àThe liquidity preference theory was an attempt to displace the prevailing theory of interest (and financial asset pricing)--the loanable funds theory (also known as the “classical” or “time preference” theories) of interest. àA successful assault on loanable funds was essential to the success of Keynes’s new theory of unemployment, since the old theory ostensibly preserves the validity of Say’s Law when a monetary economy is under consideration.

Key elements 3Humans are “present-oriented” and hence must be compensated for deferring gratification. 3Interest earned on bonds is the “reward for waiting”--that is, the monetary compensation required to induce present-oriented individuals to abstain from consumption (to save). 3The willingness to wait (saving) is a positive function of the yield of bonds (or other financial assets).

þ S is saving þI is investment þ i is the interest rate (yield of bonds) Don’t tell me you didn’t know that bond prices and yields move inversely!

S = f(i) [1]  S/  i > 0 [1a] I = (i) [2]  I/  i < 0 [2a] a S = I [3] b a Explained by the diminishing marginal product of capital b Equilibrium condition in the loanable funds market

S, I 0 S1S1 S2S2 I i1i1 i2i2 11 22 An improvement of thrift stimulates I--which explains the preference of some economists for measures (e.g., reduced taxes on capital gains) that ostensibly stimulate saving. i (%) I1I1 I2I2

I I National Income Leakages are defined as income received by households but not spent for the purchase of new goods and services in domestic goods. Injections are expenditures in domestic markets made by units other than domestic households. S

âIn a mature, industrialized economy the existing stock of debt held by individuals and institutions is vast. âThe flow of new debt issues in any brief time interval is but a tiny fraction of stock of debt outstanding. âTaking into account the development of organized secondary markets, previously issued bonds are a near- perfect substitute for newly-issued bonds (from the wealth-holders point of view). âThe primary determinant of the yield of new issues is therefore the yield prevailing in the secondary market for similar types of securities.

L  The liquidity preference function; L t  The transactions demand for liquid balances; L a  The asset or speculative demand for liquid balances; i  The yield of bonds; P B  The price of bonds; M 0  The (exogenously-determined) nominal money stock.; M 0 t  Money held for transactions purposes; M 0 a  Money held for asset purposes; Y  Real gross domestic product. Definitions

Let: D d  deposit liabilities of the banking system R a  total reserves of the banking system rr  legal reserve ratio If banks are “fully loaned up,” then: rr = R a /D d [1] It follows from [1] that: D d = R a /rr That the FED can control rr is not subject to dispute. If the more controversial proposition holds--that is, the FED can target R a (high- powered money)--then it follows that the FED can target D d. Which is to say, money is exogenous

The model L = L t + L a (1) L t =f(Y) (2) L t ’(Y) > 0 (2.1) L a = f (i) (3) L a ’(i) < 0 (3.1) M 0 = M 0 t + M 0 a (4) L = M 0 (5)

M0aM0a i (%) M, L 0 i* i1i1 0 LaLa

M0aM0a i (%) M, L 0 i2i2 i1i1 0 LaLa Bond yields fall, and bond prices rise

M0aM0a i (%) M, L 0 i2i2 i1i1 0 LaLa Bond yields rise, and bond prices fall