THE KEYNES KAHN APPROACH AND ALTERNATIVE THEORIES OF MONETARY PRODUCTION ECONOMY

Transcription

1 THE KEYNES KAHN APPROACH AND ALTERNATIVE THEORIES OF MONETARY PRODUCTION ECONOMY Theodore T. Koutsobinas Department of Actuarial Studies, Financial Mathematics and Statistics University of the Aegean Vourlioti Building, Karlovasi, Samos Abstract Which is the most important linkage between the real and the financial economy? The responses have been diverse and sound mutually exclusive. For example, for Davidson it is the interest rate in the discount process of demand prices for capital goods, for Minsky is the effect of external finance while for Tobin it is the q ratio. The important question which arises in this connection is whether variations of asset prices of different asset classes can influence the demand for capital goods in a liquidity preference framework and, if so, how? This is obviously a question that may sound familiar in the context of monetary production economy, yet it has not been explored. This paper discusses alternative theories of monetary production economy especially with respect to the proposed linkages between the real and the monetary/financial sector and examines their effectiveness with respect to this fundamental question. It is concluded that there is a theoretical void that could potentially be resolved with an elaboration of the Keynes Kahn portfolio approach. An analytical framework is suggested that explains why variations of asset prices of different asset classes influence the demand for capital goods, while it incorporates the most important features of the existing alternative theories of monetary production economy. JEL Classification: B22, E23. E24, E43, E44. E83

2 1. Introduction It has become quite evident in the last decade that the central theme of post Keynesian economics, which refers to the level of economic activity set by the level of effective demand that is not consistent with full employment should be analyzed in the context of a monetary production economy (Arestis et. al., 1999). This paper evolves around Keynesʹs idea of a ʺmonetary theory of interest and production.ʺ This idea is different from productivity based theories of interest and output because the interest rate is not determined by the net physical productivity of capital, and because it allows the ʺpureʺ interest rate to affect the level of output. In addition, this idea is interpreted as reflecting the fundamental distinction that was introduced by Schumpeter (1954) between Real and Monetary Analysis. According to Schumpeter, all neoclassical monetary theories are in essence part of Real Analysis because long run equilibrium is determined by real and not by monetary factors. In this article, the alternative paths through which equilibrium is determined by monetary or financial factors will be called monetary production linkages. In addition, Keynes (1936) argued in favour of a ʺmonetary theory of interest and productionʺ as a result of the working of liquidity preference. However, fundamental ideas of a ʺmonetary theory of interest and productionʺ such as the effect of liquidity preference on the demand of assets other than money as well as the effect of the subsequent linkage which arises between the demand for financial assets and the demand for real assets have not been elaborated to date adequately. The interdependence of financial assets was emphasised by Kahn (1954) in his analysis of the term structure of interest rates but was neither analytically formulated nor extended to real assets and, therefore, associated with the idea of a ʺmonetary theory of interest and production.ʺ On the other hand, the analysis of monetary production economy has involved so far different and sometimes contrasting with respect to their conclusions theoretical accounts of monetary production

3 linkages. The most prominent analytical frameworks are the finance motive (Davidson, 1978), the discounting process of the demand price of capital goods (Davidson, 1968; 1994; Minsky, 1986), the q ratio that introduces into the analysis the relation between the stock market and investment (Tobin, 1969), and the two price system that makes use of the impact of the differences between internal and external finance (Minsky, 1975). An alternative approach to these accounts is the Keynes Kahn portfolio approach which was endorsed by Kregel (1999) (and supported by Panico (1988) and Koutsobinas (2002)) and which emphasizes the interdependence of interest rates and asset prices. In this article, this alternative approach will be elaborated and compared constructively with the existing accounts of monetary production economy linkages. It is possible to classify the monetary production linkages in two categories: One type of linkages relate to investment while another category is associated to consumption. The alternative theories of monetary production economy that will be presented below, only the analytical framework of the finance motive relates to consumption. The other monetary production linkages are realized through investment. The purpose of this article is to develop the Keynes Kahn approach of asset prices that is based on liquidity preference in a multi asset framework. In order to propose an alternative monetary production linkage through the investment process, the paper is organized as follows: First, the various existing monetary production theories are presented. Second, the Keynes Kahn approach is elaborated. Finally, an analytical framework that manifests the relation of this approach to the investment process is proposed. It is shown that this analytical framework contains certain desirable assumptions that complement constructively the existing accounts of monetary production linkages. 2. Alternative Theories of Monetary Production Economy

