Tag Archives: money

Some Thoughts on Liquidity

The quantity theory relates not so much to money as to the whole array of financial assets exogenously supplied by the government. If the government debt is doubled in the absence of a government-determined monetary base the price level doubles just as well as in the case of a doubling of the monetary base in the absence of government debt. — Jurg Niehans, 1982

Seemingly lost in the discussion of monetary policies various QEs is a meaningful resolution of our understanding of the monetary transmission mechanism.  Sure, New Keynesians argue that forward guidance about the time path of the short term nominal interest rate is the mechanism, Bernanke argues that long term interest rates are the mechanism, and skeptics of the effectiveness of QE argue that it is the interest rate on excess reserves that is the mechanism.  I actually think that these are not the correct way to think about monetary policy.  For example, there are an infinite number of paths for the money supply consistent with a zero lower bound on interest rates.  Even in the New Keynesian model, which purportedly recuses money from monetary policy, the rate of inflation is pinned down by the rate of money growth (see Ed Nelson’s paper on this).  It follows that it is the path of the money supply that is more important to the central bank’s intermediate- and long-term goals.  In addition, it must be the case that the time path of the interest rate outlined by the central bank is consistent with expectations about the future time path of interest rates.  The mechanism advocated by Bernanke is also flawed because the empirical evidence suggests that long term interest rates just don’t matter all that much for investment.

The fact that I see the monetary transmission mechanism differently is because you could consider me an Old Monetarist dressed in New Monetarist clothes with Market Monetarist policy leanings (see why labels are hard in macro).  Given my Old Monetarist sympathies it shouldn’t be surprising that I think the aforementioned mechanisms are not very important.  Old Monetarists long favored quantity targets rather than price targets (i.e. the money supply rather than the interest rate).  I remain convinced that the quantity of money is a much better indicators of the stance of monetary policy.  The reason is not based on conjecture, but actual empirical work that I have done.  For example, in my forthcoming paper in Macroeconomic Dynamics, I show that many of the supposed problems with using money as an indicator of the stance of monetary policy are the result of researchers using simple sum aggregates.  I show that if one uses the Divisia monetary aggregates, monetary variables turn out to be a good indicator of policy.  In addition, changes in real money balances are a good predictor of the output gap (interestingly enough, when you use real balances as an indicator variable, the real interest rate — the favored mechanism of New Keynesians — is statistically insignificant).

Where my New Monetarist sympathies arise is from the explicit nature in which New Monetarism discusses and analyzes the role of money, collateral, bonds, and other assets.  This literature asks important macroeconomic questions using rich microfoundations (as an aside, many of the critics of the microfoundations of modern macro are either not reading the correct literature or aren’t reading the literature at all).  Why do people hold money?  Why do people hold money when other assets that are useful in transactions have a higher yield?  Using frameworks that explicitly provide answers to these questions, New Monetarists then ask bigger questions. What is the cost associated with inflation? What is the optimal monetary policy? How do open market operations work?  The importance of the strong microfoundations is that one is able to answer these latter questions by being explicit about the microeconomic assumptions.  Thus, it is possible to make predictions about policy with an explicit understanding of the underlying mechanisms.

An additional insight of the New Monetarist literature is that the way in which we define “money” has changed substantially over time.  A number of assets such as bonds, mortgage-backed securities, and agency securities are effectively money because of the shadow banking system and the corresponding prevalence of repurchase agreements.  As a result, if one cares about quantitative targets, then one must expand the definition of money.  David Beckworth and I have been working on this issue in various projects.  In our paper on transaction assets shortages, we suggest that the definition of transaction assets needs to be expanded to include Treasuries and privately produced assets that serve as collateral in repurchase agreements.  In addition, we show that the haircuts of private assets significantly reduced the supply of transaction assets and that this decline in transaction assets explains a significant portion of the decline in both nominal and real GDP observed over the most recent recession.

The reason that I bring this up is because this framework allows us not only to suggest a mechanism through which transaction assets shortages emerge and to examine the role of these shortages in the context of the most recent recession, but also because the theoretical framework can provide some insight into how monetary policy works.  So briefly I’d like to explain how monetary policy would work in our model and then discuss how my view of this mechanism is beginning to evolve and what the implications are for policy.

