Theory of Interest

This paper addresses a critical component of Keynesian economics — his theory of interest. In addition to an overview of his works as well as modern, "neo-Keynesian" versions of his principles, the reader also gleans an understanding of the debate surrounding the applicability of Keynesian thought in a 21^st century economic environment.

Keywords Capacity Utilization; Capital Assets; Interest; Liquidity Preference; Macro-economy; Wage Unit

Actuarial Science > Theory of Interest

Overview

Unbeknownst to many, John Maynard Keynes originally wanted to operate a railroad. Unfortunately, however, to do so, he had to pass a civil service examination, and the man who would become known as the "father of modern economics" received his lowest marks on the economics section. As Keynes would later recall, I evidently knew more about economics than my examiners" ("Young John Maynard Keynes," 2007).

While Keynes' pursuit of a career on the rails did not come to fruition, his lack of discouragement at the civil service examiners' led him to become a central figure in the reinvigoration of the western economy after the Great Depression and World War II. His theories on economic development reshaped the international community's perspective on how to address the ongoing fiscal crisis and left an impact on global economics that prevails today.

Of course, such accolades do not suggest that Keynes was free of controversy. In fact, Keynes' view that government must play a role in the revitalization of national economies, and that the goal of economic redevelopment should be to bolster the demand side of a macroeconomy, made him a target for those fearful of a leftist ideology in rebuilding the systems of the West. Even today, in the 21st century, Keynesian economics are consistently under fire by free market proponents and conservatives who view his theories as overly simplistic and even impractical in today's global economy.

This paper addresses a critical component of Keynesian economics — his theory of interest. In addition to an overview of his works as well as modern, "neo-Keynesian" versions of his principles, the reader gleans an understanding of the debate surrounding the applicability of Keynesian thought in a 21st century economic environment.

Keynes & the Future of Economics

In 1936, countries around the globe were mired in the Great Depression. Classical economic theories suggesting that the free market would correct itself (so-called laissez-faire economics; introduced by icons such as Adam Smith and John Stuart Mill) proved largely ineffectual in revitalizing the economies of the western world. A new approach was clearly warranted, and the thinking of John Maynard Keynes seemed to offer just that alternative.

In his seminal work, "General Theory of Employment, Interest and Money," Keynes advocated for a government that played a more significant role in economic affairs. By infusing monies into the demand side of the macroeconomy, Keynes suggested, economic systems under duress from recession and depression could become reinvigorated by increased consumer confidence, higher incomes and a workforce well-suited to contribute to the economy.

Keynes' argument in that work was based on acknowledgement of three central, independent variables.

• The first of these was a combination of psychological factors: Propensity to consume, the attitude concerning liquidity and an expectation of future yield from capital assets.
• Second, Keynes posited, was the wage unit, which is determined by the bargains reached between employees and their employers.
• The last of these variables, Keynes argued, is the quantity of monies as determined by the central bank.

At the core of the interaction between these variables is what Keynes called the "liquidity preference schedule." Consumers, Keynes theorized, were in essence in control of the rate of interest (which is a price which a lender may charge a borrower in a loan situation). They could therefore choose to hoard their monies and assets or invest them in the markets, depending on how much in liquid assets they possessed. Keynes asserted that this choice would be a powerful determinant of the rate of interest. If national incomes and employment rates remained static, a state of equilibrium would exist. However, Keynes assumed that this equilibrium would not be consistent in light shifts in liquidity caused by changes in consumer behavior (Lutz, 2006).

As was the case for the predominance of Keynes' "General Theory," the focus is on the demand side of a macroeconomy. Keynes asserted that governments seeking to reinvigorate their own economies through intervention (a shift in and of itself from the pure free-market economic model preferred by Classical theorists) must focus on the consumer. In terms of his views on interest specifically, the consumer's attitudes concerning the economy would drive whether or not he or she will spend his or her liquid assets or retain it. Depending on the direction in which consumer behavior leads, rate of interest shifts.

As stated earlier, J.M. Keynes' notions introduced in "General Theory" were at best controversial. Part of the debate centered around the fact that his theory of interest was largely dependent upon ideas he proffered in a work published six years prior: "A Treatise on Money." In "Treatise," Keynes laid the groundwork for an argument that, in simplified terms, asserted that investment leads to inflation and savings to recession. The connection between the two works became frayed, due in part because debate with mainstream economists brought about modifications to Keynes' framework that disconnected "General Theory" from "Treatise" (Erturk, 2006).

Keynes' ideals created a firestorm of debate, but the controversy did not stem solely from those who maintained a conservative loyalty to the Classical approach. There were many who at the time saw Keynes' work as needy of further exposition in order to ensure true validity. It is to this contemporary debate surrounding Keynes' theories that this paper turns next.

