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R. L. Crouch*
I The Respective Positions

HE demand to hold money as an asset

(when interest bearing bonds are also available) has been rationalized in different ways by John Maynard Keynes and James Tobin. Keynes based his explanation on inelastic bond price expectations. This makes bond prices (the interest rate) "sticky." Assetholders have in mind some "safe" level of interest rates and if the current rate falls below the safe rate they flood the market with bonds as they scramble for cash, confident that they will be able to buy back their bonds at a lower price in the future when the interest rate confirms their expectations and regresses towards its safe level. As asset-holders unload bonds this has the effect of driving the interest rate back up so fulfilling their expectations. To quote Leijonhufvud [2, p. 361], "in Keynes' theory, short-run variations in the interest rate are thus constrained by the prevailing market opinion of the ('safe') level of long-rate . . . I Tobin [3], on the other hand, bases his explanation on uncertainty about the future course of bond prices. The asset-holder is "assumed . . . to be uncertain about [capital gains (or losses) and] to base his actions on his estimate of its probability distribution. This probability distribution . . . has an expected value of zero and is independent of the level of r, the current rate on consols. Thus the investor considers a doubling of the rate just as likely when the rate is 5 per cent as when it is 2 per cent, and a halving of the rate just as likely when it is 1 per cent as when it is 6 per cent,"
* I would like to thank Professors T. Hatanaka, M. B. Johnson, H. G. Johnson, D. Laidler, A. Leijonhufvud, and L. Phillips together with an anonymous referee for their helpful comments on an earlier draft of this paper without implicating them in any errors of fact or judgment that may still remain. ' In Leijonhufvud [21 consider also: ....speculative ." (p. 29); "To Keynes, activity . . . stabilizes yields
the problem . . . lies . . . in the inflexibility of the long-

[3, p. 72].2 It is apparent that in Tobin's model, asset-holders have unit-elastic bond price expectations. They expect the current bond price, or any future bond price established, to prevail. Both Keynes' inelastic bond price expectations and Tobin's uncertainty vis-A-vis bond prices are logically acceptable alternative building blocks on which to establish an interest responsive liquidity preference function. Their hypotheses must, therefore, be discriminated between on empirical grounds. Some simple tests are proposed and applied in the next section. II Some Tests Statistically, the difference between Keynes' and Tobin's hypotheses can be stated in terms of a first-order autoregressive structure. Namely,
>}'t -at-1

Aort -


where r is the interest rate and the usual assumptions are made about E.' According to Tobin, a is equal to zero for all t with the implication that changes in the interest rate are normally distributed with mean zero and that every change Et is uncorrelated with every other change E, - for all k # 0. In other words, changes in the interest rate are "Brownian" and follow a "random walk." Uncovering such behavior in interest rate changes would not refute Tobin's hypothesis. It would, however, refute Keynes' hypothesis. According to Keynes, successive changes in the interest rate should be negatively autocorrelated. (This is implied by "stickiness.") In terms of equation (1), Keynes assumes a is between zero and minus unity. This implies Keynes' asserted
Compare this to Keynes [1, p. 202] where 'a longterm rate of interest of (say) 2 per cent leaves more to fear than to hope . . ." 'From here on, the discussion is presented in terms of the interest rate. Both Tobin's and Keynes' models were developed in terms of Consols and it is well-known that there is a unique relation between the price of Consols and their market yield.

level of long rate (is) 199, original emphasis). All these quotations from the most recent exegesis of Keynes' thought on the interest rate indicate "stickiness" in the interest rate. and

term rate of interest." (p. 42)

the ". . quite stable in the short run . ." (p.

