The Misleading Function of “Liquidity Preference”

John M. Keynes proposes a liquidity preference function, M= L(i) (1936, p. 168). The function is partly true. Some of us would keep larger money in cash or bank deposits than usual when there is no opportunity whatsoever from which to expect a positive return or interest receipt. Unfortunately, however, “Half knowledge is more dangerous than ignorance.”

             Whose fault may it be, the equation has long been over-relied, way too much, in Cambridge macroeconomics. Particularly, the equation is one of the four pillars in the IS-LM model, which is “pretty-well working” according a famous and infamous Nobel laurate.

             First and foremost, there on earth is no such thing as the interest rate. As well known in elementary finance, interest rate is very specific to the investor, the asset, the time horizon, the portfolio, and the social, political and economic environment. As such, there are indefinitely many rates at any time of the year so as to turn an effort to make the average futile. Like infinity, indefiniteness is beyond human imagination, not to mention aggregation and calculation.

             Worse, we could never calculate an average without confining the time period. More simply, there is no such thing as the average at a certain moment or over an undefined period. In reality, none of us has even seen any macroeconomist specify what period she has in mind. They just refer to the GDP, the price level, the unemployment rate, the inflation rate, the growth rate, and the like without naming the period. .

             Naïve questions: Is the interest rate on the ordinate of IS-LM an annual average? Is the GDP on the abscissa per annum? How closely are the two associated with each other? How well can we guesstimate the effects of fiscal policy? Nobody other than macroeconomists would have any clue. Nay, macroeconomists do not seem to mind in the first place, possibly “for the sake of convenience.”  

             Even worse, macroeconomists not excluding the former Fed Chairman Ben Bernanke claim that the central bank control “the interest rate.” To be fair, they seem to mean “the fed funds target rate.” If so, the real question is how often or how strongly each of us relies on the target rate in making the decision how much barren money to hold. Between you and me, I mind the fed funds target rate less than the barking puppy next-door.

             The real tragedy, intended or otherwise: The equation has become to represent the so-named “demand curve” in the so-called “money market.” Alas, there is no such thing as “demand for money” or “money market” as long as earthly affairs are concerned. Just open a rudimentary economics textbook to know how “the market,” “demand” and “supply” are defined. The first thing we need is the accounting period. Otherwise, there is no way to name a price or a quantity.

Consolation:  

             “Theories are approximations. Nothing is completely anything,” to borrow from “Gene” Fama at the Booth School. There certainly is a money market called “change machine.” See, I told you so!