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1 In the case of bonds and shares, where the yield is a money return which is independent
of forward sale, the forward price ought always to be below the expected price. In the forward
transactions of the London Stock Exchange, however, the yield is credited to the forward buyer
(and not to the forward seller, who actually holds the stock), hence the forward price is equal to
the current price plus interest cost and there is a " contango," (Since in this case c'=O,
FP=EP-r+q= CP?+i) " Backwardation" can only arise on the Stock Exchange if a fall in
price is expected, and this expected fall, on account of a shortage of stock for immediate delivery
which is known to be purely temporary, cannot be adequately reflected in the current price (e.g.
in the case of transatlantic stocks, when arbitrageurs run out of stock and have to wait for fresh
supplies to be sent across the Atlantic). It is always a sign, therefore, of the current price not
being in equilibrium in relation to the expected price.
2 In certain markets-such as the market for long term bonds-the lending rate is normally
always relevant, and not the borrowing rate. In this case the elasticity of interest cost can be
taken as infinite.
3 In other words, the elasticity of the marginal risk premium is likely to vary inversely with
the amount of the risk premium. When the risk premium is low, its elasticity is also likely to be
high. Cf. ?IO, p.I5 below.
I Mr. Keynes stated in the Economic Journal, September, I938, p. 45I, that the difference
between the highest and lowest price, in the same year, in the case of rubber, cotton, wheat,
and lead amounted in the average to 67 per cent over the last ten years.
2 In markets where the range of price-fluctuations is large, the marginal risk premium is also
likely to be large, thus making the range of fluctuations still larger. io per cent is a " normal "
figure in the case of seasonal crops; I to 2 per cent may be regarded as the appropriate figure in
the case of long-term government bonds.
3 Keynes, Treatiseon Money, Vol. II, p. I44.
' Ibid, p. I43.
Thus the expected long-term rate will exceed the current long-term rate if the current short-
term rate is below its expected average, and vice versa. (Cf. Hicks, op. cit., p. I52; also Hicks,
"Mr. Hawtrey on Bank Rate and the Long-Term Rate of Interest," Manchester School, I939.)
2 The current short rate is not dependent on the expected short rates, simply because the life-
time of short-term bills is much too short for expectations to have much influence. The expected
rate on bills next year can have no influence on determining the rate on a three-months' bill to-day;
while the expected rates for the next three months are very largely determined by the current rate.
It is only in exceptional circumstances that the market expects a definite change in the short-term
discount rates within the next few months. It is just because the elasticity of expectations for
very short periods is generally so near to unity, that the short-term interest market is largely
non-speculative.
Similarly, a change in the long-term rate (either the current or the expected rate) cannot
react back on the short-term rate except perhaps indirectly by causing a change in the level of
income and, hence, in the demand for cash. For, supposing the change in the long rate causes
speculators to sell long-term investments, this could only affect the short rate if they substituted
the holding of cash for the holding of long-term bonds; it cannot affect the short rate if the
substitution takes place in favour of short-term investments other than cash (savings deposits,
etc.). But there is no reason to expect, in normal circumstances at any rate, that the substitution
will be in favour of cash. "Idle balances"-i.e. that part of short-term holdings which the owner
does not require for transaction purposes-can be kept in forms such as savings deposits, which
offer the same advantages as cash (as far as the preservation of capital value is concerned) and
yield a return in addition. It is only when the short rate is so low that investment in savings
at all (or only to a very minor extent) but only on the current demand for
cash balances (for transaction purposes) and the current supply. And since
the elasticity of supply of cash with respect to the short-term rate, is normally
much larger than the elasticity of demand, the current short-term rate can be
treated simply as a datum, determined by the policy of the central bank.'
How is this related to Mr. Keynes' theory of the long-term rate of interest
being determined by liquidity-preference? It leads to much the same result
(i.e. that the rate, in the short period, is not determined by savings and invest-
ment) but the route by which it is reached is rather different. The insensitive-
ness of the long-term rate to " outside " influences (i.e. the supply and demand
for " savings ") is not due to any " liquidity premium " attached to money or
short-termbills; in fact, the notion of a " liquidity premium " appearsentirely
absent. It may be objected that it is merely replacedby the notion of a marginal
risk premium, and that Mr. Keynes' " liquidity premium" on the holding of
short-term assets is merely the negativeof our marginal risk premium on the
holding of long-term bonds. But in this case, the peculiar behaviour of the
long-term interest rate is certainly not explained by the existence of this risk-
premium.2 For let us suppose that subjective expectations are quite certain,
so that this risk premium is completely absent. In this case the current
deposits is no longer considered worth while (see footnote below) that there can be a net substitu-
tion in favour of cash; but precisely in those circumstances the elasticity of substitution between
cash and savings deposits is likely to be so high that this cannot have any appreciable effect on
the short-term rate.