[ 3681

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negative autocorrelation and that successive changes in the interest rate are not Brownian and do not follow a random walk. Thus, to discriminate between Tobin's and Keynes' hypotheses one can test to see whether successive changes in the interest rate are independent, identically distributed random variables. Tobin's hypothesis implies that they are whereas Keynes' hypothesis implies that intertemporal dependence exists. Two standard techniques for testing for independence in a series are autocorrelation analysis and an analysis of runs. These techniques were applied to the interest rate. 1) A utocorrelation The autocorrelation coefficient pa is a measure of the relationship between the value of a variable at time t and its value 6 periods earlier. Defining it to be the percentage change in the interest rate between t- 1 and t, the autocorrelation coefficient for lag 6 is: pa co var(*t) Some autocorrelation results are given instable 1. In this case the basic interest rate series emTABLE



1. -



Lag, weeks

Autocorrelation Coefficient

1 2 3 4 5 6 7 8 9

+.0123 +.0516 +.1022 +.1066 -.0092 +.0561 -.0346 +.0449 -.0144


the autocorrelation coefficient at the 5 per cent level are + 0.1096 and -0. 1193. Thus, none of the autocorrelation results reported in table 1 are significant. Changes in the weekly yield on U.K. 212-) per cent Consols do, then, conform to a random walk process. Such evidence is contrary to Keynes' hypothesis but not to Tobin's. Although the evidence reported in table 1 is only limited, many other autocorrelation analyses were performed. For example, one group used changes in the daily yield on Consols with lags from one to thirty days with the autocorrelation coefficients being calculated for the whole sample and various subsamples. Another group used changes in the monthly yield on Consols with lags from one to twelve months with the autocorrelation coefficients also being calculated for the whole sample and various sub-samples. The results thus obtained were all consistent with the random walk hypothesis, i.e., tending to refute Keynes' and not refute Tobin.' The objection could be made that the firstorder autoregressive process is too unsophisticated to capture Keynes' hypothesis and, thus, that the insignificant first-order autocorrelation coefficients that have been observed do not provide a conclusive refutation of his hypothesis. It might be argued, for example, that the intertemporal dependence of the interest rate posited by Keynes must be represented by a general autoregressive process: (3) rt + airti + Id + aqrt-q = Et. Such is the case if "investors are regarded as taking a considerable time-span of past experience into account in forming their views of what is currently a 'safe' [interest rate] . . ." Leijonhufvud [2, p. 199]. It can be shown, however, that the evidence already adduced is sufficient to reject this hypothesis, too.



Note: The interest rate used was the yield on U.K. 21/2 per cent Consols quoted on Fridays (or the nearest working day)

Bank of England Quarterly Bulletin.







ployed was the weekly yield on United Kingdom 21/2 per cent Consols. (As mentioned above, both Keynes and Tobin presented their models in the context of Consols and the United Kingdom (U.K.) provides the most accessible source of such a security.) The significance points when N = 206 for

'Of course, every autocorrelation coefficient was not insignificant. This was only to be expected when such a large number of samples were taken. The crucial point is, however, that the number of significant autocorrelation coefficients observed was not inconsistent with a statistical chance process and, moreover, there was no observable pattern among those significant autocorrelation coefficients that were observed from series to series and from sample to sample. In addition, of those significant autocorrelation coefficients that were observed, as many were positive as were negative. Thus, there was no support for Keynes' asserted dominance of inelastic bond price expectations. These more extensive results are available on request.

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E f (*t - Eit) (*t


0. Now if y = 1, all the other ,ui must also be

It has been demonstrated that:

- E t - f)yO)_

for all 0 except 0

0; yo > 0 when 0 = 0.

If (3) is multiplied by rt-, rtq, rt-q_-, ... successively and expected values of both

zero. We conclude, therefore, that no set of weights exists from which Keynes' "safe" interest rate can be calculated from past interest rates. And note that the only restrictions
placed on the
At, were

sides are taken then we obtain:

(1I + a2)
. . . .

that they decline to zero



. .


. . * +
. . .

. .

- 1=-al
. . . .


. . .



. .



*** +
. . .

. . .

. .









