The monetary authorities by varying the conditions of liquidity can determine the level of rates in the short-term money market and gradually have an important impact on rates in all sectors of the debt structure. Rates on particular classes of debts reflect a great variety of factors. For instance, they reflect the supposed risk involved, special tax considerations, the portfolio preferences of the public in relation to the volume of debts in the various sectors, the degree of competition in the area concerned, the cost of making the loan, and the like. Some debts are especially attractive because they serve as good substitutes for money, and their yields ordinarily reflect that fact in an obvious way. Long-term rates reflect a forecast of future conditions in the money market rather than conditions existing at the moment.
The monetary authorities do not necessarily have some definite level of money rates or bond yields they are trying to make effective, but they generally have limits of tolerance for short rates at least. At a given time there is usually a range of rates which they would regard as consistent with their economic goals, even though they have not decided in advance what the limits of the range would be. Although they largely reject rates as gauges of the monetary pressure they are exerting, they nevertheless have a dominating influence on rates through setting the terms and conditions under which money may be created. For instance, they may have as an immediate goal a net borrowed reserve position for the banks of 600 millions; but the rate level which results from that position at that time is attributable to monetary administration just as truly as though the authorities had deliberately sought that level.
Though a change of rate levels by the authorities requires the creation of cash to whatever extent the members of the public choose to hold additional balances at those rates, there will ordinarily be no important increase of cash to begin with. Fundamentally this is because of the inertia in the rate of expenditure in the economy. People do not radically readjust their plans for outlay in the short run just because credit is cheaper and perhaps more readily available. And since the cash balance targets of businesses and consumers are geared to their rate of spending and the cost-price structure, these targets will also show no great change. The reduced opportunity cost of holding balances, however, may result in some increase. Business corporations, for instance, may choose to hold fewer short-term government securities in the place of deposit balances as the rate falls, though in practice the change is not always discernible.
The change in the expansive effect of monetary conditions is not to be judged, however, by the change in the amount of money balances. The members of the public individually may shift as they choose from debt instruments into real assets, but in the aggregate they cannot shift out of debt instruments and cash taken together. As the attractiveness of debt instruments declines they will increase the rate of production and bid up the prices of real assets to the point where real assets have no greater attraction for the holders than debt assets. Holders must be found not only for the existing supply of debt assets but for any addition which people choose to issue at the existing market that is made effective by the conditions of liquidity.
Rate adjustments and rationing of credit by lenders will help to equalize the supply and the demand for debt assets in particular sectors of the market. But rates in all sectors will reflect the change in the conditions of liquidity; and the demand for the aggregate of debt assets must be adjusted to the supply by a response in the rate of production and in prices that temporarily reduces the relative attractions of real assets.
There seems no reason to say that business spending increases to the point at which the expected rate of return equals the relevant interest rate. Generally speaking, people have only a vague idea of what the future holds. The profitability of the outlay hinges on changes in the whole business situation, the shifting demand for products, changes in operating costs, and changes in the price level. It also depends upon labor relations, governmental decisions, and in high degree upon the quality of the management.
The question is how much to increase the level of spending from where it happens to be. The scale of operations already in effect will seem about right; going much beyond it will not seem reasonable. Analogously, the purchase of capital assets in much larger amounts or at much higher prices will not seem justifiable merely because interest rates are lower. The resistance to further investment is not primarily because of a decline in the physical efficiency of capital goods, but because of a slowness of the economy to adjust to a higher rate of expenditure. People resist changing too quickly and too much from what recent experience has seemed to justify. Nevertheless the decline in the yield on debt assets will result in some acceleration in the rate of spending as a means of equalizing the attractions of real assets and debt assets.
The attainment of a higher level of expenditure produces no permanent balance in the attractions of debt assets and of other assets. As current and anticipated receipts become greater, they gradually seem to justify a higher level of commitments; and a continued low level of interest rates takes effect in a further acceleration of commitments.
In time, the whole business climate improves. The increase of profits prospects reduces further the attractions of debt assets. An acceleration of spending that formerly reconciled the public to holding the aggregate of debt assets (or its alternative in a collective sense, cash) no longer suffices; in general it takes a greater and greater acceleration to maintain a momentary balance.
If an increase of spending caused simply a rise in profits prospects for very long, spending would become explosive. That is what happens when an economy goes into hyperinflation. But under ordinary circumstances an increase of spending brings into play also certain self-correcting tendencies of varying duration.
If the authorities were to follow a sufficiently inflationary policy over a long period, the self-correcting tendencies would generally become weaker. That is to say, there is no ground in experience for supposing that an economy has a built-in resistance to inflation that can withstand whatever mismanagement of its monetary system may confront it. But the past several decades have certainly shown us that the self-correcting tendencies are powerful and for a very long time may prevent a gradual inflation from going into panic inflation. They may also cause temporary reversals in the rate of spending and in price movements.
The economy can also put up a powerful resistance to monetary contraction for a considerable period. Because of the small amount of downward price and cost flexibility, however, and because depression tends to destroy the debt structure, the economy can put up much less resistance to persistent contraction than to expansion. An extended contraction is likely to cause the economic structure to crack up.
Before considering what the self-correcting tendencies are, let us call to mind that people usually do not know whether they are confronted with an inflationary or deflationary monetary policy. It takes time for a given trend in business to work itself out. People are inclined to trust the monetary authorities to an important degree, and if the authorities say or imply that a given tightness of money is required in order to maintain an even keel in business, the public are inclined to go along with them. People assume that, prima facie, the level of interest rates that prevails is about right, or at least that any error is soon likely to be corrected. It is only when they have lost confidence in the policies of the authorities that they believe there is an advantage in a marked shift either into real assets or away from them into debt assets. (Though collectively they can shift only from debts into cash, since under our institutional set-up the monetary system does not stand ready to monetize real assets, they can shift individually from debt assets into real assets--at a price.)
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