Money Demand Analysis: Liquidity Preference Theory

1. Introduction

The demand for money is defined as the desired holding of certain cash and other financial assets in monetary form. M1 is assets that are the most liquid of assets, and those that can most quickly be converted to cash. Those funds that are M1 include paper currency, coins, Traveler’s checks, demand deposits, negotiable order of withdrawal at depository institutions and shared draft accounts with credit unions. M1 does not include savings accounts, money market accounts, or CD’s. M1 is the most often referenced money supply by economists who use it to show the amount of money that is circulating through the economy. Inflation, supply and demand, interest rates and the state of the economy all play a factor in how and where people choose to hold their assets as well as how they decide to use those assets. This paper will look at an economic concept related to money demand through the review of scholarly articles. This concept is the Liquidity Preference Theory. Through the examination of scholarly articles, we will examine the validity of the Liquidity Preference Theory.

2. Literature Review

The Liquidity Preference Theory was introduced was economist John Keynes. His theory argued there was a relationship between interest rates and the demand for money. Keynes theory is also called a demand-for-money theory. The theory argues that consumers prefer cash over the other asset types for three reasons (Intelligent Economist, 2018). Keynes argued in his theory, that when interest is at a lower rate, people will be encouraged to increase money rather than increase the investment. People are not as willing to have a less liquid type of wealth when interest rates are low as they are when interest rates are higher. Instead, people will wait for interest rates to rise. Keynes’s theory argued that the interest rate in the demand for money is affected by supply and demand (Intelligent Economist, 2018). The Liquidity Preference Theory has a goal of remaining liquid and in order to remain most liquid people should not borrow money, so the interest rate is the cost for having to borrow money and not remaining liquid. Keynes states in his Liquidity Preference theory that there are three motives that drive people’s desire for liquidity. Those motives are the transaction motive, the precautionary motive, and the speculative motive (Pal, n.d.).

The transaction motive involves our daily purchasing habits. The money supply and the demand presented for the transaction motive can depend on how frequently a person is paid and the person’s income. Those that have higher income usually have a higher level of liquid money and can meet their daily transaction demands. Transaction demand (T_dm) for money is an increasing function of money income. It is stated by the following function: T_dm = f (Y), where Y represents the money income (Muley, n.d.).

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The precautionary motive looks toward an uncertain future. This motive focuses on income that is available for any wanted or necessary convenient purchases. The need for these uncertainties can arise from illness, injuries, loss of jobs and death (Muley, n.d). Keynes argued that those that have larger incomes will be more prepared with greater amounts of cash and assets set aside to meet the emergencies noted above. Those with smaller incomes will not have as large amounts of cash set aside for these emergencies and uncertainties that drive the precautionary motive. The precautionary motive demand for money is also an increasing function of money income (Muley, n.d.). Precautionary demand for money (P_dm) and the volume of income have a direct relationship and is illustrated with the function P_dm = f (Y) where Y stands for money income.

The speculative motive involves the income that can be gained by trading bonds and securities as the prices and interest rates fluctuate. This motive involves more uncertainty because of the fluctuating interest rates that can be affected by external factors (Muley, n.d.). People will spend speculative income when prices rise, or when interest rates fall. Alternatively, consumers will sell securities when prices fall, or when interest rates rise. So, the speculative motive shows that when interest rates are high, the demand for money is low. People who are earning money and wealth through the speculative motive likely have a preference to earn the bigger interest rates instead of having their assets having a more liquid status like cash and not earn any interest. The speculative motive shows that when interest rates are lower, people would rather have the access to the cash asset that is liquid instead of earning a low interest rate (Muley, n.d.). The speculative demand for money (S_dm) is stated by the function S_dm = f (r) where Y is the rate of interest (Muley, n.d.).

The total demand for money (D_m) is the sum of the three demands, transaction, precautionary, and speculative, and is stated with the equation: D_m = T_dm + P_dm + S_dm (Muley, n.d.). When the total demand for money (D_m) is graphed, it would result in a negative slope. The slope is negative because an inverse relationship exists between the speculative demand for money (S_dm) and the interest rate. When interest is low, a perfectly elastic negative slope will occur. Keynes discusses a “floor” interest rate that interest cannot fall below (Muley, n.d.). This floor, or minimum interest rate, indicates the absolute liquidity preference for consumers. Just as there is a floor for the interest rates, there is also a ceiling for interest rates. This ceiling places a cap which interest rates cannot rise above. So, interest rates will fluctuate between the interest floor, r-min and the interest ceiling, r-max. (Mulney, n.d.).

Keynes theory did encounter criticism and opposition for his theory on the rate of interest. The article 10 Criticisms of Keynes’ Theory of Liquidity discusses some of the criticisms and oppositions surrounding his theory:

