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Keynes, through his work, propagates the Theory of Employment, Interest and Money and through the help of other economists, explains its contribution to the economy. The theory was published in 1936. The theory focuses on the demand for money and the impact of interest rates on the economy. He strongly believes that the economy is not self adjusting as the classical theory of money tries to put. Therefore, in this paper, the focus will be on Keynes theory and its contribution to the economy.
Keynes defines liquidity as the degree to which an asset can be quickly and cheaply turned into money. Therefore, according to him liquidity preference is the desire to hold money rather than other forms of wealth (Grant, 2000). He uses this concept of liquidity preference, which refers to the demand for money, to explain: how savings and investment might temporarily be different and how interest rates in the economy are arrived at. Keynes identifies three reasons why people hold wealth as money rather than interest-bearing securities as will be discussed below.
The transaction motive
In this case, households require money to pay for their routine purchases. The degree of transactions that demand for money depends on the individual’s incomes and institutional arrangements such as how often the individual is paid and how often he or she engages in monetary transactions (Todaro, 2000).
In this case, Keynes argues that money is held in order to finance unexpected rather than planned transactions, resulting from unexpected occurrences such as ill-health or a car breaking down. He explains that precautionary demand for money depends on the level of income. The higher the total value of the transactions, the more money will be needed to guard against unexpected transactions. Therefore, according to him, interest rates is the opportunity cost of holding money and so, if interest rates rise, consumers and firms may be forced to reduce their precautionary holdings and instead hold interest bearing assets such as bonds (Hardwick & Langmead, 2001).
Keynes argues that people may choose to keep ready money to take advantage of profitable opportunities that may arise in financial markets such as to invest in bonds which may arise (or they may sell bonds for money when they fear a fall in bonds’ market prices). Keynes also argues that each individual has some expectation of a normal rate of interest, although these conceptions differ from one individual to another. This notion of normal interest rate reflects previous levels and movements of interest rate and expectations of the future level, derived from the available market information (Golfeld & Chandler, 2000). If the current interest rate were greater than the individual’s conception relating to the normal rate, the individual would expect the interest rate to decline in the near future. This implies that the higher the prevailing rates of interest, the greater the number of people who would anticipate that rates will fall in future (Golfeld & Chandler, 2000).
According to Keynesians, an increase or decrease in the money supply in the economy, only affects the demand for goods and services in an indirect manner, and hence the level of income, through a change in the rate of interest. Thus, for example, an increase in money supply leads to a fall in the rate of interest which in turn causes private investment to fall and ultimately results in a decline in the level of national income. The outcome on the economy as a result of an increase in the money supply greatly depends on the outcome that the fall in interest rates produces (Diulio, 2002). According to the Keynesian view, both consumer demand and investment demand are comparatively insensitive to interest rate changes, that is, they are moderately interest-inelastic. Keynes argues that the volume of investment depends heavily on technological changes and business confidence, and also expectations. This implies that an increase in the money supply will have a limited change on the aggregate demand and, consequently, little effect on both employment and output (Diulio, 2002).
Keynesians argue that the monetary policy will have a limited impact on the economy and national income, because increases in the money supply would be cancelled by reductions in the velocity of circulation, leaving prices and number of transactions constant. Therefore, an economy experiencing a depression can be revived through an appropriate fiscal policy. Fiscal Policy refers to the use of government expenditure and taxation to regulate the aggregate level of economic activity (Golfeld & Chandler, 2000). They argue that by increasing, say, investment or government expenditure, an initial stimulus to expenditure through the multiplier-accelerator interaction result in an even greater increase in national income. Keynesians consider it unimportant that this increased expenditure must be financed through borrowing. They argue that the size of public sector borrowing requirement (PSBR) has no effect on interest rates. This they contend is because, although it is possible for PBSR to be responsible for the growth of money supply, it is not certain that an increase in the money supply will lead to a higher inflation (Golfeld & Chandler, 2000).
Monetarists, however, disagree with Keynesian demand management approach to dealing with a depressed economy. They argue that such an economy cannot be successfully revived by an increase in public expenditure given that any increase in expenditure will normally have to be financed by increased borrowing (Hardwick & Langmead, 2001). The effect will be to further depress the economy through higher interest rates through the crowding out of private sector investment (the crowding out effect). Increased borrowing will also increase the money supply thereby causing more inflation. Monetarists, therefore, argue that the focus should be on creating the conditions for confidence in the economy and invectiveness for enterprise. Inflation is seen as a key obstacle to confidence and according to monetarists, it can be reduced by controlling the growth in money supply and reducing inflationary expectations (Hardwick & Langmead, 2001).
In conclusion, Keynes theory stands out as the most reliable explanation as to why households and the government behave the way they do. Other theories like the classical theory of money are criticized for having many assumptions. Through Keynes work, it is evident that the economy is not self adjusting; rather the government should intervene by regulating the interest rates and help maintain the economy at equilibrium.