liquidity preference framework
APPENDIX 4 TO CHAPTER
4
Supply and Demand in the Market for Money:
The Liquidity Preference
Framework
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
(1)
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
(2)
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.
W-29
W-30
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
4
Supply and Demand in the Market for Money:
The Liquidity Preference
Framework
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
(1)
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
(2)
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.
W-29
W-30
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