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Keynes, Keynesians, and Contemporary Monetary Theory and Policy


Keynes’ theoretical revolution was based on the adoption of monetary analysis and the use of the principle of effective demand to explain the existence of long-term equilibrium. Keynes’ theories have been widely used in economic models. However, many Keynesians have not accepted these issues, and they hold to a classical assumption of long term equilibrium. Many of Keynes’ monetary analyses, such as real analysis, offer a distorted view of the monetary policy responsibilities. These weaknesses are responsible for the volatility that has been experienced in the financial market since the 1990s.

Keynes’ theory has had a revolutionary impact on an economic theory contrary to the real analysis of Keynesian economists who disregard the role of monetary policy, thus contributing to the volatility of the financial sector in the past few years. Keynesians overlooked Keynes’ monetary theory since they perceived that the monetary theory advanced by Keynes did not sufficiently apply to monetary policy as opposed to fiscal policy. Keynes bases his argument on General Theory, which explains the sub-optimal performance that occurs in the laissez-faire economy and how it influences the economics view of the aggregate economy. Keynes establishes the link between monetary and real factors and integrates the function of monetary instruments in determining long-term equilibrium. He also adopted monetary analysis and applied the principle of effective demand to explain the multiple long-term equilibriums by introducing the liquidity preference that lacked in the real analysis and played a vital role in the determination of interest rate in the monetary economy. A laissez-faire economy depends on a mix of circumstances and changes in the structure on how governments, central banks, and the overall monetary system operate.

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Monetary Analysis and the Principle of Effective Demand

The monetary analysis employed by Keynesians argued that interest rate was an instrument of monetary policy and the money supply was endogenous. It applies to risk and uncertainty situations. According to Davidson (2007), Keynes provided analytical instruments used to analyze the general behavior and structure of the monetary economy. The principle of effective demand is a major analytical apparatus of monetary analysis, highlighting the possibility of multiple long-term equilibria, and it is comprised of three elements – interest rates, the marginal efficiency of capital, and propensity to consume. Keynes believes that effective demand is at the core of capitalist markets, and spending by governments, firms, and consumers is what keeps the economy afloat. The important factor is the interest rate expressed as an independent variable not affected by market forces, whereas the natural rate is determined by the money and market interest rate. Effective demand determines the level of activities, beyond which an economy fluctuates to be at full employment in the long-run.

The independent variable provides a standard, upon which the marginal efficiency of capital should exceed to accelerate the capital formation and sustainable employment levels in the economy (Dimand, Mundell, & Vercelli, 2010). There is a clear distinction between the marginal efficiency of capital and interest rates where the interest rate determines the marginal efficiency of capital. The principle explains why a laissez-faire market economy may fluctuate when the economic activity is too low to sustain full employment. Being self-adjusting, interest may fluctuate over time to a level that is too high for full employment. Hence, efforts by firms to increase output beyond employment levels lead to losses.

Keynes’ monetary analyses in a laissez-faire economy indicate that flexibility in the economy results in inflation and deflation that destabilize equilibrium, and there is no automatic achieving of full employment. This happens because the failure of the system to stabilize is not confined to rigidity and immobility of factors of production as the result of trade cycles, thus reiterating on the premise that maintaining full employment level does not occur automatically. Long-run equilibrium is achieved without full employment since the limit to the profitable expansion of output has been reached and there is no incentive to trigger a rise in aggregate demand. Thus, unless the point of effective demand is moved, an increase in output does not automatically increase demand enough to sell the increased output at a normal profit, when the marginal propensity to consume is less than unity and the interest rate does not fall automatically.

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Liquidity, Liquidity Preference, and Liquidity Transformation

Monetary factors are the key fundamentals of liquidity. Keynes’ monetary analysis stipulates that the concept of liquidity has a level of risk and uncertainty attached to it. Thus, it is determined by the ability of assets to be traded at stable market prices; the principle of effective demand uses liquidity preference theory that is different from real analysis. According to Keynes (1936), a degree of uncertainty in the economy brings about a need for liquidity preference. Liquidity preference, which is also the demand for money, is used to give an explanation of the difference between savings and investments as well as the way, in which interest rates are arrived at. Keynes further stipulates three motives as to why people choose to keep the money as opposed to interest-bearing securities. They include transaction motive to fund everyday expenditure, speculative motive to seize investment opportunities whenever they arise, for instance, buying bond or selling, when there is an anticipated fall in the prices of bonds on the market and precautionary motive to fund contingencies.

