Economics
Liquidity Preference Theory
The Liquidity Preference Theory, proposed by John Maynard Keynes, suggests that individuals prefer to hold their wealth in liquid assets, such as cash or short-term securities, rather than in illiquid assets. This preference for liquidity is influenced by the desire to have funds readily available for unforeseen expenses or investment opportunities.
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eBook - PDFIndia's Economic Prospects - A Macroeconomic And Econometric Analysis
A Macroeconomic and Econometric Analysis
- Thampy Mammen(Author)
- 1999(Publication Date)
- World Scientific(Publisher)
In order to retain Wicksell's insight into the dynamic features of the loanable funds theory, we must know the factors that determine hoarding and dishoarding (AL). This is provided by the Liquidity Preference Theory of interest. 2.3. The Liquidity Preference Theory of Interest Keynes' revolution consists in rejecting the classical theory of interest, which postulates that saving and investment are brought into equilibrium by the variations in the rate of interest, and replacing it by the postulate that it is done by variations in income. Having done that, he has to provide his own theory of interest, the Liquidity Preference Theory (Keynes, 1935, Chapters 13, 15). The hallmark of his theory is the sharp distinction he makes between two types of decisions individuals have to make. First, each individual decides how much of his or her income to consume and how much of it 56 India's Economic Prospects to save. Next, the individual must decide on the form in which he will hold the command over future consumption which he has reserved, whether out of his current income or from previous savings, (ibid., p. 166) and particularly the amount to be held in the form of money. Thus, one decision relates to the form in which one's stock of wealth must be held at a given time, and the other relates to the rate at which one's stock of wealth must be augmented (i.e., the flow of saving and investment). He suggests the Liquidity Preference Theory of interest as an explanation of the mechanism that allocates savings between idle hoards and income-yielding assets. Keynes formulates this theory in terms of the transaction motive, pre-cautionary motive, and speculative motive for holding money. These to-gether form the individual's liquidity preference, which is a schedule of the amounts of his resources, valued in terms of money ... which he will wish to retain in the form of money in different sets of circumstances (ibid., p. 166).
- G. Tily(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
In that model, the interest rate is determined as the intersection of a downward-sloping demand for funds and an upward-sloping supply curve of funds. (Stiglitz, 1999, p. 60, my emphasis) His reference to Keynes's theory is oblique, not even mentioning liquidity preference and its foundation in uncertainty; far greater emphasis is accorded to loanable funds. Among contemporary mainstream economists, only Charles Goodhart has debated the issues in any detail. Overall, Goodhart 220 Theory (1989) seems to prefer the Kaldor/Kalecki variant where the long-term rate is influenced by expectations of the short-term rate. In addition, he preserves the Robertsonian position on the specific issue of LPT /LFT: Keynes exaggerated the importance of the 'liquidity preference' effect, relative to the longer-term 'loanable funds' theory of interest, in order to differentiate his approach from the Classical. This led to an invalid concentration upon a small set of financial interest rates as providing the sole means of short-term equilibration of the demand and supply of money and, similarly, the sole transmission channel for monetary policy. (Goodhart, 1989, pp. 214-15) Keynes was, however, so keen to make a break with the previous Classical analysis that he pushed his new Liquidity Preference Theory, and his accompanying analysis of the process by which the demand and supply of money could be equilibrated, further than was justifiable. (ibid., p. 224). Like Robertson, Goodhart goes on to reject Keynes's analysis for failing to treat aspects of active demand in a comprehensive manner. He misleads too. Keynes did not derive the theory of liquidity preference for the trivial reason of 'breaking with' or 'differentiating from' with the classical theory; he rejected the classical theory of interest as incorrect. The theory of liquidity preference was the central monetary component of his revised theory, a component with the most profound practical implications.
