Transactions Demand Research Articles

Large Economic Units, Banks, and the Transactions Demand for Money: Comment

Large Economic Units, Banks, and the Transactions Demand for Money: Comment

Large Economic Units, Banks, and the Transactions Demand for Money

Large Economic Units, Banks, and the Transactions Demand for Money

KEYNES'S FINANCE MOTIVE: COMMENT

IN the March 1965 issue of this journal, Paul Davidson advances the Keynesian 'demand for finance' motive as a general theory of the transactions demand for money.1 In doing so, he adds what amounts to a major underpinning to both the static and dynamic properties of the generally accepted (i.e. the Hicks IS-LM) macroeconomic model. I shall argue that Davidson's analysis is incomplete, it does not (as he claims) qualify the traditional use of the IS-LM diagram, and it does not (as he further claims) constitute a meaningful basis for macroeconomic path analysis. What follows is intended purely as a criticism of the logical deductions Davidson has drawn from the operation of the finance motive. I offer no judgement on the empirical relevance of the issues discussed. Having denied in both the Treatise and the General Theory that increments in saving and investment can directly alter the market rate of interest, Keynes offered in June 1937 a mechanism by which changes in investment and interest might indeed be related.2 In anticipation of additional investment expenditures, entrepreneurs would raise their demand for money for 'finance', causing a direct increase in the rate of interest. Thus did Keynes prevent interest movements from straying outside of the supply-and-demand-for-money framework established for them in the General Theory,3 while at the same time acknowledging the common-sense notion that greater investment directly creates monetary stringency. In a later paper Keynes generalized this relationship, arguing that the transactions demand for money depends upon the demand for all output, not merely upon planned investment.4 Davidson revives this long-forgotten point, maintaining that the demand for money contains as its own parameters those of the consumption (C) and investment demand (I) functions. Thus any increase in the demand for goods, consumption or capital, is accompanied by a simultaneous increase in the 'entire transactions demand for money schedule' (Li).5 This 'puts additional pressure on the rate of interest'6 and shows clearly that the monetary sector (i.e. the demand

Modigliani on the Interaction of Monetary and Real Phenomena

In an important recent article,' Modigliani has renewed his analysis of the relationship between the real and monetary parts of the Keynesian system. One of Modigliani's major points in his latest article is that his famous 1944 model 2 embodied an error, for, in his opinion, it incorrectly specified the forms of the real aggregate consumption and investment demand functions.3 While we find much to agree with in this new model, we do not agree with him as to the fundamental source of error in the 1944 model. Consequently, we are in disagreement with some important aspects of the latest formulation and, as a result, with some of his more important conclusions. basic flaw in Modigliani's 1944 model is not the fact that the aggregate real spending functions were not homogeneous of degree zero with respect to prices.4 A quite different source of error was involved, and this error has been partly perpetuated in the 1963 model. While Modigliani's 1944 system contains a direct relationship between the price level and the money-wage rate,5 this relationship is omitted entirely from the monetary subset of equations. It is this relationship, however, which provides an essential link between the monetary and real sectors. In 1944, Modigliani claimed that the four equations which defined . . the system of monetary equilibrium were completely independent of the other equations in the system and formed a determinate subset.6 Consequently, Modigliani concluded that Since the money income is determined exclusively by the monetary part of the system, the price level depends only on the amount of and therefore a change in the money-wage rate could affect the price level only if it resulted in a change in the level of output.7 This surprising result is not only in conflict with Keynes' analysis of the effects of money wage changes,8 but it is also incompatible with Modigliani's own conclusion in a later section of that same 1944 paper. Towards the end of his 1944 article, Modigliani argued that a reduction in the moneywage rate will . . depress the interest rate, the money income, and money wages without affecting the real variables of the system, employment, output, real wage rate. 9 But how then can a change in the money-wage rate affect the rate of interest? If the money-wage rate change does not affect real output, then, by Modigliani's earlier assertion, it cannot affect the price level. If both the price level and the level of real output are unaffected, there should be no change in the transactions demand for cash balances and consequently no change in the rate of interest! Of course, a change in the moneywage rate does affect prices and output and, therefore, the rate of interest. Accordingly, Modigliani's belief that the monetary subset is independent of the money-wage rate must be in error. In his latest formulation, Modigliani explicitly introduces the price level variable into his demand for money equation in order to demonstrate that, given nominal money balances, changes in the money-wage rate will shift the entire money market function relating the rate of interest and the level of output.10 This implies that contrary to the 1944 model, at any given level of output, a decrease in the money-wage rate involves a reduction in prices and money incomes and therefore a decrease in the demand for transactions balances. Modigliani can now demonstrate that the moneywage rate has an impact on the demand for money equation, but, in his system, a change in the money* authors are associate professor of economics at the University of Pennsylvania and Lilly Faculty Fellow, University of Chicago, respectively. 'F. Modigliani, The Monetary Mechanism and Its Interaction With Real Phenomena, Review of Economics and Statistics, xxxxv (Feb., 1963), 79-101. 2 F. Modigliani, Liquidity Preference and the Theory of Interest and Econometrica, xiI (Jan., 1944), 4588; reprinted in Readings in Monetary Theory (New York: Blakiston, 1951), 186-239. All references are to the Readings in Monetary Theory reprint. 'F. Modigliani, The Monetary Mechanism and Its Interaction With Real Phenomena, 82. 'In fact, we shall argue that the real aggregate consumption function is incorrectly specified in the 1963 model. 'F. Modigliani, Liquidity Preference and the Theory of Interest and 188, equation 7. Ibid., 190. 7Ibid., 210. 'J. M. Keynes, General Theory of Employment, Interest, and Money, (New York: Harcourt Brace, 1936), Chap. 19. 'F. Modigliani, Liquidity Preference and the Theory of Interest and 220. 0F. Modigliani, The Monetary Mechanism and Its Interaction with Real Phenomena, 89-90.

