The optimal liquidity principle and the aggregate money demand

Abstract

The extent to which central banks are able to anticipate the effects of monetary policy can be assessed within the framework of the liquidity-preference proposition. An actuarial-based theory of liquidity preference is developed in this paper, which extends the traditional framework by introducing borrowing restrictions. This setting can be applied to describe a broad range of corporate, financial and economic decisions. A major result of the paper is that the interest rate elasticity of the money demand, and hence, the effectiveness of monetary policy, directly depends on the series of nominal output returns. Some states are characterized in particular, when the money demand is perfectly elastic and monetary policy is useless to deal with output fluctuations. An analysis of the historical data of the economy of the USA is additionally provided, which presents empirical evidence showing that the interest rate elasticity can increase in response to economic fluctuations. It is thus concluded that not only the growth and inflation rates should be taken into consideration when implementing monetary policy - as is currently the case in a majority of countries - but also the statistical description of the series of nominal output returns.