On the monetary nature of the interest rate in a Keynes–Schumpeter perspective

Abstract

Keynes, in the General Theory, explains the monetary nature of the interest rate by means of the liquidity preference theory. The objective of this article is twofold. The first objective is to point out the limits of the liquidity preference theory. The fundamental limitation of this theory is that it does not allow to realize the intent declared by Keynes in 1933 to elaborate a monetary theory of production The second objective is to present a more solid theory of the monetary nature of the interest rate. It will be shown that an essential element of this explanation is Schumpeter’s analysis of the role of bank money in a capitalist economy. In fact, this analysis represents a fundamental tool to explain the characteristics that, according to Keynes, distinguish a monetary economy from a real-exchange economy

Keywords:

• Liquidity preference theory
• bank money
• uncertainty
• Say’s Law
• the principle of effective demand

JEL Classifications:

• E12
• E43
• E51

Notes

1 “There is, I am convinced, a fatal flaw in that part of the orthodox reasoning which deals with the theory of what determines the level of effective demand and the volume of aggregate employment; the flaw being largely due to the failure of the classical doctrine to develop a satisfactory theory of the rate of interest” (Keynes 1934, 489).

2 “There is … a necessary condition failing which the existence of a liquidity-preference for money as a means of holding wealth could not exist. This necessary condition is the existence of uncertainty as to the future of the rate of interest, i.e. as to the complex of rates of interest for varying maturities which will rule at future dates” (Keynes, 1936, 168). The presence of uncertainty allows explaining that even if every individual’s expectations are held with certainty, different individuals have different expectations.

3 This sequence is consistent with the idea that “money itself is the starting point. Rather than money emerging from the market, the market emerges from money” (Smithin 2013a, 243).

4 Rogers, for example, claimed, “In its most general form the principle of effective demand demonstrates that the rate of interest sets a limit to the profitable expansion of output before full employment is achieved. Keynes also argued in the General Theory that there was no mechanism in a laissez faire monetary economy for automatically generating the natural rate of interest consistent with full employment. … Keynes makes it clear that the failure of the rate of interest to automatically fall to the level consistent with full employment is to be a key element of his analysis” (Rogers 2008, 2–8; see also Dillard 1987 and Rogers 1997a, 1997b).

5 Several economists have emphasised the desirability of integrating the Keynesian theory of income determination with Schumpeter’s theory of economic development. For example, see Minsky (1986, 1993), Morishima (1992), Goodwin (1993), Vercelli (1997), Bertocco (2007), Dosi (2012), Dosi, Fagiolo and Roventini (2010), Mazzuccato and Wray (2015), and Kurz (2016).

6 On this point see, for example, Gnos (2013) and Forstater (2013).

7 See also Bellofiore (2011, 2014) and Messori (2002, 2013).

8 “Monetary analysis introduces the elements of money on the very ground floor of our analytical structure and abandons the idea that all essential features of economic life can be represented by a barter-economy model. Money prices, money incomes, and saving and investment decisions bearing upon these money incomes, no longer appear as expressions … of quantities of commodities and services and of exchange ratios between them: they acquire a life and an importance of their own, and it has to be recognized that essential features of the capitalist process may depend upon the ‘veil’ and that the ‘face behind it’ is incomplete without it” (Schumpeter 1954, p. 278).

9 As underlined by Palley (2002), the post Keynesian endogenous money theory is characterized by the explicit consideration of the presence of banks and the process of bank money creation through bank lending. See also, for example, Smithin (2009, 2013c), Bertocco (2001, 2010) and Bertocco and Kalajzić (2016).

10 “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London, amounts to little and sometimes to nothing; or even five years hence” (Keynes 1936, 149–150).

11 Paul Davidson (2007) used the concept of “crucial decisions” to emphasize the link between Keynes and Schumpeter. In particular, he introduces the distinction between ergodic and non-ergodic systems: “If entrepreneurs have any important function in the real world, it is to make crucial decisions. Entrepreneurship […] involves cruciality. To restrict entrepreneurship to robot decision making through ergodic calculations in an ergodic stochastic world … ignores the role of the Schumpeterian entrepreneur—the creator of technological revolutions that bring about future changes that are often inconceivable even to the innovative entrepreneur” (Davidson 2007, 112). Both Keynes and Schumpeter stress that investment decisions and innovations are carried out by agents possessing particular skills, that is, agents that are guided by what Keynes (1936, 161) defined animal spirits.

