The Modern Quantity Theory and The Liquidity Preference Theory

The Modern Quantity Theory and The Liquidity Preference Theory 

Introduction

In every academic field, there are always better and better theories to help us better understand how the real world works. However, we can only close to be perfect, not actually perfect. The liquidity preference theory or the modern quantity theory all just trying to be perfect by thinking more and more deeply or more comprehensively. To figure out the pros and cons can help us learn from those mistakes and try to built a better world.

The Liquidity Preference Theory

The liquidity preference theory was developed by John Maynard Keynes, which assumes investors prefer cash or other highly liquid holdings while all other factors being equal. So, investors should demand a higher interest rate or higher return on securities that carry greater risk. 

According to this theory, cash is a commonly accepted and most liquid asset. The interest rates on short-term securities are lower because investors are sacrificing less liquidity for the opportunity cost of time. John Maynard Keynes also mentioned three motives that determine the demand for liquidity, the transactions motive, precautionary motive, and speculative motive.

The transactions motive is part of our day to day life, higher costs of living such as more expensive to feed your stomach mean a higher demand for cash and liquidity to meet those basic needs. More than that, if investors invest their funds in stocks or any other securities, may also have a high demand for liquidity to repay their obligations, paying rents, or mortgages.

The concept of precautionary motive is similar to insurance, a preference for additional liquidity in some unexpected events may require a substantial outflow of cash, such as car repairs or healthcare bills.

The speculative motive is a little similar to the precautionary motive since we all have some concerns about the future. But unlike the precautionary motive that sources from what we need, the speculative motive sources from what we want. For example, when interest rates are low, the demand for cash is high and they may prefer to hold other assets until interest rates rise. What we want is a better opportunity in the future.

If a 3-year IOU is expected to get 3% in return, then a 10-year IOU is less likely to get 2% in return. For the investor to sacrifice liquidity, they must receive a higher rate of return in exchange to have the cash tied up for a longer period.

In conclusion, the liquidity preference theory refers to money demand as measured through liquidity. In real-world terms, the more quickly an asset can be converted into currency, the more liquid it becomes.

The Modern Quantity Theory

Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. Instead, the demand for money should depend not only on the risk and return offered by money but also on the various assets which the households can hold instead of money. 

In short, transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest. 

Why?

Because Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in the comparison of expected returns, such as the differences between bonds, stocks, or even inflations.

Reference

Chen, J. (2020, September 16). Liquidity Preference Theory Definition. Retrieved October 18, 2020, from https://www.investopedia.com/terms/l/liquiditypreference.asp

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. 

20.3 Friedman versus Keynes #Notebook

20.3 Friedman versus Keynes #Notebook

The modern quantity theory is superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds). 

In Friedman’s theory, velocity is no longer a constant and does not assume that the return on money is zero. Instead, it is highly predictable.

Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. 

Md / Plv: f (Pi varies directly with, ERoB – ERoM varies indirectly with, ERoS – ERoM varies indirectly with, EIf – ERoM varies indirectly with)

The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in ERoB – ERoM, ERoS – ERoM, or EIf – ERoM because both sides would rise or fall about the same amount. 

Interest rates did not strongly affect the demand for money, so velocity was predictable and the quantity of money was closely linked to aggregate output. Except when nominal interest rates hit zero (as in Japan), the demand for money was somewhat sensitive to interest rates, it's a liquidity trap, where money demand is perfectly horizontal. Since the money demand became more sensitive to interest rate changes, velocity, output, and inflation became harder to predict.  

Transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest. 

Not as much money supply was needed to support the GDP and price level. Velocity can rise during the period that government debts are large. It then dropped as the government paid off the debt, requiring the use of more M1.

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. 

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.