Value & Capital, Chapter XX, Section 2

The author begins this section by noting that he hopes to provide clarity on such "topically interesting problems" as "the effects of saving and investment on the rate of interest" as well as "the effects of general changes in money wages."  But he observes that it is difficult to determine the correct answers to these questions.  The reason for this difficulty, he explains, involves the phrase he placed at the beginning of the previous section—essentially used as a subtitle of the chapter—namely that "the temporary equilibrium system is liable to be imperfectly stable."

As part of his discussion, the author reviews the results of his earlier analysis of stability in exchange.  He summarizes these results as follows:

In order for a system of multiple exchange to be perfectly stable (and the temporary equilibrium system is simply an extended system of multiple exchange), the following conditions must be satisfied.  A rise in the price of any commodity must make the supply of that commodity exceed the demand (a) if all other prices are given, (b) if some other prices are adjusted so as to preserve equality between demand and supply in their respective markets, (c) if all other prices are so adjusted.

He describes this last condition as being "indispensable."  Without it, "the system is not stable at all, but will break down at the slightest disturbance."  Assuming this condition is met, either of the other conditions could fail to hold, and the system would still be "stable in the end ... but we have to be prepared for its working to show queer anomalies."

When the author applied these stability tests to static systems, he "found no significant reason to suppose that they gave any particular trouble."  Hence, his analysis treated them as perfectly stable.  In the current chapter he addresses the question of "What happens when we apply the same tests to the dynamic system—or rather to the system of temporary equilibrium?" 

His plan for answering this question is to try "to construct a particular case of the temporary equilibrium system" in such a way that its formal properties match those of the static case.  This particular case will then be perfectly stable.  He will then compare the particular case with the general (imperfectly stable) case, in order to "see whether there is anything in the general case likely to upset its stability—and if so, what the disturbing element is."

Value & Capital, CHAPTER XX -- THE TEMPORARY EQUILIBRIUM OF THE WHOLE SYSTEM

In this first section of the chapter, a section titled "Its Imperfect Stability," the author, Sir John Hicks, introduces the analytical methods he will use to analyze the effects of changes in data, such as prices, on the workings of a dynamic economy.

He begins by noting how his method of analysis allows for an easy transition from analyzing the behavior of a single individual or firm to analyzing "the great issues of the prosperity or adversity, even life or death, of a whole economic system." His method works by deriving laws of market behavior for idealized, representative individuals and firms.  These laws, elaborated for what he calls "those tenuous creatures" then 

become revealed 'in their own dimensions like themselves' as laws of the behavior of great groups of economic units, from which we can readily evolve the laws of their interconnexions, the laws of the behaviour of prices, the laws of the working of the whole system.

The author then notes that an earlier chapter laid out the conditions for a (temporary) equilibrium of an economy during a particular 'week' although the discussion in that chapter did not use the "representative economic units" described above.  These equilibrium equations define the prices that will result when conditions such as preferences, resources, and expectations are specified.  The author's goal in this chapter is to "begin to set the equations to work" to determine what happens when some of the conditions change.

He explains that the analytical process will "follow out a programme exactly parallel to that which we previously followed when dealing with a static price-system," but with an important difference.  In the present context, "the laws of the working of a temporary equilibrium system" are not the ultimate goal of the analysis in the same way that the corresponding laws of a static system were.  For a temporary equilibrium system, the changes in data that will be analyzed are only hypothetical.  But investigating these changes is a necessary precondition for being able "to examine the ulterior consequences of changes in data."

He also defends the value of the short-term analysis used in the theory of temporary equilibrium.  "For many purposes, what we want to know is exactly what the theory of temporary equilibrium tells us—what immediate alteration in the course of events will follow from a particular change in data."  He also revisits the use of a 'week' as the planning period for his analysis;  he points out that such usage is rather arbitrary and that 

The main problems where it is necessary to consider more than one 'week' are those where we are specially interested in the consequences of accumulation or decumulation of capital.  These have to be held over for later consideration;  they belong to a part of dynamics which falls outside temporary equilibrium theory.

