Keynes' Monetary Theory and Bank Reserves in Britain

By Miller, Edward M. | Atlantic Economic Journal, March 1989 | Go to article overview

Keynes' Monetary Theory and Bank Reserves in Britain


Miller, Edward M., Atlantic Economic Journal


Keynes' Monetary Theory and Bank Reserves in Britain

Because Keynes was British, his economic theory was peculiarly suited to British financial institutions, particularly the lack of a distinction for reserve purposes between deposit and current accounts (time and checking accounts in American terminology). This paper will present a new interpretation of the economics of Keynes, emphasizing how British reserve customs prevented the British financial system from being an automatic stabilizer able to isolate aggregate demand from shifts in the propensity to invest. This institutional peculiarity explains why his General Theory emerged in Britain rather than elsewhere. It also suggests that the Theory was less general than Keynes or his readers thought and that it cannot be carried in an unmodified form to foreign countries (such as the United States) with different financial systems. Although the interpretation of Keynes here is simple, it has been missed by the commentators.

It was argued earlier [Miller, 1985] that the theory which became the monetary part of American Keynesianism is not Keynes' theory but one that arose from the error of translating Keynes' "money" not as bank deposits (the American phrase for his concept) but as medium of exchange money or currency plus checking deposits. This implies that American theoretical and empirical criticism of Keynesian economics (such as monetarism) should not be considered as automatically relevant to Britain. For Britain, lower requirements on deposit accounts than current accounts would improve the system's stability. In this treatment of Keynes' monetary economics, the emphasis will be on why interest rate changes in the British financial system would not provide the automatic stabilizer of classical theory, adjusting to equate changes in desired saving and desired investing.

I. Deposit Types and Motives for Holding

Money

Keynes summarized the monetary part of his General Theory [p. 199] as: M = M1 + M2 = L1(Y) + L2(r), where: M1 = Cash deposits; M2 = Saving deposits; L1 = Liquidity function for Cash-deposits; L2 = Liquidity function for Savings-deposits; M = Total Deposits; Y = Income; and r = Interest rate.

It will be argued that his M or "money" is total bank deposits (not the quantity of the medium of exchange), subdivided into its two components of current and deposit accounts, or checking and time accounts. His M1 corresponds to the amount of checking deposits and M2 to the amount of what Keynes called in the Treatise Savings-deposits, which today would be called deposit accounts or time deposits. In the General Theory, M1 is described as "the amount of cash held to satisfy the transaction--and precautionary--motives." M2 is described as [Keynes, 1936, p. 199] "the amount held to satisfy the speculative motive."

The argument will be in three stages. The first will be to show that Keynes viewed the monetary theory of the General Theory merely as an extension of the Treatise. The second stage will show that in both works, the money described as the alternative to bonds was interest paying savings deposits and not the non-interest paying medium of exchange depicted by American textbooks [Samuelson, 1981; Wonnacott, 1978]. The third stage will be to show the flow of funds in Keynes' theory and the critical role played by a banking system in which shifts from checking accounts to Savings-deposits can occur without providing the banking system with an incentive to lend more.

II. The Relationship Between the Monetary

Theory of the Treatise and the General

Theory

To understand Keynes, one must realize that by "money" he meant all bank-deposits, not merely medium of exchange. As Keynes [1936, p. 167] put it: "It is often convenient to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills. …

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