NOTE on Mr. Harrod's Dynamic Theory, pp. 14-33, Economic Journal, March 1939.

The warranted rate of growth of output or income is the rate determined by the equilibrium between the quantity of Capital per unit increment of output and the propensity to save. Its fundamental equation is

Two reasons are given on p. 22 of the Journal why the actual rate of growth diverges from the warranted rate so defined:--

1. a change in the Capital Co-efficient, C;

2. a change in the propensity to save, s.

Should not a third, and more important cause of divergence have been included, namely--

3. the operation of liquidity preference?

If l is the fraction of the increment of income kept in liquid form, the actual rate of growth of output is

where l may be either positive or negative.

The warranted rate, is a legacy from the previous period. A de-stabilising force, measured by , operates to change the warranted rate by means of the disturbance to prices caused by the inequality,

G > <

The price disturbance introduces a new momentary equilibrium,

to be destroyed in its turn by the operation of the new in distorting the value of the new G w through further price disturbance.

The equation

is important because it introduces and measures the de-stabilising effect which money exercises on industrial progress, and which is stressed in Chapter 1 (iv) of Mr. Harrod's Trade Cycle. This de-stabilising effect of money is not introduced by either of the two causes of disturbance specified on p. 22 of the Economic Journal. The change in the Capital Co-efficient, C, or in the propensity to save, s, is not caused by monetary factors. The Dynamic Theory, as described, does not appear to introduce the de-stabilising effect of money.

This de-stabilising force can be identified as being either--

1. the disturbing operation of liquidity preference on the purchasing power of money;


2. the operation of Money as a Distorter and De-stabiliser of the Value of output, rather than as a Measure of Value.

Liquidity Preference has a wide range of volume. It depends not only on changes in the volume and rate of increase of output and savings, but also on the changing phases of the Trade Cycle, the degree of Public Confidence, the Balance of Trade and the state of Internal Tension. It is not only a distorting and a de-stabilising factor; the distortion and de-stabilisation it causes vary greatly in direction and intensity from time to time.

Liquidity Preference exerts a downward pull measured by (or an upward pull if l is negative) on the value of G w , thereby causing the actual rate of increase of output or income to diverge from the warranted rate. If positive, it reduces the volume of monetary savings available to absorb the increased output. If negative, it supplements the volume of monetary savings by the amount of de-hoarding. By dislocating the Savings-Investment equilibrium in this manner, it produces price fluctuations, it destroys the stability of the purchasing power of money, and prevents Money from operating as a stable Measure of Value.

The Saving-Investment equilibrium is unstable because it is a mechanical equilibrium, liable to continuous disturbance by the divergent qualities and utilities of the two factors, money and commodities, on the two sides of the equation respectively. These divergences are:--

1. Money possesses in a very high degree the quality of liquidity, possessed by Commodities in a very low degree;

2. Commodities possess in a high degree the utilities of the satisfaction of consumption and the earning power of capital, possessed by Money in a very limited degree, if retained in its liquid form.

The varying psychological preference for liquidity and for commodities operate to disrupt the Saving-Investment equilibrium. This equilibrium is expressed in Money-Commodity terms, and, as these terms are continuously changing in psychological value, the equilibrium is unstable.

The paradox of rising prices in a period of increasing activity, and falling prices in a period of falling activity, stressed in Chapter 1 (iv) of Mr. Harrod's Trade Cycle, is simply and directly explained by the operation of liquidity preference. It reduces the operative monetary side of the Saving-Investment equilibrium, relative to the commodity side, in periods of depression, and thereby causes lower prices. Being negative in periods of activity, it increases the operative monetary side of the equation, relative to the commodity side, and so causes higher prices.

The Parliamentary Monetary Committee is interested primarily in determining the causes of the de-stabilising operation of money, and in persuading the monetary authorities to counteract this operation. Its most obvious policy seems to be to aim at counteracting directly the de-stabilising transformation of the warranted equation of output and income--

into the actual equation of output and income--

This can be done by the creation of money (notes and current deposits) in such a volume as to balance and counteract the operation of l, and so restore the warranted equilibrium--

without any price disturbance.

The test whether this objective is actually being attained, is the stability of purchasing power. The test can be applied particularly in the two forms:--

1. the world wholesale price level of primary commodities;

2. the national Cost of Living Index.

In other words, the objective of the Parliamentary Monetary Committee should be to persuade the Monetary Authorities to provide the exact amount of money needed to satisfy liquidity preference without interference with the warranted rate of progress, and so counter the disturbing and de-stabilising effect of Money, by making it a true Measure of Value.

Granted, this is not the whole problem. Nor can it be made completely effective. It keeps the actual rate of increase of output and income as close as possible (how close can be determined by experience) to the warranted rate. But it does not necessarily keep the warranted rate close to the natural rate. Monetary policy needs to be supplemented by a Public Works policy and an Investment policy to keep the proper warranted rate in close touch with the natural rate. But should this take precedence in the activities of the Parliamentary Monetary Committee? Should the Committee not concern itself primarily with the monetary problem of correcting as far as possible the de-stabilising operation of Money?

This note is made in the spirit of enquiry not of criticism.

C Morgan Webb

  1. 1. Harrod seems to have read this letter only late in July (letter to his wife, 23 July 1939, in HPBL Add. 72777/252).

    2. Harrod, "Essay in Dynamic Theory" ( 1939:7 ).

    3. Charles Morgan Webb was the chairman of the Advisory Committee of the Parliamentary Monetary Committee. On Harrod's collaboration with this Committee see note 1 to essay 20 .

    4. Harrod, The Trade Cycle ( 1936:8 ).

    1. a. ALS, two pages on one leaf, in HP IV-1213. The annexe TNS, dated, six pages on six leaves, with autograph corrections, is in HP IV-1214.

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