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8.6 Investment Spending, Liquidity, and the Non-neutrality of Money Axiom

Keynes’s theory implies that agents who planned to buy producible goods in

the current period need not have earned income currently or previously in

order to exercise this demand (D2) in an entrepreneurial, money-using economic

system. This means that spending for D2, which we normally associate

with the demand for reproducible fixed and working capital goods, is not

constrained by either actual income or inherited endowments. D2 is constrained

in a money-creating banking system solely by the expected future

monetary (not real) cash inflow (Keynes, 1936, chap. 17). In a world where

money is created only if someone goes into debt (borrows) in order to

purchase goods, then real investment spending will be undertaken as long as

the purchase of newly produced capital goods is expected to generate a future

cash inflow (net of operating expenses) whose discounted present value equals

or exceeds the money cash outflow (the supply price) currently needed to

purchase the asset.

For the D2 component of aggregate demand not to be constrained by actual

income, therefore, agents must have the ability to finance investment by

borrowing from a banking system which can create money. This Post

Keynesian financing mechanism where increases in the nominal quantity of

money are used to finance increased demand for producible goods, resulting

in increasing employment levels, means that money cannot be neutral. Hahn

(1982, p. 44) describes the money neutrality axiom as one where

The objectives of agents that determine their actions and plans do not depend on

any nominal magnitudes. Agents care only about ‘real’ things such as goods …

leisure and effort. We know this as the axiom of the absence of money illusion,

which it seems impossible to abandon in any sensible sense.

To reject the neutrality axiom does not require assuming that agents suffer

from a money illusion. It only means that ‘money is not neutral’ (Keynes,

1973b, p. 411); money matters in both the short run and the long run, in

affecting the equilibrium level of employment and real output. As Keynes

(1973b, pp. 408–9) put it:

The theory which I desiderate would deal … with an economy in which money

plays a part of its own and affects motives and decisions, and is, in short, one of

the operative factors in the situation, so that the course of events cannot be

predicted in either the long period or in the short, without a knowledge of the

behaviour of money between the first state and the last. And it is this which we

ought to mean when we speak of a monetary economy.

Once we recognize that money is a real phenomenon, that money matters,

then neutrality must be rejected. Keynes (1936, p. 142) believed that the ‘real

rate of interest’ concept of Irving Fisher was a logical confusion. In a monetary

economy, moving through calendar time towards an uncertain (statistically

unpredictable) future, there is no such thing as a forward-looking real rate of

interest. In an entrepreneur economy the only objective for a firm is to end the

production process by liquidating its working capital in order to end up with

more money than it started with (Keynes, 1979, p. 82). Moreover, money has

an impact on the real sector in both the short and long run. Thus money is a real

phenomenon. This is just the reverse of what classical theory and modern

mainstream theory teach us. In orthodox macroeconomic theory the rate of

interest is a real (technologically determined) factor while money (at least in

the long run for both Friedman and Tobin) does not affect the real output flow.

This reversal of the importance or the significance of money and interest rates

for real and monetary phenomena between the orthodox and Keynes’s theory is

the result of Keynes’s rejection of a neoclassical universal truth – the axiom of

neutral money. Arrow and Hahn (1971, pp. 356–7) implicitly recognized that

money matters when they wrote:

The terms in which contracts are made matter. In particular, if money is the good

in terms of which contracts are made, then the prices of goods in terms of money

are of special significance. This is not the case if we consider an economy without

a past or future … if a serious monetary theory comes to be written, the fact that

contracts are made in terms of money will be of considerable importance. (Italics


Moreover, Arrow and Hahn (1971, p. 361) demonstrate that, if contracts

are made in terms of money (so that money affects real decisions) in an

economy moving along in calendar time with a past and a future, then all

existence theorems demonstrating a classical full employment equilibrium

result are jeopardized. The existence of money contracts – a characteristic of

the world in which we live – implies that there need never exist, in the long

run or the short run, any rational expectations equilibrium or general equilibrium

market-clearing price vector.