A Perplexing Passage in Keynes II

David Glasner is perplexed by something Keynes wrote in The General Theory.  My main impression is that Keynes is quibbling with Fisher, because he was not pleased that Fisher thought of the Fisher effect before he did.  But Glasner is right that the two passages in The General Theory on the Fisher effect seem to contradict each other.  Briefly the issue is whether investment depends on the nominal interest rate or, as Fisher argued, on the real interest rate.  In chapter 17 Keynes agrees it depends on the real interest rate but insists on a mysterious distinction between existing and newly built capital.  The strange passage seems to argue that expected inflation must be zero or constant or maybe that the real interest rate must be zero or maybe that it is constant.  In short it is hard to understand.  The passage

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

I think I've got it ! I will comment before I think again and realise I am confused.  I think the whole passage says that expected inflation and changes in expected inflation do not create arbitrage opportunities.  It doesn't say that changes in expected inflation are impossible or that they don't have real effects.

First my confusion.  I had thought that "the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized," was presented as a proof that expected inflation is impossible in equilibrium.  This would obviously contradict the discussion in chapter 17.as you note.  But now I think it just means that neither expected inflation nor a change in expected inflation creates arbitrage opportunities.

Note the conclusion "the advantages of holding money and of holding goods are again equalized" is just saying "no arbitrage opportunity is created".  Here in chapter 11, Keynes doesn't explain how they are equalized.  In particular, he does not assert (as he seems to assert) that the real interest rate must be zero, nor that it must be constant.  Now one of his eccentricities was in denying that the distinction between fixed capital  and other goods was fundamental.  The existing goods might be say a factory and "holding goods" might mean buying the factory or a share of the factory or a share of the firm that owns the factory.

There is no discussion of the advantages of producing new "goods" including new factories, that is of NIPA fixed capital investment.  I think the passage amounts to the claim that inflation does not create an arbitrage opportunity to profit by borrowing nominal and buying stock or a commodity and storing it.  Again in chapter 17 Keynes stresses that the way that expected inflation affects NIPA fixed capital investment is by affecting the value of the newly built capital  and not by affecting the return on the purely financial strategy of buying already existing capital.  The two passages taken together hint at the Q theory of investment and, in modern terms Keynes is saying Q is equal to 1 plus marginal investment costs.  It varies, for example if the nominal interest rate is constant and expected inflation varies,  but r- Qdot/Q equals the marginal product of capital so there are no arbitrage opportunities.