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Finance Motive

By Alvin Garcia,2014-08-07 11:53
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Finance Motive

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    A reinterpretation and remedy of Keynes’s liquidity preference theory

Author: Wenge Huang

    Email: hkevin2000@yahoo.com

    Address: Room 2905, Building 4, New Town, 88 Jianguo Road, Chaoyang District, Beijing, 100022, P.R.China

    The dissension on the mechanism of determination of interest rate is always in the center of much confusion and many controversies of monetary economics. Keynes‟s liquidity preference theory remains at the core of the center. This paper starts off with analyzing the inherent logic of liquidity preference theory and presents a new interpretation of the theory in a more logical and clear manner. The reinterpretation clearly indicates the necessity of introducing liquidity preference analysis into determination of interest rate, arguing that it is the liquidity preference analysis based on finance motive, rather than on transactions motive, that plays a more fundamental role in determining interest rate. The paper then points out a crucial and unsolved mistake in Keynes‟s liquidity preference theory, i.e. interest rate is

    indeterminate, which is revealed by introducing finance motive into the theory. Further, the paper develops a logically consistent and integrated model of determination of interest rate on the basis of the liquidity preference analysis centered on finance motive. In this model,

    interest rate is not determined by the demand for and supply of money, but determined by the demand for and supply of idle money.

    Keywords: Liquidity preference theory, Finance motive, IS-LM model, Determination of interest rate

    JEL classifications: E12, E41, E43

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1. Introduction

    The dissension on the mechanism of determination of interest rate is always in the center of much confusion and many controversies of monetary economics. Keynes‟s

     liquidity preference theory remains at the core of the center. Liquidity preferencewas

    first introduced to determine interest rate by Keynes in his profoundly influential General Theory in 1936. Before that, the classical theory of interest argues that the level of interest rate is determined by two real factors: the demand for investment and supply of saving.

    In The General Theory, Keynes (1936) criticizes the classical theory of interest and presents a brand-new theory of interest, namely liquidity preference theory. In Keynes‟s opinion, interest rate is not determined by saving and investment, but by the demand for and supply of money. Demand for money, or broadly defined liquidity preference, is composed of transactions motive, precautionary motive and speculative motive. Among the three motives, transactions motive and precautionary motive mainly depend on the level of income; and speculative motive, or narrowly defined liquidity preference, mainly depends on the level of interest rate. The supply of money is the quantity of money determined by the monetary authority. Interest rate is a price, which makes the quantity of money the public would like to hold equal to the quantity of money in existence.

    Keynes‟s liquidity preference theory induced a lot of controversies soon after he

    brought it forward. Most curiously, The General Theory holds that the change of

    propensity to invest (namely, a shift of the investment demand curve or Keynes‟s investment demand-schedule) only exerts an ex post influence on interest rate indirectly via the change of transactions motive after income changes. Moreover, Keynes didn‟t explain why. Ohlin (1937) and Robertson (1937, 1940), the two most

    famous loanable funds theorists, attacked Keynes‟s theory of interest effectively on this issue. Their criticism can be summarized as: if there is an increase in propensity to invest, according to Keynes, the multiplier effect can make the level of income rise,

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    leading to investment equal to saving. However, in adjusting to the new equilibrium, desired investment and desired saving are not equal.

    In his reply to Ohlin‟s criticism, Keynes (1937B, 1937C, 1938) confessed his mistake and introduced a new and somewhat novel incentive for demanding money, namely the finance motive, in order to improve his liquidity preference theory. Keynes argues that, during the period between the date when entrepreneurs make their investment decisions and the date when they actually make their investment, there is a demand for finance. Keynes stresses that finance motive is an additional motive for demanding money and essentially a revolving fund, whilst an excess in demanding for finance resulting from the increase of propensity to invest may lead to a rise of interest rate.

    In his debate with loanable funds theorists, although Keynes kept clarifying and improving his liquidity preference theory, the theory is still known for its bizarrerie and difficulty to be understood, resulting in a lot of controversies in interpreting it. Most strangely, finance motive can hardly be found in the literatures after Keynes until Davidson (1965) rediscovered finance motive. Among the various interpretations is

    IS-LM model of NeoClassical Synthesis the most well-known.

    The prototype of IS-LM model was first presented by Hicks (1937) to elucidate the interrelationships between the theory of effective demand and the liquidity preference theory. But it should be mainly owed to the work of Hansen that IS-LM model becomes a popular model of determination of interest rate. In his book A Guide to

    Keynes, Hansen (1953) points out that interest rate is indeterminate in Keynes‟s theory of interest. Hansen‟s criticism can be summarized as: interest rate is determined by the

    total demand for and supply of money, and the transactions motive for demanding money is determined by income; however, income is determined by the investment, and the investment is determined by interest rate and marginal efficiency of capital. Thus, interest rate and income are all indeterminate. Therefore, Hansen develops IS-LM model to solve this problem by means of making the goods market and the money market attain equilibrium simultaneously. Later, IS-LM model has developed from a model of determination of interest rate to a dominant macroeconomic model of

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    NeoClassical Synthesis for many decades.

