Friday, August 12, 2005

The Danger of a Sudden Rise in Precautionary Money Demand

With the advent of his General Theory, Keynes is thought to have focused attention on the importance of the speculative demand for money and its role in determining interest rates. This part of the demand for money has subsequently received the greatest degree of notoriety. John Hicks claimed that it is the small speculative or voluntary part of the demand for money that is really important to monetary theory (See his Two Triads:Lecture I, last paragraph in his Critical Essays in Monetary Theory). The precautionary motive has been typically ignored or downplayed by most economists,although Hicks did lump it in with the speculative part.

However, Keynes makes reference to how that a rise in uncertainty, not only about the normal level of bond yields, but also about the economy in general, might cause a sudden and disastrous rise in this precautionary demand for money. It was this rush for precautionary money (in fact, base money) that caused the meltdown of the banking system in 1933 in the US. It was to happen again, over and over, in countries experiencing capital flight. Massive sales of non-monetary assets in preference for cash, intended in turn for quick conversion to a more stable currency. In a sense, this process is like people facing a fire in a theater, where the door to the lobby must be passed before exiting the door to the theater itself. The rise in precautionary money demand is extremely dangerous since it can lead to a contraction in the supply of money just as the demand for money is expanding. The ever-widening gulf between supply and demand in the money market can create a bank panic and a severe contraction. It is the fact that both demand and supply of money are moving in opposite directions that makes it problematic for the central bank to halt the contraction by simply providing reserves to the banking system. There is a psychological aspect to the problem which is not usually fully appreciated. (e.g. Albert Hettinger, Jr.'s thoughtful and gingerly written comments at the end of Friedman and Schwartz's The Great Contraction politely criticizes their analysis for just this reason--not enough emphasis on psychological factors).

Keynes never failed to appreciate the role of psychology, tempered by economic and institutional constraints. The General Theory is full of such examples with respect to the demand for money. For example, in Chapter 22 Notes on the Trade Cycle, Keynes clearly states -------"Moreover, the dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity preference" -------and it is clear that he is speaking of the precautionary component, as opposed to the speculative component of money demand. Even here Keynes is so focused upon his new toy -- liquidity preference -- that he apparently forgets that this rise simultaneously raises the currency/deposit ratio and the reserve/deposit ratio, thus contracting the money supply.

The above shows that it is of paramount importance for central banks to take pre-emptive measures to head off any chance of a sudden and catastrophic rise in the precautionary demand for money. Certainly, this responsibility far outweighs any admonition to maintain a low and steady rate of inflation.


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