eBook - ePubMoney and Capital
A Critique of Monetary Thought, the Dollar and Post-Capitalism
- Laurent Baronian(Author)
- 2022(Publication Date)
- Routledge(Publisher)
Chick, 1983 : 235). But this does not result in the same money as that given to enterprises. All the controversy about the liquidity preference and the role of banks in financial intermediation stems from the fact that it is not the same money that is lent to enterprises and through which the banking system acts on the liquidity preference – that is, the preference between credit money and asset money, between the issue of means of circulation or payment and the issue of liquid assets.For Keynes, after consumption, income holders no longer have any purchasing power that can be lent but they do have the power to determine the value of investment, given the money creation policy followed by the banks; this is the Liquidity Preference Theory. The money Keynes theorises is not circulating money but held money.(de Boyer, 1982 : 64)But the nature of the money held changes through the very function it performs. Thus in the Liquidity Preference Theory, the interest rate no longer represents the price of money considered as a flow of savings, but rather as a stock of wealth, as a stock of liquid assets existing alongside less liquid assets:Liquidity preference is the decision about the degree of liquidity at which savings should be held. Furthermore, it is a decision concerning the stock of savings – wealth – at any point in time rather than any new flow of savings alone. The rate of interest is hence not determined by the supply of and demand for of saving (flows), but by the supply of and demand for assets into which holdings of of wealth can be placed (stocks).
eBook - ePub- Fernando J. Cardim de Carvalho(Author)
- 2015(Publication Date)
- Taylor & Francis(Publisher)
In a sense, for an asset to be liquid simply means to remain in a permanent state of excess demand. Money, to be as liquid as it has to be in entrepreneurial economies, has to be rare, otherwise individuals can be saturated of money as it happens with any other class of assets or goods. The implications of such an assumption for the operation of the monetary system, and to monetary policy in particular, are explored in Chapter 4 of this book. In sum, liquidity preference, the theory according to which asset prices are determined by expectations of money yields and by their liquidity premia, is a theory of capital accumulation rather than merely a theory of money demand, or an unnecessarily original way of presenting the old QTM, as some critics frequently argue. In the approach followed in this book, it is in fact the core of the Keynesian reconstruction of economic theory initiated with the publication of the GT and other of Keynes’s works, and continued by many others, particularly, but certainly not exclusively, Post Keynesians. 15 The possibilities opened by the concept of liquidity preference presented by Keynes are multifold. The first generation of Keynesian economists, including his younger contemporaries like Richard Kahn and Joan Robinson, explored or developed many of the central arguments mentioned here. Authors such as Paul Davidson explored the foundations of the concept of liquidity (including, with emphasis, the creation of a system of forward money contracts) and the properties of money necessary to preserve its liquid nature. Hyman Minsky extended Keynes’s analysis of asset choice and pricing to full balance sheet choices, introducing the notion that perhaps even more important than discussing the liquidity of specific classes of assets may be the examination of the liquidity of balance sheets as a whole
eBook - ePubKeynes on Monetary Policy, Finance and Uncertainty
Liquidity Preference Theory and the Global Financial Crisis
- Jorg Bibow(Author)
- 2013(Publication Date)
- Routledge(Publisher)
4 On Keynesian theories of liquidity preference1It might be more accurate, perhaps, to say that the rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal. In particular, when M1 is increasing faster than M, the rate of interest will rise, and vice versa.(Keynes 1936a, JMK 7:203–4)24.1 Introduction
