ECONOMICS
Modelling Inflation with Keynes’ Liquidity Preference Theory
A short review I wrote at Imperial College discussing Liquidity Preference Theory and Quantity Theory of Money, dated 16 December 2020.
Note: This review was written in conjuction with Adam Wood, Amalie Kjaer, Bastian Shi, Henry Jones and Tom O’Brien.
The Quantity Theory of Money (QTM) proposes the following equation:
While QTM has been proven to accurately fit certain time-series data sets [1], this essay argues that the model is oversimplified in some cases. For example, inflation levels in low-inflation countries (less than 12% inflation) tend to be poorly modelled by the QTM [2].
Firstly, changing the money supply, M, can have a simultaneous effect on velocity, v, and real GDP, Y_R, which undermines the constant v and Y_R assumption. This is exacerbated by the difficulty in measuring M, P, and Y_R. Non-monetary factors such as technological advancements, monopoly power and effective demand and supply also impact price [3].
Furthermore, unemployed capital and labour further reduce the appropriateness of the model; injecting more money can increase employment and production of goods without an increase in price level [3].
Most importantly, the total quantity of money does not necessarily impose pressure on price levels, but the proportion of it which is active instead. For example, quantitative easing implemented by the Federal Reserve in 2008 did not cause a commensurate increase in inflation [4]. One contributing factor could be inactive balances (idle cash or credit which is not used for any transactions) [3], which reduces the amount of active money in circulation. This led Keynes to develop the Liquidity Preference Theory (LPT) [5].
LPT is built on three motivations that describe why individuals prefer to hold cash: a transactional motive referring to cash for meeting daily needs, a precautionary motive referring to emergency cash holdings and a speculative motive to hold cash for taking advantage of investment opportunities [3]. These three motives reduce the amount of active money in circulation.
The transactional and precautionary motive proposes that active money balances increase with income, as with higher income comes higher expenditure and consequently larger rainy day funds. The speculative motive proposes an inverse relationship between interest rates and real money balance. Higher interest rates increase the opportunity cost of holding cash, and thus real money balance decreases. These motivations can be formally expressed in the demand for real money balances, M_r / P, as shown in the following equation [6]:
Where M_r is real or active money balance in circulation, P is the general price level, i is the interest rate, Y is income, and f indicates some function to be determined.
A core benefit of LPT is that it doesn’t rely on a constant velocity of money which is a core component of QTM [7]. The model rather results from the relationship between the quantity of money and prices being considered indirect and a result of varying interest rates [5].
As shown above, the mathematical formulation of LPT has not been fully defined, so whilst the theory can be used to qualitatively describe economic scenarios, the scenarios cannot be predicted quantitively. Despite this, there are mathematical models for LPT being developed [8], which if agreed upon could potentially alter the perception of macroeconomics.
Another shortcoming of LPT is that whilst it presents interest rates as being determined by liquidity preference [5], Keynes simultaneously presents liquidity preference as being determined by interest rates, creating a contradiction that is not fully resolved [9].
This essay has highlighted some of the key issues surrounding QTM. An alternative model of price levels being determined by the quantity of money indirectly via interest rates was presented, in the form of LPT. Whilst LPT has not been fully developed, it offers an interesting perspective on macroeconomics.
[1] Barro, R. (1993) Macroeconomics. (4th ed). John Wiley & Sons.
[2] Teles, P. & Uhlig, H. (2013) Is Quantity Theory Still Alive. European Central Bank Working Paper Series. Available from: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1605.pdf [Accessed: 13th December 2020]
[3] Munro, J. (1999) Modern Quantity Theories of Money: From Fisher to Friedman. University of Toronto — Department of Economics.
[4] U.S. Department of Labor. Available from: https://www.bls.gov/cpi/home.htm [Accessed: 11th December 2020]
[5] Keynes, J. M. (1936) The General Theory of Employment, Interest and Money. U.K., Palgrave Macmillan.
[6] U.C. Davis. (2012) Money and Banking: Simple Quantity Theory and the Liquidity Preference Theory of Keynes. (2nd ed.) UC Davis.
[7] Edgmand, M. R., Moomaw, R. L. & Olson, K. W. (eds.) (1996) Economics and Contemporary Issues: Chapter 13. (3rd ed.). Fort Worth, Dryden Press.
[8] Morozovsky, A. (1999) Possible mathematical formulation of liquidity preference theory. arXiv e-prints. Physics/9910005. Available from: https://ui.adsabs.harvard.edu/abs/1999physics..10005M/abstract [Accessed 9th December 2020]
[9] Rothbard, M. (1962) Man, Economy and State. United States, Van Nostrand.