Peer Debate Over the Keynesian School of Thought

Keynes' theories understandably set off controversy and invited pointed criticism. Some of it was politically motivated. After all, to free market conservatives (many of whom were actively concerned with the spread of communism) the idea that government should play an active role in a western economy smacked of leftist ideology akin to Marxism. For others, Keynes was simply attempting to turn the establishment on its ear for revolution's sake.

Among the critiques was that of Friedrich August von Hayek, whose ideas would evolve into the school of thought known as Austrian economics. Hayek originally dismissed Keynes' theory of liquidity preference as far too rigid and only applicable in emergency situations in which the balance between supply and demand are in immediate peril. Hayek's views of Keynes, the "General Theory" and the liquidity preference were later revealed to be based on misinterpretation of Keynes' central message. In fact, Keynes made a point, in trying to help critics understand his ideas, of asserting that his main focal point, liquidity preference, was not the singular element in determining the interest rate (DeVecchi, 2006). Unfortunately, either due to the fact that Keynesian economics, by his own implication, was a work that still needed modification, or in order to answer to increasingly vocal critiques of his work in a conciliatory fashion, Keynes still needed to defend his views from a growing complement of peers.

One of Keynes' greatest critics prior to his death in 1946 was, in fact a previous collaborator. Dennis Robertson worked closely with Keynes in the 1920s, long before "Treatise" or "General Theory." Although those loyal to Keynes' ideas dismissed Classical economic theory and anything prior to "General Theory" as irrelevant in the modern industrial economy, Robertson took exception to accusations that he was the product of the antiquated world. In fact, Robertson retorted that it was Keynes who was not operating on solid ground — by seeking to discount the pre-War theoretical environment, Keynes, he argued, was abandoning not only the precepts of Classical economics but the time-honored, fundamental scientific practices of economic study that gave rise to economic thought.

Robertson, who in the 1920s was handpicked by Keynes to Chair the Economics Department at Cambridge, attempted to move away from his personal feelings toward Keynes (a man by whom he felt betrayed for dismissing the very scientific precepts on which they had worked as colleagues) to provide a more academic repudiation of Keynes' theories. His assertion was that Keynes' view of the consumer as the central mitigating factor in the determination not only of price but of interest was far too rigid and, as a result, incomplete. Consumers do have a role, Robertson admitted, but liquidity preference only worked within two regimes — an individual who was willing to spend his or her money, and an individual who refused to spend.

Robertson argued that Keynes was operating from far too limited a position. By proffering that consumer income is the singular force behind fluctuations in interest rates, Robertson claimed, Keynes was discounting exogenous factors such as trade and a multitude of consumptive activities. These issues were complicated factors that demanded consideration in addition to income as determinants of interest rate changes (Higgins & Wright, 1998).

Keynesian economics obviously had its impacts on both the Depression-era and post-World War II international stages. With traditional economic development policy coming up short, leaders found themselves willing to think "outside of the box" in order to reestablish economic and fiscal order. It comes as no surprise; therefore, that Keynes' ideals of government intervention and state funding to bolster the consumer were received warmly by political leaders who sought to make life better for constituents. As the world moved out of wartime, and the economy began improving, modern economic theorists began to wonder if Keynesian economics was becoming antiquated.

Interest Theory & the Future of Keynesian Economics

As the decades left Keynes to history in the Depression era, questions abound about the relevance of his theory of interest and liquidity preference and the quantity of money. Inflation, unemployment, international trade and other issue areas that are commonplace in the 21st century seem to support the Robertson school of thought that suggests that there are a multitude of factors, both on the supply and demand sides of a macroeconomy, that impact price and interest rates. The rigidity of Keynes' view that consumer asset behavior dictates changes in interest rates seems too limited in a world in which many other factors seem to become manifest.

Still, Keynes' theories are widely underanalyzed and studied in a less-than-comprehensive manner. Most modern economists do not flatly refute the notion of liquidity preference as a major contributor to the determination of interest rates. The problem that skeptics see is in the perceived notion that Keynes believed that liquidity preference was the sole determinant in establishing interest rates.

Some modern economists see Keynes as an individual who provided a general set of guidelines, many of which are in fact compatible with Classical and neo-classical economic theory. Their view is that gaps or rigidities in Keynes' theoretical structure, particularly with regard to liquidity preference and equilibrium as established by employment, may be general in nature and therefore open to interpretation, misinterpretation and in many ways, supplementation (Wright, 1945).