This chapter sets out to offer a macroeconomic perspective on the interaction between the financial system and the level of economic activity, focusing on the relationship between liquidity preference, investment and the role of confidence.We shall proceed as follows. Section 4.2 discusses the role of uncertainty and interest rate determination in relation to the “liquidity preference schedule.” The analysis of interest rate determination is then extended in Section 4.3 in terms of Keynes’ “own-rates analysis,” which provides a general equilibrium framework to study the interaction between interest rates and the level of economic activity. In Section 4.4 we apply this framework to analyze a “crisis in confidence” and illustrate that the likely impact of uncertainty on the level of economic activity works through two channels. Two key points emerge here. The first, on a theoretical level, is the importance of distinguishing clearly between portfolio decisions on the one hand and production and spending decisions on the other. The second, on a practical level, is that in modern monetary production economies the financial system represents an important factor in determining the level of economic activity. Sections 4.5 and 4.6 critically assess two prominent Keynesian theories of liquidity preference, those of Tobin (1958) and Hicks (1974), in the light of this framework. While I shall argue that both of these theories need to be qualified in important ways, there nevertheless appears to be scope for an interesting “synthesis.” The distinction between risk and uncertainty looms large throughout the analysis, which is concluded in Section 4.7
eBook - ePub- Friedrich A. Lutz, Friedrich Lutz(Authors)
- 2017(Publication Date)
- Routledge(Publisher)
In a dynamic analysis, if we drop this assumption, the choice between Liquidity Preference Theory – equation (1) – and loanable funds theory – equation (2) – will undoubtedly have to be decided in favour of the theory of loanable funds. In order to show the reasons for deciding in this way, let us begin with the case of an excess supply of money. We shall initially assume that the counterpart to this excess supply consists exclusively in an excess demand for commodities. According to the Liquidity Preference Theory (equation (1)) this would lead to a fall in the interest rate, even though by assumption no excess demand had arisen in the market for securities – i.e., in equation (4) still stood equal to zero. The interest rate would thus fall even though supply and demand in the market for securities were in equilibrium. 22 The Liquidity Preference Theory would yield an even more absurd result if we were to assume that the excess supply of money was accompanied by an excess supply of securities because people intended to finance their increased purchases of goods not only by reducing their cash balances but also by selling securities. In this case the Liquidity Preference Theory as expressed in equation (1) would still yield a fall in the interest rate, even though the sale of securities should bring about a rise of that rate. The theory of loanable funds, by contrast, yields reasonable results. If the effects of an excess supply of money are evident exclusively in an excess demand for goods (no changes occurring in the market for securities), the interest rate, according to this theory, will not fall. In equation (5), will be equal to zero
eBook - PDFFinance Constraints and the Theory of Money
Selected Papers
- S. C. Tsiang, Meir Kohn(Authors)
- 2014(Publication Date)
- Academic Press(Publisher)
310 Keynes , Robertso n and Friedman' s Monetar y Theorie s balances start out as demand for finance either for investment or for consumption expenditures, and end up as passive acceptance of cash toward the end of a cycle of money circulation to await reallocation at the beginning of a new cycle either as finance required for new expenditure plans again or as inactive hoards (asset balances). 15 In the analysis of interest determination, only the active demand for finance and the idle balances deliberately held should be set against the available supply of money, for only they are the objects of rational decisions of the agents concerned at the beginning of the period; i.e., the moment when decisions are supposed to be made. 16 Once the Liquidity Preference Theory is reformulated in the way we suggested (i.e., in terms of first differences), many of the most baffling remarks in Keynes' two notes on finance demand for liquidity 17 become quite understandable to us. For instance, in the 1937 note Keynes asserted that 'Finance' is a revolving fund. . . . As soon as it is used in the sense of being expended, the lack of liquidity is automatically made good and the readiness to become temporarily unliquid is available to be used over again. 18 A page later he continued: Consumption is just as effective in liquidating the short term finance as savings is. There is no difference between the two. In his 1938 reply to Robertson, he again wrote The finance or cash, which is tied up in the interval between planning and execution, is released in due course after it has been paid out in the shape of income, whether the recipients save it or spend it. There is, therefore, just as much reason for adding current consumption to the rate of increase of new bank-money in reckoning the flow of cash becoming available to provide new finance as there is for adding current savings.
