Monetary Policy and the Development of Money Markets

J.S.G. Wilson

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136520440
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book traces the developments of the post-war monetary story, with an emphasis both on theory and practice. A survey of monetary policy and a discussion of the effects of a credit squeeze are set against a survey of the very different American scene. Comparative analysis of the 'new money markets' is also included as is discussion of the significant developments in the world's major capital markets.

1

Investment in a Monetary Economy¹

I

Investment is a term used very loosely in the economic literature and all too frequently without any attempt at definition. Yet it is possible to defend an attitude which refuses to regard precise definition as an end in itself. The businessman, for example, rightly regards ‘investment’ not as a logical category with strictly definable limits, but as a rough description of a type of activity. To the businessman and to the economist, it is the purpose of any particular expenditure which matters. And, indeed, if we take a representative sample of definitions of investment, they all have this in common. Fraser, for instance, defines investment in a money economy—which is the sort of economy we are concerned with—as ‘the use of monetary resources for the acquisition of wealth of a relatively illiquid type’² and Keynes obviously had a similar definition in mind when he divided current output into ‘(a) the flow of liquid goods and services which are in a form available for immediate consumption and (b) the net flow of increments (after allowing for wastage) to capital goods and loan capital . . . which are not in a form available for consumption’.³ But what are goods of ‘a relatively illiquid type’? What is ‘capital’? Must we not define ‘capital’ before we can define ‘investment’ and as a condition of defining investment?

It is no part of our present purpose to embark upon a re-examination of the basic concepts of capital theory. That ground has already received its fair share of attention, though with no very definite results. Since there is still no general agreement as to what classes of goods should be regarded as ‘capital’, it is fruitless to define ‘gross investment’ as all expenditure on the provision or replacement of those classes of goods. It is much better to consider the purpose for which a good is used than the physical form in which it happens to appear. In this paper, therefore, the emphasis will be on the purpose of an expenditure. If goods are used in the production of further goods, that is ‘investment’. In other words, investment is ‘the act of applying a unit of input in any process of production’.⁴

However, for purposes of clarity, we must also distinguish between real investment and financial investment. If we buy shares in a corporate enterprise, or government securities, or lend money against a mortgage, or fix money at a bank in the form of a time deposit, we make a financial investment. If, on the other hand, we build a house or a factory, we make a real investment. As a rule, such real investments are measured in money terms and financial investment is undertaken with the object of making a real investment, but it is possible to conceive of one without the other. If a man applies his own labour to the resources of nature for the purpose of building a house, real investment would be the result, but, since no money was involved for labour and materials, this real investment would not be matched by any financial investment. Conversely, it is possible to invest money in a financial sense (e.g. by ‘investing’ money at interest as a time deposit in a bank) without any corresponding real investment being undertaken. Normally, of course, a bank functions in some sense as an intermediary and lends corresponding amounts of money (or money claims) to entrepreneurs for the purpose of undertaking real investment and this may then be regarded as the counterpart of the financial investment undertaken by the depositor. In times of cyclical depression, however, we have sometimes witnessed a tendency for interest-bearing deposits to rise, while bank advances have been falling. In this case, the difference between the real investment and financial investment magnitudes flows into hoards—i.e. money has been withdrawn from current expenditure on consumption without being applied to the production of future goods. As a result, there is a building up of inactive money holdings, with important repercussions on the level of real investment. So that, although there may not always be a matching of money flows with flows of real resources, in general there is a most intimate connection between them. Indeed, it is the money flows which, in a sense, both activate and determine the direction of flow of real resources.

For another reason, too, considerable importance is to be attached to the relationship between flows of money and flows of real resources. We are interested, for example, in the amount and nature of investment expenditures, because they determine in what proportions different kinds of goods will come into existence. Furthermore, we are interested in ‘how these proportions between quantities of different kinds of goods are related to the proportions in which money expenditure will be distributed between the two kinds of goods [producers’ goods and consumers’ goods], because it depends on the relation between these two proportions whether the production of either kind of good will become more or less profitable . . . we must always compare the result of investment embodied in concrete goods with the money expenditure on these goods’.⁵