Thus, while the current short rate does determine the relation between the current long
rate and the expected long rate, this is not true the other way round.
1 The nature of the equilibrium in the short-term interest
market is shown in the accompanying diagram, wherethequantity
of cash is measured along Ox, the short-term interest rate along y D
Oy. DD and SS stand for the demand and supply of money,
respectively. The demand curve is drawn on the assumption
that the volume of money transactions (i.e. the level of income)
is given. This demand curve is inelastic, since the marginal yield
of money declines fairly rapidly with an increase in the proportion \
of the stock to turnover. Below a certain point (g) the demand
curve becomes elastic, however, since the holding of short-term
assets tother than money is always connected with some risk q
(and, perhaps, inconvenience), and individuals will not invest q
short term if the short-term rate is lower than the necessary \
compensation for this. There is a certain minimum, therefore,
below which the short-term rate cannot fall, though this
minimum might be very low. (The dotted line shows X
what the demand curve would be if this risk were entirely
absent.) Hence, when the short-term rate is very low, it can be said to be determined by the
risk premium attaching to the holding of the safest short-term asset; otherwise it is determined
by the supply-price of money (i.e. banking policy) and changes in the short-term rate are best
regarded as due to shifts in this supply price. (The elasticity of the supply of money in a modem
bankingsystemis ensured partlyby the open market operations of the central bank, partly by the
commercial banks not holding to a strict reserve ratio in the face of fluctuation in the demand for
loans, and partly it is a consequence of the fact that under present banking practices a switch-over
from current deposits to savings deposits automatically reduces the amount of deposit money in
existence, and vice versa.)
2 Moreover, the long-term rate is never equal to this risk premium (or liquidity premium);
this only accounts for the difference between the long-term rate and the expected average of
short-term rates. Professor Hicks has calculated this risk premium to have been about I per cent
in Great Britain before the last war, and 2 per cent after the war (Manchester School, Vol. X,
No. I, p. 3I).
Equalisation Fund, the price of foreign exchange, and, hence, the price of
imported goods, behave in much the same manner as the prices of goods
stabilised by speculation. Hence, in addition to the "savings-investment
multiplier" there exists a "foreign trade multiplier," and the operation of
the latter must weaken the price-stabilising forces operating in the former
(and vice versa).
This can be best elucidated by an example. Let us suppose that for the
community as a whole, 25 per cent of additional income is saved, and that there
is an increase in the rate of long-term investment (financed through the sale
of securities) by L'million per week. This will immediately increase incomes
in the investment good industries by LI million and savings by ?250,000.
Thus, while in the first " week " the investment market was required to
furnish the whole of the additional expenditure of L'million out of its specula-
tive funds, in the second week it only has to furnish three-quarters of that
amount; one quarter will be furnished through the additional savings.' If
we suppose that all the income which is not saved is spent on home-produced
goods, there will be a further increasein incomes by 750,000 in the second week,
and 562,500 in the third week, and so on.2 Similarly, the outside demand for
securities will expand by I87,500 in the third week, I40,625 in the fourth week,
and so on. As a result, after a certain number of " weeks," total incomes will
have expanded by ?4 millions per week, and total savings by L'million; the
outside demand for securities will ultimately have increased in the same rate
as the outside supply. The size of speculative commitments has increased, of
course, duringthis process,but this increasewill come to a halt once the increase
in outside demand has caught up with the increase in the rate of supply;
the contribution which the speculative resources of the market have to make
is limited. Provided that the total required increase in the size of speculative
stocks is not too large relatively to the resources of the market (i.e. provided
it does not impair the degree of price-stabilising influence) there will be no
pressure on the price of securities (i.e. no tendency for the rate of interest to
rise) either in the long run, or in the short run.
