learning objective
- What is the liquidity preference theory, and how has it been
improved?
The rest of this book is about monetary theory, a
daunting-sounding term. It’s not the easiest aspect of money and
banking, but it isn’t terribly taxing either so there is no need to
freak out. We’re going to take it nice and slow. And here’s a
big hint: you already know most of the outcomes because we’ve
discussed them already in more intuitive terms. In the chapters
that follow, we’re simply going to provide you with more formal
ways of thinking about how the money supply determines output (Y*)
and the price level (P*).
Intuitively, people want to hold a certain amount of cash
because it is by definition the most liquid asset in the economy.
It can be exchanged for goods at no cost other than the opportunity
cost of holding a less liquid income–generating asset instead. When
interest rates are low (high), so is the opportunity cost, so
people hold more (less) cash. Similarly, when inflation is low
(high), people are more (less) likely to hold assets, like cash,
that lose purchasing power. Think about it: would you be more
likely to keep $100 in your pocket if you believed that prices were
constant and your bank pays you .00005% interest, or if you thought
that the prices of the things you buy (like gasoline and food) were
going up soon and your bank pays depositors 20% interest? (I would
hope the former. If the latter, I have some derivative bridge
securities to sell you.)
We’ll start our theorizing with the demand for money,
specifically the simple quantity theory of money, then discuss John
Maynard Keynes’s improvement on it, called the liquidity preference
theory, and end with Milton Friedman’s improvement on Keynes’
theory, the modern quantity theory of money.
John Maynard Keynes
(to distinguish him from his father, economist John Neville Keynes)
developed the liquidity preference theory in response to the
pre-Friedman quantity theory of money, which was simply an
assumption-laden identity called the equation of exchange:
M V = P Y
where
M = money supply
V = velocity
P = price level
Y = output
Nobody doubted the equation itself, which, as an identity (like
x = x), is undeniable. But many doubted the way that classical
quantity theorists used the equation of exchange as the causal
statement: increases in the money supply lead to proportional
increases in the price level, although in the long term it was
highly predictive. The classical quantity theory also suffered by
assuming that money velocity, the number of times per year a unit
of currency was spent, was constant. Although a good first
approximation of reality, the classical quantity theory, which
critics derided as the “naïve quantity theory of money,” was hardly
the entire story. In particular, it could not explain why velocity
was pro-cyclical, i.e., why it increased during business expansions
and decreased during recessions.
To find a better
theory, Keynes took a different point of departure, asking in
effect, “Why do economic agents hold money?” He came up with three
reasons:
- Transactions: Economic agents need money to make payments. As
their incomes rise, so, too, do the number and value of those
payments, so this part of money demand is proportional to
income.
- Precautions: S—t happens was a catch phrase of the
1980s, recalled perhaps most famously in the hit movie Forrest
Gump. Way back in the 1930s, Keynes already knew that bad
stuff happens—and that one defense against it was to keep some
spare cash lying around as a precaution. It, too, is
directly proportional to income, Keynes believed.
- Speculations: People will hold more bonds than money when
interest rates are high for two reasons. The opportunity cost of
holding money (which Keynes assumed has zero return) is higher, and
the expectation is that interest rates will fall, raising the price
of bonds. When interest rates are low, the opportunity cost of
holding money is low, and the expectation is that rates will rise,
decreasing the price of bonds. So people hold larger money balances
when rates are low. Overall, then, money demand and interest
rates are inversely related.
More formally,
Keynes’s ideas can be stated as
M d / P = f ( i <−> , Y <+> )
where
Md/P = demand for real money
balances
f means “function of” (this
simplifies the mathematics)
i = interest rate
Y = output (income)
<+> = increases in
<−> = decreases in
An increase in interest rates induces people to decrease real
money balances for a given income level, implying that velocity
must be higher. So Keynes’s view was superior to the classical
quantity theory of money because he showed that velocity is not
constant but rather is positively related to interest rates,
thereby explaining its pro-cyclical nature. (Interest rates
rise during expansions and fall during recessions.) Keynes’s
theory was also fruitful because it induced other scholars to
elaborate on it further.
In the early 1950s, for example, a young Will Baumolpages.stern.nyu.edu/~wbaumol
and James
Tobinnobelprize.org/nobel_prizes/economics/laureates/1981/tobin-autobio.html
independently showed that money balances, held for transaction
purposes (not just speculative ones), were sensitive to
interest rates, even if the return on money was zero. That
is because people can hold bonds or other interest-bearing
securities until they need to make a payment. When interest rates
are high, people will hold as little money for transaction purposes
as possible because it will be worth the time and trouble of
investing in bonds and then liquidating them when needed. When
rates are low, by contrast, people will hold more money for
transaction purposes because it isn’t worth the hassle and
brokerage fees to play with bonds very often. So transaction
demand for money is negatively related to interest rates. A
similar trade-off applies also to precautionary balances. The lure
of high interest rates offsets the fear of bad events occurring.
When rates are low, better to play it safe and hold more dough.
So the precautionary demand for money is also negatively
related to interest rates. And both transaction and
precautionary demand are closely linked to technology: the faster,
cheaper, and more easily bonds and money can be exchanged for each
other, the more money-like bonds will be and the lower the demand
for cash instruments will be, ceteris paribus.
key takeaways
- Before Friedman, the quantity theory of money was a much
simpler affair based on the so-called equation of exchange—money
times velocity equals the price level times output (MV = PY)—plus
the assumptions that changes in the money supply cause changes in
output and prices and that velocity changes so slowly it can be
safely treated as a constant. Note that the interest rate is not
considered at all in this so-called naïve version.
- Keynes and his followers knew that interest rates were
important to money demand and that velocity wasn’t a constant, so
they created a theory whereby economic actors demand money to
engage in transactions (buy and sell goods), as a precaution
against unexpected negative shocks, and as a speculation.
- Due to the first two motivations, real money balances increase
directly with output.
- Due to the speculative motive, real money balances and interest
rates are inversely related. When interest rates are high, so is
the opportunity cost of holding money.
- Throw in the expectation that rates will likely fall, causing
bond prices to rise, and people are induced to hold less money and
more bonds.
- When interest rates are low, by contrast, people expect them to
rise, which will hurt bond prices. Moreover, the opportunity cost
of holding money to make transactions or as a precaution against
shocks is low when interest rates are low, so people will hold more
money and fewer bonds when interest rates are low.