A standard New Monetarist model employs the monetary search framework of Lagos and Wright (2005).  In this framework, economic agents interact in two different markets — a decentralized market and a centralized market.  The terms of trade negotiated in the decentralized market can illustrate the effect of monetary policy on the price level. (I am going to focus my analysis on nominal variables for the time being.  If you want to imagine these policy changes having real effects, just imagine that there is market segmentation between the decentralized market and centralized market such that there are real balance effects from changes in policy.)  In particular the equilibrium condition can be written quite generally as:

P = (M+B)/z(q)

where P is the price level, M is the money supply, B is the supply of bonds, and z is money demand as a function of consumption q.  I am abstracting from the existence of private assets, but the implications are similar to those of bonds.  There are a couple of important things to note here.  First, it is the interaction of the supply and demand for money that determines the price level.  Second, it is the total supply of transaction assets that determines the price level.  This is true regardless of how money is defined.  Third, note that as this equation is presented it is only the total supply of transaction assets that determine the price level and not the composition of those assets.  In other words, as presented above, an exchange of money for bonds does not change the price level.  Open market operations are irrelevant.  However, this point deserves further comment.  While I am not going to derive the conditions in a blog post, the equilibrium terms of trade in the decentralized market will only include the total stock of bonds in the event that all bonds are held for transaction purposes.  In other words, if someone is holding bonds, they are only doing so to finance a transaction.  In this case, money and bonds are perfect substitutes for liquidity.  This implication, however, implies that bonds cannot yield interest.  If bonds yield interest and are just as liquid as money, why would anyone hold money? New Monetarists have a variety of reasons why this might not be the case.  For example, it is possible that bonds are imperfectly recognizable (i.e. they could be counterfeit at a low cost). Alternatively, there might simply be legal restrictions that prevent bonds from being used in particular transactions or since bonds are book-entry items, they might not as easily circulate.  And there are many other explanations as well.  Any of these reasons will suffice for our purposes, so let’s assume that that is a fixed fraction v of bonds that can be used in transactions.  The equilibrium condition from the terms of trade can now be re-written:

P = (M + vB)/z(q)

It now remains true that the total stock of transaction assets (holding money demand constant) determines the price level.  It is now also true that open market operations are effective in influencing the price level.  To summarize, in order for money to circulate alongside interest-bearing government debt (or any other asset for that matter) that can be used in transactions, it must be the case that money yields more liquidity services than bonds.  The difference in the liquidity of the two assets, however, make them imperfect substitutes and imply that open market operations are effective.  It is similarly important to note that nothing has been said about the role of the interest rate.  Money and bonds are not necessarily perfect substitutes even when the nominal interest on bonds is close to zero. Thus, open market operations can be effective for the central bank even if the short term interest rate is arbitrarily close to zero.  In addition, this doesn’t require any assumption about expectations.

The ability of the central bank to hit its nominal target is an important point, but it is also important to examine the implications of alternative nominal targets.  Old Monetarists wanted to target the money supply.  While I’m not opposed to the central bank using money as an intermediate target, I think that there are much better policy targets.  Most central banks target the inflation rate.  Recently, some have advocated targeting the price level and, of course, advocacy for nominal income targeting has similarly been growing.  As I indicated above, my policy leanings are more in line with the Market Monetarist approach, which is to target nominal GDP (preferable the level rather than the growth rate).  The reason that I advocate nominal income targeting, however, differs from some of the traditional arguments.

We live in a world of imperfect information and imperfect markets. As a result, some people face borrowing constraints.  Often these borrowing constraints mean that individuals have to have collateral.  In addition, lending is often constrained by expected income over the course of the loan.  The fact that we have imperfect information, imperfect markets, and subjective preferences means that these debt contracts are often in nominal terms and that the relevant measure of income used in screening for loans is nominal income.  A monetary policy that targets nominal income can potentially play an important role in two ways.  First, a significant decline in nominal income can be potentially harmful in the aggregate.  While there are often claims that households have “too much debt” a collapse in nominal income can actually cause a significant increase and defaults and household deleveraging that reduces output in the short run.  Second, because banks have a dual role in intermediation and money creation, default and deleveraging can reduce the stock of transaction assets.  This is especially problematic in the event of a financial crisis in which the demand for such assets is rising.  Targeting nominal income would therefore potentially prevent widespread default and develeraging (holding other factors constant) as well as allow for the corresponding stability in the stock of privately-produced transaction assets.

