Liquitidy Preference Theor

Liquitidy Preference Theor - APP03_p.W27-W38 3/3/05 10:18...

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W-27 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 B s plus the quantity of money supplied M s . The quantity of bonds B d and money M d that peo- ple 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: B s + M s = B d + M d (1) Collecting the bond terms on one side of the equation and the money terms on the other, this equation can be rewritten as B s 2 B d = M l 2 M s (2) The rewritten equation tells us that if the market for money is in equilibrium ( M s = M d ), the right-hand side of Equation 2 equals zero, implying that B s = B d , mean- ing 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 Supply and Demand in the Market for Money: The Liquidity Preference Framework APPENDIX 3 TO CHAPTER 4 1 Note 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 finan- cial market in which short-term debt instruments are traded.

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Appendix 3 to Chapter 4 W-28 2 Keynes did not actually assume that the expected returns on bonds equaled the interest rate but rather argued that they were closely related. This distinction makes no appreciable difference in our analysis. 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.
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This note was uploaded on 05/13/2010 for the course ECON 323 taught by Professor Jakes during the Spring '10 term at Alcorn State.

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Liquitidy Preference Theor - APP03_p.W27-W38 3/3/05 10:18...

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