The Theory Of Liquidity Preference

In his classic book, The General Theory of Employment, Interest, and Money, John Maynard Keynes proposed the theory of liquidity preference to explain what factors determine the economy's interest rate. The theory is, in essence, just an application of supply and demand. According to Keynes, the interest rate adjusts to balance the supply and demand for money.

You may recall from Chapter 11 that economists distinguish between two interest rates: The nominal interest rate is the interest rate as usually reported, and the real interest rate is the interest rate corrected for the effects of inflation. Which interest rate are we now trying to explain? The answer is both. In the analysis that follows, we hold constant the expected rate of inflation. (This assumption is reasonable for studying the economy in the short run, as we are now doing). Thus, when the nominal interest rate rises or falls, the real interest rate that people expect to earn rises or falls as well. For the rest of this chapter, when we refer to changes in the interest rate, you should envision the real and nominal interest rates moving in the same direction.

Let's now develop the theory of liquidity preference by considering the supply and demand for money and how each depends on the interest rate.

Money Supply The first piece of the theory of liquidity preference is the supply of money. As we first discussed in Chapter 15, the money supply in the U.S. economy is controlled by the Federal Reserve. The Fed alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open-market operations. When the Fed buys government bonds, the dollars it pays for the bonds are typically deposited in banks, and these dollars are added to bank reserves. When the Fed sells government bonds, the dollars it receives for the bonds are withdrawn from the banking system, and bank reserves fall. These changes in bank reserves, in turn, lead to changes in banks' ability to make loans and create money. In addition to these open-market operations, the Fed can alter the money supply by changing reserve requirements (the amount of reserves banks must hold against deposits) or the discount rate (the interest rate at which banks can borrow reserves from the Fed).

Figure 20-1

Equilibrium in the Money Market. According to the theory of liquidity preference, the interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium level (such as at r-j), the quantity of money people want to hold (Md) is less than the quantity the Fed has created, and this surplus of money puts downward pressure on the interest rate. Conversely, if the interest rate is below the equilibrium level (such as at r2), the quantity of money people want to hold (Mf) is greater than the quantity the Fed has created, and this shortage of money puts upward pressure on the interest rate. Thus, the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people are content holding the quantity of money the Fed has created.

Interest Rate

Money supply

Equilibrium interest rate

Money supply

Interest Rate

Equilibrium interest rate

Theory Demand

Quantity fixed by the Fed

Quantity of Money

Quantity fixed by the Fed

Quantity of Money

These details of monetary control are important for the implementation of Fed policy, but they are not crucial in this chapter. Our goal here is to examine how changes in the money supply affect the aggregate demand for goods and services. For this purpose, we can ignore the details of how Fed policy is implemented and simply assume that the Fed controls the money supply directly. In other words, the quantity of money supplied in the economy is fixed at whatever level the Fed decides to set it.

Because the quantity of money supplied is fixed by Fed policy, it does not depend on other economic variables. In particular, it does not depend on the interest rate. Once the Fed has made its policy decision, the quantity of money supplied is the same, regardless of the prevailing interest rate. We represent a fixed money supply with a vertical supply curve, as in Figure 20-1.

M oney Demand The second piece of the theory of liquidity preference is the demand for money. As a starting point for understanding money demand, recall that any asset's liquidity refers to the ease with which that asset is converted into the economy's medium of exchange. Money is the economy's medium of exchange, so it is by definition the most liquid asset available. The liquidity of money explains the demand for it: People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.

Although many factors determine the quantity of money demanded, the one emphasized by the theory of liquidity preference is the interest rate. The reason is that the interest rate is the opportunity cost of holding money. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned. An increase in the interest rate raises the cost of holding money and, as a result, reduces the quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded. Thus, as shown in Figure 20-1, the money-demand curve slopes downward.

Equilibrium in the Money Market According to the theory of liquidity preference, the interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly balances the quantity of money supplied. If the interest rate is at any other level, people will try to adjust their portfolios of assets and, as a result, drive the interest rate toward the equilibrium.

For example, suppose that the interest rate is above the equilibrium level, such as r1 in Figure 20-1. In this case, the quantity of money that people want to hold, Md, is less than the quantity of money that the Fed has supplied. Those people who are holding the surplus of money will try to get rid of it by buying interest-bearing bonds or by depositing it in an interest-bearing bank account. Because bond issuers and banks prefer to pay lower interest rates, they respond to this surplus of money by lowering the interest rates they offer. As the interest rate falls, people become more willing to hold money until, at the equilibrium interest rate, people are happy to hold exactly the amount of money the Fed has supplied.

Conversely, at interest rates below the equilibrium level, such as r2 in Figure 20-1, the quantity of money that people want to hold, M2, is greater than the quantity of money that the Fed has supplied. As a result, people try to increase their holdings of money by reducing their holdings of bonds and other interest-bearing assets. As people cut back on their holdings of bonds, bond issuers find that they have to offer higher interest rates to attract buyers. Thus, the interest rate rises and approaches the equilibrium level.

0 0

Post a comment