This brings us to the central problem which it is the purpose of this paper to discuss. What is the nature of the relationship between financial investment and real investment? Keynes tried to state it as follows: The schedule of the marginal efficiency of capital may be said to govern the terms on which loanable funds are demanded for the purpose of new investment; whilst the rate of interest governs the terms on which funds are being currently supplied.’⁶ While one would agree with D. H. Robertson⁷ that the wording of this assertion is perhaps unfortunate and somewhat ambiguous, yet in epigrammatic form it does distil into a single sentence the attitudes of individual businessmen. Then, in an even more significant sentence, Keynes went on to point out that ‘whilst there are forces causing the rate of investment to rise or fall so as to keep the marginal efficiency of capital equal to the rate of interest, yet the marginal efficiency of capital is, in itself, a different thing from the ruling rate of interest’.⁸ It is important, in other words, to distinguish between the real and the monetary phenomenon, between a rate of interest which is the price paid for loans of money and a real rate of return, or a ‘rate of profit’.⁹ But it is also important to consider the forces which operate to bring about this tendency for the marginal efficiency of capital (or ‘expected rate of profit’) to equal the rate of interest. To this task we must now turn.

II

In equilibrium, the marginal rate of return on an investment should equal the rate of interest, or the price paid for the use of money, and both must equal the return (in terms of convenience) to holders of money. The conditions of this equilibrium are not far to seek, but there seems to have been little study of the underlying processes. With this end in view, it is proposed, first, to analyse these processes on the basis of drastically simplifying assumptions and, second, to remove some of these assumptions, in order to establish the degree to which the complications of the real world might modify or obscure the processes in question.

For the purpose of reducing the problem to fundamentals, it is proposed to assume:—

(1) rational behaviour on the part of businessmen, such that they will, in fact, aim at maximizing their profits and will endeavour to push investment to its furthest profitable limits;¹⁰

(2) perfect foresight, so that there is an absence of uncertainty and an ability to plan future production on the basis of known data;

(3) a constant demand for money to hold,¹¹ which will enable us to concentrate our attention on that part of the total demand for loanable funds which is matched by real investment;

(4) that investment is interest-elastic;

(5) perfect shiftability of funds from one market to another, which implies the absence of any costs of shifting;

(6) a single rate of interest; and

(7) perfect mobility of resources other than money.

It may be felt at this stage that we have assumed away all our problems, but this is not our intention. There is a fundamental underlying process to be isolated. Only when that has been pinpointed is it proper to try to accommodate the complexities of the real world.

The rate of interest, as has been stated, is regarded as a monetary phenomenon. As the price paid for the use of money, it is determined by the supply and demand conditions for money and money claims. The determination of the expected rate of profit, which is the corresponding real phenomenon, is slightly more complicated. In this connection, the businessman will compare his expected stream of cost expenditures with the stream of expenditures which he anticipates consumers will direct towards his final product (and these may well be the expenditures of other entrepreneurs when his own ‘final’ product is to them an intermediate good). His cost expenditures should include payments for the hire of labour, the purchase of raw materials and power, an allowance to cover overheads, amortisation charges, his own ‘wages of management’ and interest on ‘capital’, whether borrowed or his own.¹² He may or may not make separate provision for interest on capital, and practice varies.¹³ If he does not, his ‘wages of management’ and the interest charge will be covered by a ‘customary markup’. If the goods sell at a price which covers these costs, he will make his customary profit and he has no inducement to expand or contract. If his goods will not sell at this price, he makes a loss. He may absorb this temporarily by accepting lower ‘wages of management’, or (if the money capital invested in the business is his own) by failing to charge interest on capital. In the long run, however, and assuming rational behaviour, he must go out of business or transfer his activities elsewhere. If, of course, he finds that it is possible to increase his ‘customary mark-up’ so that it exceeds his ‘wages of management’ (interest charges also being covered), he (and his competitors) have every inducement to expand and will do so as long as marginal revenue continues to cover marginal costs. In so far as he requires additional finance, the costs of securing it must be covered.

Looked at from the point of view of the community as a whole, the advantages of lending at interest must tend to equal the earnings of investment in real resources. But the level at which that equality will become effective will conceivably vary.

If the rate of interest is low in relation to the expected rate of profit, there will be an incentive to increase the rate of investment. This will have two effects. On the one hand, it will mean an increased demand for money and a tendency for the rate of interest to rise. On the other, and as the rate of investment increases, the marginal cost of producing capital goods (or of securing additional labour and materials) will tend to increase and this will immediately tend to reduce the expected rate of profit. In addition, we can expect the prospective yield of capital assets to fall, because more units are coming on to the market. Then, as a result of the convergence of these two sets of forces—the one operating to push up the rate of interest and the other to depress the expected rate of profit—equality between the two rates will eventually be brought about.

