Investment Spending, Liquidity, and the Non-neutrality of Money
Axiom
Keynes’s theory implies that agents who planned to buy producible goods in
the current period need not have earned income currently or previously in
order to exercise this demand (D2) in an entrepreneurial, money-using economic
system. This means that spending for D2, which we normally associate
with the demand for reproducible fixed and working capital goods, is not
constrained by either actual income or inherited endowments. D2 is constrained
in a money-creating banking system solely by the expected future
monetary (not real) cash inflow (Keynes, 1936, chap. 17). In a world where
money is created only if someone goes into debt (borrows) in order to
purchase goods, then real investment spending will be undertaken as long as
the purchase of newly produced capital goods is expected to generate a future
cash inflow (net of operating expenses) whose discounted present value equals
or exceeds the money cash outflow (the supply price) currently needed to
purchase the asset.
For the D2 component of aggregate demand not to be constrained by actual
income, therefore, agents must have the ability to finance investment by
borrowing from a banking system which can create money. This Post
Keynesian financing mechanism where increases in the nominal quantity of
money are used to finance increased demand for producible goods, resulting
in increasing employment levels, means that money cannot be neutral. Hahn
(1982, p. 44) describes the money neutrality axiom as one where
The objectives of agents that determine their actions and plans do not depend on
any nominal magnitudes. Agents care only about ‘real’ things such as goods …
leisure and effort. We know this as the axiom of the absence of money illusion,
which it seems impossible to abandon in any sensible sense.
To reject the neutrality axiom does not require assuming that agents suffer
from a money illusion. It only means that ‘money is not neutral’ (Keynes,
1973b, p. 411); money matters in both the short run and the long run, in
affecting the equilibrium level of employment and real output. As Keynes
(1973b, pp. 408–9) put it:
The theory which I desiderate would deal … with an economy in which money
plays a part of its own and affects motives and decisions, and is, in short, one of
the operative factors in the situation, so that the course of events cannot be
predicted in either the long period or in the short, without a knowledge of the
behaviour of money between the first state and the last. And it is this which we
ought to mean when we speak of a monetary economy.
Once we recognize that money is a real phenomenon, that money matters,
then neutrality must be rejected. Keynes (1936, p. 142) believed that the ‘real
rate of interest’ concept of Irving Fisher was a logical confusion. In a monetary
economy, moving through calendar time towards an uncertain (statistically
unpredictable) future, there is no such thing as a forward-looking real rate of
interest. In an entrepreneur economy the only objective for a firm is to end the
production process by liquidating its working capital in order to end up with
more money than it started with (Keynes, 1979, p. 82). Moreover, money has
an impact on the real sector in both the short and long run. Thus money is a real
phenomenon. This is just the reverse of what classical theory and modern
mainstream theory teach us. In orthodox macroeconomic theory the rate of
interest is a real (technologically determined) factor while money (at least in
the long run for both Friedman and Tobin) does not affect the real output flow.
This reversal of the importance or the significance of money and interest rates
for real and monetary phenomena between the orthodox and Keynes’s theory is
the result of Keynes’s rejection of a neoclassical universal truth – the axiom of
neutral money. Arrow and Hahn (1971, pp. 356–7) implicitly recognized that
money matters when they wrote:
The terms in which contracts are made matter. In particular, if money is the good
in terms of which contracts are made, then the prices of goods in terms of money
are of special significance. This is not the case if we consider an economy without
a past or future … if a serious monetary theory comes to be written, the fact that
contracts are made in terms of money will be of considerable importance. (Italics
added)
Moreover, Arrow and Hahn (1971, p. 361) demonstrate that, if contracts
are made in terms of money (so that money affects real decisions) in an
economy moving along in calendar time with a past and a future, then all
existence theorems demonstrating a classical full employment equilibrium
result are jeopardized. The existence of money contracts – a characteristic of
the world in which we live – implies that there need never exist, in the long
run or the short run, any rational expectations equilibrium or general equilibrium
market-clearing price vector.