The offerings of Harvard Professor Alvin Hansen create a similar situation concerning interpretations of Keynes' interest theory. The man some nicknamed "the American Keynes" criticized Keynes for calling Classical interest theory indeterminate. Keynes, Hansen argued, was claiming that under a Classical regime, the schedule relating savings to the rate of interest would shift as income changes, and incomes changed as interest rates changed as well. Income, according to Hansen's critique of Keynes' views, was an unpredictable factor that inevitably influences the direction in which the rate of interest shifts. Hansen pointed to what he saw as an irony in Keynes' "attack" on the Classical motif — in Keynes' paradigm (in which interest rests at the intersection between the supply schedule of money and the liquidity preference schedule), income also exists as an x-factor. Put simply, Keynes was, in Hansen's view, taking Classical interest theory to task over the unpredictability of income, while Keynes' theory itself became indeterminate over the same unpredictability of income (Nevin, 1955).

Hansen's issue with Keynes proceeds with the assumption that Keynes' ideals, in failing to account for the very issue for which Classical theory failed to account, were incomplete. This argument is difficult to confirm, for the aforementioned evolution of Keynes' interest theory (modified between "Treatise" and "General Theory") was not a complete work in historical contexts. In fact, the theory of interest offered by Keynes was, by virtue of both the ongoing debate over his sea-change departure from Classical theory and a change in the economy from its pre-World War II state to a modern, global industrial 21^st century economy.

The ambiguity of income's impact on interest, while the subject of debate among Keynes and those taking exception to Keynes' departure from Classical theory, does appear to have piqued the interest of those who view Keynesian economics as a work on which exposition was not just possible, but necessary. Post-Keynesian economists have taken note of the holes in Keynesian and Classical interest theories as they relate to income, but have done so in such a way that they do not look at these flaws that are unworkable. Rather, they look to fill in those holes.

One post-Keynesian study, for example, supplements changes in wages with capacity utilization, a term that applies to the relationship between real and potential output. According to the study, an increase in real wages, by raising consumption demand, also increases productive capacity utilization. However, because the distribution of capacity utilization profits is evenly spread, the ambiguity of interest persists. Still, the application of productive capacity utilization (and the leveling effect it brings with it) in many ways fills in the gaps created by Keynesian and Classical theorists and, at the very least, helps the observer understand the establishment of interest rates and supply-demand equilibrium (Meirelles & Lima, 2006).

The interest theory espoused by Keynes obviously established a legacy among modern economists, although this legacy is mixed at best, given the changing world and apparent shortcomings on the issue of income.

Conclusion

In one century, the world has undergone an incredible transformation. After World War I, it became clear that the world was moving toward an environment of interstate interconnectivity, with President Woodrow Wilson stressing the common global system with the introduction of the League of Nations. Two decades later, the Great Depression underscored this global environment, although not in the manner humanity had hoped — the US market crash sent shockwaves around the world, and other nations succumbed to the Depression's malaise.

With an ever-evolving economic system that remained anemic, it became clear that a different policy was warranted. The urgency of economic development became more and more manifest. John Maynard Keynes, espousing a policy that favors the demand side of a macro-economy and government intervention that addresses the needs of consumers, became a central figure in that change in regimes.

Keynes' approach to economics entailed an emphasis on demand rather than the traditional view of business development as the central theme. Income, according to Keynesian theory, is the central element that affects how the rate of interest increases or decreases. This point is, according to the theory, due to the fact that there are a variety of conditions under which a consumer will spend his or her money (or choose not to). Focusing on the consumer's liquidity preference schedule is therefore a pivotal part of economic recovery from such devastating conditions as the Depression.

The fact that Keynes' ideas were widely adopted by world governmental economic policymakers does not mean that his ideas were well-received by economists. That his concepts of demand-side government appropriations were new was not the issue — the controversy lied in the fact that Keynes arrived at his conclusions by apparently rejecting methods of economic study that had been the norm for nearly two centuries. Keynes had, in the eyes of his peers (many of whom had worked with him prior to his publication of "Treatise" and the tome in which his most controversial theories, "General Theory"), chosen to pursue his economic theories by rejecting not just the preferred focus of Classical economics. He had arrived at his conclusions by rejecting the commonly accepted practices of economic research utilized by Classical theory as well.

Keynes' theory of interest was of particular controversy in this regard, as the debate concerning his general theory of interest, as proffered in "General Theory," can be placed in two categories. The first of these arenas is political — Keynes had distanced himself from the aforementioned well-established Classical school of economic theory. He had even fomented the consternation of those peers and colleagues who had worked closely with Keynes himself within the Classical regime. In an era of considerable mistrust toward the increasing promulgation of Marxism and Communism, Keynes' apparent call for a reversal away from the free-market system and one that relied on government intervention and/or interference was particularly abhorrent for some politically-charged peers.

