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# Money and Banking, v. 1.1

by Robert E. Wright and Vincenzo Quadrini

## 20.2 Liquidity Preference Theory

### Learning Objective

1. What is the liquidity preference theory and how has it been improved?

The very late and very great John Maynard Keynes (to distinguish him from his father, economist John Neville Keynes) developed the liquidity preference theory in response to the rather primitive pre-Friedman quantity theory of money, which was simply an assumption-laden identity called the equation of exchange:

$M V = P Y$

where:

M = money supply

V = velocity

P = price level

Y = output

Nobody doubted the equation itself, which, as an identity (like x = x), is undeniable. But many doubted the way that classical quantity theorists used the equation of exchange as the causal statement: increases in the money supply lead to proportional increases in the price level. The classical quantity theory also suffered by assuming that money velocity, the number of times per year a unit of currency was spent, was constant. Although a good first approximation of reality, the classical quantity theory, which critics derided as the “naïve quantity theory of money,” was hardly the entire story. In particular, it could not explain why velocity was pro-cyclical, i.e., why it increased during business expansions and decreased during recessions.

To find a better theory, Keynes took a different point of departure, asking in effect, “Why do economic agents hold money?” He came up with three reasons:

1. Transactions: Economic agents need money to make payments. As their incomes rise, so, too, do the number and value of those payments, so this part of money demand is proportional to income.
2. Precautions: S—t happens was a catch phrase of the 1980s, recalled perhaps most famously in the hit movie Forrest Gump. Way back in the 1930s, Keynes already knew that bad stuff happens—and that one defense against it was to keep some spare cash lying around as a precaution. It, too, is directly proportional to income, Keynes believed.
3. Speculations: People will hold more bonds than money when interest rates are high for two reasons. The opportunity cost of holding money (which Keynes assumed has zero return) is higher and the expectation is that interest rates will fall, raising the price of bonds. When interest rates are low, the opportunity cost of holding money is low, and the expectation is that rates will rise, decreasing the price of bonds. So people hold larger money balances when rates are low. Overall, then, money demand and interest rates are inversely related.

More formally, Keynes’s ideas can be stated as

where:

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

An increase in interest rates induces people to decrease real money balances for a given income level, implying that velocity must be higher. So Keynes’s view was superior to the classical quantity theory of money because he showed that velocity is not constant but rather is positively related to interest rates, thereby explaining its pro-cyclical nature. (Recall from Chapter 5 "The Economics of Interest-Rate Fluctuations" that interest rates rise during expansions and fall during recessions.) Keynes’s theory was also fruitful because it induced other scholars to elaborate on it further.

In the early 1950s, for example, a young Will Baumolhttp://pages.stern.nyu.edu/~wbaumol/ and James Tobinhttp://nobelprize.org/nobel_prizes/economics/laureates/1981/tobin-autobio.html independently showed that money balances, held for transaction purposes (not just speculative ones), were sensitive to interest rates, even if the return on money was zero. That is because people can hold bonds or other interest-bearing securities until they need to make a payment. When interest rates are high, people will hold as little money for transaction purposes as possible because it will be worth the time and trouble of investing in bonds and then liquidating them when needed. When rates are low, by contrast, people will hold more money for transaction purposes because it isn’t worth the hassle and brokerage fees to play with bonds very often. So transaction demand for money is negatively related to interest rates. A similar trade-off applies also to precautionary balances. The lure of high interest rates offsets the fear of bad events occurring. When rates are low, better to play it safe and hold more dough. So the precautionary demand for money is also negatively related to interest rates.

### Key Takeaways

• Before Friedman, the quantity theory of money was a much simpler affair based on the so-called equation of exchange—money times velocity equals the price level times output (MV = PY)—plus the assumptions that changes in the money supply cause changes in output and prices and that velocity changes so slowly it can be safely treated as a constant. Note that the interest rate is not considered at all in this so-called naïve version.
• Keynes and his followers knew that interest rates were important to money demand and that velocity wasn’t a constant, so they created a theory whereby economic actors demand money to engage in transactions (buy and sell goods), as a precaution against unexpected negative shocks, and as a speculation.
• Due to the first two motivations, real money balances increase directly with output.
• Due to the speculative motive, real money balances and interest rates are inversely related. When interest rates are high, so is the opportunity cost of holding money.
• Throw in the expectation that rates will likely fall, causing bond prices to rise, and people are induced to hold less money and more bonds.
• When interest rates are low, by contrast, people expect them to rise, which will hurt bond prices. Moreover, the opportunity cost of holding money to make transactions or as a precaution against shocks is low when interest rates are low, so people will hold more money and fewer bonds when interest rates are low.