Liquidity transformation is the process of exchanging securities for money on the financial markets that act as intermediaries between individual investors and producers in organized markets. In simpler terms, banks use deposits, which are short term debts, to advance loans that are long-term investments to their customers. Banks and financial institutions are the major actors in liquidity transformation.

Keynes Policy Proposal

I. Keynes made two important policy proposals from his revolutionary theory aimed at establishing a permanent structural change, shifting the point of effective demand close to full employment. The policy proposal has affected change in the behavior and structure of economies, increasing the function of governments in managing the aggregate economy by creating central banks that oversee the actions of financial institutions in order to safeguard the public interest. These include socialization of investment and replacement of gold by ‘green cheese’ under public control.

The first proposal, which is the socialization of investment policy, aims to create a less volatile environment that enables entrepreneurs to thrive through creating a culture that can facilitate coordination between public and private institutions. This was done to protect private property, individuals, and the freedom to choose. Bellofiore (2014) asserts that the economy is stabilized by establishing the average levels of economic activity that are consistent with high or full employment. Keynes proposed expanding the role of government investment to stabilize aggregate demand and reduce uncertainty experienced by firms as well as their understanding of a sustainable marginal efficiency of capital (Hyman, 2014). The policy emphasized inducting the government as a reliable and permanent economy stabilizer rather than an agency, responding to the effects of trade cycles by using fiscal policy instruments of tax and public spending.

However, according to Keynes (1936), preference to discretionary fiscal policy by Keynes and the use of the word socialization is not to be misconstrued to refer to socialism which supports collective decision-making, the government manages key aspects of the economy and it has full control of resource-producing firms. Keynes further expounded on the socialization of investment policy to infer that the policy did not require the government to take control of factors of production but to determine the total amount of resources employed to increase factors of production and yield to the owners of factors of production, ultimately fulfilling its role of resource allocation.

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In the second policy proposal, Keynes (1936) asserted that the replacement of gold by ‘green cheese’ under public control was purposed to shift the point of effective demand to a level that was consistent with full employment. Green cheese is used to refer to bank money. Keynes argues that unemployment arises due to individuals demanding high compensation for their services, but the amount of money demanded cannot be achieved; therefore, there is no incentive to persuade them to work on set terms and having a central bank for public control of the bank money. Central bank exists as a regulator to ensure that interest rate is maintained at a desirable level, where effective demand is consistent with full employment (Davidson, 2007). Under the gold standard in a free economy with a certain amount of gold, the interest rate would be controlled by the private sector and it would set high levels that cannot sustain full employment.

Contemporary Monetary Theory and Policy

The contemporary monetary theory ignores Keynes’ monetary analysis and the principle of effective demand relying on Keynesian’s real analysis of the economy. Real analysis negatively influences the stance economists to take on money and monetary policy, hence overlooking significant building blocks necessary in the general field of economics. The model used for policy analysis in contemporary monetary theory consists of the Philips curve, interest rate, and the IS-LM curve, which is a reflection of the real analysis as opposed to monetary analysis. Thus, the Philips curve is a model used to show the inverse relationship between unemployment and inflation rate in an economy. An increase in employment has a corresponding increase in the inflation rate. According to Thornton (2012), the application of the Philips curve compromises the sustainability of inflation targeting where the central bank in the short-run makes an announcement on a clear inflation target rate in the economy, making the assumption that monetary policy can only affect growth in the long-run through maintaining price stability.

Keynesians argued that fiscal policy was appropriate in reviving an economy subdued in depression. Public spending and, in extreme cases, taxation would control the level of aggregated demand in the economy. Borrowing is not necessary to finance expenditure despite growth in the money supply. An increase in the money supply does not automatically lead to inflationary pressures. Modern monetarists are against government intervention in increasing aggregate demand since the increase in public expenditure financed by borrowing will lead to crowding out private investment while further increasing interest rates. Attention is given to minimizing inflationary expectations, providing incentives for firms reinforcing confidence in the economy to control market conditions.