4 A. The finance motive. Davidson argued that there is an interdependence in the IS LM apparatus due to the effect of the finance motive (see Davidson, 1971, pp ). This idea has a broad accepeptance. For example, Leijonhufvud also considered the interdependence of IS and LM curves when money income varies (see Leijonhufvud, 1983, pp ). The finance motive was advanced by Keynes in his article, ʺAlternative Theories of the Rate of Interestʺ as a subcategory of the transactions motive on the ground that entrepreneurs hold cash balances between payment periods in order to meet obligations stemming from entering into the forward market of capital goods. Thus, when the level of investment increases, the extra finance involved will constitute an additional demand for money. Davidson argued that the introduction of the finance motive associated with the demand for transactions balances is a function of the aggregate planned spending for goods and that, consequently, the finance motive is associated with shifts in the demand for transactions purposes (see Davidson, 1971, p. 166). Therefore, Davidson differs from Hicks because he portrays the demand for transactions purposes as a function of aggregate planned spending rather than as a function of the actual level of output at each level of output. Thus, Davidsonʹs model refers to the transactionsʹ demand for money balances rather than to the speculative precautionary demand for money. Moreover, in Davidsonʹs model the monetary production linkage arises because of the working of the finance motive without having implications for portfolio effects due to variations in relative asset prices attributed to variations in liquidity preference. B. The Discounting Process on the Determination of Real Capital Assets Another approach deals with the impact of the discounting process in the determination of investment. This process has been stressed by Davidson (1978; 1994) and Minsky (1980; 1986) in the Post Keynesian tradition. In what

5 follows in this section, Davidson s framework is presented while Minsky s analysis will be discussed below in conjunction with his views on external finance. Davidson advances the capital asset and flow approach, in which he incorporates the accumulated capital asset with the flow of capital goods in the determination of investment. The basic idea is explained in a capital stock demand curve (Dk) as DK= f1 (Pk, id, φ. E) where pk is the market price of capital goods, id is the rate of discount (related to the interest rate), φ is a set of expectations about the growth in demand and the consequent future stream of quasi rents, E is the number of entrepreneurial investors who can obtain finance for their demand for capital goods, and f 1pk < 0, f 1id < 0, f 1φ > 0, f 1E > 0. Variations in any one of the independent variables influence the others. For example, a change in the market interest rate does not influence only the discounting process but also has an impact on φ, the set of expectations about future sales and through future interest rates on E, the number of entrepreneurial investors who can obtain finance for their demand for capital goods. Davidson recognizes at this point that the timing of investment projects will be influenced by temporary market financial conditions through the impact of the organization of the financial markets, the willingness of banks to provide loans and underwriters to float new issues (Davidson, 1972, ch. 10, ch.13). Thus, this impact is confined to the market period rather than extended to short run or long run analysis. As long the spot demand price for capital exceeds the minimum flow supply price of capital goods, there is an increase in new gross investment. For Davidson, it is solely the impact of variations in the rate of interest on the discounting process that links the money rate of interest to the level of

6 investment output. This argument follows closely Keynes s remark that a fall in the rate of interest stimulates the production of capital goods not because it decreases the costs of production but because it increases their demand price. However, the conclusion that the money rate of interest can limit in the short run through the discounting process the demand for capital is confined in the two asset model that includes money and real capital goods. This approach contrasts with the implications of Keynes Kahn approach, which will be presented in a subsequent section, according to which in a multi asset framework there is another effective monetary production linkage beyond the discounting process. Furthermore in Davidson s analysis there is utilization of the spot and forward prices for capital goods in the investment decision. The forward market involves the delivery of specific capital goods at a future date. However, there is no discussion whether there are linkages between these forward markets for capital with other forward markets for financial markets even whether these forward markets for heterogeneous capital goods are possible to be standardized as commodities futures markets are. In short, this approach is essentially a two asset framework, which includes money and real capital assets and in which there is no discussion of the portfolio effect on real activity C. Tobin s Q ratio Theory and the Cost of Equity Capital Tobin does not endorse the liquidity preference theory so his relation to monetary production analysis seems at first paradoxical. However, his q theory focuses on asset substitution between equities and real capital assets in a framework where the price of the former is determined by portfolio equations in financial markets, although these equations are not liquiditypreference dependent. Contrary to Keynes s approach, Tobin confines this analysis to disequilibrium context. Yet, Tobin s analysis relies heavily on a