1. But it is known that yo > Oand y1 = y(,+j = 0 from which it is ..,

= a,, =

eventually and sum to unity. This conclusion, very economically arrived at, corroborates Starleaf and Reimer's [4] findings for their weights (which were arbitrarily selected to correspond to the weights used by Friedman to calculate permanentincome).
2) Analysis of Runs

immediately obvious that a,


For the interest rate, there are three different 0. Thus, the insignificant first-orderautopossible types of change and, therefore, three correlation coefficients already observed are differentpossible types of run. Positive changes sufficient to refute (3) as well. give rise to plus runs, negative changes to minus Having refuted (3), we can now make an- runs, and zero changes to no change runs. A other interesting refutation.) An intuitively ap- plus run, for example, is a sequence of consecupealing specification of Keynes' "safe" interest tive positive price changes preceded and folrate rs would be a weighted average of passed lowed by either a negative change or a zero interest rates.6 Thus, let: change. For a stationary series in which any q given change is independent of all previous (4) rts i rt-i changes the total expected number of runs of i=1 all signs is given by: where the A sum to unity and eventually de- EnI2]/N (7) m = [N(N+1) cline to zero at q + 1. Now, according to Keynes, this period's change in the interest which has the standard error: ) ? ( Eni[2[n,2+N (N+ 1) ]-2N:n,3-N3 rate will be a function of the divergencebetween X (Til = ( lN2(N-1) the "safe" interest rate and the observed inter(8) est rate in the previous period. That is, where N is the total number of price changes, q and the ni are the number of price changes of (5) rt [4,rt-iit -Y l) each sign.7 j=j According to Keynes' hypothesis the number However, lag (5) one period and subtract the result from (5) to obtain, after re-arrange- of runs observed should be greater than the number expected in a stationary independent ment: series since the interest rate is alleged to be ?yA2rt-2 rt = (yi - y + 1) rt-i + "sticky" due to the fact that a fall (rise) in (6) + . . * + 7iq/t-q. current rate generates expectations of a the But (6) is completely analogous to (3) and rise (fall) in the future rate. Thus, if this is we have already proved that the a1 in that equathere will be a larger number of reversals true, tion are zero. It follows immediately that the in than a stationary independent series sign coefficients in (6) must also be zero. Examiwould generate. According to Tobin's hypothnation of the coefficienton r,_1 reveals that this esis, successive changes are independent and, coefficient can only be zero if y = 1 and /x = thus, the expected numberof runs should correspond to that computed from (7). 'The following piece of analysis was originally suggested An analysis of runs was made on the same to me by the comments of the anonymous referee.
6 Such an approach has been adopted by Starleaf and Reimer [4, p. 73]. The specific weights they employ are those used by Friedman to calculate permanent income.

'See Wallis and Roberts [5, p. 569]. The summations in every case are over i = 1 . . . 3.

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body of data as that used in the autocorrelation analysis discussed in the previous section. That is to say, daily, weekly, and monthly changes in the yield on U.K. 21/2 per cent Consols for various periods and sub-periodsthereof. Every such analysis refuted Keynes' hypothesis and corroboratedTobin's hypothesis. In no single test was the observednumberof runs statistically larger than the expected number of runs. By way of illustration (using the same data as that employed to calculate the autocorrelation coefficients presented in table 1) the expected number of runs is 115 while the observed number was 112. The ninety-per cent confidence intervals in this test were 103 and 125. Clearly, the observed number of runs is consistent with that to be expected from a stationary independentseries and inconsistent with that to be expected from a series containing negative dependence. By way of summary, then, all the evidence marshalled in preparation of this note (of which that reported is the merest fraction since

the repetition of essentially duplicate results would seem to serve no useful purpose) refutes Keynes' rationalizationof the asset demand for money based on inelastic bond price expectations and does not refute Tobin's rationalization based on uncertainty about future bond prices.

REFERENCES [1] Keynes, J. M., The General Theory of Employment, Interest and Money (New York: Macmillan Company 1936). [2] Leijonhufvud, A., On Keynesian Economics and the Economics of Keynes (London: Oxford University Press, 1968). [3] Tobin, J., "Liquidity Preference as Behavior Towards Risk," XXV, Review of Economic Studies, (Feb. 1958). [4] Starleaf, D. R., and R. Reimer, "The Keynesian Demand Function for Money; Some Statistical Tests," Journal of Finance, XXII, no. 1, (Mar. 1967). [5] Wallis, W. A., and H. V. Roberts, Statistics; A New Approach (Glencoe, Illinois: Free Press, 1956).

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