Conversely, if the rate of interest is high in relation to the expected rate of profit, there will be a tendency to curtail investment and, as a result, the prospective yield of existing capital assets will gradually be raised, as these assets wear out and become shorter in supply.¹⁴ Concurrently, the falling off in the demand for money will tend to lower the rate of interest. Again, there is a tendency towards equality between the rate of interest and the expected rate of profit in consequence of this two-way effect. Or, if one prefers, one can state the position in terms of a cross-relationship. Any change in the expected rate of profit (e.g. as a result of technological progress) will influence the rate of interest through its effect on the demand for money. Likewise, current and prospective levels of the rate of interest will in their turn influence expectations of future yields from investment.

It is convenient to consider here a qualification to the argument which appears above. Objection was taken recently to ‘the dogmatic assertion that the effect of investment on further investment decisions is bound to be depressing; that over time, and in the absence of unforeseen change, the marginal efficiency of capital will decline’,¹⁵ and it was pointed out that this could only be so where all capital goods are more or less perfect substitutes. We can agree at once that ‘the mode and magnitude of investment repercussions in any given situation depends on the shape of the capital structure in which the complementarity relations obtaining between all capital resources find their expression’.¹⁶ In point of fact, we are always discovering examples of new investment which ‘makes it possible to use certain existing capital resources complementary to it in a new and more profitable way’.¹⁷ But is this any different from the general search for new and more profitable combinations of resources? Lachmann was right to attack dogmatism, but in the final analysis presumably more and more investment must lead to a depression of returns, for eventually we reach a situation in which people lack the time to consume the abundance of goods being produced and all goods become ‘free’. That day is still a long way off, but given sufficient investment activity in particular fields, it will still be possible to reach a situation of temporary and localised ‘full investment’ and a related saturation of consumer demand for particular types of goods (with, of course, repercussions on the demand for other types of goods). That is all that it is necessary to claim for the purpose of our present argument.

III

We must now remove our simplifying assumptions and study the effects which will follow under less restricted conditions.

Two main effects would seem to follow the introduction of the factor of uncertainty. First, there is the increased difficulty of formulating a production plan, when for definite expectations it becomes necessary to substitute a range of expectations, not all of which will be held to have the same order of probability.¹⁸ In other words, it now becomes necessary to allow for a margin of error. But, despite uncertainties of future technical conditions and of the market, it is reasonable to suppose that ‘a firm, which is only concerned to draw the maximum profit from a given situation, . . . will have to draw up a fairly definite “plan” to attain that end’.¹⁹ The effect of uncertainty in these circumstances will be a desire to retain a measure of flexibility and a capacity to adjust the ‘plan’ from time to time. Flexibility can be secured by keeping in reserve a generalized command over goods and services which only the holding of, or access to, a money balance can provide. Secondly, then, there will be a desire to keep a money balance (or to have access to one—by means of an unexercised overdraft authority) in excess of ‘transactions’ requirements. In other words, there will be a ‘speculative’ demand for money balances.²⁰ This will not only swell the demand for money and loanable funds, but will also have repercussions on the level of the rate of interest. Other things being equal, this ‘speculative’ demand for money will tend to force up the rate of interest and to require that eligible investment projects should be rather more profitable than would otherwise have been necessary. The monetary authorities (in theory) might offset this to a certain extent by adding to the supply of money. Nevertheless, the occurrence of fluctuations in the ‘speculative’ demand for money may be extremely difficult to establish and the monetary authorities may find themselves working in the dark. In this event, the demand for money (for all purposes) will become much less predictable (here we can relax assumption 3) and not only shall we be concerned with a tendency for the expected rate of profit to equal the rate of interest at the margin, but both must now not exceed (in equilibrium) the ‘convenience value’ of holding idle money balances, as measured in terms of opportunities forgone. In the result, any rise in the ‘convenience value’ of holding money will tend to force u...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• PREFACE
• 1. Investment in a Monetary Economy
• 2. Credit Rationing and the Relevant Rate of Interest
• 3. The Radcliffe Report—In Search of Guidance
• 4. External Aspects of Monetary Policy—Some Reflections on the Radcliffe Committee’s Report
• 5. Defending the Pound Sterling
• 6. Monetary Policy in the 1960s
• 7. America’s Changing Banking Scene
• 8. American Banking Revisited
• 9. The Structure of Money Markets
• 10. The Indian Money Market
• 11. The Canadian Money Market Experiment
• 12. Australian Banking and Money Market Institutions
• 13. The New Money Markets
• 14. The Internationalization of Capital Markets
• INDEX