1. Indeterminate. Like the classical theory of the rate of interest, the liquidity preference curve shifts up and down with the changes in income (Agarwal, n.d.).
2. Narrow version. Criticized as too narrow an explanation of the rate of interest because it unduly treats interest rates as price necessary to overcome the desire for liquidity. In reality, liquidity arises from many different factors (Agarwal, n.d.).
3. Hoarding. It is argued that Keynes’ theory does not properly explain hoarding. The volume of hoarding and the propensity to hoard are not analyzed in Keynes’ theory (Agarwal, n.d.).
4. Liquidity. Liquidity and illiquidity are not so easily distinguishable as Keynes implies (Agarwal, n.d.).
5. Inconsistent. Keynes’ theory is argued to be inconsistent in that the facts he tried to explain, he would contradict (Agarwal, n.d.).
6. Waiting Leads to Savings. According to Keynes, interest rate is not a reward for waiting or saving. Other scholars and studies argue, first earn income, save part of it, then decide how to save, either in cash or bond form (Agarwal, n.d.).
7. Productivity. Critics argue that interest is not the only reward for parting with liquidity (Agarwal, n.d.).
8. Limited Validity. Arguments state that it is not always possible to change supply and demand by lowering interest rates and increasing money supply. It is just as possible that an increase in money supply and an increase in the liquidity preferences will result in an interest rate that stays unchanged (Agarwal, n.d.).
9. For Advanced-Economies. Keynes’s theory may be applicable in advanced economies that have a wide money market, but it would not work in a backward developing economy (Agarwal, n.d.).
10. One-sided. Keynes’s theory is a one-sided theory. It gives preference to liquidity and does not look at any factors on the supply side (Agarwal, n.d.).

3. Model

A regression model is used to determine the strength of the relationship between the variables. The economic data was given for the regression model. The regression model uses the equation, M1=a+b1(interest)+b2(time). Interest is equivalent to the federal interest rate and time is the variable for the transaction demands, a is the only dependent variable in the formula. When interest rates are at low rates, people will hold onto cash assets in the hopes that the interest rates will increase, and as the interest rates rise the asset prices for things like stock will fall because people will want to hold on to more cash and less stocks.

4. Results of the Model

The R-squared, is the coefficient of determination. This coefficient is a statistical percentage of how closely the data fits to the regression line. In most cases, the higher the R-squared variable, the better the data will fit the model. In this case, the R squared value is 0.958026537, or 95.80% of the data fits the model.

The Adjusted R-squared is just as it sounds, an adjusted or modified version of the R-squared. The adjusted R-squared uses different predictor numbers and can provide an unbiased estimate of R-squared. The above model has an adjusted R-squared value of 0.957895165. This means that 95.79% of the predictors were true.

The Standard Error is the measure of the spread, and quite similar to standard deviation. As the number increases, it indicates that the data is more spread out. The standard data uses statistics and indicates how far the sample can move away from the actual mean. The above model has a standard error of 642.

The F-stat in regression takes into comparison various models. The F-stat includes the Null hypothesis, which states that the intercept only model and the model are equal. The other hypothesis states that the fit of the intercept only model will be significantly reduced when compared to the model. Our given model has a regression F-stat of 7292.452378 and a significant F-stat of 0.

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The T-stat is calculated using the sample data in the hypothesis test. The T-stat is calculated and compared to the data by what is expected in the null hypothesis. The sample size and variability are taken into account when calculating the t-stat values. If the t-stat value is equal to a value of zero, the result indicates that the sample is equal to the null hypothesis. The increase in the difference between the null hypothesis and the sample value mean an increase in the absolute t-stat value. The regression model above has a t-stat of 4.788313397.

The P-value is beneficial in determining the model results in the hypothesis tests. These tests are used to determine the accuracy of the claims made for population. A claim can be a null hypothesis or if the null hypothesis is untrue it would be an alternative hypothesis. Any hypothesis test that is performed measures the p-value and weighs the strength of any evidence presented in the hypothesis. P-value is always a number between 0-1. A number that is less than or equal to 0.05 is considered a small p-value. A small p-value typically implies strong evidence against the null hypothesis. When there is strong evidence against the null hypothesis it should be rejected. If the p-value is greater than or equal to 0.05 then there is little evidence to support against the null hypothesis, therefore the null hypothesis would fail to be rejected. These are considered large p-values. Those p-values that are very close to 0.05 are called marginal and could be considered either small p-values or large p-values. The model above has a p-value of 2.09203E-06 and would be considered a small p-value.

 The coefficients in the regression model are used to show the relationship between the dependent variable and the independent variables given. The coefficient will either have a positive or negative relation between the dependent and independent variables. A negative coefficient implies that the dependent variable decreases while the independent variable increases. A positive coefficient suggests that both the dependent and independent variable values are increasing. The above model has a coefficient of 59.28318528.

5. Summary

The supply of money is closely and deeply affected by the economy and variables that

affect the economic conditions. These variables can include the unemployment rate, inflation, and even the political condition of the country. John Keynes presented a theory, the liquidity preference theory that provided an explanation for the demand for money based on three motives. Without a doubt as the economy continues to grow and change, there will continue to be a need for new theories and new ideas on how the demand for money develops and progresses.

References

• Agarwal. M. (n.d.). 10 Criticisms of Keynes’ Theory of Liquidity. Retrieved October 1, 2018 From: http://www.economicsdiscussion.net/theories/liquidity-preference-theory/10-criticisms-of-keynes-theory-of-liquidity-preference/7957
• Intelligent Economist. (2018). Liquidity Preference Theory. Retrieved October 3, 2018. From: https://www.intelligenteconomist.com/liquidity-preference-theory/
• Muley, R. (n.d.). Keynes’ Liquidity Preference Theory of Interest Rate Determination. Retrieved October 9, 2018. From: http://www.economicsdiscussion.net/keynesian-economics/keynes-theory/keynes-liquidity-preference-theory-of-interest-rate-determination/17187
• Pal, D. (n.d.). Keynes’s Liquidity-Preference Theory of Interest Rate. Retrieved October 1, 2018 From: http://www.economicsdiscussion.net/keynesian-economics/preference-theory-of-interest-rate/keyness-liquidity-preference-theory-of-interest-rate/14531