Procrustean Art of Backtracking: “Interest Rate as a Variable”

 

John M. Keynes illustrates the “liquidity preference” function: M= L(r) (1936, p. 168). Next year, John R. Hicks in “interpretation of Mr. Keynes” comes up with the money demand “equation of Cambridge Quantity”: M= k∙P∙Y.

             To be fair, they like us “demand” money to spend in the near future primarily because “Money is useless until we get rid of it” (Paul Samuelson and William Nordhaus, Economics, 2010, p.458); such getting rid of can never be “now or in the past.” On the other hand, both the interest rate and GDP are already given from outside (read: already determined).

             In mathematics jargon, the interest rate and GDP are a parameter as opposed to a variable. By definition, the parameter is exogenous, while the variable is supposed to be determined in, or “exogenous” of, the market. Wait, a mathematical parameter does not take time in varying but an economic parameter does take some time in changing.

             Case #1. The Money Market: In the model, the interest is variable subject to determination by liquidity preference (M^d) of the private sector and money supply (M^s) by the public sector.

             What? According to Keynes, the interest rate means “the complex of rates of interest on loans of various maturities and risks” (1936, p.28). Apparently, Keynes has “financial markets” as a whole in his mind. To be fair, “the money market” as in macroeconomics is a small drop in the bucket of “money market” in Finance, which in turn is an invisibly-small drop in the gigantic tank of financial markets all across the nation.

             Apparently, macroeconomists envision “the money market” first and then customize narratives thereto. In the process they wag a dog with the tail.

             Case #2. The Market for Loanable Funds: The interest rate is variable yet to be determined by “investment” (I) and “saving” (S). In the first place, John M. Keynes buries the classical theory only to be exhumed a year hence by John R. Hicks. Not surprising at all, their Disciples are themselves confused and propose all different narratives as regards “the market” of loanable funds.

             Speaking the General, the more confident the narrator, the shorter the narrative. When anyone is too proud or too prejudicial, he might well customize his feet to his bed in “so many words.”

             Case #3. The IS-LM: Now macroeconomists synthesize the gorgeous, graceful and glamorous IS-LM model. One curve slopes upward and the other downward and that so gently as to beget crossing and “differentiability.” Lo and behold, the equilibrium GDP (Y) and the equilibrium interest rate (r). So nice, but for their whim that the interest rate be announced by the central bank!

             All in all: So very convenient is the bed for Procrustes!