Reporta: Gerente General y a todas las jefaturas

Liquidity preference is the name given to the theory based on the demand for and supply of money. It was developed by John Maynard Keynes in the 1930s. The supply of money is the stock of money, and the demand for money, or “preference for liquid-ity,” is how much money spending units wish to hold. The supply of and demand for money are both mea sured at a point in time and refer to actual stocks. The stock of money is partially determined by the central bank through its control over the stock of reserves and reserve requirements. Also, remember from Chapter 2 that the de-mand for money is based on the spending plans of spending units. Dede-mand is posi-tively related to income, and quantity demanded is negaposi-tively or inversely related to the interest rate, ceteris paribus. The interest rate adjusts to equate the quantity sup-plied (stock) of money with the quantity demanded.

The loanable funds theory developed in this chapter is based on fl ows as opposed to stocks. Flows are mea sured through time, whereas stocks are mea sured at a point in time. Thus, if I offer you a job for $10,000, you will want to know whether this is per week, per month, or per year. Not so for stocks. If I give you a $10,000 savings account, there is no relevant time dimension. The loanable funds theory develops the argument that the interest rate is determined by the supply of and demand for loanable funds. The demand for loanable funds refl ects borrowing plans by net borrowers, while the supply of loanable funds refl ects lending plans by net lenders. Ceteris paribus, the quantity de-manded of loanable funds is inversely related to the interest rate, while the quantity supplied of loanable funds is directly related to the interest rate. The interest rate adjusts to equate the quantity demanded of loanable funds with the quantity supplied.

To help you see that the theories complement each other, consider what hap-pens when the Fed increases bank reserves. When reserves increase, banks create money by incurring deposit liabilities as they acquire loans as assets. In doing so, banks have simultaneously augmented the supply of loanable funds. According to li-quidity preference, an increase in the supply of money, ceteris paribus, causes the in-terest rate to fall, while according to the loanable funds theory, an increase in the supply of loanable funds has the same effect. Likewise, if the Fed decreases the supply of reserves, you should be able to verify that both the stock of money and the supply of loanable funds decrease, leading to a higher interest rate. Again both theories predict that the interest rate changes in the same direction.

Next consider what happens when the demand for loanable funds increases, refl ecting an increased desire by people to borrow more at every interest rate. Be-cause banks acquire loan assets when they create checkable deposits, which are also money, an increase in the demand for loanable funds corresponds to an increase in the demand for money. According to both theories, an increase in the interest rate results. Likewise, a decrease in the demand for loanable funds translates to a decrease in the demand for money and a lower interest rate.

From an intuitive standpoint, we can reconcile the two theories by recogniz-ing that when there is a change in a stock mea sured at different times, a fl ow has

A Closer Look

twentieth century. The available evidence, such as that shown in Exhibit 5- 6, does show that nominal interest rates are highly correlated with infl ation and infl ationary expectations.

Now suppose the commercial paper rate is 5 percent and the current and expected rate of infl ation is 3 percent. This means that the expected real interest rate is 2 percent.

What happens if borrowers and lenders revise their expectation of future infl ation up-ward to 6 percent? If the commercial paper rate remains at 5 percent, they will expect the real interest rate to be minus 1 percent. This is the real cost of borrowing funds.

The fall in the expected real cost of borrowing will produce a rise in the nominal de-mand for funds. The rise in dede-mand should, in turn, put upward pressure on the nomi-nal commercial paper rate.

What about lenders of funds in the commercial paper market? Initially, they would have expected a real return of 2 percent (.05 − .03 = .02). If the lenders also revise occurred; that is, a fl ow over time results in a change in a stock. For example, if I have a gallon of milk in the morning, go to the refrigerator for a glass of milk repeatedly throughout the day, and have half a gallon left at the end of the day, then I can safely say that I consumed half a gallon of milk during the day. Consumption of milk over the course of the day represents a fl ow, but the amount of milk in the refrigerator at a point in time is a stock. The change in the stock of milk as mea sured at two different points in time depicts the fl ow. If I save $100 per year, at the end of the year my stock of wealth will have increased by $100 (ignoring interest payments for the time being).

Correspondingly, changes in the supply (fl ow) of loanable funds entail changes in the stock of money as mea sured at two different points in time. Likewise, changes in the demand (fl ow) of loanable funds entail changes in the demand for money. A theory stated in fl ows can always be reformulated in terms of stocks and vice versa.

5-6

Infl ation and the Interest Rate, 1964–2008

20.000 18.000 16.000 14.000 12.000 10.000 8.000 6.000 4.000 2.000

1964 1969 1974 1979 1984 1989 1994 1999 2004

0.000

Percent Change in CPI Interest Rate, 6th Month T-Bill

Annual: Percent Change in CPI and 6-month T-Bill Rate

5-7

Infl ation and Interest Rates: A Graphical Treatment

Interest Rate (Percent)

Loanable Funds (in Billions)

$500

8 E2

E1

SS S'S'

D'D'

DD 5

We begin, as in Exhibits 5- 3, 5- 4, and 5- 5, with an initial equilibrium at point E₁ and a prevailing interest rate of 5 percent. If the expected infl ation rate, p ^e, is 3 percent, this nominal rate, i, implies a real rate, r, of 2 percent (i = r + p ^e or 5 percent = 2 percent + 3 percent). Assume now that p ^e rises to 6 percent, ceteris paribus.

At a 5 percent nominal rate, lenders will now expect a lower real rate (−1 percent instead of + 2 percent).

Accordingly, they will be willing to lend less, shifting SS to S’S’. As for the borrowers, the rise in p ^e means that the expected real cost of borrowing at a 5 percent nominal rate has fallen (from + 2 percent to −1 per-cent). In response, they will want to borrow more, shifting DD to D’D’. The eventual result of the fall in sup-ply and rise in demand is an increase in the nominal rate equal to the change in infl ationary expectations.

their expectations of infl ation upward to 6 percent, it seems reasonable to presume that an expected real return of minus 1 percent would make them less willing to lend and would thus reduce the nominal supply of funds available in the commercial paper mar-ket. The reduction in supply would also put upward pressure on the nominal commer-cial paper rate.

The combined effect of the increase in demand and reduction in supply, as shown in Exhibit 5- 7, is a rise in the interest rate from 5 to 8 percent. With expected infl ation rising from 3 to 6 percent, the infl ation premium and, therefore, the nominal interest rate rises by 3 percent, from 5 to 8 percent. In this example, the increase in the interest rate is equal to the increase in infl ationary expectations. In an imperfect world— the real world— this may not always be the case, but we can be pretty certain that the direction of the change in interest rates will match the direction of the change in infl ationary expectations.

In sum, expectations of infl ation affect portfolio choices that help determine the demand and supply of loanable funds. Because interest rates respond to changes in de-mand and supply, and expectations of infl ation affect dede-mand and supply, we can con-clude that expectations of infl ation affect interest rates. Given this relationship, we can rewrite Equation (5- 7) as follows:

(5-10) i = f Y M p( ,^{+ −}, ^+e)