Liquidity preference
Encyclopedia
In macroeconomic theory, Liquidity preference refers to the demand
for money
, considered as liquidity. The concept was first developed by John Maynard Keynes
in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate
by the supply and demand
for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds
. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless, refrained from consuming all his current income. Instead of a reward for saving, interest in the Keynesian analysis is a reward for parting with liquidity.
According to Keynes, demand for liquidity is determined by three motives:
The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model
).
rejected Keynes' theory of liquidity preference. In his book America's Great Depression
, Rothbard argued that interest rates are instead determined by time preference
. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall—because time preferences have fallen."
Money demand
The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 , or for money in the broader sense of M2 or M3....
for money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
, considered as liquidity. The concept was first developed by John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
by the supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless, refrained from consuming all his current income. Instead of a reward for saving, interest in the Keynesian analysis is a reward for parting with liquidity.
According to Keynes, demand for liquidity is determined by three motives:
- the transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.
- the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
- speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).
The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model
IS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...
).
Criticisms
Murray RothbardMurray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
rejected Keynes' theory of liquidity preference. In his book America's Great Depression
America's Great Depression
America's Great Depression is a 1963 treatise on the 1930s Great Depression and its root causes, written by Austrian School economist and author Murray Rothbard. The fifth edition was released in 2000.-Brief summary:...
, Rothbard argued that interest rates are instead determined by time preference
Time preference
In economics, time preference pertains to how large a premium a consumer places on enjoyment nearer in time over more remote enjoyment....
. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall—because time preferences have fallen."