Financial Markets in Keynesian Macroeconomic Theory 101

class insession

Yesterday when I published my post on Krugman and the vulgar Keynesians not understanding the meaning to the term ‘liquidity trap’ I came to realise that many readers — both sympathetic and hostile — do not really understand the Keynesian theory of financial markets. I then realised that this was actually quite understandable given that it is not much discussed today (with some notable exceptions such as Jan Kregel and Minskyians like Randall Wray).

Some years ago the financial markets were very much so discussed and understood. Key references in this regard are the works of Keynes himself (particularly the Treatise on Money), GLS Shackle, Roy Harrod’s book Money and Joan Robinson’s essay ‘The Rate of Interest’. There are also some more minor works but I will not here provide a bibliography. (From a purely theoretical point-of-view I have found Shackle’s work the best while from an institutional point-of-view I have found Harrod’s work best).

Okay, let’s first start by what we mean by ‘cash’ and ‘bonds’ in Keynesian financial theory. Most people are being led down a wayward path by the likes of vulgar monetary economists like Krugman in this regard (or was he a trade economist? someone remind me…). They seem to think that ‘cash’ is money — deposits, notes, coins, that sort of thing — and ‘bonds’ are government securities. Actually, in financial marketspeak cash includes short-term government securities. It also includes money market funds and other highly liquid investments. There is a nice guide to this at the money manager Charles Schwab’s website here. In this guide the author writes:

What is cash?

Many people think of cash as physical currency—actual bills and coins in circulation. For practical purposes, however, the term “cash” also includes traditional bank deposits, such as checking and savings accounts, where you generally have access to your funds on demand and without risk of losing any principal (up to FDIC limits).

In an investment context, however, the definition of cash expands to other types of cash investments, including short-term, relatively safe investment vehicles such as money market funds, US Treasury bills (T-bills), corporate commercial paper and other short-term securities.

For the purposes of financial macroeconomics I think that we would be best to exclude corporate commercial paper. This is very short-term debt issued by corporations. Although highly liquid, it nevertheless displays many dynamics associated with what should properly be called ‘bonds’. I would also say that, following the Modern Monetary Theorists (MMTers), we should probably be clear that government securities should only be treated as cash proper if they are denominated in the currency of issuance. (For practical purposes we can modify this when needed).

What about stocks? Stocks are unusual in that they do not yield a rate of interest. Yes, they throw off dividends but this is not the same thing. The rate of interest on bonds is inversely related to the price of the same bonds. When the price rises, the rate of interest falls. When the price falls, the rate of interest rises. On stocks, however, this relationship is by no means clear. Dividends are a completely different beast. Nevertheless, we can count stocks as ‘bonds’ to a large extent if we remember that they do not have the same interest rate dynamics. Stocks are generally expected to rally when the price of actual bonds is high and their interest rates low.

Now this might seem rather odd because we all know how central banks control the interest rate, right? When the central banks want to lower the interest rate they buy up government securities, while when they want to raise the rate of interest they sell government securities and drain reserves. But if government securities are counted as ‘cash’ this really makes no difference. What the central bank is trying to do is to use cash and cash substitutes (government securities) to affect the interest rates in other markets.

The primary goal of, say, lowering the interest rate is to allow companies to borrow more cheaply. Here is a nice graph showing some interest rates to get a feel for what is going on in the financial markets. We will examine this in more granular detail later.


As we can see, the three-month Treasury bill rate tracks the overnight rate set by the Fed. This is because these are basically cash substitutes. The Corporate Baa Bond Yield, on the other hand — and this is only one of many interest rates I could have chosen — does track the other two to some extent but not completely. Although it generally gravitates toward the overnight rate it does display some independent dynamics of its own.

The gap between the yield on bonds and the ‘cash’ interest rate — to deploy our terminology — is a measure of what Keynes called ‘liquidity preference’. It reflects the market’s taste for low yield ‘cash’ over higher yield ‘bonds’. Let us be clear: in a functioning market there will always be a spread here to reflect relative risk. But, as we shall see, this spread is not fully under the control of the monetary authorities at all times and the amount by which it fluctuates day-to-day and month-to-month is reflective of liquidity preference. Schwab provides us with a nice table telling their customers how to hold this ‘cash’ liquidity.


Very broadly speaking we can say, in Keynesian terms, that checking, saving (and deposit) accounts are used for what Keynes called the ‘transactions motive’. While all the others are used for what he called the ‘precautionary motive’ and the ‘speculative motive’.

Let us zoom here on a recent period to get a better idea of what is going on.


Here I have marked two recent periods where we see financial markets clearly responding to increased perceived risk. Looking at the time series we see that the Baa Corporate Bond Yield follows the overnight rate quite smoothly. But just prior to the 2001 recession while there was turmoil in the stock markets we see a clear, small spike that is not in keeping with the general smooth movement. This spike accounts for a jump in interest rates on Baa bonds of nearly 0.5%. This may not seem all that significant but in the land of the financial markets it is a very significant event and is indicative of heightened liquidity preference.

