"Life Cycle" Hypothesis of Saving: Aggregate ... - Arabictrader.com

342 Miscellanea
are equal: one must also show that, no other value of X, would be sustainable.
Keynes’s masterly contribution consists in demonstrating that when X differs
from X*, and there is therefore an excess demand (or excess supply) of money,
a mechanism is triggered m that pushes X toward X*, reducing the excess demand
(or supply) until it is eliminated, when X equals X*.
In order to carry out this demonstration, he had to “invent” and elaborate a
series of concepts and interactions that were either new or neglected by the pre-
Keynesian theory, and in particular by the classical theory. In the process, he gave
rise to a new branch of economics, known as Macroeconomics, including a subbranch,
international macroeconomics and Finance.
IV The Keynesian Mechanism
The foundations of the Keynesian construction are provided by four major building
blocks: Liquidity Preference, The Investment Function, The Consumption
Function, and The Investment Multiplier.
IV.1 Liquidity Preference
Liquidity Preference is generally identified with the proposition that the demand
for money depends also on the interest rate, and is frequently regarded as an interesting
minor refinement to the theory of money demand. In reality it brings to
light a very fundamental misconception in the classical monetary theory. For that
theory—explicitly or implicitly—assumes that money is used exclusively to buy
commodities, and hence its price is its purchasing power in terms of commodities.
But, it fails to recognize—that, besides the market for commodities, there is
another market of overwhelming importance in a developed economy: the market
for assets, especially intangibles. Thus, it neglects the fact that money is also
extensively used (and growingly so) to acquire (and liquidate) financial assets,
which represent claims to future cash returns. These may be characterized as
instruments whose attractiveness depends on the nature of their return. In particular,
reducing current cash holdings by a buck, one can acquire a buck’s worth
of, say, (short-term) “bonds” yielding a return measured by the interest rate. This
transaction can be thought of as the exchange of a buck now for an instrument
promising (1 + r) bucks next period. Similarly, one can acquire a spot buck at the
cost of 1 + r bucks next period by selling a bond from one’s portfolio or by borrowing
at the rate r from the market or an intermediary. Thus (1 + r) is the quantity
of money that has to be paid in the next period, per unit of money delivered
in the current period, or the price of “money” (now) in terms of money next
period. The classics refer to 1/P as the purchasing power or price of money in