Tag Archives: liquidity preference theory is wrong

Supply and Demand for Money: Where Keynes Went Wrong

  • The notion that “supply and demand for money determines the interest rate” is an idea that seems innocuous and entirely plausible. In fact, it is a very dangerous and misleading idea: an idea that has sent the science of economics on an 80-year journey down the wrong path.
  • The fundamental problem with this Keynesian theory is that it implicitly denies a role for the market value of money in the determination of “money prices”. The view of The Money Enigma is that supply and demand for money determines the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy. (As the market value of money falls, prices rise).
  • Let’s start with what should be a simple concept: “every price is a relative expression of the market value of the two items being exchanged”. Think about a simple trade in which two items are exchanged, for example, a certain amount of money for a certain number of apples. Both items being exchanged (apples and money) must possess the property of market value in order for a trade to occur (no is going to part with something of value for something that has no value).
  • The ratio of exchange of one item for another (also known as the “price” of the trade) depends upon the market value of the first good (apples) relative to the market value of the second good (money). For example, if an apple is three times as valuable as one dollar, then the price of an apple is three dollars.
  • If this theory of price determination is correct, then something must determine the market value of money. By far the best candidate for this role is supply and demand for money (or, more specifically, supply and demand for the monetary base).
  • Where Keynes went wrong is that he assumed that every price is determined by only one set of supply and demand. For example, he assumed that the price of apples is determined solely by supply and demand for apples. Therefore, supply and demand for money, to Keynes’ mind, doesn’t have a direct role to play in the determination of the price of apples.
  • The view of The Money Enigma is that this traditional model is wrong: every price is a function of not one, but two sets of supply and demand. In terms of our example, this means that the price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money.
  • In summary, supply and demand for money can determine only one of two things: either it can determine the interest rate (Keynesian view), or it can determine the market value of money (Money Enigma view). It can’t determine both. If you choose “the interest rate”, then implicitly you are denying any role for the value of money in the determination of money prices.

Liquidity Preference Theory: a Naïve and Dangerous Idea

Keynes’s liquidity preference theory states that supply and demand for money determines the interest rate. It is one of the core theories of modern economics and stands largely unchallenged in orthodox economics circles to this day.

The view of The Money Enigma is that liquidity preference theory represents a naïve and dangerous view about the nature of money and the role of money in the price determination process. Moreover, liquidity preference theory has only survived because microeconomics has failed to develop a sensible theory of universal price determination (a theory of price determination that can be applied to the determination of all prices, not just money prices).

We will explore these assertions in more detail in a moment. But first, let’s step back to the year 1935, the year John Maynard Keynes wrote “The General Theory of Employment, Interest, and Money” and think about why Keynes might have come up with the notion that supply and demand for money determines the interest rate.

Keynes was a student of the great economist Alfred Marshall. Although Keynes never officially graduated with an economics degree, he did do one term of postgraduate work with Marshall and it was Marshall that gave Keynes the job lecturing in monetary economics at Cambridge when Keynes finished his short 18-month stint as a clerk at the India Office. (See Robert Skidelsky’s fawning biography of Keynes titled “John Maynard Keynes: Economist, Philosopher, Statesmen”, page 125).

You might think that someone with such limited qualifications shouldn’t be teaching economics at Cambridge. But, as fairly noted by Skidelsky, there really wasn’t much economics to teach at that point in time. [Or at least there wasn’t much “English” economics: there was quite a bit of “German/Austrian” economics that had been written but most respectable English gentlemen in the 1930s weren’t that interested in what the Germans had to say].

For those studying economics at Oxford or Cambridge in the 1930s, there were only a small number of books that would have been considered “required reading”. One of those books was Alfred Marshall’s “Principles of Economics”.

Marshall’s “Principles of Economics” is an important book in the history of economics because that book, more than any other, was instrumental in popularizing the supply and demand diagram that we use today. Marshall’s supply and demand diagram, with “price” on the y-axis, remains one of the most fundamental concepts in economics today and Keynes would have been well versed in this theory.

The problem is that the modern-day interpretation of Marshall’s work presents a very one-sided view of the price determination process. Marshall appreciated that his representation of price determination, the standard supply and demand diagram that we use today, implicitly assumes a constant or uniform value for money.

In Chapter III.IV.17-19, Marshall discusses the issues with his derivation of the standard demand curve: “So far we have taken no account of the difficulties in getting an exact list of demand prices… To begin with, the purchasing power of money is constantly changing, and rendering necessary a correction of the results obtained on our assumption that money retains a uniform value” (my emphasis added in italics).

At least superficially, Marshall seemed to appreciate that the standard supply and demand diagram that we use today assumes a constant market value for money. However, a naïve view of Marshall “scissors analysis” is that the price of a good is determined solely by supply and demand for that good.

The naïve view of Marshall’s work leaves open an obvious question: if supply and demand for a good determines the price of a good, then what does supply and demand for money determine?

