Keynes’ General Theory provides an interesting metaphor for asset markets: they are like newspaper competitions where contestants have to pick up the six prettiest faces from a hundred photographs, and the prize would go to one whose choice is closest to the average preferences. Keynes did not explicitly formalise the metaphor but his observations about the bond market and the speculative demand for money are closely related to this vision of asset markets. Our paper develops a class of decision rules from the suggestions in the General Theory and Keynes' QJE(1937) paper, and introduces a concept of ‘equilibrium guess’ which was not explicit in the newspaper competition idea. Using them we model a bond market which shows that the ‘newspaper competition’ amounts to endogenous determination of asset quality, and is capable of producing familiar Keynesian features: (i) demand for money develops infinite elasticity as interest rate approaches a low critical value; (ii) a shock to expected interest rate when the current rate is small, can lead to mass flight into money; and (iii) the more unanimous the market opinion, the more unstable the market, and the more difficult it is for monetary policy to be effective.
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Paper provided by EconWPA in its series Macroeconomics with number
0501015.
Find related papers by JEL classification: B22 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Macroeconomics E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
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