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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11 Key excerpts on "Liquidity Preference Theory"
eBook - ePub- Fiona MacLachlan(Author)
- 2005(Publication Date)
- Routledge(Publisher)
Treatise , Keynes had analysed in detail the working of financial markets and was well acquainted with the fact that the bearish sentiment on the part of wealth-holders could determine the price of bonds. All he needed to do was to see that this analysis could serve not just as an explanation of the level of interest in the short-run, but that it might be the long-run explanation as well. It was only when he began to think about interest rate theory seriously that he realized the conventional explanations were flawed and that an alternative long-run theory was needed.Arriving at the central idea seemed to be quite effortless for Keynes. The real work began when he attempted to write down a theory that would persuade others. The first task was to communicate exactly what he meant by liquidity and liquidity preference.THE MEANING OF LIQUIDITY AND LIQUIDITY PREFERENCE IN KEYNES' THEORY
Understanding Keynes' Liquidity Preference Theory of interest is made difficult by the imprecise and often conflicting senses in which he uses the terms liquidity and liquidity preference. In the standard textbook presentations of his theory, liquidity is defined as a quantity of either real or nominal money balances and liquidity preference is then construed as the demand for those balances. Now, while the textbook interpretation can easily be found in Keynes' writings (1936:202; [1937] 1973, 14:223), it raises a number of questions. The first is why he framed the curious term ‘liquidity preference’ instead of more simply calling it the demand for money. The adoption of a different term suggests that he might have had something else in mind. The second question is why, if his theory was simply a supply and demand for money theory, he was so adamant (Keynes [1937] 1973, 14: 202) that it was distinct from and very much at odds with the loanable funds theories being propounded by other theorists at the time (Robertson 1936; Ohlin 1937a, b; Hawtrey 1937: a, b). Those theorists, and others since (Fellner and Somers 1941; Tsiang 1956), have contended that a supply and demand theory for money is equivalent to a supply and demand theory for loanable funds. Keynes' insistence that there was something irreconcilable about his theory and the loanable funds theories could be explained if it was true that by a Liquidity Preference Theory he meant something different from simply saying that the interest rate is determined by the demand for nominal, or real, money balances in relation to the supply.
eBook - ePubEncyclopedia of Political Economy
2-volume set
- Phillip O'Hara(Author)
- 1999(Publication Date)
- Routledge(Publisher)
Davidson (1968) and Chick (1973) maintained the significance of liquidity preference, emphasizing the interconnectedness of time, UNCERTAINTY and money. Recent developments in post-Keynesian monetary theory have reasserted this significance, incorporating a broad interpretation of the concept of liquidity preference as applying to a wide range of assets, and extending it to the banks themselves. Keynes himself had set a precedent for the latter development (see Dow 1996), in passages which anticipate the endogenous money approach in emphasizing the private sector in determining credit creation. But Keynes emphasized the power of the banks, while the modern endogenous money theorists have emphasized the passivity of the banks in the face of credit demand. By considering the liquidity preference of banks, the supply of credit itself is seen to be a function of liquidity preference; a fall in bank liquidity preference leads to a rise in bank assets and liabilities, as well as a changing composition of assets. By considering the liquidity preference of borrowers in their investment decisions, as well as the disposition of their assets, the demand for credit is also seen to be a function of liquidity preference. Thus, households and firms may increase their borrowing and asset purchases, as well as changing the composition of their assets, in response to a fall in liquidity preference. The concept of liquidity preference thus now applies to the size of portfolios as well as their disposition.A further recent, indeed ongoing, development in the liquidity preference concept stems from work on Keynes’s philosophy, with its implications for our understanding of his theory of uncertainty and expectations. This work puts new emphasis on the precautionary demand for money. The speculative demand for money is a demand which is formulated when financial investors behave as if they know the probability distributions of asset prices, that is, they act as if they are certain (within stochastic variation). This was what had made the speculative demand for money so easy to incorporate in the neoclassical synthesis. Since it was grafted onto a theoretical framework which assumed stability of economic functions, there was no cause for shifts in speculative demand, and the other motives referred to the (stable) income level.
eBook - ePub- Fernando J. Cardim de Carvalho(Author)
- 2015(Publication Date)
- Routledge(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 - 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).