eBook - ePubContributions to Economic Theory, Policy, Development and Finance
Essays in Honor of Jan A. Kregel
- D. Papadimitriou(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
The adjustment to equilibrium comes via an analysis of the movement of the a factor. Keynes thus provides a system in which the own rate of own return for every investment possibility, r, is adjusted by a, the discount or premium, and will be determined by the relative importance of q, c and l. (Kregel 2010, p. 251–52) Townshend called this a Liquidity Preference Theory of asset pricing, or of value. While we could in principle choose any asset as the standard of value, Keynes chooses money and its return (the marginal efficiency of money) as the ‘rooster’. This is because of money’s special properties that generally ensure that its own rate (the MEM) falls more slowly as its supply expands in comparison to all other commodities. ‘In other words, the present money-price of every commodity other than money tends to fall relatively to its expected future price. Hence... a point comes at which it is not profitable to produce any of the commodities, unless the cost of production at some future date is expected to rise above the present cost by an amount which will cover the cost of carrying a stock produced now to the date of the prospective higher price’ (Keynes 1964, p. 228). This gives Keynes his formal definition of a monetary economy – i.e., one in which expectations of the future determine present decisions, as one in which there is an asset whose rate of return declines more slowly than all others in the presence of an increase in demand (or, alternatively, the definition of a nonmonetary economy as one in which there is no asset whose liquidity premium is greater than its carrying costs). ‘In such an economy, there is no guarantee that all rates of return will come into equality at a level of investment that produces full employment. Conversely, where this conditions [sic] is not met, investment will continue until all resources have been employed – which might require an increase in the employment of labor to produce money’ (Kregel 2010, p
eBook - ePub- Ryuzo Kuroki(Author)
- 2012(Publication Date)
- Taylor & Francis(Publisher)
The General Theory. Keynes defines the liquidity premium as follows:The amount (measured in terms of itself) which they are willing to pay for the potential convenience or security given by this power of disposal (exclusive of yield or carrying cost attaching to the asset), we shall call its liquidity-premium l.(1936: 226)Namely, it is the marginal rate of substitution between consumption and real money balances. It is represented by vπ (m)/uπ (c) where u(c) and v(m) stand for utility of consumption and utility of money respectively and satisfyUsing the concept of the liquidity premium he defines a non-monetary economy:Consider, for example, an economy in which there is no asset for which the liquidity-premium is always in excess of the carrying-costs; which is the best definition I can give of a so-called ‘non-monetary’ economy.(Keynes, 1936: 239)Thus, a monetary economy is an economy in which there is an asset for which the liquidity premium is always strictly positive. A liquidity trap arises when the liquidity premium reaches the lower bound.He takes the liquidity trap as a factor that prevents investment from increasing. He writes:Our conclusion can be stated in the most general form (taking the propensity to consume as given) as follows. No further increase in the rate of investment is possible when the greatest amongst the own-rates of own-interest of all available assets is equal to the greatest amongst the marginal efficiencies of all assets, measured in terms of the asset whose own-rate of own-interest is greatest.In a position of full employment this condition is necessarily satisfied. But it may also be satisfied before full employment is reached, if there exists some asset, having zero (or relatively small) elasticities of production and substitution, whose rate of interest declines more closely, as output increases, than the marginal efficiencies of capital-assets measured in terms of it.
- Maria Cristina Marcuzzo, Ghislain Deleplace, Paolo Paesani, Maria Cristina Marcuzzo, Ghislain Deleplace, Paolo Paesani(Authors)
- 2020(Publication Date)
- Palgrave Macmillan(Publisher)
212), and to make it depend entirely on the speculative demand for money in relation to the supply of money to accommodate it. Indeed, in the logic of the GT, there is nothing natural about the interest rate: on the contrary, it is ‘highly conventional’ (Keynes [ 1936 ] 1973, p. 203). Significantly, Robertson does not reply on this point in his counternotes: it remains his blind spot, which causes him to miss the essence of the Liquidity Preference Theory as a full and consistent theory of the interest rate. In fact, Robertson concedes that it is theoretically possible that, under certain circumstances, liquidity preference can create a difficulty for monetary policy to reduce the interest rate with a view to boosting the economy. However, Robertson immediately advances several counterarguments to downplay the role of liquidity preference in preventing the interest rate from falling (to the level required to restore what he calls equilibrium), particularly in the long run. (1) Robertson’s first objection to the relevance of monetary policy ineffectiveness revolves around the speculative demand for money as a decisive component of the liquidity preference in the determination of the interest rate: ‘According to Mr. Keynes, the liquidity schedule proper is a phenomenon of “speculation,” turning on the expectation of reversals in the downward movement of interest rates. It is not evident that it is right to attach much importance to it in connection with the long period problem now under discussion’ (Robertson 1936, p
