KEYNESIAN LIQUIDITY PREFERENCE

In macroeconomic theory liquidity preference refers to the inclination of investors for holding

liquid assets (cash) rather than securities or long-term interest-bearing investments. The concept

was first developed by John Maynard Keynes to explain determination of the interest rate by the

supply and demand for money.

According to Keynes, people demand liquidity or prefer liquidity because they have three

different motives for holding cash rather than bonds and other assets. These motives are,

Transaction Motive, Precautionary Motive and Speculative Motive

a) Transaction Motive

Day-to-day transactions are done by individuals as well as firms. An individual person has to buy

things during a day. For this purpose people want to keep some cash money with them. This type

of demand for liquidity is for carrying day to day transactions is called demand for liquidity for

transaction motive. So we can say that money needed by consumers, businessmen and others in

order to complete economic transactions is known as the demand for money for transactions

motive. The demand for money for this purpose is completely interest inelastic however it

depends upon the following:

If size of the income is high more will be the transactions and vice versa. If a person gets his pay

daily he will demand less cash money. On the other hand if time gap is more a person will

demand more money to carry on his daily transactions. If a person spends a lot of money, he will

do more transactions. Naturally he will demand more money and he will demand less money if

he has a habit of spending less.

b) Precautionary Motive

Every man wants to save something or wants to keep some liquid money with him to meet some

unforeseen emergencies, contingencies and accidents. Similarly business firms also want to keep

some cash money with them to safeguard their future. This type of demand for liquidity is called

demand for precautionary motive. The demand for money for precautionary motive is also

completely interest inelastic but it depends upon the following factors:

If the size of the income of a person or a firm is large, he will demand more money for

safeguarding his future. Some persons are optimistic while others are pessimistic .The former

think always about the bright side of future. So they anticipates less, if any risk and danger in the

future. Naturally such persons will demand less money for precautionary motive. On the

contrary, pessimistic people or firms foresee many dangers, calamities and emergencies in the

future. In order to meet these, they want to have more cash with them. A farsighted person can

see better about the future. He will make a proper guess of the future. Thus if he expects more

emergencies, he will keep more money with him in cash and if he does not expect more

emergencies she will keep less money with him in cash.

c) Speculative Motive

People want to keep cash with them to take advantage of the changes in the prices of bonds and

securities. In advanced countries, people like to hold cash for the purchase of bonds and

securities when they think it is profitable. If the prices of the bonds and securities are expected to

rise speculators will like to purchase them. In this situation they will not like to keep cash with

them. On the other hand if prices of the bonds and securities are expected to fall people will like

to keep cash with them. They will buy the bonds and securities with the cash only when their

prices would fall. So liquidity preference will be more at lower interest rates

Putting the Three Motives Together

Combining the three motives for holding money balances into a demand for real money balances

led to what Keynes called the liquidity preference function,

M d

P=L(i ,Y ) …………….……………………………………………………………….. (1)

Equation 1 says that the demand for real money balances is negatively related to the nominal

interest rate and is positively related to real income.

An important implication of Keynesian theories of money demand is that velocity is not a

constant and will fluctuate with changes in interest rates. We solve for velocity as follows:

V = PYM =

YL(i , Y ) …………..……………………………………………………………….. (2)

It is known that the demand for money is negatively related to interest rates; when i goes up,

L(i,Y) declines, and therefore velocity rises. Because interest rates have substantial fluctuations,

Keynesian theories of the demand for money indicate that velocity has substantial fluctuations as

well. Thus Keynesian theories cast doubt on the classical quantity theory view that nominal

income is determined primarily by movements in the quantity of money.

Determination of the Interest Rate

The interaction of demand and supply of money determines the interest rate.