He concludes the section by discussing the distinction between two kinds of effects from price changes, namely those effects that "result simply from people's awareness of the initial effects" and "those effects which depend on capital accumulation" (and whose speed may be limited by the "duration of the processes needed to bring about changes in productive equipment.")  He explains that his method of analysis will "[suppose] the first sort of effect to go through with the maximum of rapidity," and that while this may not be realistic, it poses no great difficulty.

Value & Capital, CHAPTER XIX, Section 5

In this section, the final one of the chapter, the author begins by noting that the preceding discussion of an entrepreneur's expenditures assumed these expenditures to include both those expenses going toward running the business, as well as spending on consumption goods.

The author explains that it was a "theoretical convenience" to suppose the entire financial aspect of the business to involve transfers into or out of the entrepreneur's private account, although in practice this supposition is unrealistic.  For a private firm, the distinction between the firm's account and the individual's account may be somewhat artificial; for a joint-stock company, however, the situation is different.

There is a real line of division;  the financial side of the firm's operations has an existence of its own quite separate from the private accounts of the shareholders—a separation maintained by the legal principle of limited liability.

The analysis of the present chapter would apply "perfectly well" to a firm's financial account being treated as a sort of private account, but there is a remaining difficulty when it comes to joint-stock companies, namely their decisions about payment of dividends.  The author concludes this section (and the chapter) by explaining the difficulty as follows:

No clear principle is left to determine on what scale dividends should be paid—that is to say, how much should be paid out in dividends in the current period and how much should be 'ploughed back into the business'.  Nor does there seem to be any theoretical device by which this arbitrariness can be removed;  it is a ... real peculiarity of the joint-stock company. ... [T]he only implication for the general dynamic theory ... is that we must be prepared sometimes to treat dividend policy as an independent variable.

Value & Capital, CHAPTER XIX, Section 4

In this section, the author adds to his preceding discussion of the reasons for holding money in stationary conditions.  The additions in this section amount to two further reasons for holding money when conditions are not stationary.

The first reason is the result of a person's planning to undertake "some considerable increase in his expenditure in the near future."  Because of uncertainty about when such funds would be needed, as well as the convenience of transferring needed funds in a single transaction, a person planning on such a rise in future expenditure will very likely prepare for it by increasing his demand for money in the present.

A second reason results from having plans, not for increased consumption, but for increased investment in securities in the near future.  As the author implies, the reason an individual would make such investments is "to be able to be able to spend more than he receives at some distant and probably conjectural future date." For the near term, however, such increased holding of cash reflects a plan to purchase securities, given an assumption that such investments are cheaper when multiple 'weeks' of 'savings' are consolidated into a single transaction.

The author summarizes his findings thus far as being that "we should not go far wrong if we said that the demand for money depends on the rate of interest, and upon the volume of planned expenditures in the near future (in money terms), some attention being paid to the confidence with which it is expected that this expenditure and no more will be carried out."  This summary, as he notes, does not apply to his last reason for holding money, namely, "an increase in the amount of securities that the individual plans to buy in the near future."  He calls this "an awkward exception" to his rule for the demand for money but states that, "I do not see any convenient way of reformulating the rule by which it can be avoided."

Value & Capital, CHAPTER XIX, Section 3

In this section, the author begins describing special cases of analysis to help address the general question of how an individual will distribute his funds between money and securities.

The first and simplest case is defined so that the individual involved will have a demand for money that is "nil."  Or, put another way, the individual will choose to hold all of his funds in the form of securities instead of money.

Suppose that the interest on the securities he possesses at the planning date, together with any other kinds of revenue which may be due him, is expected to yield a constant flow of receipts, the same amount in every future week.  Suppose, further, that he plans to spend, in every future week, the same amount as he receives, no more and no less.  Then, if he is perfectly confident that he can carry out his plan, his demand for money will be nil.  All the money he receives will be paid out again at once; he will need to keep over from one week to another no money balance at all to finance his transactions.

The author goes on to discuss two reasons why this example is unrealistic.

