A Tract on Monetary Reform

by John Maynard Keynes

CHAPTER III
THE THEORY OF MONEY AND OF THE FOREIGN EXCHANGES

The evil consequences of instability in the standard of value have now been sufficiently described. In this chapter[19] we must lay the theoretical foundations for the practical suggestions of the concluding chapters. Most academic treatises on monetary theory have been based, until lately, on so firm a presumption of a gold standard régime that they need to be adapted to the existing régime of mutually inconvertible paper standards.

[19] Parts of this chapter raise, unavoidably, matters of much greater difficulty to the layman than the rest of the book. The reader whose interest in the theoretical foundations is secondary can pass on.

I. The Quantity Theory of Money

This Theory is fundamental. Its correspondence with fact is not open to question.[20] Nevertheless it is often misstated and misrepresented. Goschen’s saying of sixty years ago, that “there are many persons who cannot hear the relation of the level of prices to the volume of currency affirmed without a feeling akin to irritation,” still holds good.

[20] “The Quantity Theory is often defended and opposed as though it were a definite set of propositions that must be either true or false. But in fact the formulæ employed in the exposition of that theory are merely devices for enabling us to bring together in an orderly way the principal causes by which the value of money is determined” (Pigou).

The Theory flows from the fact that money as such has no utility except what is derived from its exchange-value, that is to say from the utility of the things which it can buy. Valuable articles other than money have a utility in themselves. Provided that they are divisible and transferable, the total amount of this utility increases with their quantity;—it will not increase in full proportion to the quantity, but, up to the point of satiety, it does increase.

If an article is used for money, such as gold, which has a utility in itself for other purposes, aside from its use as money, the strict statement of the theory, though fundamentally unchanged, is a little complicated. In present circumstances we can excuse ourselves this complication. A Currency Note has no utility in itself and is completely worthless except for the purchasing power which it has as money.

Consequently what the public want is not so many ounces or so many square yards or even so many £ sterling of currency notes, but a quantity sufficient to cover a week’s wages, or to pay their bills, or to meet their probable outgoings on a journey or a day’s shopping. When people find themselves with more cash than they require for such purposes, they get rid of the surplus by buying goods or investments, or by leaving it for a bank to employ, or, possibly, by increasing their hoarded reserves. Thus the number of notes which the public ordinarily have on hand is determined by the amount of purchasing power which it suits them to hold or to carry about, and by nothing else. The amount of this purchasing power depends partly on their wealth, partly on their habits. The wealth of the public in the aggregate will only change gradually. Their habits in the use of money—whether their income is paid them weekly or monthly or quarterly, whether they pay cash at shops or run accounts, whether they deposit with banks, whether they cash small cheques at short intervals or larger cheques at longer intervals, whether they keep a reserve or hoard of money about the house—are more easily altered. But if their wealth and their habits in the above respects are unchanged, then the amount of purchasing power which they hold in the form of money is definitely fixed. We can measure this definite amount of purchasing power in terms of a unit made up of a collection of specified quantities of their standard articles of consumption or other objects of expenditure; for example, the kinds and quantities of articles which are combined for the purpose of a cost-of-living index number. Let us call such a unit a “consumption unit” and assume that the public require to hold an amount of money having a purchasing power over k consumption units. Let there be n currency notes or other forms of cash in circulation with the public, and let p be the price of each consumption unit (i.e. p is the index number of the cost of living), then it follows from the above that n = pk. This is the famous Quantity Theory of Money. So long as k remains unchanged, n and p rise and fall together; that is to say, the greater or the fewer the number of currency notes, the higher or the lower is the price level in the same proportion.

So far we have assumed that the whole of the public requirement for purchasing power is satisfied by cash, and on the other hand that this requirement is the only source of demand for cash; neglecting the fact that the public, including the business world, employ for the same purpose bank deposits and overdraft facilities, whilst the banks must for the same reason maintain a reserve of cash. The theory is easily extended, however, to cover this case. Let us assume that the public, including the business world, find it convenient to keep the equivalent of k consumption units in cash and of a further k´ available at their banks against cheques, and that the banks keep in cash a proportion r of their potential liabilities (k´) to the public. Our equation then becomes