A Tract on Monetary Reform

by John Maynard Keynes

Thus during the depression k rose from 230 to 300 and k´ from 1333 to 1700, which means that the cash holdings of the public at the former date were worth 23/30, and their bank balances 1333/1700, what they were worth at the latter date. It thus appears that the tendency of k and k´ to increase had more to do, than the deflation of “cash” had, with the fall of prices between the two periods. If k and k´ were to fall back to their 1920 values, prices would rise 30 per cent without any change whatever in the volume of cash or the reserve policy of the banks. Thus even in Great Britain the fluctuations of k and k´ can have a decisive influence on the price level; whilst we have already seen (pp. 51, 52) how enormously they can change in the recent conditions of Russia and Central Europe.

The moral of this discussion, to be carried forward in the reader’s mind until we reach Chapters IV. and V., is that the price level is not mysterious, but is governed by a few, definite, analysable influences. Two of these, n and r, are under the direct control (or ought to be) of the central banking authorities. The third, namely k and k´, is not directly controllable, and depends on the mood of the public and the business world. The business of stabilising the price level, not merely over long periods but so as also to avoid cyclical fluctuations, consists partly in exercising a stabilising influence over k and k´, in so far as this fails or is impracticable, in deliberately varying n and r so as to counterbalance the movement of k and k´.

The usual method of exercising a stabilising influence over k and k´ especially over k´, is that of bank-rate. A tendency of k´ to increase may be somewhat counteracted by lowering the bank-rate, because easy lending diminishes the advantage of keeping a margin for contingencies in cash. Cheap money also operates to counterbalance an increase of k´, because, by encouraging borrowing from the banks, it prevents r from increasing or causes r to diminish. But it is doubtful whether bank-rate by itself is always a powerful enough instrument, and, if we are to achieve stability, we must be prepared to vary n and r on occasion.

Our analysis suggests that the first duty of the central banking and currency authorities is to make sure that they have n and r thoroughly under control. For example, so long as inflationary taxation is in question n will be influenced by other than currency objects and cannot, therefore, be fully under control; moreover, at the other extreme, under a gold standard n is not always under control, because it depends on the unregulated forces which determine the demand and supply of gold throughout the world. Again, without a central banking system r will not be under proper control because it will be determined by the unco-ordinated decisions of numerous different banks.

At the present time in Great Britain r is very completely controlled, and n also, so long as we refrain from inflationary finance on the one hand and from a return to an unregulated gold standard on the other.[25] The second duty of the authorities is therefore worth discussing, namely, the use of their control over n and r to counterbalance changes in k and k´. Even if k and k´ were entirely outside the influence of deliberate policy, which is not in fact the case, nevertheless p could be kept reasonably steady by suitable modifications of the values of n and r.

[25] In the case of the United States the same thing is more or less true, so long as the Federal Reserve Board is prepared to incur the expense of bottling up redundant gold.

Old-fashioned advocates of sound money have laid too much emphasis on the need of keeping n and r steady, and have argued as if this policy by itself would produce the right results. So far from this being so, steadiness of n and r, when k and k´ are not steady, is bound to lead to unsteadiness of the price level. Cyclical fluctuations are characterised, not primarily by changes in n or r, but by changes in k and k´. It follows that they can only be cured if we are ready deliberately to increase and decrease n and r, when symptoms of movement are showing in the values of k and k´. I am being led, however, into a large subject beyond my immediate purpose, and am anticipating also the topic of Chapter V. These hints will serve, nevertheless, to indicate to the reader what a long way we may be led by an understanding of the implications of the simple Quantity equation with which we started.

II. The Theory of Purchasing Power Parity.

The Quantity Theory deals with the purchasing power or commodity-value of a given national currency. We come now to the relative value of two distinct national currencies,—that is to say, to the theory of the Foreign Exchanges.

When the currencies of the world were nearly all on a gold basis, their relative value (i.e. the exchanges) depended on the actual amount of gold metal in a unit of each, with minor adjustments for the cost of transferring the metal from place to place.