The Control of Interest Rates

In any given state of expectation, a fall in r will be associated with an increase in M2. This is because:

1. If the general view as to what is a safe level of r is unchanged, every fall in r reduces the market rate relatively to the “safe” rate and therefore increases the risk of illiquidity.

2. Every fall in r reduces the current earnings from illiquidity, which are available as a sort of insurance premium to offset the risk of loss on capital account, by an amount equal to the difference between the squares of the old rate of interest and the new.

If the rate of interest on a long-term debt is 4%, it is preferable to sacrifice liquidity unless on a balance of probabilities it is feared that the long-term rate of interest may rise faster than by 4% of itself per annum, i.e. by an amount greater than 0.16% per annum.

If, however, the rate of interest is already as low as 2%, the running yield will only offset a rise in it of as little as 0.04% per annum. This is perhaps the chief obstacle to a fall in the rate of interest to a very low level.

Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2% leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear. The rate of interest is a highly psychological phenomenon.

In equilibrium at a level below the rate which corresponds to full employment because at such a level a state of true inflation will be produced, with the result that M1 will absorb ever-increasing quantities of cash.

But at a level above the rate which corresponds to full employment, the long-term market-rate of interest will depend, not only on the current policy of the monetary authority, but also on market expectations concerning its future policy.

The short-term rate of interest is easily controlled by the monetary authority, both because it is not difficult to produce a conviction that its policy will not greatly change in the very near future, and also because the possible loss is small compared with the running yield (unless it is approaching vanishing point).

The long-term rate may be more recalcitrant when once it has fallen to a level which, on the basis of past experience and present expectations of future monetary policy, is considered “unsafe” by representative opinion. For example, in a country linked to an international gold standard, a rate of interest lower than prevails elsewhere will be viewed with a justifiable lack of confidence; yet a domestic rate of interest dragged up to a parity with the highest rate (highest after allowing for risk) prevailing in any country belonging to the international system may be much higher than is consistent with domestic full employment. Thus a monetary policy which strikes public opinion as being experimental in character or easily liable to change may fail in its objective of greatly reducing the long-term rate of interest, because M2 may tend to increase almost without limit in response to a reduction of r below a certain figure.

The same policy, on the other hand, may prove easily successful if it appeals to public opinion as being reasonable and practicable and in the public interest, rooted in strong conviction, and promoted by an authority unlikely to be superseded. It might be more accurate to say that the rate of interest is a highly conventional, rather than a highly psychological.

Its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable. This is subject to fluctuations.

In particular, when M1 is increasing faster than M, the rate of interest will rise, and vice versa. But it may fluctuate for decades about a level which is chronically too high for full employment. Particularly, if it is the prevailing opinion that the rate of interest is self-adjusting, so that the level established by convention is thought to be rooted in objective grounds much stronger than convention.

The failure of Employment to attain an optimum level being in no way associated with the prevalence of an inappropriate range of rates of interest.

The difficulties in the way of maintaining effective demand at a level high enough to provide full employment, which ensue from the association of a conventional and fairly stable long-term rate of interest with a fickle and highly unstable marginal efficiency of capital, should be, by now, obvious to the reader.

It is because the convention is not rooted in secure knowledge, that it will not be always unduly resistant to a modest measure of persistence and consistency of purpose by the monetary authority. Public opinion can be fairly rapidly accustomed to a modest fall in the rate of interest and the conventional expectation of the future may be modified accordingly.

Thus preparing the way for a further movement — up to a point. The fall in the long-term rate of interest in Great Britain after her departure from the gold standard provides an interesting example of this. The major movements were effected by a series of discontinuous jumps.

This is because the public’s liquidity function is used to each successive reduction. It became ready to respond to some new incentive in the news or in the policy of the authorities.

Thus, in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions-motive or the precautionary-motive. This will manifest as actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash.

It is this potentiality which is summed up in the liquidity function L2.

Corresponding to the quantity of money created by the monetary authority, there will, therefore, be cet. par. a determinate rate of interest or, more strictly, a determinate complex of rates of interest for debts of different maturities.

The same thing, however, would be true of any other factor in the economic system taken separately. Thus this particular analysis will only be useful and significant in so far as there is some specially direct or purposive connection between changes in the quantity of money and changes in the rate of interest.

Our reason for supposing that there is such a special connection arises from the fact that, broadly speaking, the banking system and the monetary authority are dealers in money and debts and not in assets or consumables.

If the monetary authority were prepared to deal both ways on specified terms in debts of all maturities, and even more so if it were prepared to deal in debts of varying degrees of risk, the relationship between the complex of rates of interest and the quantity of money would be direct.

