202 THE GENERAL THEORY OF EMPLOYMENT BK. IV

any given state of expectation, a fall in r will be asso-ciated with an increase in M2 . In the first place, ifthe general view as to what is a safe level of r is un-changed, every fall in r reduces the market rate rela-tively to the “safe” rate and therefore increases therisk of illiquidity; and, in the second place, every fallin r reduces the current earnings from illiquidity, whichare available as a sort of insurance premium to offsetthe risk of loss on capital account, by an amount equalto the difference between the squares of the old rate ofinterest and the new. For example, if the rate ofinterest on a long-term debt is 4 per cent., it is prefer-able to sacrifice liquidity unless on a balance of proba-bilities it is feared that the long-term rate of interestmay rise faster than by 4 per cent, of itself per annum,i.e. by an amount greater than 0.​16 per cent, per annum.If, however, the rate of interest is already as low as2 per cent., the running yield will only offset a rise init of as little as 0.04 per cent, per annum. This, indeed,is perhaps the chief obstacle to a fall in the rate ofinterest to a very low level. Unless reasons are be-lieved to exist why future experience will be verydifferent from past experience, a long-term rate ofinterest of (say) 2 per cent, leaves more to fear than tohope, and offers, at the same time, a running yieldwhich is only sufficient to offset a very small measureof fear.

It is evident, then, that the rate of interest is ahighly psychological phenomenon. We shall find,indeed, in Book V. that it cannot be in equilibrium at alevel below the rate which corresponds to full employ-ment; because at such a level a state of true inflation willbe produced, with the result that Mi will absorb ever-increasing quantities of cash. But at a level above therate which corresponds to full employment, the long-term market-rate of interest will depend, not only on thecurrent policy of the monetary authority, but also onmarket expectations concerning its future policy. The