Inmacroeconomic theory,liquidity preference is thedemand for money, considered asliquidity. The concept was first developed byJohn Maynard Keynes in his bookThe General Theory of Employment, Interest and Money (1936) to explain the determination of theinterest rate by thesupply and demand for money.The liquidity preference theory by Keynes was a refinement ofSilvio Gesell's theory that interest is caused by thestore of value function of money.[1]
Thedemand for money as an asset was theorized to depend on the interest foregone by not holdingbonds (here, the term "bonds" can be understood to also representstocks and other lessliquidassets in general, as well asgovernment bonds). Interest rates, he argues, cannot be a reward for saving as such because, if a personhoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is a potentially valuable attribute of an asset, in circumstances requiring cash money to meet obligations or contingencies. The more quickly an asset can be converted into cash money at or near the present value of its expected long-term cash flow, the more liquid it is said to be.[2]
Keynes acknowledged that the German-Argentine economistSilvio Gesell developed some of the central elements of a precursor theory of interest, decades before he publishedThe General Theory of Employment, Interest and Money in 1936.[1]Gesell created aRobinson Crusoe economythought experiment which showed that interest rates tend to exist in monetary economies while not existing inbarter economies.[3][4]
Gesell identified that interest rates are a purely monetary phenomenon.[1][5]However, Keynes believed that Gesell's theory only amounted to "half a theory",[6] since Gesell failed to discern the importance of liquidity.Keynes improved upon Gesell's theory of interest by explicitly recognizing that money has the advantage of liquidity over commodities.Other scholars likeGuido Giacomo Preparata have claimed Keynes essentially stole Gesell's ideas, and then deradicalized them to aid the existingcapitalist order.[7]
According to Keynes, demand for liquidity is determined by three motives:[8]
The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (seeIS/LM model).
According to theFreiwirtschaft school of economics, if the liquidity preference theory of interest rates is correct, thendemurrage currency would theoretically have no interest rates, since demurrage money cannot be used as a long-termstore of value.[6]
A major rival to the liquidity preference theory of interest is thetime preference theory, to which liquidity preference was actually a response. Because liquidity is effectively the ease at which assets can be converted into currency, liquidity can be considered a more complex term for the amount of time committed in order to convert an asset. Thus, in some ways, it is extremely similar totime preference.
InMan, Economy, and State (1962), Murray Rothbard argues that the liquidity preference theory of interest suffers from a fallacy of mutual determination. Keynes alleges that the rate of interest is determined by liquidity preference. In practice, however, Keynes treats the rate of interest asdetermining liquidity preference. Rothbard states "The Keynesians therefore treat the rate of interest, not as they believe they do—as determined by liquidity preference—but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system."[9]
Criticism emanates also frompost-Keynesian economists, such ascircuitistAlain Parguez [it], professor of economics,University of Besançon, who "reject[s] the keynesian liquidity preference theory ... but only because it lacks sensibleempirical foundations in a true monetary economy".[10]
It is convenient to mention at this point the strange, unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight and who only just failed to reach down to the essence of the matter. In the post-war years his devotees bombarded me with copies of his works; yet, owing to certain palpable defects in the argument, I entirely failed to discover their merit. As is often the case with imperfectly analysed intuitions, their significance only became apparent after I had reached my own conclusions in my own way.
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{{cite book}}:ISBN / Date incompatibility (help)[Gesell] shows how it is only the existence of a rate of money interest which allows a yield to be obtained from lending out stocks of commodities. His dialogue between Robinson Crusoe and a stranger[28] is a most excellent economic parable — as good as anything of the kind that has been written — to demonstrate this point.
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