7 process in which investment in real capital assets is influenced by financial markets, in essence, a monetary production framework. For Tobin, the market evaluation of equity q relative to the replacement cost of the physical assets it represents is the focal point of analysis. The q ratio is the major determinant of investment because the latter is encouraged when capital is valued more highly than what it costs to produce it and is discouraged in the opposite case. For Tobin, the market evaluation of equity is the ratio of the market yield on equity to the marginal efficiency of capital, that is, to the expected real return on capital. Thus, for Tobin, the evaluation of investment goods relative to their cost is the prime indicator and proper target of monetary policy (Brainard and Tobin, 1968, p.104). Tobin argues that q is a more effective target since the quantity of money or the interest rate are in essence an imperfect and derivative indicator of the effective thrust of monetary events and policies (Brainard and Tobin, 1968, p.104). Tobin accepts that shifts in asset allocation may bid up or down interest rates and equity yields simultaneously, yet the exact nature by which a simultaneous change in interest rates or equity yields is achieved is not clearly spelled out (see Brainard and Tobin, 1968, p.104). On the other hand, Tobin utilizes a framework of rate of return equations in a multi asset framework. According to Tobin, although Keynes s General Theory deals with four or five assets, there are only two rates of return: the rate of return on money and the rate of interest common to securities and physical capital (see Tobin, 1961, p.223). Tobin instead conducts his analysis in a multi asset portfolio context that includes many market yields (see Tobin, 1969, p. 332). For Tobin, the most critical factor is the supply price of capital to which his proposition of the q ratio is tied. On the contrary, he undermines the importance of the long term interest rate, the Keynesian interest rate, because in practice there are cases in which a fall of the long term interest rate may cause the supply price of capital to rise. Another limitation of Tobin s

8 analysis is that the differentials across assets are assumed to be constant independent of the relative supplies or demands. Thus, once one of the market rates is fixed, the others are assumed to deviate by fixed premia accounting for risk and price appreciation. It is evident that Tobin is critical of the liquidity preference theory because for him liquidity preference theory expectations of a rise in the interest rate leads to greater liquidity preference and a higher long term interest rate that is discouraging for investment. He argues that the liquidity preference theory is erroneous because the marginal efficiency of capital does not compete only with the market long term interest rate but with that quotation less the expected capital losses (Tobin, 1969, p.227). In addition, for Tobin, in Keynes s framework there is no discussion of a broader adjustment in response to the equalization process of marginal efficiency of capital and the long term interest rate, an adjustment that includes shifts in asset allocation from capital to bonds (see Brainard and Tobin, 1968, p.106). Yet, despite these remarks, there is no discussion in Tobin s analysis how portfolio allocation variations occur with the equalization process of market yields even in the cases in which the latter differentiate variably with respect to strong uncertainty expectations, a critical idea for Keynes. D. Minsky s Two Price Approach and the Impact of External Finance Like Davidson, Minsky puts an emphasis on the effect of interest rates on the discounting process and the demand prices on capital (Minsky, 1986, pp ). But, unlike Davidson s analysis, Minsky s framework emphasizes more the impact of finance on investment. More importantly, Minsky s approach introduces explicitly the distinction between internal and external finance and emphasizes their effective impact on investment (Minsky, 1986, pp ). External finance consists of the credit process, borrowing from banks or