- 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(Author)
- 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 - ePubContributions to Economic Theory, Policy, Development and Finance
Essays in Honor of Jan A. Kregel
- D. Papadimitriou, D. Papadimitriou, D. Papadimitriou(Authors)
- 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)
- Routledge(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 - ePubEmerging Economies and the Global Financial System
Post-Keynesian Analysis
- Bruno Bonizzi, Annina Kaltenbrunner, Raquel A. Ramos, Bruno Bonizzi, Annina Kaltenbrunner, Raquel A. Ramos(Authors)
- 2021(Publication Date)
- Routledge(Publisher)
1936 , p. 241). This shows that the liquidity premium covers much more than liquidity in the narrow sense. In our simple portfolio model, we assume two types of monetary wealth – liquidity or short-term monetary wealth and long-term financial wealth. Money is here understood as liquidity including demand deposits, short-term time deposits and other liquid assets. The definition of liquidity depends on the concrete situation of a financial system. However, it should be clear that the character of assets as liquid can quickly change. Short-term liquidity earns a liquidity premium and a short-term interest rate. The latter is completely determined by the central bank via its refinancing rate. Long-term financial wealth earns a long-term interest rate plus also a liquidity premium. For simplification we also assume that firms for investment purposes can only take long-term credits.The portfolio equilibrium for monetary wealth is thenor in gross returnsi l + l B = l M + i sEq. 11 + i l + l B = 1+ l M + i sEq. 2with i l as long-term interest rate, l B as marginal liquidity premium of long-term interest-bearing wealth, l M marginal liquidity premium of money, respectively short-term liquidity, and i s short-term interest rate determined by the central bank. We assume falling marginal liquidity premiums with increasing stocks of wealth held in an asset. For short-term liquidity the fall of the liquidity premium with increasing liquidity holding may be small. In an extreme case of a so-called liquidity trap, the marginal liquidity premium may not fall at all with an increasing stock of liquidity.The long-term interest rate increases when the central bank increases its refinancing rate, when the level of the marginal liquidity premium of short-term liquidity increases or the level of the marginal liquidity premium of long-term wealth decreases, for example because of the expectation of higher default rates.The portfolio model also allows us to explain functional distribution of income in the monetary Keynesian approach. According to Keynes (1936 , chapter 17) money earns a marginal liquidity premium which in an uncertain world does not go down to zero. Interest rates cannot fall, so Keynes, below the marginal liquidity premium. ‘If, however, the interest rate exceeds zero, a new element of cost is introduced which increases with the length of the process.’ This leads to a situation that ‘the prospective price has increased sufficiently to cover the increasing costs’ (Keynes 1936 , p. 216). In an economy of pure competition only the existence of a positive interest rate allows profits; otherwise, competition would bring prices down to levels without profit. Of course, this model can be made much more complicated with the central bank fixing a minimum interest rate or with a certain spread between the interest rate and the rate of return of productive capital. A second explanation of profit is the existence of monopolistic, oligopolistic or monopsonistic markets, but this goes beyond this analysis (Herr 2019
eBook - ePub- (Author)
- 2021(Publication Date)
- Wiley(Publisher)
liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term and that these premiums increase with maturity. Thus, given an expectation of unchanging short-term spot rates, Liquidity Preference Theory predicts an upward-sloping yield curve. The forward rate provides an estimate of the expected spot rate that is biased upward by the amount of the liquidity premium, which invalidates the unbiased expectations theory. The liquidity premium for each consecutive future period should be no smaller than that for the prior period.For example, the US Treasury offers bonds that mature in 30 years. Most investors, however, have shorter investment horizons than 30 years. For investors to hold these bonds, they would demand a higher return for taking the risk that the yield curve changes and that they must sell the bond prior to maturity at an uncertain price. That incrementally higher return is the liquidity premium. Note that this premium is not to be confused with a yield premium for the lack of liquidity that thinly traded bonds may bear. Rather, it is a premium applying to all long-term bonds, including those with deep markets.Liquidity Preference Theory fails to offer a complete explanation of the term structure. Rather, it simply argues for the existence of liquidity premiums. For example, a downward-sloping yield curve could still be consistent with the existence of liquidity premiums if one of the factors underlying the shape of the curve is an expectation of deflation (i.e., a negative rate of inflation resulting from monetary or fiscal policy actions). Expectations of sharply declining spot rates may also result in a downward-sloping yield curve if the expected decline in interest rates is severe enough to offset the effect of the liquidity premiums.
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