The Timing of Payments and the Demand for Money

Money is the asset which can be used to make payments. The classical theory of the demand to hold money balances rests on the lack of synchronisation between the time patterns of receipts and of payments. Because, for any individual, every payment is not matched by a simultaneous and equal receipt, some money is held in anticipation of future expenditures. The classical analysis assumed, moreover, that the time patterns of receipts and of payments are only capable of slow change over time. That is, the payments habits of people and institutions were regarded as lacking in flexibility in the short run. This assumption, which is still generally accepted,2 underlies the Keynesian postulate that the transactions demand for money is a stable increasing function of national income. The ratio of the money stock to national income (and therefore its inverse the income velocity of circulation) has varied considerably over time. This fact, together with an acceptance of the classical assumption of inflexible payments habits, led Keynes and others to introduce variables, additional to national income, into the demand function for money. Keynes expressed this extension in terms of there being other motives (the precautionary and the speculative) as well as the transactions motive for holding money. This form of language, together with the notational distinction between M1 and M2 balances, has been responsible for the widespread practice of dividing the demand for money into two parts, the one related to the making of payments and the other to the choice between assets to hold. The latter part has been at the centre of post-Keynesian theorising about money; but as regards the former, there is general agreement with Keynes' acceptance of the classical assumption. A theory of the timing, as distinct from the volume, of payments is worked out in this article. It shows that the time-lags between payments are variable, and therefore rebuts the classical assumption. The analysis has three aspects: (i) That changes in the expected yield rates on real assets can alter the timing of transactions, especially those in financial assets (including trade credit), and thereby alter the demand for money. I I am indebted, for valuable comments, to L. R. Klein and P. Davidson of the University of Pennsylvania and to W. J. Baumol of Princeton University. ' A notable exception in this respect is R. Turvey. See his Interest Rates and Asset Prices, 1960, chap. 3, and On the Transactions Demand for Money , in 25 Economic Essays in Honor of Erik Lindahl, 1956.

Classical, Loanable-Fund, and Keynesian Interest Theories

Keynes attacked the classical theory of interest on the ground that it is indeterminate. According to classical theory the rate is determined by the intersection of the investment demand-schedule and the saving-schedule schedules disclosing the relation of investment and saving to the rate of interest. No solution, however, is possible because the position of the saving-schedule will vary with the level of real income. As income rises, the schedule will shift to the right. Thus we cannot know what the rate of interest will be unless we already know the income level. And we cannot know the income level without already knowing the rate of interest, since a lower interest rate will mean a larger volume of investment, and so, via the multiplier, a higher level of real income. The classical analysis, therefore offers no solution. Now exactly the same criticism applies to the Keynesian theory. According to the Keynesian theory the rate of interest is determined by the intersection of the supply-schedule of money (perhaps interest inelastic, if rigorously fixed by the monetary authority) and the demand-schedule for money (the liquidity-preference schedule). This analysis also is indeterminate because the liquidity-preference schedule will shift up or down with changes in the income level. Here we are concerned with the total liquidity-preference schedule including both the transactions demand and the demand for money. If we separate the total demand schedule for money into its two component parts, we could perhaps argue that the pure liquiditypreference schedule is independent of the level of income.' But this does not help matters, since we cannot know, given the total money supply, how much money will be available to hold as an asset unless we first know the level of income. Thus the Keynesian theory, like the classical, is indeterminate. In the Keynesian case the money supply and demand-schedules cannot give the rate of interest unless we already know the income level; in the classical case the demand and supply schedules for saving offer no solution until the income is known. Keynes' criticism of the classical theory applies equally to his own theory.

Revisions in Economic History: XII. The Trends in Italian Economic History in the Later Middle Ages

T-i HE current conclusions about the nature and the origins of long trends as a rule derive from the unique experience of the upward movement which accompanied and followed the Industrial Revolution. But from the point of view of both economic theory and economic history it is important to study the trends before the middle of the eighteenth century. Needless to say, studies of this kind are much impeded by deficiency of documentation-a deficiency which is specially marked in relation to the quantitative aspect of the problem. Nevertheless it is not altogether impossible to derive useful impressions from such evidence as there is. Italian economic evolution between the twelfth and fifteenth centuries can be made an object of interesting observations, for it is quite possible that movements of Italian economy in that period had almost the same international importance as movements of American economy have in our own time. But whatever their international significance, it is possible to discover certain distinct and welldefined trends in Italian economic evolution between the thirteenth century and the sixteenth.' From I200 to I300 a clear upward trend is discernible. Although quantitative measurements are lacking, there is little doubt that production was passing through a secular expansion. Thus in the thirteenth century it is possible to observe the great development of the Florentine cloth industry, of the Lucca silk industry, and of shipbuilding in the naval republics. The development reached its peak in the thirteenth century. The transaction demand for money grew progressively over a considerable period.2 Although the movements of prices have not been fully investigated the available indices create a strong presumption that the period saw a secular rise of values: the supply of money grew more, than the transaction demand for it. From the end of the thirteenth century and the first decades of the fourteenth there occurred a series of crises comparable in their gravity (if the scale of contemporary economy is taken into account) to the crisis which struck modern economy between I929 and I935. It will be sufficient here to cite the famous bankruptcy of the Florentine banking-houses. These crises ushered in a downward trend which continued to I400 or thereabouts. The existing documentation about the volume of production in this period is very deficient. We know, however, with certainty that production of cloth in the main industrial centre of the times-Florence-continually declined: from ioo,ooo pieces in the year