9 financial intermediaries and external financial instruments such as the issuance of corporate bonds and equities or, nowadays, more complex tools such as LBO s and venture capital schemes. For Minsky, the financial aspect of investment, through the distinction between internal and external finance is a marked characteristic of our economy (Minsky, 1986, p. 190). Like Davidson, Minsky makes use of the demand and supply prices of capital in determining investment. However, contrary to Davidson s approach, these prices are influenced by external finance factors, which can shift the demand and the supply schedules for real capital assets. These external finance factors take the form of borrower s risk and lender s risk, a notion borrowed by Kalecki but present in Keynes s General Theory. For Minsky, risk is not introduced in the probabilistic sense of risk premium, a measure involving the standard deviation of returns but merely as a representation of exposure to external finance. The latter is expressed in the form of margins of safety that are considered by either buyers of capital goods through borrowing or by producers of capital goods through lending (Minsky, 1986, p. 1990). Increased margins of safety to compensate for increased borrower s risk or exposure to failure to respond successfully to debt contract obligations lower the demand price of capital and vice versa. On the other hand, higher interest rates increase the lender s risk and shift the supply price of capital goods upwards,. This shift is greater the longer the production period is. Shifts in the demand price and the supply price of capital goods through variations in the exposure to external finance (in the form of borrower s risk and lender s risk determine equilibrium levels of investment that differ from these that are attained in situations of internal finance only (Minsky, 1986, pp ). Minsky s analysis is consistent with the framework of monetary production economy because he analyzes explicitly the impact of external finance on investment. Long term interest rates tend to vary through the discounting process the demand prices of capital while short term interest

10 rates change the supply prices of capital. However, there are notable differences from the discounting process as well. Minsky stresses the impact of various facets of external finance, which is not confined to the market period but is important for short run equilibrium. He introduces the idea of margins of safety for external finance. These margins of safety are associated with relative returns on assets such as the real return on capital or the interest rate on debt instruments. In order for margins of safety to be applied the interest rate must be lower than the real return on capital. In his framework, an analogy is drawn between the price of bonds and the cost of investment projects and between the interest rate and the expected profitability. 3. The Keynes Kahn approach Despite a few exceptions, Kahn s analysis (1954) has been overlooked in recent attempts to develop a liquidity theory of asset prices on the basis of Keynes s theory of interest and production. The relation of this theoretical framework impact with the determination relative asset prices was stressed by many authors, Kregel (1988), Panico (1988) and Rogers (1989). More recently, Kregel (1998) argued in favour of the Keynes Kahn approach that emphasizes the impact of interest rates on asset prices. This approach is consistent with Keynesʹs monetary theory of interest and production according to which the rate of interest as a monetary factor implies that the multiplier and liquidity preference are two aspects of the same phenomenon (Kregel, 1988). In this context, the changes which are required in the demand for investment goods to restore equilibrium in the commodities market can be explained by a liquidity preference theory of asset prices. This solution is in essence a shifting equilibrium, which can be considered as an alternative to the static equilibrium solution, which was proposed by Rogers (1989). In the latter monetary production approach, there is an exogenously determined conventional money rate of interest which sets

11 the long run rate of return to which all the rates of return or marginal efficiencies of various assets must adjust including the marginal efficiency of capital (Rogers, 1989, p. 245). Those alternatives reflect Kregel s distinction between a static and a shifting equilibrium solution. In the static state, long term expectations are stable and short term expectations are realized while in the shifting case longterm expectations change because they are affected by disappointed shortterm expectations. This framework stands in contrast with the idea that changing liquidity preference is a situation of portfolio disequilibrium and that the restoration of liquidity preference as an essential and defining element of the Post Keynesian architecture will therefore require a restatement of the main principles outside the confines of equilibrium analysis (Brown, 2005). This idea is not also the same as Minsky s two price theory (see for an exposition, Kregel 1992). This view holds that the prices of capital goods are determined in financial markets by profit expectations that are reflected though not always accurately as we shall see in securities prices, while consumer goods prices are determined by the relative magnitude of consumer demand in relation to the available supply. Kahn advances the idea that beyond the standard macroeconomic equilibrium conditions, financial assets are in equilibrium when the marginal investors equalize the money rates of interest of all financial assets. This financial portfolio equilibrium determines the equilibrium values of a range of rates of return of financial assets such as the long term interest rate, the rate of return on equity and the interest rate on corporate bonds. 1 The second step to elaborate the Keynes Kahn approach is to analyze how the determination of these financial rates of return may influence investment. In order to elaborate the various aspects of the Keynes Kahn finance investment process, it is important to clarify certain issues. First, there

