Asset Price Bubbles, Liquidity Preference and the Business Cycle

Abstract

In his Treatise on Money, Keynes relied on two different themes to argue that the interest rate need not rise with rising levels of expenditure. One of these was the elasticity of the money supply, and the other was the interaction between financial and industrial circulation. A decrease (increase) in what Keynes called the bear position was similar in its impact to that of a policy-induced increase (decrease) in the money supply. In the General Theory, this second line of argument lost much of its force as it became reformulated under the rubric of Keynes liquidity preference theory of interest. Assuming that the expected return on capital adjusts to the interest rate in short-period equilibrium, Keynes ignored the effect of bull or bear sentiment in equity markets as a second-order complication that can be ignored in analyzing the equilibrium level of investment and output. The objective of this paper is to go back to this old theme from the Treatise and underscore its importance for Keynesian theory of the business cycle. This paper is motivated by the author's perception that Keynes' Treatise on Money sheds much better light on many of today's economic problems than his better known General Theory (GT), whether it is the burst of the asset price bubble in the US, liquidity trap in Japan, currency crises in emerging markets or the threat of global deflation. Whereas financial circulation, asset price expectations and market speculation were an integral part of Keynes' macroeconomic analysis in the former work, they have been pushed to the background in the latter. Keynes' remarks in GT-both in his famous chapter on long-term expectations and the one on the trade cycle-about market speculation was much more forceful than anything one can find in his Treatise. However, these penetrating insights on how securities markets could malfunction were not woven back into his analysis of how investment and output Metroeconomica 57:2 (2006) 239-256

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