Liquidity Preference and Loanable Funds : Stock and Flow Analysis

Abstract

Despite Hicks' demonstration nearly twenty years ago of the equivalence between liquidity-preference and loanable-funds theories of interest, thte debate on this issue continues to fill the pages of the journals. Indeed, on this issue the 1950's have seen a revival of the polemics of the 1930's. It is not my purpose here to provide a systematic survey of this revival. Instead I shall restrict myself to two arguments that have been advanced in implicit or explicit rebuttal of Hicks' demonstration-and will show why they are invalid. The first argument bases itself on the distinction between stock and flow analysis -and will be discussed in Section 1. The second bases itself on the distinction between static and dynamic analysis-and this will be discussed in Section 2.2 The argument of both these sections is carried out on the assumption of full employment; a generalization-under certain assumptions-to the case of unemployment is presented in Section 3. 1. Let us start with Hicks' classic demonstration.3 This can be restated in the form of the following two propositions: 1 (a) Consider an economy with n goods, consisting of n-2 commodities (inclusive of services), bonds (perpetuities), and money. In the corresponding system of n excess-demand equations, one of the equations is redundant and can be eliminated-that is, if any n-i excess-demand equations are satisfied, the remaining one must also be satisfied. This will be called Walras' Law. (b) It follows that a general-equilibrium analysis of the commodity and bond markets yields exactly the same equilibrium rate of