12 are two distinct although closely related markets, the markets for financial markets (for liquid) assets and secondly the markets for real capital assets. The Keynes Kahn equilibrium condition cannot be extended to include real capital assets since there is no secondary market for them. This highlights the agency differences between entrepreneurs or real capital asset investors and financial investors. Financial investors trade in financial markets, in which the existence of secondary markets is essential. Through their activity, financial markets provide finance to entrepreneurs to invest in real capital assets. But, it is obvious that financial investors do not invest directly in real capital assets for the benefit of their proceeds from their utilization in their production process, an implication that could be erroneously be drawn in the context of Tobin s q ratio analysis. There is an alternative effect though in the sense that financial markets can provide the finance to investors to buy existing investment projects (and their real capital assets) rather than real capital assets at the newly produced replacement cost. Thus, the role of finance for the realization of investment can be very important. It should be noted at this point that investment consists of two parts: investment financed internally from past earnings and investment financed externally. The latter component is partitioned further since it consists of investment financed by being subjected to debt (i.e., corporate bonds and credit) or by equity (either raising or sharing). For simplicity, the case of bank credit is not considered at this stage in order to assess the impact of financial markets. Investment therefore is also function of external finance, that is, debt finance and equity finance. If investment is financed only internally, it would be only a function of the discounted expected rate of return. However, since external finance is also involved, investment is not only a positive function of the discounted expected rate of return but also a negative function of both bonds and the cost of equity raising. 2 The cost of equity capital is inversely

13 related to the price of equity and the rate of return on equity. 3 Not, only this but the quantity of equities that is required to be externally financed (i.e, a proxy for the number of entrepreneurs who can obtain external finance) varies inversely with the price and the rate of return on equities. 4 According to Minsky, to the providers of external finance the interest rate or the charge for equity raising is analogous to the internal rate of return determined by the anticipated cash flows from owning capital assets. This reflects also the views of Keynes (Minsky, 1986, ). Thus, the financial rates of return can be expressed as a percentage of the internal rate of return. Since the difference between the discounted expected rate of return the interest rate of corporate bonds and the cost of equity raising can be expressed in a parametric mode, investment is a function of the expected rate of return on capital assets and a parameter that manifests the costs of external finance. 5 This external finance parameter influences the demand price of capital goods. When the long term interest rate is consistent with the short term rate and there is no influence of the liquidity preference in the demand for financial assets, the result is consistent with a two asset model that includes money and real capital assets. But, when there is a deviation between long term rates and short term rates, the discounted expected profitability should be compared with the long term interest rate and the cost of equity capital. This lowers the demand for capital as it shown in figure 1 using an elaboration of Davidson s framework. Applying this result in Davidson s two asset framework, the forward price of demand for capital goods is influenced by the external finance parameter, as it is shown in diagram 1. In order to simplify the exposition, it must be noted that the interest rate of corporate bonds is determined in financial markets according to Kahn s marginal equilibrium condition.

14 On the other hand, in reality there is no cost of equity sharing that is determined in financial markets through a secondary market. However, this cost is influenced by the level of the stock price. The higher stock prices and the return on equity are, the lower is the cost of equity sharing for the entrepreneurs. Thus, Tobin s q ratio could be an indicator of the cost of equity raising. But, this is different from accepting that it is a direct determinant because this would imply that investors in financial markets are entrepreneurs in real capital markets, an assumption that does not take into account the proper notional differences in the capacities of entrepreneurs and investors in financial markets. Thus, it is more precise to say that since Tobin s q ratio could be an indicator of the cost of equity raising it is an indirect determinant of investment. For neoclassical financial economists, the discount rate is the cost of equity capital for an all equity firm. However, for financial economists of various strands who do not espouse the rational expectations approach, the cost of capital is determined realistically differently. For example, for Rockfeller the hardest problem all through my business career was to obtain enough capital to do all the business I wanted to do and could do, given the necessary amount of money (Chernow (1997), p. 68.). Apart from information asymmetries between entrepreneurs or managers and financial investors about expected future cash flows and agency differences that arise often because investors do not believe that expected cash flows are as high as management forecasts, a critical problem for existing firms is that management may have to give up too much of the value of the firm to raise the capital it wants. This problem is more serious when the price of stocks is depressed and management is under pressure to give much more of the value of the firm. Thus, we can draw the following table that compares the alternative liquidity preference dependent approaches of monetary production to the

