Liquidity preference
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John Maynard Keynes developed the Liquidity Preference of Interest in the General Theory of Employment Interest and Money. The primary consideration of the liquidity preference is the demand for money as an asset, as a means for holding wealth. Interest rates, he argues, cannot be a reward for savings as such because, if a person hoards his savings in cash, he will receive no interest, although he has nevertheless, refrained from consuming all his current income. Instead of a reward for savings, interest in the Keynesian analysis is a reward for parting with liquidity.
Here is a diagram to illustrate the "liquidity preference" idea.
In the diagram, we show the quantity of money on the horizontal axis and the interest rate on the vertical axis. For example, if the rate of interest is Ra, people want to hold Ma of money, whereas if the rate of interest were to go down to Rb, people would increase their demand for monetary assets to Mb. The Fed can use this relationship, in reverse, to influence the interest rate. Suppose the Fed sets the total quantity of money at Ma. Then people will try to shift their assets out of the less liquid accounts into liquid money accounts as long as the rate of interest is less than Ra, or in reverse, to buy nonliquid assets whenever the rate of interest is greater than Ra. Since they cannot all shift their assets at once -- the total quantity of assets of each kind is known -- their competition for liquid or nonliquid assets will drive the interest rate to Ra. We may say that Ra is the "equilibrium interest rate" with a money supply of Ma. If the Fed wants to push interest rates down to Rb, they would increase the money supply to Mb.
There are two points of controversy about this.
There may be a lower limit to how far the Fed can push the interest rates down. In the diagram, the demand for money increases without any limit as the interest rate falls toward Rt. Thus, no matter how much the Fed increases the money supply, it could never push the interest rate below Rt. Rt is called "liquidity trap." Some economists have questioned the possibility of a "liquidity trap;" but others observe that the Japanese economic system, in the late 1990s, behaved very much like it was at the "liquidity trap" interest rate level. In any case, interest rates can never go lower than zero, and Japanese interest rates in the late 1990s were sometimes so low that the zero lower limit would be relevant. The Fed can use the liquidity preference relationship to influence interest rates only to the extent that the relationship is stable, or at least predictable. But some economists believe that it is very unstable and unpredictable -- a source of trouble rather than a means of control. In the fall of 1998, with the collapse of a major "hedge fund," and again just before January 1 2000, the Fed believed that there would be bid increases in liquidity preference. Indeed, for a short period in 1998, it seemed as if the U. S. economy had a liquidity trap at an interest rate of several percent. But because they predicted these changes, the Fed adjusted the money supply to keep the interest rates more nearly stable, and they were successful on the whole.
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