APPENDIX 4 TO CHAPTER
Supply and Demand in
the Market for Money:
The Liquidity Preference
Whereas the loanable funds framework determines the equilibrium interest rate using the supply of and demand for bonds, an alternative model developed by John Maynard Keynes, known as the liquidity preference framework, determines the equilibrium interest rate in terms of the supply of and demand for money. Although the two frameworks look different, the liquidity preference analysis of the market for money is closely related to the loanable funds framework of the bond market.1 The starting point of Keynes’s analysis is his assumption that there are two main categories of assets that people use to store their wealth: money and bonds. Therefore, total wealth in the economy must equal the total quantity of bonds plus money in the economy, which equals the quantity of bonds supplied Bs plus the quantity of money supplied Ms. The quantity of bonds Bd and money Md that people want to hold and thus demand must also equal the total amount of wealth because people cannot purchase more assets than their available resources allow. The conclusion is that the quantity of bonds and money supplied must equal the quantity of bonds and money demanded: Bs ϩ Ms ϭ Bd ϩ Md
Collecting the bond terms on one side of the equation and the money terms on the other, this equation can be rewritten as
Bs Ϫ Bd ϭ Ml Ϫ Ms
1Note that the term market for money refers to the market for the medium of exchange, money. This market differs from the money market referred to by finance practitioners, which is the financial market in which short-term debt instruments are traded.
Appendix 4 to Chapter 4
The rewritten equation tells us that if the market for money is in equilibrium (Ms ϭ Md), the right-hand side of Equation 2 equals zero, implying that Bs ϭ Bd, meaning that the bond market is also in equilibrium.
Thus it is the same to think about determining the equilibrium interest rate by equating the supply and demand for bonds or by equating the supply and demand for money. In this sense, the liquidity preference framework, which analyzes the market for money, is equivalent to the loanable funds framework, which analyzes the bond market. In practice, the approaches differ because by assuming that there are only two kinds of assets, money and bonds, the liquidity preference approach implicitly ignores any effects on interest rates that arise from changes in the expected returns on real assets such as automobiles and houses. In most instances, both frameworks yield the same predictions.
The reason that we approach the determination of interest rates with both frameworks is that the loanable funds framework is easier to use when analyzing the effects from changes in expected inflation, whereas the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of money.
Because the definition of money that Keynes used includes currency (which earns no interest) and checking account deposits (which in his time typically earned little or no interest), he assumed that money has a zero rate of return. Bonds, the only alternative asset to money in Keynes’s framework, have an expected return equal to the interest rate i.2 As this interest rate rises (holding everything else unchanged), the expected return on money falls relative to the expected return on bonds, and this causes the demand for money to fall.
We can also see that the demand for money and the interest rate should be negatively related by using the concept of opportunity cost, the amount of interest (expected return) sacrificed by not holding the alternative asset—in this case, a bond. As the interest rate on bonds i rises, the opportunity cost of holding money rises, and so money is less desirable and the quantity of money demanded must fall. Figure 1 shows the quantity of money...
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