15 integrated approach followed here. The integrated framework, which is an extension of the Keynes Kahn approach is a multi asset framework which allows for the influence of strong uncertainty in expectation formation and liquidity preference theory and for the impact of financial markets on real capital assets through the role of external finance. Assets Uncertainty Financial External LP Theory Markets Finance Davidson Two Yes No No Minsky Two Yes No Yes Tobin Multi No Yes Yes Kahn Multi Yes Yes No Integrated Multi Yes Yes Yes It should be acknowledged that the Keynes Kahn approach does not provide an explicit analysis of investment formation. Yet, the extension of this framework to the determination of the level of investment and the demand of real capital assets has very important implications and avoids certain shortcomings of the existing monetary production accounts. First, the Keynes Kahn approach introduces both the Keynesian liquiditypreference interest rate (i.e., in the form of the long term interest rate and its variants such as the corporate bond interest rate) and the cost of equity capital (as a similar measure to the q ratio). In this framework, it is superior from accounts that stress only one of the above mentioned variables because it provides a general account. If the external finance takes predominantly one form such as debt or equity capital, then the Keynes Kahn approach can be easily translated to a Keynesian interest rate approach or alternatively, to a cost of equity capital approach. The latter is similar but not the same as the q ratio approach because it implies in essence a variable across assets liquiditypreference dependent financial q ratio. In addition, the Keynes Kahn approach highlights more importantly the role of the long term interest rate, a fundamental point of policy divergence from the neoclassical analysis. The

16 neoclassical remedy to recession is to lower the short term interest rate, a measure that if it becomes achieved exogenously is consistent with current central bank policy practice as well as with the endogenous money approach. But, as the relation of the short term interest rate and the long term interest rate is admittedly weak (Romer, 2000), if the short rate of interest is exogenously administered it remains to the long term interest rate (and to its variants such as the corporate bond rate) to absorb the influence of liquiditypreference and the Keynes Kahn approach is an excellent venue that proves this relation, renders invalid the neoclassical contention of convergence to full employment equilibrium and supports the principle of effective demand. In periods of financial crisis, the exogenously administered short term interest rate becomes very low and after point its variation do not affect the discounting process and the demand price of real capital asses. But, the variation of liquidity preference across financial assets influences the longterm interest rate and the cost of equity capital and determines the financially constrained demand price of capital. This mechanism is important because as it is fully responsible for phenomena such as the constraint on investment in real capital assets imposed by external finance as well as the impact of interest rates on future consumption that influences directly expected cash flows and profitability (both being key variables in Davidson s two asset account). Not only this, but the Keynes Kahn approach shows also how liquiditypreference influences the cost of equity capital, a consideration that was absent in Tobin s analysis. With respect to this latter consideration, the Keynes Kahn provides an analytical justification for the empirical troubles of the q ratio in the sense that it does not undermine the impact of a range of important liquidity preference dependent variables. 4. Variations to the Same Framework