The second period I have marked is much more extreme. Here the Fed was rapidly lowering interest rates. Markets were anticipating this lowering too. Yet the Baa bond yield spiked by two full percentage points. This is a liquidity trap proper. The market were roiled by the turmoil that was taking place after 2008 and they all rushed for cash even though the interest rate on this cash was falling. By 2010 the liquidity trap had subsided. This was mainly in response to the markets coming to believe that the bailouts were convincingly going to fix the financial system. TARP did more to ease the liquidity trap, I would argue, than QE did.

Well, that’s all for today class. Use this knowledge to go out and attack the vulgar Keynesians that are clogging up the general discourse with poorly defined terms and nonsense. Today we do not face a liquidity trap. Rather we face a situation in which investment is not responding to low interest rates. That is what vulgar ISLMist Keynesians call an ‘investment trap’ and it takes place when the IS-curve on the ISLM diagram is vertical. While I do not buy into this notion it is far closer to where we are today than being in a liquidity trap. If one must worship at the temple of ISLM at least get it right, for God’s sake!


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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20 Responses to Financial Markets in Keynesian Macroeconomic Theory 101

  1. NeilW says:

    “This is a liquidity trap proper.”

    Is it, or is it just a portfolio reconfiguration based upon the fact that the ‘bonds’ can go bust. All of a sudden the risk of corporate failure changed (funnily enough because the facts changed!) You’d probably see the same in the share market.

    Now the underlying company doesn’t give two hoots about this movement because it is not limited to issuing corporate bonds to borrow. It also has the option of going to a bank…

    ISTM that economists spend *way* too much time worrying about interest rates. Certainly way more time than pretty much anybody in business.

  2. Rob Rawlings says:

    “Here the Fed was rapidly lowering interest rates. Markets were anticipating this lowering too. Yet the Baa bond yield spiked by two full percentage points. This is a liquidity trap proper. The market were roiled by the turmoil that was taking place after 2008 and they all rushed for cash even though the interest rate on this cash was falling”

    You describe here a situation where risk premia go up and cause the differential between interest rates on “safe” and “risky” assets to widen..

    This is clearly different from ZLB conditions, but is it what Keynes meant by a liquidity trap ? Didn’t he talk about a situation where interest rates on bonds were expected to rise in the future so everyone holds cash in anticipation of this ?

    Can you point to where Keynes described in detail his concept of the liquidity trap ?

    • Keynes barely discusses the liquidity trap. I think that Minsky is the one who really dealt with it in detail. You can find some relevant quotes here.

      • Rob Rawlings says:

        I agree (based on your earlier post) that Minksy’s description of a LT matches yours.

        Its just not clear to me that this very specific circumstance is what Keynes had in mind in his much more vague description of how “liquidity-preference may become virtually absolute” that you also quote there. Couldn’t this be any circumstance where the interest rates is low and people prefer to hold interest-free riskless assets (both becasue the extra return is not worth the bother , and becasue they fear capital loss if rates rise in the future).?

  3. paul davidson says:

    I am surprised you do not mention my 2002 book FINANCIAL MARKETS, MONEY AND THE REAL WORLD which makes the important point that some financial assets are illiquid and others are liquid. Why?

    also the book explicitly predicted the possibility of a global financial collapse because of the creation of derivatives that claimed to convert illiquid assets into liquid assets. That is impossible! Why? you might try reading my book to find out — because you will not find it in Minsky, Kregel, Wray, etc.

    And the financial collapse of 2007-2008 involved these mortgage backed derivatives that were suddenly recognized as illiquid.

  4. Jamie says:

    As a non-economist, I’m not in a position to judge whether what you are saying is right or wrong. However, there is definitely a problem in economics regarding inconsistent vocabulary and it’s not just related to terms for sophisticated concepts such as ‘liquidity trap’.

    In the past week, I have come across a debate between two PhD economists who were arguing about the meaning of the word ‘inflation’. In a separate post, another PhD economist asked for ideas on the meaning of the term ‘aggregate demand’ even though this PhD economist uses the term regularly and is a well-known name in the profession. (I have not provided links because my point is not about specific economists debating specific terms).

    In general, as far as I can see, economists don’t have common definitions even for basic terms such as money, credit, cash, investment, saving , savings (different from saving), capital, financial asset. This makes it impossible for non-economists to follow economic debates. Problems arise first because economists use terms inconsistently from each other (e.g. ‘liquidity trap’); second because they use terms ambiguously (e.g. ‘inflation’ is a generic term which could be applied to anything, so which ‘inflation’ do you mean?); and third because economists use terms inconsistently from general use without making this clear (e.g. most people would think of ‘cash’ as physical notes and coins, as in “I paid for my meal with cash” as opposed to “I paid for my meal with a cheque” or “I paid for my meal with a credit card”).

    Economics feels like it is the equivalent of what chemistry would be like if the periodic table didn’t exist and different chemists used different names for the various elements, or indeed for concepts such as ‘element’.