The first is that expenditures and receipts "do not come in at exactly the same moments."  Thus some money balance would typically be held because trying to invest it in securities is not worth the trouble.  The author argues that these effects, from the standpoint of the economy as a whole, probably cause the holding of "a fairly constant amount of money, only liable to some quite regular fluctuations at quarter-days and Christmas and so on."  Moreover, he indicates that this source of demand for money is not much affected by interest rate changes.

The second reason why money is held is that even if expenditures and receipts tended to coincide, there is always uncertainty to be guarded against.  Because the costs associated with selling securities on the spur of the moment could be considerable, "the mere risk of needing to do this would be sufficient to offset a moderate gain in interest."  The degree to which an individual will choose to hold money for this reason will depend on "the individual's attitude to the risk and upon the size of the gain offered by investment in securities."  Therefore this effect is sensitive to interest rates, "but it is also very susceptible to changes in the risk factor."

An important example of a business needing to hold money for the purpose of paying claims on short notice is that of banks.  The author calls this "the clearest case" of a business incurring liabilities that it may be called on "to meet at dates which cannot be quite certainly predicted."  But, as he notes in closing this section, "the holding of money against uncertain future expenditures ... is practiced to some extent by all businesses, and by many private individuals as well."

Value & Capital, CHAPTER XIX, Section 2

In this section the author reviews several of his conclusions from the analysis of money in Chapter XIII.  In many cases money and securities function as close substitutes for one another.  While securities pay interest and money does not, people still prefer to hold some money.  As the author notes, "Even the safest and most negotiable securities, which are not money, involve some risks to their holders, and some costs of acquisition and disposal, from which money is free."

Thus the demand for money depends strongly on the rate of interest (or, as the author elaborates, "on the system of interest rates").  Because of the existence of a wide variety of securities which "form a chain of very close substitutes" between money and other securities, money and securities tend to "behave as very close substitutes, from the point of view of the economy as a whole."  A rise in the interest rate would tend to decrease the demand for money (and increase the demand for securities).

The author closes the section by asking, "If rates of interest are given, what determines the way in which an individual will distribute his funds between money and securities?"  He then previews the discussion in upcoming sections by noting that this question can be approached "most easily if we consider a number of special cases."

Value & Capital, CHAPTER XIX -- THE DEMAND FOR MONEY

In this section, the first one of the chapter, the author, Sir John Hicks, sets up his discussion of what determines an individual's demand for money.

He begins by noting a deficiency in the discussion up to this point of the individual's consumption plan.  This is the simplifying assumption made earlier that any difference between an individual's receipts and expenditures in a time period (e.g. a week) will be made up entirely by an incremental change in his or her holding of securities.  This assumption was made for convenience, but according to Hicks "it would let us down badly in the applications we want to make later on."  And of course it is not truly realistic.

In reality, individuals typically hold some money along with securities and can react to surpluses or deficits by adjusting their holdings of both.  Hicks notes that "It is a matter of considerable importance which form the balancing takes," so he seeks a way of addressing this question within the structure of his theory.  His analysis could easily accommodate money, if money can be treated as though it were some sort of durable consumer good.

It is a condition of equilibrium for the individual that the marginal rate of substitution between acquisitions of any commodities at given dates must equal the ratio of their discounted prices; this rule could be taken as applying to money as well.  The marginal rate of substitution between money now and any other commodity now would equal the current price of that commodity (just the same rule as we found for the standard commodity in statics); the marginal rate of substitution between the acquisition of money now and the acquisition of money at a later date would equal the discount ratio over the period of deferment.  This implies that the interest charge over a period would measure the sacrifice involved in postponing the acquisition of a marginal unit of money to the end of the period .... In other words, the rate of interest would measure the impatience to possess money now instead of money in the future.

The rules for how interest rate changes affect the demand for present commodities would also apply to the demand for money in the present.  Therefore, an interest rate increase "may be expected to diminish the demand for money." Also, a general rise in commodity prices should tend to increase the demand for money.

Hicks concludes the section by stating that these rules for the behavior of money that would apply if it were a durable consumption good are "very reasonable," and that "it would be surprising if more careful attention to the true nature of money were to make it necessary to alter them very considerably."