A Tract on Monetary Reform

by John Maynard Keynes

n = p(k + rk´).

So long as k, k´, and r remain unchanged, we have the same result as before, namely, that n and p rise and fall together. The proportion between k and k´ depends on the banking arrangements of the public; the absolute value of these on their habits generally; and the value of r on the reserve practices of the banks. Thus, so long as these are unaltered, we still have a direct relation between the quantity of cash (n) and the level of prices (p).[21]

[21] My exposition follows the general lines of Prof. Pigou (Quarterly Journal of Economics, Nov. 1917) and of Dr. Marshall (Money, Credit, and Commerce, I. iv.), rather than the perhaps more familiar analysis of Prof. Irving Fisher. Instead of starting with the amount of cash held by the public, Prof. Fisher begins with the volume of business transacted by means of money and the frequency with which each unit of money changes hands. It comes to the same thing in the end and it is easy to pass from the above formula to Prof. Fisher’s; but the above method of approach seems less artificial than Prof. Fisher’s and nearer to the observed facts.

We have seen that the amount of k and k´ depends partly on the wealth of the community, partly on its habits. Its habits are fixed by its estimation of the extra convenience of having more cash in hand as compared with the advantages to be got from spending the cash or investing it. The point of equilibrium is reached where the estimated advantages of keeping more cash in hand compared with those of spending or investing it about balance. The matter cannot be summed up better than in the words of Dr. Marshall:

“In every state of society there is some fraction of their income which people find it worth while to keep in the form of currency; it may be a fifth, or a tenth, or a twentieth. A large command of resources in the form of currency renders their business easy and smooth, and puts them at an advantage in bargaining; but on the other hand it locks up in a barren form resources that might yield an income of gratification if invested, say, in extra furniture; or a money income, if invested in extra machinery or cattle.” A man fixes the appropriate fraction “after balancing one against another the advantages of a further ready command, and the disadvantages of putting more of his resources into a form in which they yield him no direct income or other benefit.” “Let us suppose that the inhabitants of a country, taken one with another (and including therefore all varieties of character and of occupation), find it just worth their while to keep by them on the average ready purchasing power to the extent of a tenth part of their annual income, together with a fiftieth part of their property; then the aggregate value of the currency of the country will tend to be equal to the sum of these amounts.”[22]

[22] Money, Credit, and Commerce, I. iv. 3. Dr. Marshall shows in a footnote as follows that the above is in fact a development of the traditional way of considering the matter: “Petty thought that the money ‘sufficient for’ the nation is ‘so much as will pay half a year’s rent for all the lands of England and a quarter’s rent of the Houseing, for a week’s expense of all the people, and about a quarter of the value of all the exported commodities.’ Locke estimated that ‘one-fiftieth of wages and one-fourth of the landowner’s income and one-twentieth part of the broker’s yearly returns in ready money will be enough to drive the trade of any country.’ Cantillon (A.D. 1755), after a long and subtle study, concludes that the value needed is a ninth of the total produce of the country; or, what he takes to be the same thing, a third of the rent of the land. Adam Smith has more of the scepticism of the modern age and says: ‘it is impossible to determine the proportion,’ though ‘it has been computed by different authors at a fifth, at a tenth, at a twentieth, and at a thirtieth part of the whole value of the annual produce.’” In modern conditions the normal proportion of the circulation to this national income seems to be somewhere between a tenth and a fifteenth.

So far there should be no room for difference of opinion. The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted, is as follows.

Every one admits that the habits of the public in the use of money and of banking facilities and the practices of the banks in respect of their reserves change from time to time as the result of obvious developments. These habits and practices are a reflection of changes in economic and social organisation. But the Theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k´,—that is to say, in mathematical parlance, that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k´, must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.

Now “in the long run” this is probably true. If, after the American Civil War, the American dollar had been stabilised and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k´ would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

In actual experience, a change of n is liable to have a reaction both on k and k´ and on r. It will be enough to give a few typical instances. Before the war (and indeed since) there was a considerable element of what was conventional and arbitrary in the reserve policy of the banks, but especially in the policy of the State Banks towards their gold reserves. These reserves were kept for show rather than for use, and their amount was not the result of close reasoning. There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way. Consequently, when gold became relatively abundant they tended to hoard what came their way and to raise the proportion of the reserves, with the result that the increased output of South African gold was absorbed with less effect on the price level than would have been the case if an increase of n had been totally without reaction on the value of r.