LIQUIDITY PREFERENCE OR LOANABLE FUNDS: INTEREST RATE DETERMINATION IN MARKET DISEQUILIBRIUM

Abstract

THE purpose of this paper is threefold: (1) to specify a generalized disequilibrium macroeconomic model which explicitly incorporates the concept of spillover in non-tatonnement financial and real markets; (2) to relate the model, and particularly the concept of spillover, to the liquidity preference and loanable funds theories of interest rate determination; and (3) to investigate the implications of these two interest rate theories for the timing of monetary policy. The notion of market spillover is well established in the literature on non-tatonnement market processes. As early as 1952 Patinkin ([17], p.41) recognized that markets in disequilibrium imply a general pattern of 'spillover', which he defined as the market condition in which ...buyers who have not succeeded in spending all they intended to at given prices... redirect part of their unspent income. Clower [2] provided a choicetheoretic basis for the spillover concept by focusing on the individual maximization process in situations of constrained demand. However, it was Grossman [8, 9] who synthesized Patinkin's concept of spillover with the Hahn-Negishi [16] non-tatonnement transaction process and the Clower dual decision hypothesis to develop a non-tatonnement model incorporating spillover. Despite well established micro-foundations for spillover, the important disequilibrium macroeconomic studies of Tucker [19], Feige [3], Laidler [12, 13], and Grossman and Dolde [10] do not explicitly consider the concept. The contribution of this paper is to extend Grossman's discussion of market spillover to a generalized disequilibrium macroeconomic model which also includes gradual adjustment of expectations and demand. The liquidity preference and loanable funds theories of interest rate determination are then shown to represent special cases of the model, and the dynamic implications of these two theories are examined. More specifically, it is shown that the degree to which excess demand for commodities spills over into the bond market creates special cases of the model which conform to the alternative interest rate theories. In addition, the implications of spillover for monetary policy are examined by solving the dynamics of the