    However, IS-LM model has also been criticized by many economists. Among the various criticisms, the most fundamental and common attack is that the approach with a character of simultaneity doesn‟t apply to Keynes‟s theory, making IS-LM model

    logically inconsistent. For example, Pasinetti (1974) has argued that Keynes‟s theory should not be analyzed simultaneously but sequentially. That is, Keynes‟s theory ought to be considered as a sequence of alternating decisions in monetary sector and real sector. Davidson (1978) argues that the IS and LM schedules are interdependent when finance motive is introduced. Chick (1982) also attacks IS-LM model on the basis of its internal logic.

    Which one is correct, the mainstream interpretation of liquidity preference theory or the criticism of it? Or neither of them is fully correct? Further, can liquidity preference theory be correctly interpreted without finance motive? If not, what kind of role should finance motive play in liquidity preference theory?

    These questions inspire me to explore the essence of liquidity preference theory. Section 2 starts off with analyzing the inherent logic of liquidity preference theory and presents a new interpretation of the theory in a manner I believe more logical and clear. Through bridging the gap between the classical theory of interest and liquidity preference theory, the reinterpretation clearly indicates the necessity of introducing liquidity preference analysis into determination of interest rate. The reinterpretation also suggests that it is the liquidity preference analysis based on finance motive, rather than on transactions motive, that plays a more fundamental role in determining interest rate. Section 3 then argues that Keynes makes a crucial and yet unsolved mistake in his theory of interest, i.e. interest rate is indeterminate, which is revealed by his introduction of finance motive into the theory. Further, Section 4 develops a logically consistent and integrated model of determination of interest rate on the basis of the liquidity preference analysis that is centered on finance motive. In this model, interest

    rate is not determined by the demand for and supply of money, but determined by the demand for and supply of idle money. Section 5 discusses some other

    controversies in respect of liquidity preference theory. Finally, Section 6 provides a

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    brief conclusion.

2. Reinterpretation of liquidity preference theory

    After analyzing the previous literatures on liquidity preference theory, I have found that the research approach adopted by subsequent economists may be improper. It seems that they limit themselves to Keynes‟s literature, and even stick to the sequence

    of Keynes‟s presentation when they study the motives with respect to the demand for

    money, i.e. analyzing transactions motive first and finance motive last. This approach makes them very likely to ignore the inherent logic of liquidity preference theory. In my opinion, liquidity preference theory is not dreamed up by Keynes without any foundation. It reveals the objective law of determination of interest rate. Keynes does not create the law, but discover the law. The researches that are confined to Keynes‟s

    literature may be misled by Keynes‟s mistake. Accordingly, by focusing on the internal

    logic of liquidity preference theory, I attempt to present a new interpretation of the theory to uncover its essence.

    It seems we can start from the problem of the classical theory of interest since Keynes tried to develop a new theory of interest after he was aware that there is something wrong with the classical theory. But when criticizing the classical theory of interest in his General Theory, Keynes makes chaos and conceals the essence of the

    problem by his unsuccessful attack. Given that the problem of the classical theory is still not clear, I feel the following quote from Keynes can be a more clear and reliable start:

    [A]s I have said above, the initial novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments, which lead up to this initial conclusion, are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory. But the result of it was to leave the rate of interest in the air. If the rate interest is not determined by saving and investment in the same way in

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    which price is determined by supply and demand, how is it determined? (Keynes, 1937B, p.212)

    It can be clearly deduced from this quote that the initial divarication between the classical theory of interest and Keynes is whether interest rate or income will change along with the change of propensity to invest (no matter which of them changes, saving would equate investment anyway). When propensity to invest changes, the classical theory holds that interest rate will change and income will not change, but Keynes thinks that it is not interest rate but income that will change. To settle the divarication, we should analyze the ex ante situation first. If, for example, there is an increase of propensity to invest (namely, an outward shift of the investment demand curve or Keynes‟s investment demand-schedule), desired

    investment will increase and exceed desired saving.

    According to the classical theory, at the moment, a rise of interest rate will decrease desired investment and increase desired saving. The interest rate will continue to rise until desired investment equates desired saving. Therefore, ultimately interest rate changes and income maintains unchanged. Moreover, interest rate is directly determined by desired investment and desired saving.

    But how can Keynes‟s prediction that income will change be right? It is not difficult

    to see that income will change if the economy can draw idle money from

    somewhere to fill up the gap between desired investment and desired saving in the ex ante situation.

    Thus, the debate on whether interest rate or income will change transforms to another equivalent debate: whether there exists idle money outside economic

    operation. If there doesn‟t exist idle money, income won‟t change, and the classical

    theory is right. If there exists idle money, income will change and interest rate cannot be determined by desired investment and desired saving.

    Obviously, the idle money here is just Keynes‟s “inactive balances” or “idle balances”. Why there exists idle money? Just as Keynes argues, the reason why the

    wealth-holders would like to hold money without gaining interest is the existence of

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    speculative motive for demanding money. Accordingly, the concept of liquidity preference comes out naturally. Is there any cost to draw idle money into the economic operation? To make the wealth-holders give up holding money, according to Keynes, requires the rise of interest rate: the higher the demand for idle money, the more the rise of interest rate. In this way, liquidity preference analysis is logically introduced into determination of interest rate in the ex ante situation.