Postscript:  Overall, this represents my view on money and monetary policy.  However, recently I have begun to think about the role and the effectiveness of monetary policy more deeply, particularly with regards to the recent recession.  In the example given above, it is assumed that the people using money and bonds for transactions are the same people.  In reality, this isn’t strictly the case.  Bonds are predominantly used in transactions by banks and other firms whereas money is used to some extent by firms, but its use is more prevalent among households.  David Beckworth and I have shown in some of our work together that significant recessions associated with declines in nominal income can be largely explained through monetary factors.  However, in our most recent work, it seems that this particular recession is unique.  Previous monetary explanations can largely be thought of as currency shortages in which households seek to turn deposits into currency and banks seek to build reserves.  The most recent recession seems to be better characterized as a collateral shortage, in particular with respect to privately produced assets.  If that is the case, this calls into question the use of traditional open market operations.  While I don’t doubt the usefulness of these traditional measures, the effects of such operations might be reduced in the present environment since OMOs effectively remove collateral from the system.  It would seem to me that the policy implications are potentially different.  Regardless, I think this is an important point and one worth thinking about.

Money, the Money Multiplier, and Monetary Theory

John Williams recently gave a speech on teaching about monetary theory and policy after the financial crisis. Here is the basic thesis:

When I was an undergraduate at Berkeley in the early 1980s, much of the monetary economics that I learned was based on theories from the 1950s or even earlier. These included the quantity theory of money, Keynes’s LM curve, Milton Friedman’s monetarism, and the Baumol-Tobin theory of money demand, to name a few examples. Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga. The theories of that era need to be adapted to the brave new world in which we now live.

I am not sure what this means, however, given the remainder of the speech. Despite the fact that Williams claims that the work of Friedman, Tobin, and Keynes represent “elegant statements of fundamental economic principles”, he subsequently goes on in the speech to largely disparage this work; in particular, the quantity theory of money and the Baumol-Tobin inventory-theoretic model of money demand. While I share Williams view that we need to understand modern innovations in economic thinking, I also think that it is important to understand and appreciate contributions of the likes of Friedman, Tobin, Keynes, and others. There is much that we can learn from the history of economic thought and, in this respect, it is important to read primary sources of the literature and not second-hand accounts (note: this is a general statement, not a knock against Williams). Thus, while I share Williams’ view that we need to appreciate recent contributions, I think that it is important to give fair treatment to earlier important contributions as well. I will elucidate this point below.

Williams seems to disparage the quantity theory of money by pointing to a fairly standard objection:

There have been a number of attempts to find a broader measure of “money” that has a stable relationship with nominal spending — that is, a constant velocity.

He then proceeds to detail differences in different monetary aggregates and their growth rates during the crisis. Differing growth rates and changes in velocity over the past few decades are then cited as evidence that using using the money supply to forecast nominal spending or inflation is a fool’s errand. This reasoning is flawed for two reasons. First, constant velocity is a straw man as Thomas Sowell details in On Classical Economics:

The idea that the price level is rigidly linked to the quantity of money by a velocity of circulation which remains constant through all transitional adjustment processes cannot be found in any classical, neoclassical, or modern proponent of the quantity theory of money. Changes in the velocity of circulation — short run and/or long run — were analyzed by David Hume, Adam Smith, Henry Thornton, T.R. Malthus, David Ricardo, Nassau Senior, John Stuart Mill, Alfred Marshall, Knut Wicksell, Irving Fisher, and Milton Friedman.

As I have illustrated before, velocity is not constant, but appears to be a stable function of the interest rate. (See Allan Meltzer’s graph.)

