Keynes: A Tract on Monetary Reform

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Although the Great Britain had elected to reinstate the pre-WWI Gold Standard, much has changed in the actual system that was in operation during the interwar years.

1. The internal price level is determined by the amount of credit created by the banks, which is in turn measured by the volume of the banks’ deposits. In practice, the banks keep a more or less fixed proportion of the aggregate deposits in hand and at the bank of England. Today, we refer to this proportion as the reserve ratio. By changing this proportion, the banks could adjust their total creation of credit. Therefore, the level of prices, and hence the level of exchanges, depends in the end on the policy of the Bank of England and of the Treasury.

2. Cash, a broad notion that encompasses bank or currency notes, is supplied ad libitum, or at the pleasure of the central bank in practice. In theory, however, there was a limit to the issue of currency notes, though this limit was never observed in practice. Therefore, the creation of credit dictated the creation of currency.

3. The Bank of England’s gold is immobilized, meaning it is neither sold nor bought.

4. The foreign exchanges are unregulated and fluctuating freely. In the long-run, they depended on the relative price levels at home and abroad. However, officially, the Bank of England still aspired to maintain fixed dollar exchange rate.

Because of the four features above, the interwar system looked much more like one that directed bank rate and credit policy by reference to internal price level rather than by reference to the amount of gold reserves in the bank (and hence of cash in circulation) or the dollar exchange rate.

What about this trade-off between the stability of sterling prices and the stability of the dollar exchange? Keynes recommends that the Bank of England adopt sterling price stability as their primary objective, and strive toward exchange stability as a secondary objective.

What are the necessary conditions of implementing this policy?

1. A criterion of price stability is needed. Keynes accepts Irving Fisher’s idea of an official price index of a standard composite commodity. The authorities were to adopt this as their standard of value.

2. A way to deal with the temporary fluctuation of the balance of payment. Keynes thinks the bank of England can do this by regulating the price of gold without pegging the sterling to the price of gold. "A willingness on the part of the Bank both to buy and to sell gold at rates fixed for the time being would keep the dollar-sterling exchange steady within corresponding limits" will help maintain a day-to-day stability of the sterling-dollar exchange.

3. Demonetization of gold. Given the disadvantages of the gold standard, regulation of note issue--by raising or lowering the bank rate--is better off to employ criteria other than the ratio of gold reserves to note issue.

In conclusion, Keynes argues that the objects of British government should be the stability of trade, price, and employment. The gold reserve should be demonetized. However, this does not mean that gold serves absolutely no purpose anymore. Rather, it is a store of value and a means of correcting the influence of a temporarily adverse balance of payment.[1]

See also

John Maynard Keynes


  1. Keynes, JM. A Tract on Monetary Reform. London: Macmillan, 1924. Preface; pp 141-154.