Axiom
Keynes’s theory implies that agents who planned to buy producible goods in
the current period need not have earned income currently or previously in
order to exercise this demand (D2) in an entrepreneurial, money-using economic
system. This means that spending for D2, which we normally associate
with the demand for reproducible fixed and working capital goods, is not
constrained by either actual income or inherited endowments. D2 is constrained
in a money-creating banking system solely by the expected future
monetary (not real) cash inflow (Keynes, 1936, chap. 17). In a world where
money is created only if someone goes into debt (borrows) in order to
purchase goods, then real investment spending will be undertaken as long as
the purchase of newly produced capital goods is expected to generate a future
cash inflow (net of operating expenses) whose discounted present value equals
or exceeds the money cash outflow (the supply price) currently needed to
purchase the asset.
For the D2 component of aggregate demand not to be constrained by actual
income, therefore, agents must have the ability to finance investment by
borrowing from a banking system which can create money. This Post
Keynesian financing mechanism where increases in the nominal quantity of
money are used to finance increased demand for producible goods, resulting
in increasing employment levels, means that money cannot be neutral. Hahn
(1982, p. 44) describes the money neutrality axiom as one where
The objectives of agents that determine their actions and plans do not depend on
any nominal magnitudes. Agents care only about ‘real’ things such as goods …
leisure and effort. We know this as the axiom of the absence of money illusion,
which it seems impossible to abandon in any sensible sense.
To reject the neutrality axiom does not require assuming that agents suffer
from a money illusion. It only means that ‘money is not neutral’ (Keynes,
1973b, p. 411); money matters in both the short run and the long run, in
affecting the equilibrium level of employment and real output. As Keynes
(1973b, pp. 408–9) put it:
The theory which I desiderate would deal … with an economy in which money
plays a part of its own and affects motives and decisions, and is, in short, one of
the operative factors in the situation, so that the course of events cannot be
predicted in either the long period or in the short, without a knowledge of the
behaviour of money between the first state and the last. And it is this which we
ought to mean when we speak of a monetary economy.
Once we recognize that money is a real phenomenon, that money matters,
then neutrality must be rejected. Keynes (1936, p. 142) believed that the ‘real
rate of interest’ concept of Irving Fisher was a logical confusion. In a monetary
economy, moving through calendar time towards an uncertain (statistically
unpredictable) future, there is no such thing as a forward-looking real rate of
interest. In an entrepreneur economy the only objective for a firm is to end the
production process by liquidating its working capital in order to end up with
more money than it started with (Keynes, 1979, p. 82). Moreover, money has
an impact on the real sector in both the short and long run. Thus money is a real
phenomenon. This is just the reverse of what classical theory and modern
mainstream theory teach us. In orthodox macroeconomic theory the rate of
interest is a real (technologically determined) factor while money (at least in
the long run for both Friedman and Tobin) does not affect the real output flow.
This reversal of the importance or the significance of money and interest rates
for real and monetary phenomena between the orthodox and Keynes’s theory is
the result of Keynes’s rejection of a neoclassical universal truth – the axiom of
neutral money. Arrow and Hahn (1971, pp. 356–7) implicitly recognized that
money matters when they wrote:
The terms in which contracts are made matter. In particular, if money is the good
in terms of which contracts are made, then the prices of goods in terms of money
are of special significance. This is not the case if we consider an economy without
a past or future … if a serious monetary theory comes to be written, the fact that
contracts are made in terms of money will be of considerable importance. (Italics
added)
Moreover, Arrow and Hahn (1971, p. 361) demonstrate that, if contracts
are made in terms of money (so that money affects real decisions) in an
economy moving along in calendar time with a past and a future, then all
existence theorems demonstrating a classical full employment equilibrium
result are jeopardized. The existence of money contracts – a characteristic of
the world in which we live – implies that there need never exist, in the long
run or the short run, any rational expectations equilibrium or general equilibrium
market-clearing price vector.
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