Problems

As the previous chapter has detailed, the theory of liquidity preference had – mostly – not been understood, and, indeed, much of its central message had been reduced to a much tamer respecification of the demand for money, rather than a theory of asset prices, as it truly was.

Over the course of the 1970s some post-Keynesian authors came to revisit the theory, and they found it extremely problematic – to the point of rejecting it. The crucial problems can be summarized as follows.

Keynes shaped the liquid preference theory as an equilibrium in the market for liquid hoards, relegating to a footnote (1936: 167 n.1) the fact that bank deposits could also be included in this vision. It may have been just convenient for Keynes to emphasize the demand for liquid hoards, but it is also true that, at the time, the Bank of England exercised a much tighter control over the extension of credit by the commercial banking system. So, restricting the analysis to hoards was a suitable approximation, abandoning, or not stressing as much, the position on banking and their deposits, he had expressed in his earlier Treatise on Money (Keynes 1930). But, leaving aside the historical context of the 1930s, could hoards of cash really be considered such a substantial phenomenon in a modern, fully intermediated economy? The answer, inevitably, was in the negative. What households typically held and hang on to were bank deposits, not cash under the mattress. In some cases, these bank deposits did pay interest, so it became very problematic and somewhat anachronistic to argue that it was the existence of cash hoards that dictated the equilibrium of the economy.

Secondly, Keynes talked about the interest rate, but the reality is that there are a number of interest rates. It is true that they are related to each other by a number of inequality conditions, but it nonetheless became difficult to transfer the insights of the theory onto the observed reality of a term structure of interest rates.

Thirdly, and much more importantly, liquidity preference is stated in the General Theory for a given stock of the money supply.