17 One important variation of the framework discussed above is accomplished by introducing Minsky s idea of margins of safety. The latter are implicit monetary premia that are imposed in the primary markets for debt instruments and equity. The margins of safety reflect organizational aspects of financial markets, change with experience and although they are not the same with the rates of return for the assets (i.e., bonds) they are consistent with their variations. 6 For example, an increase in margins of safety for the issuance of corporate bonds should be expected with an increase in long term interest rates and rates of corporate bonds attributed to an increase in uncertainty and vice versa. However, the extent of the change in margins of safety will depend on organizational experience. The introduction of the margins safety implies that beyond the discounted expected profitability the demand of investment is not directly or purely a function of rates that observable in financial markets but of the organizational disposition of financial intermediaries to impose margins of safety that are consistent although not the same with the observed rates. In this case, if safety margins are introduced, investment financed by external finance is influenced by the observed rates and the organizational exposure that was introduced in the analysis above. This will modify accordingly the external finance parameter for investment. In any case, this will be consistent with Davidson s model such as expectations of future proceedings influenced by the propensity to consume and rates of interest rate for consumer loans and the number of entrepreneurs who can obtain finance. In the framework of this paper, the last factor is expressed as the level of investment that is undertaken by obtaining external finance in Figure 1. At this point, the analysis could be differentiated further with the introduction of credit markets as a component of external finance through debt instruments. It is through this component that the impact of endogenous money is expressed and provides a counterforce to liquidity preference in

18 circumstances in which the latter is not very strong and uncertainty is not great. The interest rate on credit instruments can be expressed through a mark up on the rate of corporate bonds. For the purpose of simplicity, the impact of credit markets will not be discussed further in this article as it constitutes a different subject that needs to be investigated further. There is a final variation that requires consideration and this is the time of the purchase of equity, in which certain categories of financial investors (such as venture capitalists) have an additional incentive to have the price of equity revised downwards to reflect the possibility of the failure of the investment project. In this case, they seek security by seeking a near majority part of equity through a low purchase equity price so that in case of failure they would be able to sell the investment project. Thus, although real capital assets do not have a secondary market whole investment projects (with their real capital assets) have a value in a secondary market and are influenced by liquidity preference considerations at the time of equity sharing. Thus, Rockfeller s anxiety to obtain enough capital to do his entrepreneurial business is associated with liquidity preference considerations on whole investment projects of financial investors to equity and debt instruments. This constitutes a particular extension of the Keynes Kahn approach, since it does not refer to separate real capital assets but to investment projects that include many real capital assets Conclusion The focal issue in this paper was the analysis of the relevance of the portfolio effect caused by liquidity preference in a multi asset model for the real economy relatively to various suggested theories of monetary production economy. The analysis showed that there is a theoretical lacuna, with respect to the potential impact of the portfolio effect. For Davidson, an important consideration is the importance of the interest rate in the discounting process

19 of the prospective yields and in the determination of the demand prices while the relation of financial asset prices (and equity) and real investment is undermined. For Tobin the Keynesian interest rate is completely overlooked in favour of an asset substitution effect caused by the relation of equities to real investment in capital goods. For Minsky, the role of internal and external finance is crucial in determining investment but this is the result of credit risk rather than of the effect of asset prices. Furthermore, the analysis highlights that this theoretical lacuna can be overcome if the Keynes Kahn approach is developed further, especially in view of the contemporary growth of financial markets. A theoretical framework was presented, which while it incorporates valuable ideas such as the discounting process, the portfolio approach and the internal external finance dichotomy and the idea of cost of equity capital in a financial q framework, it shows evidently that the effect of variations in various asset prices and portfolio balances on the real economy is important and that among them both the long term interest rate and the cost of equity capital are determinants of the demand price of capital assets and investment. Further research is required however to weigh the exact impact of alternative monetary production linkages under assumptions that differentiate the conditions of economic activity. APPENDIX 1. Kahn s equations as depicted in Panico, (1988) and Koutsobinas (2002) can be extended to the determination of investment as follows: τ = i l + B B BB α B (1) B τ = i L l L + α L (2)

20 τ = r E l E + α E (3) I = I ( r K i L c E ) (4) where: I is the demand for investment projects; r E is the expected return from equity; rk is the expected return computed from discounted expected cash flows from investment projects; τj is the own rate of money interest of asset j. ij is the yield of an asset; lj is the ʺilliquidity discountʺ of an asset; aj is the rate of appreciation of an asset relative to money due to the state of confidence; σj is the marginal risk premium of asset j. Subscript, B, denotes bills; Subscript, L, denotes bonds; E denotes investment projects; Subscript, K, denotes investment projects in real capital assets. 2. The same result is obtained if we follow a balance sheet approach of the impact of internal and external finance on investment. I= IIN + IEX I= IIN + (IEX,D + IEX,E) I= I(rK) + I(iL) + I(cE) I= I(rK il ce)