The theory of regularized financial markets is explained by the Arrow-Debrev Model that interprets the basis for efficient financial markets and gives proof that a competitive equilibrium exists. According to Allen and Carletti (2007), the Arrow-Debreu model of efficient markets was applied to explain aspects of liquidity and that the main problem experienced in incomplete markets was in the fact that there was no efficient provision of liquidity. This happens due to an element of risk in determining liquidity in banks and other financial institutions. Asset prices are dependent on liquidity. Therefore, liquidity provision is achieved by selling assets when required on the market. The model assumes that money and banks do not exist incomplete markets, and all commodities traded in the economy are equally liquid. Consequently, there is no trading on liquidity and risk management.

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Allen and Carletti (2007) further indicate that incomplete markets are the norm, with assets sold for cash cheaply. An evaluation of efficiency between the two markets, complete and incomplete ones, is impossible because of the assumptions made by the Arrow-Debrev model with regard to complete markets. Hence, the relationship between asset price speculation, liquidity, and financial fragility, which is as the result of liquidity transformation occasioned by credit creation in organized asset markets, cannot be explicitly established within the realms of the model (Allen & Carletti, 2007). Attempts made by other economists to justify the operation of complete markets do not provide strong foundations for monetary theory and policy, and attention reverts back to monetary policy.

It is worth noting that contemporary monetary theories provide an understanding of how the current monetary system functions and demystifies the dynamics of the economy. As opposed to the gold standard, modern money is flexible and it can be managed to maintain inflation at acceptable levels. A desirable level of inflation promotes growth, encourages consumption and investments as well as discourages speculation. The present state of monetary theory can be assessed by considering inflation targeting. The focus on monetary policy on the level of inflation targeting due to the occurrence of the asset price increase and decline at close intervals in the past years as well as inflation targeting been used to maintain consumer price at safe levels, as explained by Thornton (2012).

Using real analysis in inflationary targeting is based on the assumption that there is a constant long-run equilibrium determined by real factors that achieve full employment. Money is considered neutral, and inflation is the only variable that can be manipulated by central banks in the long-run. However, it has been argued that inflation targeting does not guarantee stability in financial markets. The element of uncertainty is introduced, and Keynes has provided a framework that aids in understanding the behaviors of financial markets. These include liquidity, functions of the central bank in ensuring price stability and monetary stability of financial markets as well as overseeing the actions of institutions for public interest and the process of liquidity transformation.

The effects of monetary policy on interest rates and not money supply have determined the efficiency of monetary policy. The central bank would have to make significant shifts in the interest rates to increase aggregate demand. The expectations about future returns influenced investment decisions, as opposed to interest rates, hence monetary policy efficacy was criticized for being disproportionate.

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The use of real analysis by the contemporary policy of regularized financial sector and inflation targeting makes the government and the regulatory body, the central bank, vulnerable to incomplete analysis and wrong deduction concerning stability in financial markets. As a result, asset price inflation triggers the central bank to institute measures to control the increase in asset price. The actions by the central bank have been criticized for being quite destabilizing due to focus on one area of the economy and neglecting the rest. Change in interest rates by the central banks does not yield real results as the speculation demand for money is heightened, causing instability and triggering a further change in interest rates. Therefore, the regulatory institution further distorts stability, thus increasing the volatility of financial markets, and the general confidence of the public in the central bank’s ability to control the interest rate is eroded.


To sum up, it is noted that Keynes’ school of thought advocated key policy proposals on structural change to the laisses-fair economy with particular emphasis on the government and central bank that ensured monetary and financial stability, but it overlooked the level of activities in the economy necessary for full employment. The principle of effective demand and property of monetary analysis, as proposed by Keynes, supports the notion of efficiency on markets and neutral money. Inefficiencies on the financial markets are mitigated by the central bank’s responsibility and provide the tools for maintaining stability. Keynesians’ focus on the real analysis provided a divergent stance on the classical economist by claiming that the only objective of the monetary policy included inflation targeting. The monetary analysis provides the cure to market distortion through the application of Keynes’ general analytical framework to the contemporary aspects such as inflation targeting and deregulation of financial markets.

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