The Demand for Money and the issue of liquidity preference

The demand for money and the issue of excessive liquidity preference.

Keynes developed his notion of liquidity preference as outlined in the GT (1936) building on ideas he may have developed in part through his earlier supervision of Fredrick Lavington who had been a student of Keynes and later he was the Girdler Lecturer in Economics at Cambridge. His work The English Capital Market was first published in 1921. Lavington lectured at Cambridge from 1918 to 1927 and spent seven prior years at the Board of Trade. He died in 1927. ( See Donald Moggridge, Maynard Keynes An Economist‘s Biography, Routledge, London&NYC, 1992; F. Lavington, The English Capital Market, Methuen, London 1921.) In addition Keynes made use of his considerable insights from his work The treatise on Money published in 1930.

Keynes developed his money demand and Money supply theory in the following way starting from classical assumptions but then building in risk, uncertainty, complexity in financial markets and liquidity preference in order to show that there was a non zero demand for cash balances. This is what permits what I once called quasi hoarding of money . If that is so then it is understandable how such idle balances do not produce full employment and financial markets can be unstable. Disequilibrium is a real possibility and Say‘s law does not hold.

Keynes writes that M = M1+M2=L1(Y)+L2(r) where M is the total demand for money M1 is transactions and precautionary demand, M2 is the speculative motive demand; L1 is the liquidity function corresponding to an income Y which determines M1 and L2 is the liquidity function of the rate of interest r which determines M2 .

Keynes then states It follows that there are three matters to explore. i) the relation of changes in M to Y and r, ii) what determines the shape of L1; and iii) what determines the shape of L2 (GT p.200).All the changes in M occur as a change in money income. The new level of additional income can be the result of the Government through the Fed creating additional money buying treasuries, for example, and expanding its balances sheet. But Keynes points out that the new higher level of income will not necessarily be high enough for the requirements of M1 to absorb the whole of the increase in M; some of the money will seek an outlet in buying securities or other financial assets until r has fallen so as to bring about an increase in the size of M2 sufficient to stimulate a rise in Y to the extent that the new money is absorbed either in M2 or in M1 which corresponds to the rise in Y caused by the fall in r.Remember that bond prices always move in the opposite direction to the rate of interest.Buying bonds bids up their price and lowers the rate of interest.Selling them lowers their price and hence bids up the rate of interest.

Keynes goes on to specify that V is the velocity of money and there is no reason to assume it is a constant. Hence he writes L1 (Y) = Y V = M1 where YV is Y divided by V. The value of V will depend on the character of banking and industrial organization, on social habits, on the distribution of income and on the effective cost of holding idle cash balances. In the short period (and in my view Keynes errs here which helps the classical find their way back to the quantity of money argument) We can safely assume no material change in these factors and we can treat V as nearly enough constant ,(GT pp200-201) In the Marshallian instant period which is no more than a snapshot in time this might be true but not always so.The current Covid crisis shows how quickly things can change.

About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
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1 Response to The Demand for Money and the issue of liquidity preference

  1. Spencer Hall says:

    Like Dr. William Barnett said (a former NSA Rocket Scientist), “the Fed should establish a “Bureau of Financial Statistics”.

    You can’t duplicate this accounting today (after the DIDMCA of March 31st 1980), an act that laid the legal basis for the abolition of 38,000 financial intermediaries and the addition of 38,000 commercial banks to the 14,000 we already had.

    1979: Double-entry Bookkeeping on a National Scale

    Loans and investments =$1229.8
    Cash and Due from Banks =$169.5
    Total Assets—Total Liabilities + Net Worth =$1480.3

    Demand Deposits =$400.5
    Time deposits =$675.8
    Borrowings =$180.5 (principally E-$s since 1969)
    Currency outside the banks =$106.1
    Reserve Bank Credit 128.3

    MONETARY AND BANKING CHANGES End of 1939 to end of 1979 (figures in billions of dollars)

    (1) Net effect on the volume of time and demand deposits and borrowing of all factors, except commercial bank credit (principally capital accounts) =$13.5
    (2) Net expansion of commercial bank credit =$1189.1
    (3) Net increased in time and demand deposits and borrowings =$1202.6

    Source: Computed from data reported in All-Bank Statistics, U.S. 1896-1955 and the Federal Reserve; and the Federal Reserve Bulletin

    The fact is that from a systems’ standpoint the banks pay for their earning assets with new money not existing deposits. This drastically changes everything in macro. For instance, the source of time deposits is demand deposits, i.e., the bank collectively pay for what they already own (very stupid and less profitable).

    M1 = currency outside the banks plus DD, including U.S. Treasury General Fund Account
    M2 = M1 plus all time deposits in the DFIs

    Bank deposit growth is almost exclusively tied to credit creation. There are many factors which can, and do, alter the volume of bank deposits, including changes in currency held by the nonbank public, in Reserve Bank credit, in bank capital accounts, etc.

    Although these items are the largest in the aggregate, they nevertheless have been peripheral in altering the aggregate total of banks deposits.

    Altogether, taking into account the principal factors affecting the lending capacity of the banking system, outside factors have made a negligible contribution to bank deposit growth.

    That is to say, the capacity of the commercial banking system to lend, and the aggregate size of the system, given ample opportunities to make bankable loans and acquire eligible securities, are determined by monetary policy, not the savings practices of the public.

    In other words, a growth in the lending capacity of the banking system is not derived from the savings of the public, nor indeed from the savings effected by the banks themselves. Rather is this great benefit derived from the expansion of Reserve bank credit. It is, like manna from heaven, showered on the banking system and is costless to the banking system. The commercial banks could continue to lend even if the nonbank public ceased to save altogether.

    All monetary savings originate within the payment’s system. But a growth in time deposits depletes demand deposits by the same amount. And savers never transfer their savings out of the payments system in the first place, unless they hoard currency or convert to other national currencies.

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