Rate MS

of

Interest

i

LP Source (Mishkin, 2012)

In the above diagram LP is the demand for money and the Ms is the supply of money. This gives

an equilibrium rate of interest i. At any rate of interest above i, the supply of money exceeds

demand and this will pull down the rate of interest, while at any rate of interest below i the

demand for money exceed supply and this will bid up the rate of interest. Once the rate of

interest is established at i, it will remain at this level until there is a change in the demand for

money and or the supply of money. This implies that the authorities have two choices:

Qm

They can fix the supply of money and allow interest rates to be determined by the demand for

money; or they can fix the rate of interest and adjust the supply of money to whatever level is

appropriate so as to maintain the rate of interest.

DEMAND FOR MONEY

John Maynard Keynes developed a theory of money demand that he described as liquidity

preference theory. Liquidity preference theory, examines the demand for money in terms of the

real goods and services it can buy. In his liquidity preference theory, Keynes presented three

motives behind the demand for money: the transactions motive, the precautionary motive, and

the speculative motive.

Transaction Motive; In the quantity theory approach, individuals are assumed to hold money

because it is a medium of exchange that can be used to carry out everyday transactions. Keynes

initially accepted the quantity theory view that the transactions component is proportional to

income. Precautionary Motive; Keynes also recognized that people hold money as a cushion

against unexpected needs. Suppose that a person has been thinking about buying a new car and

now sees that it is on sale at 25% off. If the person is holding money as a precaution for just such

an occurrence, she can immediately buy it. Keynes argued that the precautionary money balances

people want to hold would also be proportional to income. Speculative Motive; Keynes also

believed people choose to hold money as a store of wealth, which he called the speculative

motive. Because the definition of money in Keynes’s analysis includes currency (which earns no

interest) and checking account deposits (which typically earn little interest), he assumed that

money earns no interest and hence its opportunity cost relative to holding other assets, such as

bonds, is the nominal interest rate on bonds, i. As the interest rate i rises, the opportunity cost of

money rises (it is more costly to hold money relative to bonds) and the quantity of money

demanded falls.

HOW DEMAND FOR MONEY IS DIFFERENTIATED FROM THE DEMAND OF

OTHER COMMODITIES

The demand for money is a derived demand; the aims of those demanding money differ from the

aims of those demanding vendible commodities. Commodities, they say, are demanded

ultimately for consumption, while money is demanded in order to be given away in further acts

of exchange.

The use which people make of money consists eventually in its being given away. But first of all

they are eager to accumulate a certain amount of it in order to be ready for the moment in which

a purchase may be accomplished.

THE QUANTITY THEORY OF MONEY

The theory developed by the classical economists over hundreds of years ago, relates to the

amount of money in the economy to the nominal income. American economist Irving Fisher

gave the clearest exposition of this theory in his influential book, The Purchasing Power of

Money, published in 1911. Fisher examined the link between:

i) The total quantity of money M (the money supply)

ii) P x Y, the total amount of spending on final goods and services produced in the

economy, where P is the price level and Y is the aggregate output (income).

Velocity of Money and the Equation of Exchange

The link between money and output is called the velocity of money, it refers to the average

number of times per year (not necessarily) that a shilling is spent, or turns over, in buying goods

and services produced in the economy. We calculate velocity V by dividing total spending

(P x Y) by the quantity of money M:

V =P x YM …………….……………………………………………………………….. (1)

On the other hand the equation of exchange is written as follows:

MV=PY

The equation of exchange is an identity because it states that the quantity of money multiplied by

the number of times that this money is spent in a given year to buy goods and services must

equal to the amount of goods times their prices (the total nominal income spent on goods and

services in that year).

In order to move towards the quantity theory of money, Fisher made two key assumptions:

First, Fisher viewed velocity as constant in the short run. He reasoned that velocity is affected by

institutions and technology that slowly change over time.

Second, Fisher like all classical economists believed that flexible wages and prices guaranteed

output Y to be at its full employment level, so output was also constant in the short run.

Now putting the two assumptions together, let us have a look again at the equation of exchange

MV = PY ……………………………….…………….………………………………….. (2)

If both V and Y are constant then changes in M must cause changes in P to preserve the equality

between MV and PY. This is the quantity theory of money.

