Keynes Effect

The so-called Keynes effect claims that deflation has a stimulating effect on the economy due to the falling interest rates with the adjustment of cash holdings. The Keynes name is based on the neoclassical synthesis of John R. Hicks and is in complete contradiction to the views of John Maynard Keynes on the effect of deflation on the economy. It is an effect on the demand for goods that has an indirect effect on the investment via the securities market. Due to the excessive cash holdings with falling prices, the demand for securities increases, so interest rates fall and investments increase. In the IS-LM model, the LM curve shifts to the right, income and employment increase.

Thesis and reason

As a result of a falling price level, the real cash holdings (transaction and speculative cash) rise beyond the scope of the desired cash holdings and households and companies try to reduce the excessive cash holdings again through higher demand on the bond market. As demand increases, bond prices rise and interest rates fall as a result. When interest rates fall, investment, demand for goods and employment increase.

If the price level rises, the effect is exactly the opposite. In the IS-LM model , the price level is not an independent determinant of the overall economic demand for goods. Therefore, price changes have no direct impact on the demand for goods. However, a price change has an effect on the money market. According to the money market equilibrium condition M / P = L (where M / P stands for the real money supply and L for the macroeconomic demand for money) an increase in the price level leads to a decrease in the real money supply. This results in excess demand on the money market. The economic agents are now ready to make securities liquid in order to satisfy their demand for money. A surplus of supply on the securities market, however, is assumed to result in falling prices and rising interest rates (market value = nominal interest rate / market interest rate).

The interest rate is now a determinant of the macroeconomic demand for goods and causes a corresponding increase or decrease in private net investment. This results in an increase or decrease in the demand for goods and thus also an increase or decrease in the macroeconomic equilibrium income, since the supply of goods is assumed to adapt flexibly to the demand for goods.

So, seen in isolation, changes in price level cause equipotential interest rate changes.

The Keynes effect is also referred to as the indirect real cash effect , as the price changes first affect the goods market via the money market and then via the interest rate transmission channel.

special cases

The Keynes effect is ineffective if private investment demand is completely non-elastic, i.e. does not react to changes in interest rates. Changes can only be seen here on the money market (investment trap).

Furthermore, an increase in the real money supply by lowering the price level has no effect on investment demand if we are already in the liquidity trap . The excess supply on the money market now flows completely into the speculative fund , since the economic subjects only want to hold money and not securities due to pessimistic interest rate expectations.

criticism

The thesis that deflation has a stimulating effect on the economy is based on the fact that nominal interest rates fall as prices fall. However, when prices fall, real interest rates rise, resulting from the nominal interest rate plus the deflation rate. The real interest rate is decisive for investments and the economy. According to Keynes, deflation is devastating to employment as entrepreneurs cut production if they expect wages and prices to continue falling.

According to Paul Krugman, the real cash effect from the increase in the value of the amount of money in circulation is negligible. The increase in the purchasing power of the money supply as a result of deflation is offset by much greater losses, for example in the real estate sector, as in the current financial crisis. During the Great Depression of 1929–33, deflation led to an enormous drop in stock market prices. Falling prices also devalue all investments in real estate and, with falling sales of their products, the farms and factories.

The naming of the effect after Keynes is based only on a one-time and still very limited statement in the same paragraph that a reduction in wages and prices can lead to falling nominal interest rates and favor investments. In general, Keynes believed that deflation had a negative effect on the economy, investment and employment.

Comparable concepts

What all comparable concepts have in common is that, like the Keynes effect, they claim, in complete contrast to Keynes' view of the crisis-worsening consequences of deflation, an economic stimulus effect of deflation, which in a crisis would lead to economic equilibrium and full employment again.

The real cash effect

When wealth effect (real balance effect) the real cash rises through a falling prices above or lowered by a rising price level below the desired cash balances. In the IS-LM model, lower prices result in a right shift of the LM curve and the intersection with the IS curve. The real cash effect is the basis for the effects named after Pigou, Keynes and Patinkin.

The Pigou Effect

The Pigou effect generally resembles the real cash effect in its mode of action, but particularly emphasizes the wealth effect for the holders of government bonds, for whom the falling price level creates the feeling of being wealthier. As a result, their consumer spending increases and with it the amount of goods demanded in an economy.

The patinkin effect

Don Patinkin's approach is known as the augmented real cash effect or real cash holding effect . The real cash position is adjusted to the desired cash position after a price change due to rising or falling consumer demand. Falling prices therefore lead to rising demand for goods due to the increased real cash. In doing so, Don Patinkin considers cash management under the benefit concept, and a balance is sought between the marginal benefit of cash management and the marginal benefit of additional consumption.

Individual evidence

↑ Manfred Borchert: Money and Credit: Introduction to Monetary Theory and Monetary Policy, Oldenbourg-Verlag, Munich 2003 p. 174
^ Keynes, Social Consequences of Changes in the Value of Money (1923), Essays in Persuasion, Norton Library 1963, p. 103
↑ P.Krugman: Real balance effects (wonkish)
↑ Keynes: General Theory, Duncker & Humblot, Berlin 2006, p. 222