For Keynes, the most obvious answer to this question was “supply and demand for money determines the interest rate”. It’s the obvious answer and it is wrong.

The problem is that Keynes has implicitly assumed that a price is determined by only one set of supply and demand. For instance, if supply and demand for apples determines the price of apples, then supply and demand for money must determine something else.

The problem with this theory is that it does not recognize the notion, as implicitly acknowledged by Marshall, that every price depends on not only the market value of the good in question, but also the market value of money.

Unfortunately, Marshall failed to take his work one step further. Namely, if price is a relative expression of the market value and market value is determined by supply and demand, then every price must be determined by two sets of supply and demand.

Keynes never entertained the notion that price is determined by not one, but two sets of supply and demand. Therefore, he never considered the idea that supply and demand for money determines the market value of money, which, in turn, is the denominator of every money price in the economy.

Price Determined by Two Sets Supply and DemandThe view of The Money Enigma is that the “money price” of a good (the price of a good in money terms) is a function of both supply and demand for the good itself and supply and demand for the monetary base. This concept is illustrated in the slide opposite.

The key to this diagram, as we will discuss in a moment, is the y-axis unit of measurement. “Market value” on the y-axis is measured in absolute terms, using a “standard unit” for the measurement of market value.

Every Price is Determined by Two Sets of Supply and Demand

As young economists, we are all taught the price of a good is determined by supply and demand for that good. So, how is it possible for a price to be determined by two sets of supply and demand? This is a good question and one that we have discussed in several previous posts including “A New Economic Theory of Price Determination”, “Every Price is a Function of Two Sets of Supply and Demand” and “Is the Price of Apples Determined by Supply and Demand for Bananas?”

I find that the easiest way to explain this theory is to use a simple example.

Consider the following question: “In a barter economy, what determines the price of apples, where the price of apples is measured in terms of bananas?”

Is it (a) supply and demand for apples, or (b) supply and demand for bananas?

The answer is (c), “both”.

Price Determination Barter EconomyClearly, the price of apples, in banana terms, depends upon supply and demand for apples: if there is a supply shortage of apples, then the market value of apples will rise and the price of apples, as measured in banana terms, will rise.

But what about supply and demand for bananas? Does supply and demand for bananas have any impact on the price of apples as measured in banana terms?

The short answer is “yes”. Imagine you live in that barter economy and then think about what happens if there is a supply shortage of bananas.

If there is a supply shortage of bananas, then bananas become “more valuable”. If you have bananas and bananas become more valuable, then you would expect more apples for every banana that you sell.

The ratio of exchange, apples for bananas, will shift such that there are more apples required for one banana. One way to say this is that the price of bananas, in apple terms, would rise. The other way to say this is that the price of apples, in banana terms, would fall. A decrease in banana supply will, all else remaining, lead to a fall in the price of apples, where that price is measured in banana terms.

Price Determination TheoryThe general principle is illustrated in the slide opposite. The market value of the “primary good”, denoted as “V(A)”, is determined by supply and demand for the primary good. The market value of the “measurement good”, denoted as “V(B)”, is determined by supply and demand for the measurement good. The price of the primary good, in terms of a measurement good, is determined by the market value of the primary good relative to the market value of the measurement good.

Price Determined by Two Sets Supply and DemandWhat Keynes missed is that this principle also applies to the determination of “money prices”. The price of a good, in money terms, depends upon both the market value of the good (as determined by supply and demand for that good) and the market value of money (as determined by supply and demand for money).

On the left hand side, supply and demand for the good determines the market value of the good. On the right hand side, supply and demand for the monetary base determines the market value of money. The price of the good, in money terms, depends upon the numerator (the market value of the good) and the denominator (the market value of money). If the market value of money falls, then, all else remaining equal, the price of a good, in money terms, will rise.

First time readers may have trouble interpreting some of these diagrams. The key to appreciating these diagrams is getting your head around the y-axis unit of measurement.

Traditional supply and demand diagrams use price on the y-axis: “price” is a relative measure of market value. The diagrams above use a “standard unit” for the measurement of market value: in this sense, supply and demand in the diagrams above are plotted in terms of “absolute market value”.

This is a complex subject that is addressed in detail in “The Measurement of Market Value: Absolute, Relative and Real”. Please read this post if you really care about this subject.

Conclusion

So, where did Keynes go wrong?

The short answer is that Keynes assumed that a price is determined by only one set of supply and demand.

By assuming that supply and demand for money can have no direct role in the determination of “money prices”, Keynes was forced to look for something that supply and demand for money could determine. The obvious candidate may seem to be “the interest rate”, but this doesn’t make it right.

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The price of a good in money terms is a relative expression of both the market value of the good and the market value of money. Therefore, the price of a good in money terms is determined by two sets of supply and demand: supply and demand for the good and supply and demand for money.

Supply and demand for money determines the market value of money, the denominator of every money price in the economy.