Tag Archives: liquidity preference theory

The Interest Rate is Not the Price of Money

This week we will explore one of the most poorly understood concepts in economics: the price of money. More specifically, what does supply and demand for money determine?

The traditional textbook view, as originally developed by John Maynard Keynes, is that supply and demand for money determines the interest rate. This simple notion lies at the heart of all modern macroeconomics. While some economists have disputed this notion, particularly those in the Austrian tradition, few have offered a sensible alternative.

The reason that Keynes’ liquidity preference theory has stood for so long is that offering a sensible alternative this theory requires an overhaul of the current microeconomic theory of price determination. In particular, if supply and demand for a good determines the price of that good, then how can supply and demand for money be incorporated in microeconomic price determination?

The key intellectual leap that needs to be made is recognizing that every price is a function of two sets of supply of demand. The price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

Price Determination Theory

The view of The Money Enigma is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy.

Price Determined by Two Sets Supply and Demand

Economists struggle with supply and demand for money because economics has not developed a sensible paradigm for the measurement of “market value”. As a result, current models of price determination present a very “one-sided” of the price determination process.

Every price is a relative expression of two market values. If the market value of one banana is three times the market value of one dollar, then the price of bananas, in dollar terms, is “three dollars”.

Supply and demand for a good determines that good’s market value. However, in order for us to calculate the price of a good, in terms of another good (such as money), we need to know the market value of that second “measurement good”. The market value of this measurement good is determined by supply and demand for that measurement good.

The “money price” of a good is determined by two sets of supply and demand: supply and demand for the good itself, and supply and demand for money.

The trick to understanding this concept is recognizing that the property of “market value” can be measured in both absolute and relative terms. All properties can be measured in absolute or relative terms. For example, the speed of a car can be measured in absolute terms (in terms of some invariable measure of speed such as “miles/hour”), or in relative terms (in terms of some other object that possesses the property of speed, for example, the car is doing twice the speed of the bus).

Market value can also be thought of in absolute or relative terms. The way we experience market value in every day life is in “price” terms. Price is a relative measure of market value. For example, “the price of the banana is three dollars” is a way of measuring the market value of bananas in terms of another good that possesses the property market value, namely “the dollar”.

However, both the banana and the dollar must possess the property of market value and we can measure the market value of each good individually in terms of an invariable measure of market value (just as the speed of the car and the bus can both be measured in terms of “miles/hour”, an invariable measure of speed).

In the diagram below, the price of Good A, in money terms, is determined by two sets of supply and demand. On the y-axis, market value is measured in absolute terms, that is to say, in terms of a theoretical and invariable measure of market value, or what one might call a “standard unit” of market value.

Price Determined by Two Sets Supply and Demand

The price of good A, in money terms, can rise for one of two basic reasons. Either, the market value of good A can rise, or the market value of money can fall. For example, if demand for money falls, then the demand curve on the right side of our diagram shifts downward and the market value of money falls. What happens to the price of good A? The price of good A, in money terms, rises. Why? Because price is a relative expression of two market values.

Let’s circle back around to our original question. What is the price of money?

This is not a straightforward question because price is a relative expression of two market values. Therefore, the first follow up question that needs to be asked is the price of money in terms of what? What is the measurement good?

We can measure the price of money in banana terms. For example, if the price of bananas in money terms is three dollars, then the price of money in banana terms is one-third banana.

Alternatively, we might measure the price of money in terms of a basket of goods. The price of the basket of goods, in money terms, is the price level. The price of money, in terms of the basket of goods, is the inverse of the price level, also commonly referred to as “the purchasing power of money”.

Therefore, we can’t say that the price of money is the price level, but we can say that the price of money is the inverse of the price level.

What we can’t say is that “the price of money is the interest rate”.

If you step back and look at the history of economics, it becomes clear why Keynes posited that supply and demand for money determines the interest rate.

Keynes was a pupil of the great Alfred Marshall, author of “Principles of Economics” (1890), a book that did more than any other to popularize the notion that the price of a good is determined by supply and demand for that good.

But Marshall’s work left one question unanswered. If supply and demand for a good determines the price of a good, then what does the supply and demand for money determine?

If you don’t recognize, as Keynes did not, that every price is, in fact, a function of two sets of supply and demand, then this leaves you looking for candidates. The only plausible candidate that Keynes could find was “the interest rate”.

Despite the fact that it should have been clear to Keynes (and all modern day economists) that the interest rate is determined by supply and demand for bonds, Keynes came up with his awkward justification of the notion that supply and demand for money determines the interest rate.

Just to be clear, it is perfectly correct to say that central bank operations can influence the interest rate. If a central bank creates money and uses it to buy bonds, then the demand curve for bonds shifts to the right and the price of bonds rises (the interest rate falls).

What is not correct is to say that since these central banking operations influence the interest rate, that supply and demand for money determines the interest rate.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. Supply and demand for money determines the market value of money, the denominator of every “money price” in the economy. We can measure the market value of money in absolute terms (in terms of our invariable measure of market value, “units of economic value”). Alternatively, we can measure the market value of money in relative terms: this is “the price of money” in terms of some other good, basket of goods or even other currency. The point is that there are multiple ways to measure the price of money, but none of them are “the interest rate”.

I would encourage all those who are interested in a critique of liquidity preference theory and an alternative view on price determination to read The Enigma Series.