The second flaw in the analysis is that Williams is relying on simple sum aggregates, which are theoretically flawed and often produce puzzling empirical results. The question surrounding the quantity theory of money is essentially whether or not money can forecast inflation and nominal income growth and the answer is yes especially using longer time horizons and low frequency data.

Williams similarly caricatures analysis of the money multiplier:

The breakdown of the standard money multiplier has been especially pronounced during the crisis and recession. Banks typically have a very large incentive to put excess reserves to work by lending them out.

I assume that what Williams means by “the standard money multiplier” is the framework put forward in Phillips’ (1920) Bank Credit in which the money multiplier is a parameter. This view of the multiplier might be taught in principles, but I don’t think that it is used beyond that point. Even in Mishkin’s Money and Banking text, which does include analysis of the multiplier, there are explicit references to changes in the underlying factors that determine such a multiplier. Indeed, the literature on monetary theory has long recognized that the money multiplier could not be viewed as fixed coefficient. In the post-war era, this view was recognized by Gurley and Shaw (1960) and Tobin (1963). In addition, Brunner and Meltzer (e.g. JPE, 1968; JPE, 1972) explicitly modeled the money multiplier as a function of interest rates.

Jurg Niehans (1978: 274) elaborates on the points above:

While this fixed-coefficient approach, though perhaps pedestrian, is often useful and , for certain purposed, illuminating, it is also subject to serious limitations. Taken at face value it seems to say that money is very different from other things, inasmuch as demand has no influence on the quantity available; the quantity seems to be purely supply-determined. However, this is a superficial impression. It is well recognized that the coefficients appearing in the multiplier are not, in fact, technological constants, but depend, in turn, on interest rates (Brunner and Meltzer, 1968).

In addition, as Niehans (1978: 274) details, the general equilibrium approach in which interest rates are jointly determined with the money supply was developed by Tobin (1963), but actually has “its long ancestry in the pre-Phillips tradition of money supply theory.” Those who have used the money multiplier in discussions of the crisis have, by and large, recognized these points as well.

Like Williams, I agree that the financial crisis and the broader recession pose important questions for monetary theorists and teachers. However, I believe that there is much to be learned in both the present literature and the past literature on issues of monetary analysis and central banking (see Perry Mehrling’s The New Lombard Street, for example). And I wish that Tobin and Friedman would have received fairer treatment from Williams.

The Failure of Modern Macroeconomics

Since the financial crisis began, I have been one of the most vehement supporters of modern macroeconomics. While I have my own quarrels with the current research, I have found much (not all) of the criticism wanting. Nevertheless, there is one notable and glaring failure in the macro literature that has come to the forefront during this recession. That failure is regarding the zero lower bound on nominal interest rates. Not only do I believe that a consensus is needed on this topic, but I also believe that the zero lower bound is of little practical importance.


The tool of modern macroeconomics is the dynamic, stochastic, general equilibrium (DSGE) model. Monetary models often consist of the baseline New Keynesian model and extensions thereof. This model is characterized by two equations and an interest rate rule. The first equation is the dynamic IS equation, which is expressed in logarithms as follows:

y(t) = E(t)y(t+1) – (1/a)[R(t) – E(t)P(t+1)]

where y(t) is the output gap at time t, E is the mathematical expectation operator, R is the nominal interest rate, P is inflation, and a is a parameter.

The second equation is the New Keynesian Phillips curve:

P(t) = bE(t)P(t+1) + ky(t)

where b and k are parameters.

The system is then closed by a monetary policy rule. This is typically formulated as a Taylor-type rule in which the monetary authority adjusts the nominal interest rate in response to inflation and the output gap. Together with the assumption of sticky prices, the adjustment of the nominal interest rate leads to a corresponding adjustment in the real interest as well.

It is important to note that money is not part of this model. Rather movements in the interest rate pin down the rate of inflation (so long as the policy rule leads to an increase in the real rate of interest when inflation is higher than its target). The purported benefits of these types of models is that they can neglect any reference to money demand and the interest rate captures the complete transmission mechanism through which monetary policy and monetary shocks influence the system. As it turns out, however, this framework contributes to what I believe to be the failure of modern macro in light of this recession. [I also have quarrels with the empirical evidence that justifies this approach, but I will leave that for a separate post.]