    When there exists idle money, determination of interest rate is related not only to the difference between desired investment and desired saving, but also to the interest elasticity of liquidity preference. The higher the interest elasticity of liquidity preference, the lower the cost of drawing idle money, the less the rise of interest rate, the more the increase of income. Contrarily, the lower the interest elasticity of liquidity preference, the higher the cost of drawing idle money, the more the rise of interest rate, the less the increase of income.

    Further, I would argue that the difference between desired investment and desired saving as mentioned above is equivalent to what Keynes (1937C) says an excess finance motive as a result of the increase of propensity to invest. That is, finance motive will increase first when propensity to invest increases. Only when the excess finance motive is satisfied by the idle money, the excess investment can be realized and income can increase. After the multiplier effect makes the level of income rise, the idle money will change to revolving fund, which makes desired saving equal to desired investment if the increase of propensity to invest lasts.

    According to Keynes, finance motive exists during what I call an

    investment-realization period, the period between the date when entrepreneurs make

    their investment decisions (at the same time, they arrange their finance) and the date when they actually make their investment. Let‟s see Figure 1, which tries to clarify the role of finance motive in a simplified investment-realization period.

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     Making investment Making production Signing purchase Production Delivery and payment decisions decisions contracts process (by entrepreneurs) (by producers)

    Transactions motive Investment is realized Finance motive

    increases increases

    Fig.1.A simplified investment-realization period

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    A simplified investment-realization period begins with making investment decisions

    by entrepreneurs. If propensity to invest increases, finance motive will increase simultaneously, drawing idle money from inactive balances into economic operation and leading to the rise of interest rate. Then the purchase contracts of investment goods will be signed between entrepreneurs and producers. After that, producers will make production decisions and seek more working capital for producing more investment goods. Consequently, transactions motive will increase, drawing more idle

    money from inactive balances into economic operation and leading to the rise of interest rate once more. After the investment goods are delivered and payment is made, the investment process is completed, and the investment is finally realized. Moreover, if the increase of propensity to invest lasts, the increase of finance motive and transactions motive will last in subsequent investment-realization periods. The above analysis demonstrates two points:

    First, finance motive doesn‟t merely exist when investment increases, but exists at any time. When the economic operation is constant, finance motive is a constant revolving fund, the amount of which equates to the amount of the desired investment or desired saving during an investment-realization period. When all the other conditions are the

    same, the amount of finance motive depends on the length of the investment-realization period: the longer the investment-realization period, the more the finance motive for demanding money. In this way, finance motive transforms the flow demand for funds into the stock demand for money.

    Second, finance motive and transactions motive are different demands for money and play different roles in economic operation. They simultaneously exist in economic operation and change at different time in expansion or contraction of economy. Therefore, finance motive cannot be just a subcategory or addendum of transactions motive. Furthermore, I would like to argue that in determining interest rate, the

    liquidity preference analysis based on finance motive plays a more fundamental role than does the liquidity preference analysis based on transactions motive, because: 1) finance

    motive bridges the classical theory of interest and liquidity preference theory, thereby

    illuminating the necessity of introducing liquidity preference analysis into determination

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    of interest rate; and 2) finance motive is the start point of liquidity preference analysis

    since finance motive changes first when propensity to invest changes.

    Hereto, we arrive at a new interpretation of liquidity preference theory. Without

    finance motive, liquidity preference theory is terribly half-baked, or even false. However, it is very strange that finance motive can hardly be found in the literatures after Keynes, e.g. IS-LM model and most other interpretations of liquidity preference theory all overlook finance motive.

    In my opinion, Keynes‟s mistake of initially overlooking finance motive in The

    General Theory mainly contributes to this strange phenomenon. Although Keynes later added finance motive to correct this mistake, the strong first impressions of The

    General Theory make most economists still consider his initial mistake the innovation and elite of the theory. This misunderstanding results in that they think that transactions motive plays a fundamental role in liquidity preference theory and finance motive is dispensable. Thus, the inherent logic and essence of liquidity preference theory are covered up, leading to much confusion and many misinterpretations. If Keynes had firstly introduced finance motive with its ex ante effect on interest rate, then brought forward transactions motive with its succedent effect on interest rate, liquidity preference theory would have become more logical and clear, and all the misunderstandings and controversies would have been cleared up naturally.

3. Keynes’s crucial and unsolved mistake in his theory of interest

    After introducing finance motive, Keynes summarized his liquidity preference theory in Mr Keynes ‘Finance’:

    [T]he rate of interest is determined by the total demand and total supply of cash or liquid resources. The total demand falls into two parts: the inactive demand due to the state of confidence and expectation on the part of the owners of wealth, and the active demand due to the level of activity established by the decisions of the entrepreneurs. The active demand in its turn falls into two parts: the demand due to the time lag

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