A change in money supply M results in an equal percentage change in price level P. We can

further modify this relationship by dividing both sides by V

M = ( 1V ) PY

Since V is constant we can replace 1V with some constant K and when the money market is in

equilibrium, money demand equals to money supply so we can replace M by M d to give:

M d=M

Dividing both sides of the equation by P, leads to the quantity theory of money demand:

M d=K . PY ………………………………………………………………………………….. (3)

This equation tells us that the demand for real money balances, that is, the quantity of money that

people want to hold in terms of the goods and services that it can purchase, is proportional to

income. Furthermore it tells us that under the quantity theory of money, money demand is a

function of Income and does not depend on interest rates.

A constant velocity is a key to the quantity theory of money. For Fisher the assumption was a

leap of faith since data on GDP and the money supply did not exist in 1911. However velocity is

not constant even in the short run. In particular velocity dropped significantly during the

recession with the problem of the Great Depression, economists began to look for factors other

than income which can influence money demand. These other factors are explained by the

Keynes liquidity preference theory.

FRIEDMAN’S VIEW ON THE QUANTITY THEORY OF MONEY

Nobel Prize winner, Milton Friedman, developed a model for money demand based on the

general theory of asset demand. Money demand like the demand for any other asset should be a

function of wealth and the returns of other assets relative to money. His money demand function

is as follows:

M d

P=f ¿)

Where

Y P= permanent income (the expected long run average of current and future income)

rb= the expected return on bonds

rm= the expected return on money (money placed in banks)

re= the expected return on stocks

πe= the expected inflation rate (the expected return on goods since inflation is the increase in the

price or value of goods)

Money demand is positively related to permanent income. However since permanent income is a

long run average, it is more stable than current income so this will not be a source of a lot of

fluctuation in money demand

The other terms in Friedman’s money demand function are the expected returns on bonds, stocks

and goods relative to the expected return on money. These items are negatively related to money

demand: the higher the returns of bonds, equity and goods relative to the return on money, the

lower the quantity of money demanded.

Friedman did not assume the return on money to be zero. The return on money depended on the

services provided on bank deposits (check cashing, bill paying, etc) and the interest on some

checkable deposits.

DEMAND FOR CURRENCY, DEPOSITS AND OTHER FINANCIAL ASSETS

i) Demand for Currency

According to Handa (2009), currency holdings do not involve any charges such as trips to the

bank, for making payments from them. Currency involves lower costs of usage, so that the

optimizing individual will hold currency only and not demand deposits. This seems to be the

case in many less-developed economies and especially in those rural areas poorly served by

banks. However it is relatively less safe to hold currency than demand deposits. The greater the

concern with the safety and convenience of currency holdings, the lower will be the relative

demand for currency balances. For example, Japan, with an extremely low theft and robbery rate,

is an economy in which ordinary persons have higher demand for currency and pay for most

transactions in money. Conversely, persons carrying large sums in currency in the United States

would be very concerned about their personal safety and the safety of these sums, and tend to

prefer to hold demand deposits for meeting most of their transactions needs.

ii) Demand Deposits

Demand deposits, bank money or scriptural money are funds held in demand deposit

accounts in commercial banks. These account balances are usually considered money and form

the greater part of the narrowly defined money supply of a country. The checkable or demand

deposits are ones against which withdrawals can be made by check or debit cards. Demand

deposits do have positive own costs of usage since they require some trips to the bank for

making deposits and the banks often levy deposit and withdrawal charges on checks. Further, the

most common types of demand deposits do not pay interest. In most developed economies or the

urban sectors of developing economies, most individuals hold demand deposits. The major

reason to hold demand deposits is the relative safety as compared to that of holding currency.