The Zero Lower Bound

In the model presented above, monetary policy is conducted by a central bank that adjusts ‘the’ interest rate. The change in the interest rate in turn inversely impacts the output gap through the IS relation. Supposing that we begin from a zero inflation steady state, the increase in the interest rate causes output to fall below the natural rate. As a result, inflation declines in accordance with the New Keynesian Phillips curve.

What this process illustrates is that the interest rate is the sole mechanism through which monetary policy affects the economy. The importance of this point centers on the fact that the nominal interest rate is limited in that it cannot take on a value less than zero. Thus, if we believe this model accurately captures the world in which we live, there exists a precarious position for central banks when the output gap is negative and the nominal interest rate is zero.

The zero bound therefore places a limit on the effects of monetary policy conducted using an interest rate.

Theoretical Foundations

As with all modern theoretical macro models, the New Keynesian model is derived from microeconomic foundations. In other words, the IS equation is derived from utility maximization in which a representative household maximizes utility subject to a budget constraint. In the basic New Keynesian model illustrated above, there is a consumption good and one asset (bonds). The analysis can be extended to include money, but for typical money demand functions, money is essentially a mirror for changes in the interest rate. Nonetheless, the existence of only two assets — money and bonds — is at the heart of the problem.

If monetary policy is ineffective at the zero bound, this is referred to as a liquidity trap. Put differently, if the interest rate on bonds is zero, money and bonds become perfect substitutes. Whereas open market operations would typically be used to increase reserves and thereby lower the federal funds rate, in a liquidity trap agents simply hold the additional cash balances in place of the bonds. Increases in the money supply do not result in real changes, only alterations to the composition of portfolios.

So what is the problem with this analysis?

Well, the problem surrounds the fact that there are only two assets in the model. Monetary policy is impotent because money and bonds are perfect substitutes. Contrary to this model (and others), there are actually substantially more than two assets in the real world. Thus, a natural question to ask is whether these other assets matter for our analysis. In their 1968 paper, Karl Brunner and Allan Meltzer do precisely that. They extend the analysis beyond the two asset world. In such a case, the condition for a liquidity trap is that the marginal rates of substitution for money and all other assets must be equal to zero. As Karl Brunner would have said, we simply know this isn’t true.

This condition, I believe, represents substantial reason for pause in considering the possibility and policy implications of a liquidity trap. In fact, I would argue that it suggests that liquidity traps don’t exist. Put differently, as Scott Sumner has suggested:

Zero rates don’t really make monetary policy more difficult, they make interest rate-oriented monetary policy more difficult.

Indeed, in the absence of a liquidity trap, the zero lower bound is merely a signal that monetary policy needs to employ other methods.

The Evidence . . . Or, Am I alone?

A subsequent question is whether (a) evidence suggests that monetary policy is impotent, and (b) whether I am alone in suggesting that “unconventional” monetary policy — defined as non-interest rate policy — is useful at the zero bound.

Regarding point (a), I will be brief. In a fairly recent paper, Allan Meltzer examines the monetary transmission mechanism by comparing the behavior of the real interest rate and real money balances during periods of deflation. The impetus behind this reasoning is that during periods of deflation, the real interest rate and real balances will increase. If the monetary transmission mechanism is solely captured by the real interest rate as implied by the New Keynesian framework, then one would expect output to decline as the real interest rate rises. In contrast, the monetarist proposition has long been that the monetary transmission mechanism is reflected by the behavior of real money balances as individuals re-allocate their portfolios thereby inducing relative price adjustments on financial assets and subsequently on non-financial, or real, assets. Thus, the mechanism implies that as real balances rise, output should be expected to rise. He finds that in each case the behavior of real money balances is a much better predictor of movements in output than the real interest rate. This not only suggests that there is little reason to fear the zero lower bound, but there is also reason to doubt that the interest rate represents the correct mechanism for analysis of the monetary transmission process.

