Keynes on the Special Properties of Money

Keynes in the General Theory (1936) showed that fiat money and even commodity money have special properties:

“… money has, both in the long and the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority;—elasticity of production meaning, in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced;—labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed. Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money;—as we see to be the case in gold-mining countries, though for the world as a whole the maximum diversion in this way is almost negligible” (Keynes 1936: 230–231).

Money has a zero or very small elasticity of production. This means that a rise in demand for money and a rising “price” for money (i.e., an increase in its purchasing power) will not lead to businesses “producing” money by hiring workers.

Even under the gold standard, when money was a type of producible commodity, production of gold or silver in significant quantities was severely limited to certain countries and brief times. For example, if the UK was hit by a deflationary depression in the 1880s, with a rising purchasing power for money as demand for it increased as a hedge against future uncertainty (that is, a rise in its value due to deflation), could UK businesses just hire unemployed workers to “produce” gold in the UK? They could not.

The property of zero or very small elasticity of production also applies to liquid financial assets. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines. The price of financial assets will rise and it is possible that the price of money could also rise. But private businesses cannot hire the unemployed to “produce” or “manufacture” more money or financial assets to exploit profit opportunities in the high-price liquid assets (Davidson 2010: 255–256).

A further point is that money and financial assets have zero or near zero elasticity of substitution with producible commodities:

“The elasticity of substitution between all (nonproducible) liquid assets and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Davidson 2002: 44).

The gross substitution axiom is a fundamental assumption of neoclassical economics and the Austrians appear to tacitly assume the axiom as well. But the gross substitution axiom is wrong, and all inferences made from it in economic theories are also wrong.

This is also one of the reasons why Say’s law, in its various forms, does not work.

BIBLIOGRAPHY

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money, Macmillan, London.

F. H. Hahn in a Candid Moment on Neo-Walrasian Equilibrium

The neo-Walrasian economist Frank H. Hahn is a respected neoclassical economist. Unlike other neoclassicals, however, he has been rather more honest in admitting the limitations of neo-Walrasian general equilibrium theory.

John Maynard Keynes stressed that money has special properties. Money has a zero or very small elasticity of production, and money and financial assets have zero elasticity of substitution with producible commodities. Keynes and modern Post Keynesians thus reject the “gross substitution axiom,” an idea held by neoclassicals and probably by many Austrians as well.

As Paul Davidson has noted (Davidson 2010), Frank H. Hahn in 1977 came to a similar conclusion about money and financial assets:

“there are ... resting places for saving other than reproducible assets. In our model this is money. But land, as Keynes to his credit understood, would have just the same consequences and so would Old Masters. It is therefore not money which is required to do away with a Say’s Law-like proposition that the supply of labour is the demand for goods produced by labour. Any non-reproducible asset will do. When Say’s law is correctly formulated for an economy with non-reproducible goods it does not yield the conclusions to be found in textbooks. As I have already noted Keynes was fully aware of this and that is why he devoted so much space to the theory of choice amongst alternative stores of value” (Hahn 1977: 31).

Furthermore, Hahn also questioned the role that flexible money wages are supposed to play in clearing markets and reducing unemployment:

“One can certainly now see that the view that with ‘flexible’ money wages there would be no unemployment has no convincing argument to recommend it … Even in a pure tatonnement in traditional models convergence to an equilibrium cannot be generally proved. In a more satisfactory model matters are more doubtful still. Suppose money wages fall in a situation of short-run non-Walrasian unemployment equilibrium. The argument already discussed suggests that initially this will lead to a redistribution in favour of profit. The demand for labour, however, will only increase on the expectation of greater sales since substitution effects in the short run can be neglected. If recipients of profit regard the increase as transient (as they sensibly might) their demand for goods will not greatly increase. On the other hand, if wage-earners have few assets their demand will decrease. But that means that producers get a signal to reduce output. Wages continue to fall and prices begin to fall also. Real cash balances increase but expectations about future prices may give a positive rate of return to money. There may be many periods for which falling money wages go with falling employment. Where the system would end up in the ‘long run’ I do not know” (Hahn 1977: 37).

Hahn (1977: 39) also noted that in any economy “which is not a barter economy … any non-reproducible asset allows for a choice between employment inducing and nonemployment inducing demand.” Hahn was right, but Keynes knew this long before Hahn.

BIBLIOGRAPHY

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267

Hahn, F. H. 1977. “Keynesian Economics and General Equilibrium Theory: Reflections on Some Current Debates,” in G. C. Harcourt (ed.), The Microeconomic Foundations of Macroeconomics, Macmillan, London. 25–40.