21 3. The price on equity is given as follows by Palley (1999) PE = V E (t) e d(t)t dt /E Where V E (t) is the expected level of discounted cash flows, that is profits at time t conditional on information available at time t=0 and d(t) is the discount rate used by share holders, The cost of equity capital is therefore given by ce = V E /PE E For simplicity and notational compatibility reasons, it is assumed that the relation of expected discounted profits on real capital assets and the expected level of discounted profits is rk = V E (t) e d(t)t dt Thus, the cost of equity capital is given by ce = rk /PE E The net return to external finance on capital goods for entrepreneurs is therefore f= r K i L c E which is consistent with the elaboration of investment here. 4. From the cost of equity capital equation, if finance is partitioned in two parts, that is, internal finance, EN and external finance, Ex then the level of external finance is Ex = (VE/PE,t ce) EN Thus, given the level of internal finance, the expected profitability and the cost of equity capital that entrepreneurs are willing to undertake, a fall in the price of equities increases the level of external finance for investment projects.

22 Thus, if the cost of equity is influenced by the level of dividends, D and the exogenous growth of dividends, then the influence of external finance is given as follows: ce=( D/ PE) + gd ce= (1+Ex/E) (D/ PE) + gd 5. The role of external finance can be introduced as a parameter, il + ce = m rk Then, I= I[(1 f) rk)] Where rk is the expected return on investment discounted appropriately by the one year interest rate for the number of years for which cash flows from the use of real capital assets. 6. If safety margins are introduced, investment financed by external finance is influenced by them. Margins of safety can still be treated as a mark up to explicit or implicit rates as follows I= I(rK) + I(m(iL, F)) + I(m(rR, F )) Where F is the organizational dispositions of financial intermediaries, influenced by experience and m are the mark up margins of safety on explicit and implicit rates such as the long term interest rate and the cost of equitycapital respectively. 7. In the case in which security is sought by financiers in the case in which the investment project on real capital assets is doomed to fail, then at the time of the purchase of equity, the price of equity is revised downwards to reflect implicitly the following equation

23 re le=rk lk Thus, a high liquidity discount on the investment project of real capital assets as a whole will lower the required return on equity and therefore will revise downwards the price of equity PE since re, t =(PE,t PE,0)/ PE,0 REFERENCES Arestis.P., Dunn S. P. and M. Sawyer On the Coherence of Post Keynesian Economics: A Comment on Walters and Young, Scottish Journal of Political Economy, 1999, vol. 46, issue 3, pages Boulding, K. E. ʺA Liquidity Preference Theory of Market Prices,ʺ Economica, Vol. 11, no. 42, Brown, C., Toward a reconcilement of endogenous money and liquidity preference, Journal of Post Keynesian Economics / Winter , Vol. 26, No Chernow, Ron, 1998, Titan: The life of John D. Rockfeller, Sr., Random House, New York, NY. Dardi, M. Kahn s Theory of Liquidity Preference and Monetary Policy, in Cambridge Journal of Economics, Davidson, P. Money and the Real World. London: Macmillan, 1971; 2nd edn Davidson, P. Controversies in Post Keynesian Economics. Aldershot, U.K.: Elgar, 1991.

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27 Tobin, J. (1996) Interview with James Tobin The Region, Banking and Policy Issues Magazine. Minneapolis: Federal Reserve Bank of Minneapolis. December. Tobin J. (1997) A General Overview of the General Theory. In G.C. Harcourt and P.A. Riach (eds.), A Second Edition of The General Theory, Vol. 2. Wray, R. L. ʺAlternative Theories of the Rate of Interest,ʺ Cambridge Journal of Economics, 16, 69 89, The three measures of financing costs considered here (long-term interest rates, cost of equity, and the composite cost of financing measure) show the expected negative correlation with investment. Over the common sample of available data for the three cost measures, the cost of equity shows the strongest link with investment. This may reflect the fact that developments in share prices which underpin this variable are linked to corporate investment not only via the implied cost of share issuance but also because both variables are influenced by expectations of future economic activity.