    I have often wondered if it would be possible to develop a periodic table-like diagram (or a set of diagrams) of economic terms which would help non-economists understand the formal relationship between these terms and also force economists to use common definitions. For example, maybe the economy is made up of ‘commodities’, ‘assets’, ‘goods’, ‘services’ and ‘waste’. Assets are then made up of ‘physical assets’ and ‘financial assets’. ‘Financials assets’ are then made up of A, B and C. A is made up of A1, A2, A3 and A4 etc.

    Alternatively, economists could set up a single website containing the ‘official’ definitions of terms. For example, the definition of ‘liquidity trap’ could include what it is; what it is not; what it includes; what it excludes; whether it is measured or estimated or just a thinking device; who first coined the term and why; real world examples to illustrate the concept. Definitions could then be improved over time when ambiguities and errors were pointed out.

    Why do you think that most economists don’t seem to even acknowledge this problem, far less solve it? Who would have the initiative and determination to define and develop a solution, as well as the authority to make the solution stick?

    • Thorstein says:

      I think it would be very complicated, even impossible, to provide a consistent and definitive set of definitions. I think that it would require an agreed world view underlying these notions, which does not exist in economics. Different schools of thought will use the same word to say different things, in frameworks that are often not commensurable.

      Here Philip is pointing out that the notion of liquidity trap has been absorbed and is used by the mainstream in a manner which is betraying the original sense of the term. But given the theoretical construct of this paradigm, it could not have been otherwise. The liquidity trap, linked to the preference for liquidity and so to expectations and uncertainty, cannot be adopted unaltered by the mainstream since (for instance) the latter element is absent from their framework.

      • NeilW says:

        Co-opting and changing the meaning of the word is common in politics.

        Which is of course all that economics is really.

      • Jamie says:


        I feared that might be the answer. However, that just begs further questions. Either it is possible to create common definitions for core vocabulary or it is not.

        Case 1: If it were possible then it makes sense for economists to sell their discipline as a sort of science where the rest of us should expect a “right answer” to certain questions developed using a combination of the core vocabulary, logic and observation etc.

        Case 2: If, as you suggest, it is not possible, then we are in an entirely different place. If economists use words inconsistently then it’s as though some economists speak English, others German, others Spanish and they will never speak the same language.

        If we are in case 1 then it makes sense for Philip to berate others for misusing a key term. However, if we are is case 2 then it doesn’t. Languages steal terms from each other all the time and then re-invent the terms. Even variations within a single language are allowed e.g. US English versus UK English. You can’t have it both ways.

        If there is no common vocabulary then one set of economists cannot impose terminology on others. The concept of the ‘wrong’ use of words is itself wrong.

        As a non-economist, one of the key questions I ask myself is which economists should I believe. If we are in case 2 then it seems like this choice is pretty arbitrary, like deciding whether to speak English, German or Spanish. The problem with that is that the most sensible answers are to side with the largest team (as that will allow the widest information sharing) or to side with the team that says what you want to hear (as that is most convenient for convincing yourself that your political prejudices are ‘correct’).

        I don’t like the implications of that but, if that’s the case, then economists need to set expectations for what the rest of us can expect from the subject.

        Finally, even if it is not possible to set consistent definitions across the entire economics discipline, the same questions are relevant for subsets. The problem is the same even if we are talking about a single school of thought. If I have been reading economists from another school of thought who have been filling my head with one set of definitions then I will only understand you if you are clear and consistent about your definitions and, optionally, also about how your definitions differ from those used by other schools.

  5. LK says:

    On this subject, this post really clarifies things well and effectively.

    Again just to clarify, for Post Keynesian financial market theory, we should define “cash” as:

    (1) physical currency, such notes and coins in circulation
    (2) demand deposit and demand deposit-like accounts (checking accounts, transactions accounts, savings accounts)
    (3) short-term, liquid money market funds
    (4) short-term, liquid government bills/bonds (denominated in the currency of issuance.)


    • Yes, I think so. Some might find 10-Year Treasuries controversial. But they never succumb to liquidity trap dynamics and when liquidity preference increases people buy 10-Years. I think this is key: cash is whatever the market perceives to be cash. I.e. what they rush to when they want liquidity.

      • LK says:

        And surely real capital investment can be fitted in here too as a type of highly illiquid investment?

        In periods of uncertainty and rising liquidity preference, capitalists will not engage in risky investment in real and illiquid capital projects. Their retained earnings will probably be moved into cash as defined above?

      • Yes, real investment is one of the most illiquid types of investment. That is why in Keynesian theory real and financial investment are separated. Liquidity preference drives financial markets, animal spirits drives the real investment markets. I have formalised all this in a long chapter on finance and investment in my forthcoming book.

  6. NeilW says:

    “Their retained earnings will probably be moved into cash as defined above?”

    Or into property, or large company shares, or commodities like gold.

    To avoid the ‘loss on cash’.

    To me the flight is to ‘quality’, however that is defined by the financial herd currently. Could be tulip bulbs.

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