Regarding point (b), consider some recent papers that examine the zero lower bound. First, Marco Del Negro, Gauti Eggertson, Andrea Ferrero, and Nobuhiro Kiyotaki (HT: David Beckworth):

This paper extends the model in Kiyotaki and Moore (2008) to include nominal wage and price frictions and explicitly incorporates the zero bound on the short-term nominal interest rate. We subject this model to a shock which arguably captures the 2008 US financial crisis. Within this framework we ask: Once interest rate cuts are no longer feasible due to the zero bound, what are the effects of non-standard open market operations in which the government exchanges liquid government liabilities for illiquid private assets? We find that the effect of this non-standard monetary policy can be large at zero nominal interest rates. We show model simulations in which these policy interventions prevented a repeat of the Great Depression in 2008-2009.

Next, Michael Woodford, the founder of the moneyless approach exemplified by the New Keynesian model, and Vasco Curdia:

We extend a standard New Keynesian model both to incorporate heterogeneity in spending opportunities along with two sources of (potentially time-varying) credit spreads and to allow a role for the central bank’s balance sheet in determining equilibrium. We use the model to investigate the implications of imperfect financial intermediation for familiar monetary policy prescriptions and to consider additional dimensions of central bank policy—variations in the size and composition of the central bank’s balance sheet as well as payment of interest on reserves—alongside the traditional question of the proper operating target for an overnight policy rate. We also study the special problems that arise when the zero lower bound for the policy rate is reached. We show that it is possible to provide criteria for the choice of policy along each of these possible dimensions within a single unified framework, and to achieve policy prescriptions that apply equally well regardless of whether financial markets work efficiently or not and regardless of whether the zero bound on nominal interest rates is reached or not

And finally, Paul Krugman:

Even if the economy is in a liquidity trap in the sense that the nominal interest rate is stuck at zero, the monetary expansion would raise the expected future price level P*, and hence reduce the real interest rate. A permanent as opposed to temporary monetary expansion would, in other words, be effective – because it would cause expectations of inflation.

An astute reader will note that I have chose these authors because they are supporters of or seem content with the interest rate view of monetary policy. Nevertheless, in each case, they find that monetary policy can be effective at the zero lower bound.

Taken together with the evidence by Meltzer above, I think that we have sufficient reason to doubt the existence of liquidity trap.

Brief Conclusion

The zero lower bound represents a key failure of modern macro in that there is little consensus or agreement about the effects of monetary policy in such a circumstance. The issue is of central importance for determining the correct policy prescriptions — both monetary and fiscal. It is my hope that the recent surge in research on the zero lower bound will ultimately reach a consensus. What’s more, I hope that this consensus takes into account that we live in a world with more than two assets and, as a result, that the zero lower bound is nothing more than an intellectual curiosity.

Further Reading: For those interested in the topic, I think that these papers might be of use as well:

Sumner, Scott. 2002. “Some Observations of the Return of the Liquidity Trap.” Cato Journal.

Goodfriend, Marvin. 2000. “Overcoming the Zero Lower Bound on Monetary Policy.” Journal of Money, Credit, and Banking.

Meltzer, Allan. “Monetary Transmission at Low Inflation: Lessons from Japan.” (.doc link here).

Reflections on J.M. Keynes

The work of Keynes can be separated into two categories, the general theory and the applied theory.  Unfortunately, much of what survives as Keynesianism in today’s lexicon is the applied theory, which essentially consists of the government serving as the facilitator of increased demand during a recession or a depression.  I must confess that I myself frequently fail to distinguish between each theory when discussing what I believe to be the failures of Keynesian aggregate demand management.  Nevertheless, Keynes’ general theory was an important, but Keynes’ most profound ideas are not the ones that are emphasized in economics today.

Keynes’ applied theory has been the subject of a great deal of criticism and rightfully so.  However, his general theory has also been attacked (often by those who oppose his applied theory).  These attacks often fail to understand exactly what is important in Keynes’ general theory.  There is no doubt that reading Keynes’ General Theory is at times akin to gnawing on a two-dollar steak, but there are profound insights to be discovered.