The concern with theft and robbery if large sums were kept in currency was a major reason for

the origin and spread of deposit banking in eighteenth- and nineteenth-century Europe and

continues to be a major determinant of the relative demand for demand deposits versus currency,

(Handa, 2009).

iii) Savings Deposits

Non-checkable savings deposits can be viewed as a “bond” which pays interest but which cannot

be directly used to make payments to others. Before the introduction of automatic banking

machines and of telephonic and electronic transfers, a trip had to be made to a bank branch to

transfer funds from savings accounts to a checking account or to obtain currency, such a trip

involved time and inconvenience, which are elements of the brokerage cost. The increase of

automatic banking machines and electronic transfer of funds through one’s home computer as

well as the general reduction in the banks’ conditions and charges for such transfers have

reduced this element of brokerage cost very considerably. Up to the 1960s, commercial banks

also often imposed other costs, sometimes including a period of prior notice for withdrawal from

savings accounts, for handling such transfers. The imposition of such notice has virtually

disappeared. The result is that payments from savings deposits are now not very different in

terms of costs and delays than from demand deposits (Handa, 2009)

iv) Other Financial Assets

There has been the creation of new types of financial assets and the increasing liquidity of some

of the existing assets. These encompass institutional innovations such as interest-bearing demand

deposits and checkable savings deposits, which did not become prevalent until the 1970s. They

also include the issuance by banks of money market and other mutual funds, without a

significant monetary brokerage charge for buying and selling such funds, and their divestiture

into demand deposits at short notice. Such money market mutual funds, especially those sold by

banks, became common only in the 1990s. Such innovations have shifted the transactions

demand functions for currency, demand deposits and savings deposits.

Stocks are one of the only financial assets that do not have an agreed upon ending date. Investing

in stock means the investor has part ownership of a company and shares in the company’s profits

and losses. He or she can keep the stock for any length of time or decide to sell it to another

investor.

Bonds are often sold by corporations or governments to investors in order to help fund short-

term projects. They are a type of legal document detailing the amount of money an investor

loaned a borrower and the length of time it needs to be paid. A bond represents how much

interest is guaranteed to be returned to the investor along with the original loan amount.

In recent decades, the reduction in brokerage fees for transfers between money and non-

monetary financial assets (bonds and stocks) and the Internet revolution in electronic banking

have meant a reduction in the demand for money.

CURRENCY SUBSTITUTION

Currency substitution occurs when the inhabitants of a country use a foreign currency in parallel

to or instead of the domestic currency. Currency substitution can be full or partial. Full currency

substitution has taken place in small countries, mostly in Latin America, the Caribbean and the

Pacific that are heavily dependent on the United States. Partial currency substitution occurs when

residents of a country choose to hold a significant share of their financial assets denominated in

foreign currency. The major currencies used as substitutes are the United States dollar, the euro,

the New Zealand dollar, the Swiss franc, the Indian rupee, the Australian dollar, the Armenian dram,

the Turkish lira, the Israeli shekel, and the Russian ruble.

DOLLARIZATION

Dollarization refers to abandoning the local currency in favor of the exclusive use of the U.S.

dollar (or another major international currency, such as the euro). This is known as “full

dollarization.”

A country may decide to implement full dollarization in order to reduce its country risk, thereby

providing a stable and secure economic and investment climate. Countries seeking full

dollarization tend to be developing or transitional economies, particularly those with high

inflation. Full dollarization, however, is an almost permanent resolution: the country's economic

climate becomes more credible as the possibility of speculative attacks on the local currency

and capital market virtually disappears.

“Partially dollarized economies” – defined as ones in which the domestic currency and the

foreign one circulate side by side, with buyers and sellers indifferent between their use in settling

transactions. Handa (1988) argued that economic agents in even very open economies but

without effective dollarization tend to use the domestic currency as the preferred medium of

payments and do not easily switch to the use of foreign currencies for payments because of the

transactions costs imposed on retail payments. He therefore designated the domestic currency as

being the “preferred habitat” for the domestic medium of payments.

For example, while sellers in Canada often accept US dollars, it is uncommon for Canadian

buyers to offer, because there is a greater cost to paying in the US dollar than is specified by the

bank exchange conversion rate. Hence, under the transactions approach, the degree of

substitution between the US dollar and the Canadian dollar need not be high and could be quite

low. The Canadian dollar finds almost no acceptance in the United States, so they are poor

substitutes in the US economy.