Let us suppose now, however, that not three-quarters,but only a half of
the marginal income is spent on home-producedgoods; and while 25 per cent
is saved, another 25 per cent is spent on additional imports. In that case the
" multiplier " will not be 4, but only 2 ; the ultimate increase in incomes,
following upon a Li million increase in the rate of investment, will be ?2
millions (per week) and of savings ?500,000. Hence, even after incomes have
been fully adjusted to the change in the level of investment the rate of outside
demand for securities will have only increased by one-half of the increase in
the rate of supply; if the rate of interest is to remain unchanged, speculators
will have to furnish ?500,000 per week, indefinitely.
It is true that in this case the increasein speculative stocks in the securities
market is attended by a decrease in stocks (of gold and foreign exchange) in
1 On the assumption, of course, that all increase in " genuine savings " is directed at the
purchase of long-term assets.
2 Abstracting from any involuntary reduction in stocks in the hands of retailers and whole-
salers, which is purely temporary; this will merely delay adjustment, not prevent it.
1 There will be an initial increase in the demand for short-term funds with the increase in
incomes; but provided this demand is satisfied by the banking system, no further contribution
is required to keep the short-term rate stable. The continuous increase in the short-term indebted-
ness of the speculators in securities will be exactly offset by the decrease in the short-term
borrowings of the foreign exchange market.
2 " The Ex-Ante Theory of the Rate of Interest," Economic Journal, December, I937,
p. 669.
3 Mr. Keynes' own proof of this proposition is that there must " always be exactly enough
ex-post saving to take up the ex-post investment and so release the finance which the latter had
been previously employing" (ibid., p. 669). Ex-post investment and ex-post saving will always
be equal if " ex-post investment " is so defined as to include consequential changes in stocks (in
our example, foreign exchange balances). But in order that the funds released through the reduc-
tion in stocks should be available for the finance of long-term investment somebody must perform
In the long run; therefore, the monetary authorities are not free to vary
the short-term rate as they like; if they want to maintain activity at a satis-
factory level, they must keep the mean level of the short-term rate sufficiently
low so as to secure a long-term rate which permits a sufficient amount of long-
term investment. Alternatively, if they want to secure stability by means of
monetary policy, they must allow the average level of employment to fall to
a low enough level to permit the mean level of the short-term rate to be suf-
ficiently high. Thus the two main aims of monetary policy, to secure a satis-
factory level of incomes, and to secure stability of incomes, may prove incom-
patible: the one may only be achieved by sacrificingthe other.
Assuming that the monetary authorities regard the achievement of a
satisfactory level of activity as their paramount consideration,we must expect
the bank rate mechanism, as an instrument of economic policy, to become
increasingly ineffectual. As real incomes increase, savings rise, and the avail-
able investment opportunities become smaller, the bank rate, though still
available for dealing with an occasional boom, becomes more and more ineffec-
tive as a safeguard against the ravages of deflation.
Mr. Hawtrey is well aware of this constitutional weakness of the bank
rate mechanism; and he calls the state of affairs where the mechanism is put
out of action through the bank rate having reached its minimum level, a
" credit deadlock." But he is too much inclined, I think, to attribute the
emergence of a " credit deadlock " to past mistakes in banking policy-to the
Central Bank not having lowered the rate sufficiently soon, or sufficiently
suddenly-rather than to the inherent causes connected with the long-term
rate.' If Professor Hicks' calculations are right,2 and 2 per cent is now to be
regarded as the necessary marginal risk premium by which the current long-
term rate exceeds the average savings deposit rate, then a 3 per cent rate on
Consols presupposes a i per cent average on deposits; and a i per cent rate
on deposits is perilouslynear its absolute minimumlevel. If " full employment "
requires a long-term rate which is below 3 per cent, and this is what the
monetary authorities aim at, the "credit deadlock" becomes a more or less
permanent state of affairs.
In a world of perpetual or semi-perpetualcredit deadlock, stability cannot
be achieved by monetary policy (in the sense in which this term is ordinarily
understood); nor can fluctuations in the level of activity be regarded as a
" purely monetary phenomenon." For in those circumstancesmonetary factors
can neither be said to have caused the fluctuations, nor have they the power
to prevent them.
London. NICHOLAsKALDOR.
1 This is because he is sceptical of any influence of the short-term rate on the long-term rate
(either the current short rate or the average of past short rates) and regards the two rates as
independently determined. But it is difficult to see how the long-term rate can remain below the
short-term rate, once the prevailing level of the short-term rate comes to be accepted as " normal."
The supply of long-term funds comes from savers, and why should savers place any money in
long-term investments if they expect a higher return on savings deposits ?
2 Manchester School, Vol. X, N. I, p. 3I.