eBook - PDF- Robert E. Lucas Jr., Max Gillman, Robert E. Lucas, Jr., Robert E Lucas, Max Gillman(Authors)
- 2013(Publication Date)
- Harvard University Press(Publisher)
300 . 13 . Liquidity and Interest Rates 1. Introduction This paper analyzes a series of models in which money is required for asset transactions as well as for transactions on goods.* This modification to more familar cash-in-advance models of monetary economies is a step to-ward realism: According to the Federal Reserve Bulletin, about 11% of all demand deposits in the United States are held by financial businesses, and financial businesses hold about twice as many deposits per employee as do other businesses. One can imagine societies in which at least the most so-phisticated financial markets clear, Arrow-Debreu style, without the use of non-interest-bearing reserves, but this is not the way U.S. financial mar-kets operate today, nor do they show any trend toward operating in such a way. If cash is required for trading in securities, then the quantity of cash— of “liquidity”—available for this purpose at any time will in general influ-ence the prices of securities traded at that time. That is, the price of a secu-rity will in general depend not only on the properties of the income stream to which it is a claim—its “fundamentals”—but also on the liquidity in the market at the time is traded. In view of the mounting evidence that theories of asset pricing based solely on fundamentals cannot adequately account for observed movements in securities prices, there should be no Journal of Economic Theory 50, no. 2 (April 1990): 237–264. *Lars Peter Hansen, Robert Hodrick, Nancy Stokey, and Neil Wallace provided very helpful criticism. Chi-Wa Yuen carried out all the calculations. I am also grateful for the comments of seminar participants at U.C.L.A., Yale, the Money and Banking Workshop at Chicago, and the 1988 Summer Research Workshop at Northwestern, and for research sup-port provided by NSF Grant SES 8420420. 13 n Liquidity and Interest Rates 301 difficulty in motivating a theoretical study of a non-fundamental influ-ence on asset prices.
eBook - ePubThe Economics of John Maynard Keynes
The Theory of a Monetary Economy
- Dudley Dillard(Author)
- 2018(Publication Date)
- Papamoa Press(Publisher)
The increasing risk of loss at lower rates of interest will be reflected in the liquidity-preference schedule by a flattening out of the liquidity curve. This flattening of the curve indicates a growing elasticity of the liquidity-preference function:-Translated into monetary policy, this means a point will be reached below which it is extremely difficult to lower the interest rate any further. At about 2 per cent, Keynes suggests the liquidity curve may become horizontal, indicating perfect elasticity, and meaning that no further reduction in the rate can be attained merely by increasing the quantity of money. When this point is reached, the demand for money has become absolute in the sense that everyone prefers to hold money rather than long-term securities yielding a return of 2 per cent or less.When Keynes wrote the General Theory , he no longer believed in the adequacy of mere monetary policy, but nevertheless he thought the full possibilities of interest rate control had never been tested. Central bank purchases in the open market had been too limited in amount and confined mainly to short-term securities to the neglect of long-term securities bearing directly upon the much more important long-term rate of interest. The interest rate is a highly psychological or conventional phenomenon and investors who have become accustomed to high rates as “normal” will continue to harbor the hope of a return to “normalcy” unless and until bold monetary policy by the banking authorities breaks through conventional beliefs to convince the public that low long-term rates are both sound and certain to continue. Any monetary policy that appears experimental is self-defeating. The chief hope of lowering the long-term interest rate to a point consistent with full employment rests upon the ability of the monetary authority to convince the community that it should accept as a permanent fact lower rates of return on long-term debts. Such a policy should not be neglected just because it will ultimately reach a limit where it will no longer be effective because of the flattening out of the liquidity curve.Hoarding and liquidity preference
There is a relationship but not an identity between Keynes’ concept of liquidity preference for the speculative motive and the common-sense notion of hoarding. Unemployment and depression are sometimes attributed to “hoarding” although the exact meaning of this term is usually not clear. “Hoarding” in the sense of an actual increase in cash balances in the hands of the public is an incomplete and misleading notion. Since the total quantity of money cannot be altered by the public, but only by the banking system, the public can merely try to hold more money. It may increase its liquidity preference.
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