It is clear from reading Keynes that he either misunderstood some of the classical economists or was not well read in their theory with respect to Say’s Law and monetary disturbances.  Nevertheless, this criticism is to some extent aesthetic, as Keynes was arguing as much against the classical economists as he was against the Marshallian market adjustment process. (It is in this argument against the Marshallian adjustment process that Keynes arrives at his great insight, which will be discussed later.)

First and foremost, Keynes’ theory is a monetary theory.  It begins with Keynes’ Treatise on Money and is extended through the General Theory.  This is often overlooked as Keynes’ applied theory emphasizes the impotency of monetary policy in correcting the shortfalls in aggregate demand that result in recessions.  Keynes monetary theory in the Treatise can be outlined as follows.  Each businessman has his own subjective expectations of future profitability and other business conditions.  If these expectations are pessimistic, businesses will invest less and therefore reduce the amount of securities that are issued.  This decrease in the supply of securities leads to excess demand and therefore raises the price of securities and therefore lowers the natural rate of interest.  As the market rate of interest begins to decline in accordance with the natural rate, bear speculators who were used to getting the higher rate of return begin to sell some of their ‘old’ securities and therefore the market rate is prevented from completely adjusting with the natural rate and the market ‘clears’ at a point of disequilibrium.  The result is an excess demand for money and a corresponding excess supply of commodities.

It is at this point that we must understand Keynes’ profound insight of The General Theory.  Keynes’ insight is that in the absence of perfect price flexibility, the adjustment process will come from output rather than the price level (which ran counter to the conventional wisdom of the Marshallian adjustment process).  The result is therefore a recession.

Unfortunately, the key insight of Keynes is often highlighted by modern macroeconomists as either the importance of insufficient demand or of sticky prices.  Each of these insights downplays the role of Keynes’ general theory and fails to differentiate Keynes from his classical counterparts.  The idea of sticky wages and prices is not something created or even truly advocated by Keynes (see the work of Leland Yeager or Clark Warburton for a detailed summary of the lineage of sticky prices).  Rather Keynes’ emphasis was on the fact that prices were not perfectly flexible and therefore a reduction of stickiness would not alleviate the problem.  (It is actually quite amusing that so-called “New Keynesians” adopted sticky prices in his name when in fact his theory was written in a time of rapidly falling wages and prices.)

The prevailing theory of business fluctuations (in the U.S.) was monetary disequilibrium theory, which held that when there is excess demand for money, there will be deflationary pressure which can only be eased by an increase in the money supply or a decrease in the price level.  However, the presence of sticky prices will prevent the necessary decline in the price level and output and employment will fall as a result.  In this scenario, the presence of sticky prices is to blame for the downturn.  However, in Chapter 19 of the General Theory, Keynes refutes this point, claiming that prices need not be sticky, but only lack infinite flexibility.  Further, Keynes points out that if the prices were allowed to change, it may exacerbate the problem by inducing a scenario of debt-deflation (Keynes does not use the term, but it fits his analysis).  So while the mainstream continues to adhere to this idea of sticky prices as a product of the work of Keynes, a reading of Chapter 19 suggests otherwise.

The work of Keynes is, of course, not without significant error.  His applied theory is clearly a source of frustration.  More importantly, however, is the abandonment of the Wicksell-foundation of the natural rate and market rate of interest in favor of the liquidity preference (a topic which would require another post altogether).  What’s more, it is not clear to me that Keynes’ general theory is all that general, but rather more specific to the time in which he was writing and specific periods of downturn.  Advocates of his theory may disagree with this analysis and point to the current credit crisis as an example that fits with the theory, but I am not convinced that this is the case (nor are the Austrians, of whom I am sympathetic).

This post should by no means be construed as an advocacy of Keynes’ general theory, but rather an emphasis on what he got right – something that is missing from much of the present day discussion.  Keynes’ work is best understood as a lineage of evolving ideas (an evolution, which regrettably did not remain wholly consistent with the Wicksell-foundations).  His General Theory is certainly a flawed work (this seems to fit, however, with Keynes’ famous quote, “I would rather be vaguely right than precisely wrong”), but his insights regarding output adjustments and disequilibrium should nevertheless be appreciated.