Transcript M 0

The liquidity preference theory was an attempt to
displace the prevailing theory of interest (and
financial asset pricing)--the loanable funds theory
(also known as the “classical” or “time preference”
theories) of interest.
A successful assault on loanable funds was
essential to the success of Keynes’s new theory of
unemployment, since the old theory ostensibly
preserves the validity of Say’s Law when a monetary
economy is under consideration.
Key elements
Humans are “present-oriented” and hence must
be compensated for deferring gratification.
Interest earned on bonds is the “reward for
waiting”--that is, the monetary compensation
required to induce present-oriented individuals to
abstain from consumption (to save).
The willingness to wait (saving) is a positive
function of the yield of bonds (or other financial
assets).
Don’t tell me you didn’t know that
bond prices and yields move inversely!
 S is saving
I is investment
 i is the interest rate (yield of bonds)
S = f(i)
[1]
S/i > 0
[1a]
I = (i)
[2]
I/i < 0
[2a]a
S=I
[3]b
a Explained by the diminishing marginal product of capital
b
Equilibrium condition in the loanable funds
market
i (%)
i2
S1
S2
1
i1
0
An improvement of
thrift stimulates I--which
explains the preference of
some economists
for measures (e.g., reduced
taxes on capital gains) that
ostensibly stimulate
saving.
2
I1
I2
I
S, I
I
I
•Leakages are defined as
income received by
households but not spent
for the purchase of new
goods and services in
domestic goods.
•Injections are
expenditures in domestic
markets made by units
other than domestic
households.
National
Income
S
In a mature, industrialized economy the existing stock
of debt held by individuals and institutions is vast.
The flow of new debt issues in any brief time interval
is but a tiny fraction of stock of debt outstanding.
Taking into account the development of organized
secondary markets, previously issued bonds are a nearperfect substitute for newly-issued bonds (from the
wealth-holders point of view).
The primary determinant of the yield of new issues is
therefore the yield prevailing in the secondary market for
similar types of securities.
Definitions
L  The liquidity preference function;
Lt  The transactions demand for liquid balances;
La  The asset or speculative demand for liquid balances;
i  The yield of bonds;
PB  The price of bonds;
M0  The (exogenously-determined) nominal money stock.;
M0t  Money held for transactions purposes;
M0a  Money held for asset purposes;
Y  Real gross domestic product.
That the FED can control rr
is not subject to dispute.
If the more controversial
proposition holds--that is, the
FED can target Ra (highpowered money)--then it
follows that the FED
can target Dd. Which is to
say, money is exogenous
Let:
•Dd  deposit liabilities of the
banking system
•Ra  total reserves of the banking
system
•rr  legal reserve ratio
If banks are “fully loaned up,” then:
rr = Ra/Dd
It follows from [1] that:
Dd = Ra/rr
[1]
The model
L = Lt + La
(1)
Lt =f(Y)
(2)
Lt’(Y) > 0
(2.1)
La = f (i)
(3)
La’(i) < 0
(3.1)
M 0= M 0t + M 0a
L = M0
(4)
(5)
i (%)
M0a
i1
i*
0
0
La
M, L
i (%)
M0a
Bond yields
fall, and
bond prices
rise
i2
i1
0
0
La
M, L
i (%)
M0a
Bond yields
rise, and
bond prices
fall
i2
i1
0
0
La
M, L