why there would be no reaction in the arithmetical value of PT. A decrease of velocity tends to be reflected in an increase of idle balances.

The arithmetic value of M can change as a result of autonomous forces acting on the economy, e.g. the discovery of a gold mine as well as by reason of monetary manipulation. The persistent equality of MV and PT can be maintained in many ways. If by reason of an increase of money an equivalent increase of transactions has been induced then a monetary impulse has had a non-monetary, or economic effect on the economy. Why wait for a new gold mine if money can be increased in other ways with such salutary effects? - so the argument runs.

If, however, an increase of M is not balanced by an increase of T (or a decrease of V) there will be an impact on the economy as a consequence of rising prices (P) and the resulting inflationary situation is in general anything but salutary.

Changes in V are reflected in changes in the amount of cash balances which people are willing to hold and the length of time they hold them. There are various possible reasons why people should be willing to increase their idle cash balances. If interest rates are low and are expected to rise, then the capital value of fixed interest bonds is expected to fall, however gilt edged they may be.

If one buys on the basis of a 4% yield and in the near future the market value of the same security fails to the level of a 5% yield for a new transaction the investor on the 4% yield basis will have suffered a 20% loss of capital value which will wipe out many years of interest payments on the 4% yield basis.

Idle balances do indeed yield no interest but the expectation of rising yields to investments at a later date is a very good reason for increasing the idle balances at one's command for the time being. Hence the expectation of rising rates causes an increase of what is called the liquidity preference for money. An expectation of falling commodity prices is also a very good reason for increasing one's command of idle cash balances.

It should be noted that holding idle cash balances does involve a loss of interest. Consequently there is a relation between the rate of interest and the amount of idle cash balances which people will be willing to hold. Apart from expectations of change the general relation is that the lower the rate of interest the less is the sacrifice involved in holding idle cash balances.

If people react to a low interest rate by holding a greater volume of idle cash balances, is it possible that by manipulating an increase of idle cash balances the rate of interest can be induced to fall? This is the central feature of the Keynesian liquidity preference theory of the rate of interest.

The Classical School of Economists held a non-monetary theory which prevailed in the nineteenth century. It is summarised under three heads in Korteweg and Keesing - A Textbook of Money, page 287:

(1) The fluctuation of the rate of interest ensures the equation of saving and investment.

(2) The supply of commodities creates a corresponding demand for other goods and there can be no discrepancy between aggregate supply and aggregate demand.

(3) Money plays a mediatory role and has no independent impact on the economy.

The Classical School theory is now regarded as far from adequate, but one may note that Berkeley, as long ago as 1735 held that money can be so manipulated as by its increase to produce a real and salutary Impact on the economy. In the circumstances of his age and country he was quite right. His particular contribution to the theory of money has (like his country) always remained in a kind of economic backwater. His social philosophy has never been absorbed in the canonically accepted stream of orthodox economic thought. In essence he anticipated much of what is of permanent value in modern Keynesian ideas.

The Swedish economist Wicksell (1851-1926) was the first in modern times to break through the hard crust of Classical non-monetary theories. He pointed out that a net increase in the volume of bank lending could increase the monetary total of savings otherwise available and thus affect the supply price at which money could be borrowed for purposes of real investment.

Any theory of the rate of interest must explain why there is a supply price for savings and why there Is a demand price for the use of other people's savings. In this aspect non-monetary considerations still count for something.

People discount the value of future monetary acquisition and will not part with £X now unless they reassured of £(X + Y) during the course of a future period. From the side of demand it is worth while for the entrepreneur to borrow so long as he can do so at a rate which s attractive in comparison with his estimate of the marginal efficiency of the relevant increment of real productive assets.

(Keynes' definition of marginal efficiency will be found on page 135 of the General Theory of Employment Interest and Money).

However it remains true that monetary factors and especially the activities of the Government and the Banking System can make a difference to the effective rate of interest.

In Keynes' theory interest is essentially a reward for the relinquishment of liquidity and for the risks incurred when money is lent. "The function of interest in the economy is to bring about the situation in which aggregate liquidity preference will be equal to the money supply."

As we have seen, the lower the rate of interest the greater will be the total money supply and the proportion of idle balances in the total money supply, other things being equal. Hence it seemed to follow that whoever could influence the rate of interest downwards could determine the total volume of money. Since an increase in real investment would be encouraged by a lower interest rate and was in itself desirable for the relief of unemployment and the increase of the national income, it seemed desirable that the monetary authorities should provoke a fall of interest rates by increasing the volume of money.

This in effect was done in the middle 1930's when the Banking System (facilitated by the Bank of England) bought gilt edged securities at increasing prices from the general public; thus the rate of interest was lowered and an increase took place in idle balances held as bank deposits by the general public. This was done with success in the 1930s but was a disastrous failure when an apparently similar policy was attempted by Dalton as Chancellor of the Exchequer in 1946 and 1947.

The essential difference between the middle 1930s and 1946-47 was that the liquidity premium on holding money was at a maximum in the 1930s but that in 1946-47 other things e.g. commodities property or equity shares were a much safer and nearly equally convenient store for one's surplus wealth.

When prices are stable or tending downwards money can safely be increased with a possible effect on lowering the general rate of interest. When prices have a strong upward tendency from inflation in any of its forms, idle balances are apt to become extremely active.

The higher prices become the, greater will be the volume of money needed for current transactions, and the smaller will become the proportional volume of idle balances which alone is relevant to the general rate of interest.

The Keynesian theory of liquidity preference and interest as compensation for the relinquishment of monetary liquidity is appropriate only to a static situation. In such a situation it explains why people hold so much of their store of wealth as they do in the form of idle cash balances. When money is losing its liquidity premium in favour of other things by reason of loss of confidence in its future purchasing power, the general rate of interest can not be reduced by increasing the quantity of money.

The concept of liquidity preference is nevertheless a valuable one. In an era of stable prices money is a most convenient way in which to keep a substantial part of one's store of value. In a time of rising prices other things which seem likely to rise in value with rising prices become much more desirable as a store of value than idle balances of cash. Since the early 50s there has been a growing demand for "growth stocks' as a preferable store of value and these have regularly been bought on the basis of a yield less than 3 per cent whereas undated gilt edged securities yielded 6 per cent or more.

Summarising one may say that velocity of circulation is affected by expectations of rising or falling prices and interest rates; further the variations of velocity are directly related to changes in the relative amounts of idle cash balances in the total monetary supply. There are non-monetary as well as monetary causes determining the level of interest rates for loans of different periods. In some rather unique circumstances interest rates can be influenced in a downward direction by an increase in the quantity of money.

In the opposite case it is certainly true that a reduction of the amount of money, as a result of a restrictive credit policy, will bring about an upward movement of interest rates in general. The relations between planned voluntary (or involuntary) saving and planned real investment in a significant period are of paramount importance in determining the general rate of interest. Monetary manipulation, though sometimes apparently magical in its potency, can in general only operate on the fringe.

Some navigational notes:

Copyright Dr Roy Johnston 1999