Open Market Operations

The demand for money to satisfy the former motives generally responds to the actual change in:

• economic activity and
• the level of incomes.

The aggregate demand for money to satisfy the speculative-motive continually responds to changes in the interest rate, as a curve.

• These changes are in the changing prices of bonds and debts of various maturities.
• This is why “open market operations” are done.

Normally, the banking system is always able to buy or sell bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount.

• The more they buy bonds and debts, the more cash they create.
  • The greater the fall in interest rate.
• The more they sell bonds and debts, the more cash they cancel.
  • The greater the rise in interest rate.

In the US (1933-1934), open-market operations have been limited to buying very short-dated securities. Its effect:

• is mainly confined to the very short-term interest rate and
• has little reaction on the much more important long-term interest rates.

With speculation, it is important to distinguish between:

• the changes in the interest rate from changes in the supply of money available to satisfy speculation, without having any change in the liquidity function
• the changes which are primarily due to changes in expectation affecting the liquidity function itself.

Open-market operations may influence the interest rate through both channels since they may:

• change the volume of money
• change expectations on the future policy of the Central Bank or the Government

Changes in the liquidity function itself, due to a change in the news which causes a change of expectations, will often be discontinuous.

• It will therefore, give rise to a corresponding discontinuity of change in the rate of interest.
• Only in so far as the change in the news is differently interpreted by different individuals or affects individual interests differently will there be room for any increased activity of dealing in the bond market.

If the change in the news affects everyone’s judgment precisely in the same way, the interest rate will be adjusted to the new situation without any market transactions being necessary.

Thus, in the simplest case, a change in expectations cannot cause any displacement of money.

• It will simply change the interest rate to offset the desire of each individual, felt at the previous rate, to change his holding of cash in response to the new expectations.

No transactions will result. This is because everyone will change his ideas as to the rate which would induce him to alter his holdings of cash in the same degree.

Each set of expectations has an appropriate interest rate. There will never be any question of anyone changing his usual holdings of cash.

A change in expectations will influence people differently.

• This will cause some realignment in individual holdings of money.

Thus, the new equilibrium interest rate will be associated with a redistribution of money-holdings.

We will focus on the change in the interest rate, rather than the redistribution of cash.

• The redistribution is incidental to individual differences

The shift in the interest rate is usually the most prominent in the news.

The newspapers say that the movement in bond-prices is “out of all proportion to the activity of dealing”.

The amount of cash that we hold for need and security is Necessary Cash.

• This is not entirely independent of our cash for speculation or Gambling Cash.
• These 2 are largely independent of each other.

This creates 2 liquidity functions:

• Income Level
  • Income determines Necessary Cash
• Interest Expectation -Interest Rate determines Gambling Cash

Money = Necessary Cash + Gambling Cash = Income Level(Y) + Interest Expectation(Interest Rate)

It follows that there are 3 matters to investigate:

1. The relation of changes in Money to Income and Interst Rate

This depends, in the first instance, on the way in which changes in Money come about.

Suppose that:

• Money consists of gold coins
• changes in Money can only result from increased returns to the activities of gold-miners

In this case, changes in Money are, in the first instance, directly associated with changes in Income , since the new gold accrues as someone’s income.

Exactly the same conditions hold if changes in Money are due to the Government printing money wherewith to meet its current expenditure.

In this case also, the new money accrues as someone’s income.

• The new level of income, however, will not continue sufficiently high for the requirements of Money, to absorb the whole of the increase in Money.

Some portion of the money will seek an outlet in buying securities or other assets until r has fallen so as to bring about an increase in the magnitude of M, and at the same time to stimulate a rise in Y to such an extent that the new money is absorbed either in M2 or in the M1 which corresponds to the rise in Y caused by the fall in r.

Thus at one remove this case comes to the same thing as the alternative case, where the new money can only be issued in the first instance by a relaxation of the conditions of credit by the banking system, so as to induce someone to sell the banks a debt or a bond in exchange for the new cash.

It will, therefore, be safe for us to take the latter case as typical.

A change in M can be assumed to operate by changing r A change in r will lead to a new equilibrium partly by changing M2 and partly by changing Y and therefore M1.

The division of the increment of cash between M1 and M2 in the new position of equilibrium will depend on the responses of investment to a reduction in the rate of interest and of income to an increase in investment.[1]

Since Y partly depends on r, it follows that a given change in M has to cause a sufficient change in r for the resultant changes in M1 and M2 respectively to add up to the given change in M.

2. It is not always made clear whether the income-velocity of money is defined as the ratio of Y to M or as the ratio of Y to M1. I propose, however, to take it in the latter sense. Thus if V is the income-velocity of money,

L1(Y) = Y/V = M1

V is not constant.

Its value will depend on the character of banking and industrial organisation, on social habits, on the distribution of income between different classes and on the effective cost of holding idle cash.

Nevertheless, if we have a short period of time in view and can safely assume no material change in any of these factors, we can treat V as nearly enough constant.

3. Finally there is the question of the relation between M2 and r.

Chapter 13 said that uncertainty in the future rate of interest is the sole explanation of the type of liquidity-preference L2 which leads to the holding of cash M2.

It follows that a given M2 will not have a definite quantitative relation to a given rate of interest of r.

What matters is not the absolute level of r, but the degree of its divergence from what is considered a fairly safe level of r, having regard to those calculations of probability which are being relied on.