The liquidity preference

In the neoclassical theory, the interest rate equalizes savings and investments. i is a real variable that depends on the gap between S and I on markets.

The quantity equation of exchange defines the amount of money (M) that individuals wish to hold as proportional to nominal national income (PY, where is the price level and Y the real income):

MV = PY

(where V is the velocity). After the formulation of money demand used by economists at Cambridge University ( in Great Britain) in the early twentieth century, the inverse of velocity, k=(1/v), is used to identify the Cambridge equation:

M=kPY.

Then, the quantity theory is formulated in terms of the quantity of liquid balances which individuals wish to keep in relation to the real income they earn. Consequently, money is demanded for its services in the purchasing of goods. As purchases are not completely planned, liquid reserves are required as transactionary and precautionary stock. Individuals had liquid assets because of the uncertain future.

In this view, money is the liquid asset hold by individuals. But money is also necessary to finance investment. The entrepreneurs, in order to finance their investment expenditure, issue form of liabilities (bonds, bills of exchange, bank debts) that they sell in exchange for money. The buyers of these forms of liabilities renounce holding money and hold non-liquid assets. Therefore, the demand for money depends not only on the level of transactions, as in the Cambridge equation, but also on the level of the interest rate which gives the liquidity premium allowing agents to part with their money balances. On one hand, the mechanism depends on the assumption that the quantity of money is fixed exogenously by the monetary authorities. If this is not true and if the quantity of money is endogenous (determined by the monetary-financing needs of economic agents), the authorities are not able anymore to control the money supply. This is the view depended nowadays by the Post Keynesian theory.

On the other hand, we have to remark that money is demanded also to finance speculation. The speculators, by selling or buying securities with the intention of realizing speculative gains, contribute to modifying the stock market variables. In abnormal times, speculators do not take into account the fundamental values, but try to make capital gains with a very short-run perspective. This kind of behaviour destabilises the market and reduces the effectiveness of monetary policies which aim to setting the interest rate in a discretionary way. The objectives of monetary policy are frustrated by speculators’ expectations. Moreover, even if we agree with the assertion that the monetary authorities are able to set the interest rate, we cannot know in what degree a variation in the interest rate level would influence the investment decisions of economic agents. If profit expectations basically depend on the moods of the entrepreneurs which are very unstable and subjective, as Keynes seems to believe, then changes of the interest rate could not modify themselves the entrepreneurial expectations about the future state of affairs. There is an inertia that makes the expectations difficult to modify solely by interest rate changes in the short-run. The Keynesian theory tries to point out the difficulties of functioning of a market economy at a given equilibrium point. The market economy’s evolution is a consequence of private economic agents’ decisions. These decisions are decentralized and depend on some uncontrollable subjective factors. The state interventions are viewed as necessary in order to orient the decisions towards a collectively viable economic situation. Keynes was not a opponent of the liberal economy, he believed that State interventions should not abolish the market economy but help it to manifest itself and render it viable. The idea of administered market economy has to be understood by this way. That is the core of the Keynesian economics.

Date: 2016-01-14; view: 456