20.2 Liquidity Preference Theory #Notebook

20.2 Liquidity Preference Theory #Notebook

The John Maynard Keynes developed the liquidity preference theory, the equation of exchange:

MV = PY = Nominal GDP = Price Level x Real GDP

M = money supply 

V = velocity

P = price level

Y = output

Money Supply x Velocity = Price Level x Output

Classical quantity theorists used the equation of exchange as the causal statement, the increases in the money supply lead to proportional increases in the price level. 

Although a good approximation of reality, the classical quantity theory could not explain why velocity was pro-cyclical and why it increased during business expansions and decreased during recessions.

Therefore Keynes searched for a better theory to explain these situations.

So, why do economic agents hold money?

Transactions: To make payments. As their incomes rise, do the number and value of those payments, so this part of money demand is proportional to income. Transaction demand for money is negatively related to interest rates. When interest rates are high, people will hold as little money for transaction purposes because people tend to only liquidate them when needed. 

When rates are low, people will hold more money for transaction purposes because it isn’t worth the brokerage fees to play with bonds very often. 

Precautions: To keep some spare cash lying around as a precaution. It is directly proportional to income. The lure of high-interest rates offsets the fear of the devil. When rates are low, it's better to play it safe. So the precautionary demand for money is also negatively related to interest rates.

Speculations: People hold larger money balances when rates are low. Money demand and interest rates are inversely related.

Keynes’s ideas can be stated as Md / P = f ( i <−>, Y <+> )

Md/P = demand for real money balances

f means “function of” (this simplifies the mathematics) 

i = interest rate

Y = output (income)

<+> = varies directly with

<−> = varies indirectly with

Keynes’s view was superior to the classical quantity theory of money because he showed that velocity is not constant.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.