12 See, for example, Fontana (2006, 2009), Skidelsky (2009, 2011) and Asensio (2013).

13 “It is now an accepted point that there is a link of interdependence between liquid stocks and uncertainty, in the sense that, in a world without uncertainty and frictions, in which the costs related to information and exchange were null, there would be no valid reason to demand a liquid stock. But, once the link between money demand and uncertainty has been accepted, it remains doubtful whether it should be understood that uncertainty imposes the transition to an economy based on monetary exchanges, or whether the shift to monetary exchanges has led to the economy of uncertainty” (Graziani 1991, 17).

14 With regard to this point, it is worth recalling that, to underline the profound differences between a real-exchange economy and a capitalist economy, Schumpeter rejected the existence of Wicksell’s natural rate of interest: “The roots of [the natural rate of interest] reach very far into the past … Its role in the thought of our own time is due to the teaching of Knut Wicksell and the work of a brilliant group of Swedish and Austrian economists. For us, however, there is no such thing as a real rate of interest, except in the same sense in which we speak of real wages: translating both the interest and the capital items of any loan into real terms by means of the expected variation in an index of prices. … But nominal and real rates in this sense are only different measurements of the same thing … Hence, the money market with all that happens in it acquires for us a much deeper significance than can be attributed to it from the standpoint just glanced at. It becomes the heart, although it never becomes the brain, of the capitalist organism.” (Schumpeter 1939, 101–102).

15 In the United States, for example, the Fed reacted immediately after the outbreak of the crisis by bringing the federal funds rate to zero in December 2008. Because this measure was not enough to encourage recovery, the Fed resorted to less conventional monetary tools. The main tool was the large-scale asset purchases, known as “quantitative easing.” Bernanke described the effects produced by quantitative easing in the following way: “this was really a monetary policy by another name: instead of focusing on the short-term rate, we were focusing on longer-term rates. But the basic logic of lowering rates to stimulate the economy is really the same” (Bernanke 2013, 104–105).

16 For a detailed analysis, see Bertocco 2017. This model in consistent with Pasinetti’s analysis of the principle of effective demand (Pasinetti 1997, 2001). Furthermore, it is consistent with the methodology suggested by Smithin (2016), which consists in the use of simple arithmetical examples to illustrate theoretical problems.

17 Also the farmers’ production decisions are taken under conditions of uncertainty. In fact, they take their decision on the employment of agricultural workers based on their expectations about the number of workers that will be hired to carry out the investments-innovations. Equation 4), which specifies $N_{ag}$, should thus include the level of income expected by the farmers $\left(Y^e\right)$ instead of the actual level of income $\left(Y\right)$. For the sake of simplicity, the model was built by assuming that $Y^e=Y$.

18 Given that $Y = C + I$, and that $C = w{N}_{ag}$, while $I = L^{*}=w{N}_i$, we obtain $Y=w\left(N_{ag}+N_i\right)$ and $Y/w=N.$

19 “Railroads have not emerged because any consumers took the initiative in displaying an effective demand for their service in preference to the services of mail coaches. Nor did the consumers display any such initiative wish to have electric lamps or rayon stockings, or to travel by motorcar or airplane, or to listen to radios, or to chew gum. The great majority of changes in commodities consumed has been forced by producers on consumers who, more often than not, have resisted the change and have had to be educated up by elaborate psychotechnics of advertising” (Schumpeter (1939) [1964], 47).

Additional information

Notes on contributors

Giancarlo Bertocco

Giancarlo Bertocco is an Associate Professor of Macroeconomics and Monetary Economics at the Department of Economics, University of Insubria, Varese, Italy.

Andrea Kalajzić

Andrea Kalajzić is PhD at the Department of Economics, University of Insubria, Varese, Italy.