Liquidity Preference and Financial Intermediation

Abstract

We examine the characteristics of optimal monetary policies in a general equilibrium model with incomplete markets. Markets are incomplete because of uninsured preference uncertainty, and because productive capital is traded infrequently. Rational individuals are willing to hold a liquid asset—money—at a premium. Monetary policy interacts with existing flnancial institutions to determine this premium, as well as the level of precautionary holdings. We show that inflation is expansionary, and that the optimal inflation rate is positive if there is no operative banking system (the Tobin effect). Otherwise, efficiency requires that money be undominated in its rate of retum (the Friedman Rule), We analyse the preference for liquidity and evaluate the effects of monetary policy in a framework where individuals optimize, and goods and asset markets are competitive. Liquidity needs of individuals, and characteristics of assets, are consequences of the structure of preferences, technology and information. Equilibrium is compatible with diiferences in the rates of retum on assets differing in liquidity; with divergences between household savings and aggregate investment in productive capital; and distortion of household consumption plans. We examine how these quantities are determined in altemative financial environments, the extent to which monetary or interest rate policies are effective and desirable, and the relative efficiency of altemative instruments which serve private liquidity needs. We find that monetary policy is effective, and infiation is expansionary, if the consumption plans of individuals are constrained by the lack of liquidity. At the same time, such expansion can be welfare inferior. Intermediation, which allows liquid assets to be issued against productive investment, is both feasible and desirable. Unlike infiation, intermediation achieves welfare enhancing expansion. This allows a comparison of the Tobin effect (Tobin (1965)) and the Friedman mle (Friedman (1969)) in a general equilibrium model. Cmdely speaking, the first indicates that infiation is desirable, while the other claims that defiation is. The difference, as we show, depends on the degree of intermediation. Money and productive capital are simultaneously held by individuals, even when money has a lower rate of retum. This is due to the fact that money is liquid—it can be used to pay for goods at any time and in all states of nature. Capital, on the other