EMPIRIAL STUDIES OF THE DEMAND FOR MONEY IN DEVELOPING

COUNTRIES

The source of high money supply growth that causes hyperinflations to occur is typically fiscal

imbalances, and the hyperinflation in Zimbabwe that started in the early 2000s is no exception.

After the expropriation of farms, which were redistributed to supporters of Robert Mugabe, the

president of the country, agricultural output dropped, and along with it tax revenue. The result

was that the government’s expenditures now greatly exceeded revenues. The government could

have obtained revenues to cover its expenditures by raising taxes, but given the depressed state

of the economy, generating revenue in this way was both hard to do and would have been

politically unpopular. Alternatively, the government could have tried to finance its expenditure

by borrowing from the public, but given the distrust of the government, this was not an option.

There was only one route left: the printing press. The government could pay for its expenditures

simply by printing more currency (increasing the money supply) and using it to make payments

to individuals and businesses. This is exactly what the Zimbabwean government did and the

money supply began to increase rapidly.

As predicted by the quantity theory, the increase in the money supply led to a rapidly rising

price level. In February 2007, the Reserve Bank of Zimbabwe, the central bank, outlawed price

increases on many commodities. Although this tactic has been tried before by governments in

countries experiencing hyperinflations, it has never worked: criminalizing inflation cannot stop

inflation when the central bank keeps on printing money. In March 2007, the inflation rate hit a

record of over 1,500%. By 2008, Zimbabwe’s official inflation rate was over two million percent

(but unofficially over ten million percent). In July of 2008, the Zimbabwean central bank issued

a new $100 billion bank note. That’s a lot of zeros, but it was not impressive. One of those bills

could not even buy a bottle of beer. Zimbabwean currency became worth less than toilet paper.

In 2009, the Zimbabwean government allowed the use of foreign currencies like the dollar for all

transactions, but the damage had already been done. The hyperinflation wreaked havoc on the

economy, and an extremely poor country became even poorer, (Mishkin, 2012)

A paper titled, “An Empirical Analysis of the Money Demand Function in Syria” investigates if

a stable money demand function can be found for Syrian economy for the period 1990:1 up to

2009:4. The existences of a well defined and stable money demand function is an essential

condition for the reliable transmission of the money supply impact to aggregate demand.

Furthermore, this stability is the key choice for Central Bank to select between monetary policy

tools. The empirical results showed that real money demand M2 and its economics determinants

were weakly co-integrated. On the other hand, stability test and Error Correction Model provided

a support that money demand function is unstable in the Syrian economy, and this instability was

due to structural changes in the function. These findings supported the choice of exchange rate as

a nominal anchor for Syrian monetary policy to tie down the price level and achieve its stability.

There were two main reasons beyond the gradual giving up the money supply as an intermediate

target in the Syrian monetary policy. First; the transition process to the social market economy in

2000s, which was accompanied by ongoing financial and trade liberalization, interest rate was

not employed effectively and the credibility of monetary policy was not built yet, and as a result,

unstable money demand function existed. Second; the path from a fixed exchange rate regime to

more flexible one, where the only way for any desired adjustments under fixed regime will be

through the inflation (increase the money supply) in the economy.

REFERENCES

Liquid Preference. (2011, July 15). Retrieved October 7, 2014. from

http://www.tutors2u.com/rte/File/Economics/LIQUIDITY%20PREFERENCE%20THEORY.pdf

Berg, A., & Borenzstein, E. (2000, December 10). Economic Issues No. 24 -- Full Dollarization.

Retrieved October 7, 2014, from http://www.imf.org/external/pubs/ft/issues/issues24/index.htm

Mishkin, F. (2012). Macroeconomics: Policy and Practice. Boston: Pearson Addison-Wesley.

Handa, J. (2009). Monetary Economics (2nd ed.). London: Routledge.

Mouyad, A. (2010). An Empirical Analysis of the Money Demand Function in Syria. Retrieved October

7, 2014.