Liquidity premia and the money-rate of interest in a monetary theory of interest and production

This dissertation is an interpretation and then a development of the content of chapter 17 of Keynes's General Theory regarding the notion of the money-rate of interest of assets to a theory which supports his conclusion that unemployment equilibrium exists and his argument in favor of a "monetary theory of interest and production". This theory is different from "productivity" theories of interest and output because it does not attribute interest to the net physical productivity of capital, and it implies that there is a "pure" interest rate which affects the level of output. This "monetary" theory is exemplified in this dissertation by an analysis which shows the interdependence between the IS and LM schedules as a result of arbitrage in capital markets which is initiated by changes in the propensity towards liquidity. The argument is supported by an interpretation and codification of Keynes' idea of expectations based on a "conventional" manner which is in turn related to the "regression" method which was proposed by Pesaran and leads to the development of a new formulation of "liquidity premia" on real capital assets. This approach which attributes liquidity premia to real capital assets is applied to a variety of standard investment functions, and typically results in shifts in the demand for investment. An important finding is that, under certain conditions, the investment demand schedule is not identical to the marginal productivity schedule, the elasticity of investment with respect to the marginal product of capital varies with changes in the propensity towards liquidity and the investment schedule may shift in a pendulum manner. A simple macroeconomic model is proposed in which changes in the propensity towards liquidity initiate an arbitrage process in the capital markets which causes shifts in both the demand for money and the investment demand schedule and, as a consequence, results in the interdependence between the investment function and the finance function. This result contrasts with those generated by the standard IS-LM model. It is also similar to the conclusion obtained by other authors (notably Paul Davidson) but the argument is novel in its emphasis on capital market arbitrage.