The second arena is that of a misunderstanding of Keynes' methodologies and data. Whether actual or perceived, this position asserted that Keynes' ideals were based largely on speculation and, more importantly, established parameters in the interest rate schedule that were far too rigid and dependent on one element (namely the liquidity preference schedule). There are many individuals, including the ones cited in this paper, who believe that the debate that immediately met Keynes' interest rate theory caused an exchange of ideas, reconsiderations and modifications that only left the skeletal framework of what Keynes was expressing (and connecting to his largely underanalyzed earlier work, "Treatise"). For others, Keynes was simply laying a foundation on which others may build. His theories were not inflexible nor were they incomplete — they were dynamic and capable of evolving, should those who shared his perspective take the torch into the next era.

In the decades that followed Keynes' introduction of the theory of interest, as well as his other "revolutionary" theories of economic development, much has happened to change the world regime. Whereas pre-World War II nations could choose to limit their international commerce activities, the world of the latter 20^th and early 21^st century relies on linkages between countries and systems. In fact, some may argue that, in business terms, national governments are becoming less relevant in comparison to multinational corporations and international business partnerships. Most nations (even those with Communist governments) have embraced some semblance of the free market model, and while government involvement is by no means nonexistent (most governments intervene when their economies experience downturns or when trade relations become imbalanced), there is some question as to the modern relevance of the theories of a man who at one time hoped to become a railroad operator. Perhaps a better understanding of the complete methodologies of J.M. Keynes will prove effective in determining whether there is a 21^st century application to be seen for one of the first relevant economic development theories of the early 20^th century.

Terms & Concepts

Capacity Utilization: Economic term identifying the relationship between real and potential production output.

Capital Assets: Tangible property that cannot be easily be liquidated into cash, such as land and real estate.

Interest: Price charged by a lendor to a borrower as a condition of the transaction.

Liquidity Preference: Keynesian economic indicator that identifies consumer behavior as it relates to investment or savings.

Macro-economy: Economic system comprised of aggregate demand and aggregate supply.

Wage Unit: One of three central variables of consumer behavior in Keynes' theory of interest, referencing the salary agreement established between employer and employee.

Bibliography

Chick, V., & Dow, S. (2013). Keynes, the long run, and the present crisis. International Journal of Political Economy, 42(1), 13-25. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91860285&site=ehost-live

DeVecchi, N. (2006). Hayek and the general theory. European Journal of the History of Economic Thought, 13(2), 233-258. Retrieved January 24, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=21193759&site=ehost-live

Erturk, K.A. (2006, January). Speculation, liquidity preference and monetary circulation. The Levy Economics Institute's Working Paper Series. Retrieved January 23, 2008, from http://www.econ.utah.edu/~korkut/handbook%5f05.pdf

Higgins, A.L. and Wright, Jr., J.W. (1998). Keynes' antagonist. American Economist, 42(1), 82-89. Retrieved January 23, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=819286&site=bsi-live Lee, D.R. (2012). The Keynesian path to fiscal irresponsibility. CATO Journal, 32(3), 473-491.

Lerner, A.P. (2013). Mr Keynes' 'general theory of employment, interest and money'. International Labour Review, 15236-46. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85862025&site=ehost-live

Lutz, F. (2006). The theory of interest. Aldine Transaction. Retrieved January 22, 2008, from http://books.google.com/books?id=mJjzvdzqEAIC.

Meirelles, A.J.A. & Lima, G.T. (2006). Debt, financial fragility and economic growth. Journal of Post-Keynesian Economics, 29(1), 93-115. Retrieved January 24, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22665392&site=bsi-live

Nevin, E. (1955). Professor Hansen and Keynesian interest theory. Quarterly Journal of Economics, 69(4), 637-643. Retrieved January 24, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=7703501&site=bsi-live

Wright, D.M. (1945). The future of Keynesian economics. American Economic Review, 35(3). Retrieved January 23, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=8692875&site=bsi-live

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Suggested Reading

Cesaroni, G. (2001). The finance motive, the Keynesian theory of the rate of interest and the investment multiplier. European Journal of the History of Economic Thought, 8(1), 58-74. Retrieved January 27, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=5180495&site=ehost-live

Colander, D. (1999). Teaching Keynes in the 21^st century. Journal of Economic Education, 30(4), 364-372. Retrieved January 25, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=2328900&site=bsi-live

Kregel, J.A. (1983). Post-Keynesian theory. Journal of Economic Education, 14(4), 32-43. Retrieved January 27, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5422110&site=bsi-live

Wray, L.R.. (2006). Keynes' approach to money. Atlantic Economic Journal, 34(2), 183-193. Retrieved January 26, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22930163&site=bsi-live