Liquidity Preference and the Theory of Interest and Money

This 1944 Econometrica paper by Franco Modigliani sets out to reconcile the Keynesian and classical theories of interest and money by building three complete macrostatic systems of equations – a “Keynesian” system, a “crude classical” system built on the quantity theory, and a “generalized classical” system – that share identical saving, investment, and money-demand (liquidity-preference) relations and differ only in the equation describing the supply of labor: perfectly elastic at a fixed money wage up to full employment in the Keynesian case, versus a wage rate that adjusts to a market-clearing real wage in the classical cases. Working through the resulting model in Part I, using the LL curve (money-market equilibrium) and IS curve (goods-market equilibrium) apparatus built on Hicks’s earlier work, Modigliani argues that Keynesian underemployment equilibrium is in general due to rigid, institutionally fixed money wages rather than to liquidity preference as such, and that liquidity preference alone under fully flexible wages is sufficient to produce underemployment equilibrium only in a special limiting case – the “Keynesian case” – where the interest rate needed to restore full employment falls below the minimum rate at which the demand for money to hold becomes infinitely elastic. He similarly argues that liquidity preference is neither necessary nor sufficient to explain why the interest rate depends on the money supply; that dependence, too, is in general a consequence of wage rigidity rather than of liquidity preference itself. In Part II, Modigliani uses this framework critically: he argues that a shortfall of investment causes unemployment only in the Keynesian case rather than in general; that Oscar Lange’s charge of a logical contradiction in the classical dichotomy between money and real variables fails once the required homogeneity of expectations functions is properly specified; that A. P. Lerner’s claim that saving and investment play no role in determining the interest rate rests on mistaking a reduced-form relation, obtained only after solving the whole system, for a primitive demand-for-money schedule; and that J. R. Hicks’s attempt to explain the interest rate by the “imperfect moneyness” of securities and the cost of investing conflates a necessary condition for money to be held at all with an explanation of the level of the interest rate, which the paper instead locates in the propensities to save and invest under flexible wages, and in those propensities together with money supply and wage rigidity in the general case.

Franco Modigliani | Macro Paper Warehouse

Liquidity Preference and the Theory of Interest and Money