Excessive Liquidity Preference

Any recession by definition is associated with an excessive liquidity preference. An ex ante excess supply of goods and services, i.e. the demand for goods and services falling short of the base output at the base prices corresponding to that output, which is what a recession is, must be associated with an ex ante excess demand for money at that output and prices. This is simply Walras’ Law. The present recession in world economy however is characterized by “excessive liquidity preference” in a somewhat different and far stronger sense, namely it is an ex ante excess demand for money at the base prices and output that is not overcome through larger supplies of money. There is also a second aspect to the current “excessive liquidity preference”. The fact that the ex ante excess demand for money does not disappear at the base prices and output even when the supply of money in the possession of economic agents increases, holds not just for the economic agents that are usually called “the public”; it holds for banks as well, indeed for all economic agents including both the “public” and all manner of financial institutions. The demand for money at the base output and base prices corresponding to it, in short, is infinitely elastic, so that all increases in money supply to the “public” are simply held without preventing a fall in output/prices. What is more, if money, of the “high-powered” variety, is directly injected into the banks and other financial institutions, then it too is simply held by these institutions without causing any increase in the money supply with the “public”. Of course, the impact of variations in the ex ante excess demand for money on the output/prices of the non-money goods and services, is mediated through the interest rate. It follows then that the “excessive liquidity preference” characterizing the current recession is one where at the prevailing interest rate there is an infinitely elastic demand for money both among the “public” and among the financial institutions, especially banks. Keynes’ (1949) “liquidity trap” related only to a situation of infinitely elastic demand for money at the going interest rate by the “public”. The present situation of an infinitely elastic demand for money by both “the public” and also by banks, constitutes in Stiglitz’s words a new version of the liquidity trap. We may call it “liquidity trap in the broad sense” as distinct from Keynes’ liquidity trap, which is “liquidity trap in the narrow sense”. The hallmark of any liquidity trap is that an injection of liquidity by the monetary authorities has no impact on the interest rate, i.e. the interest rate is at a floor level. In Keynes this was because everyone holding bonds at this floor rate of interest expected the bond prices to fall at a rate equal to this interest rate; that is, everyone holding bonds was at the money-bonds margin and nobody was a “bull”. If we take an alternative interest rate theory where we do not have “two views” among wealth-holders but instead “a dense