The complex of rates of interest would simply be an expression of the terms on which the banking system is prepared to acquire or part with debts; and the quantity of money would be the amount which can find a home in the possession of individuals who — after taking account of all relevant circumstances — prefer the control of liquid cash to parting with it in exchange for a debt on the terms indicated by the market rate of interest.

Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management.

In practice, the extent to which the price of debts as fixed by the banking system is “effective” in the market, in the sense that it governs the actual market-price, varies in different systems.

Sometimes the price is more effective in one direction than in the other.

The banking system may undertake to purchase debts not necessarily to sell them at a price near to its buying-price to represent no more than a dealer’s turn, though there is no reason why the price should not be made effective both ways with the aid of open-market operations.

There is also the more important qualification which arises out of the monetary authority not being, as a rule, an equally willing dealer in debts of all maturities.

The monetary authority often:

• concentrates on short-term debts
• leaves the price of long-term debts to be influenced by belated and imperfect reactions from the price of short-term debts.

Though here again, there is no reason why they need do so.

Where these qualifications operate, the directness of the relation between the rate of interest and the quantity of money is correspondingly modified.

In Great Britain, the field of deliberate control appears to be widening.

But in applying this theory in any particular case allowance must be made for the special characteristics of the method actually employed by the monetary authority. If the monetary authority deals only in short-term debts, we have to consider what influence the price, actual and prospective, of short-term debts exercises on debts of longer maturity.

Thus, there are certain limitations on the monetary authority’s ability to establish interest rates:

1. The monetary authority’s practices in limiting its willingness to deal to debts of a particular type.

2. After the rate of interest has fallen to a certain level, liquidity-preference may become absolute.

Everyone prefers cash to holding a debt which yields so low an interest.

In this event, the monetary authority would have lost effective control over the rate of interest.

This might become practically important in future, but I know of no example of it hitherto.

Most monetary authorities are unwilling to deal boldly in long term debts.

• This is why this has not been tested.

If this did happen, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

3. The complete breakdown of stability in the interest rates, due to the liquidity function flattening out has occurred in very abnormal circumstances.

This happened in Russia and Central Europe after the war, as a currency crisis.

• No one could be induced to keep money.
• Even a high interest rate was unable to keep pace with the returns on investments (especially of stocks of liquid goods) because people expected an ever greater fall in the value of money

In 1932, a financial crisis happened in the US when no one could be induced to part with money.

4. Chapter 11, Section 4 mentions the difficulty of bringing down the effective interest rate.

This is important in an era of low interest-rates.

The intermediate costs of bringing the borrower and the ultimate lender together, and the allowance for risk, especially for moral risk, which the lender requires over and above the pure rate of interest.

The pure rate of interest declines it does not follow that the allowances for expense and risk decline pari passu.

Thus, the rate of interest which the typical borrower has to pay may decline more slowly than the pure rate of interest, and may be incapable of being brought, by the methods of the existing banking and financial organisation, below a certain minimum figure.

This is particularly important if the estimation of moral risk is appreciable. For where the risk is due to doubt in the mind of the lender concerning the honesty of the borrower, there is nothing in the mind of a borrower who does not intend to be dishonest to offset the resultant higher charge.

It is also important in the case of short-term loans (e.g. bank loans) where the expenses are heavy; — a bank may have to charge its customers 1 1/2 to 2 per cent., even if the pure rate of interest to the lender is nil.

What is the relationship between interest rates and the Quantity Theory of Money?

In a static society where no one feels any uncertainty about the future rates of interest, the Liquidity Function L2 or the propensity to hoard, will always be 0 in equilibrium.

Hence in equilibrium:

M2 = 0 and M = M1.

Any change in M will cause the rate of interest to fluctuate until income reaches a level at which the change in M1 is equal to the supposed change in M.

M1V = Y

• V is the income-velocity of money as defined above
• Y is the aggregate income

Thus if it is practicable to measure the quantity, 0, and the price, P, of current output, we have Y = OP, and, therefore, MY = OP; which is much the same as the Quantity Theory of Money in its traditional form.[2]

The great fault in the Quantity Theory is that it does not distinguish between changes in prices which are a function of changes in output, and those which are a function of changes in the wage-unit.[3]

The explanation of this omission is, perhaps, to be found in the assumptions that there is no propensity to hoard and that there is always full employment.

For in this case, O being constant and M2 being zero, it follows, if we can take V also as constant, that both the wage-unit and the price-level will be directly proportional to the quantity of money.

Author’s Footnotes

1. We must postpone to Book V. the question of what will determine the character of the new equilibrium.

2. If we had defined V, not as equal to Y/M, but as equal to Y/M, then, of course, the Quantity Theory is a truism which holds in all circumstances, though without significance.

3. This point will be further developed in Chapter 21 below.