Liquidity preference as rational behaviour under uncertainty

Fernando Mierzejewski ()

MPRA Paper from University Library of Munich, Germany

Abstract: An important concern of macroeconomic analysis is how interest rates affect the cash balance demanded at a certain level of nominal income. In fact, the interest-rate- elasticity of the liquidity demand determines the effectiveness of monetary policy, which is useless under absolute liquidity preference, i.e. when the money demand is perfectly elastic. An actuarial approach is developed in this paper for dealing with random income. Assuming investors face liquidity constraints, a level of surplus exists which maximises expected value. Moreover, the optimal liquidity demand is expressed as a Value at Risk and the comonotonic dependence structure determines the amount of money demanded by the economy. As a consequence, the interest-rate-elasticity depends on the kind of risks and expectations. The more unstable the economy, the greater the interest-rate-elasticity of the money demand. Moreover, part of the adjustment to reestablish the short-run monetary equilibrium may be performed through volatility shocks.

Keywords: Money demand; Monetary policy; Economic capital; Distorted risk principle; Value-at-Risk (search for similar items in EconPapers)
JEL-codes: E0 E12 E40 E41 E44 E52 E58 (search for similar items in EconPapers)
Date: 2006-11-30
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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