Liquidity preference in a portfolio framework and the monetary theory of Kahn

This paper examines the relation between variations in the propensity towards liquidity preference, price-adjustment and shifts in portfolio allocation by expanding Kahn's idea of marginal equilibrium under strong uncertainty in financial markets and contributes to recent post-Keynesian attempts to develop a liquidity preference theory of asset prices by providing an analysis of the price-adjustment mechanism.

The notion of the own-rate of money interest is utilised to develop a multi-asset liquidity preference framework, which is consistent with uneven variations of liquidity-premia across assets in response to changes in the degree of strong uncertainty that is specific to different investors with variable allocation of assets in their portfolios. More specifically, in the context of this portfolio framework it is established that an increase in the state of strong uncertainty (state of bearishness) makes less liquid assets further less inconvenient than more liquid assets. In periods characterised by greater strong uncertainty, equilibrium is restored through a greater demand for more liquid assets including money relative to the demand for less liquid assets and, therefore, through a higher own-rate of money interest for less liquid assets than warranted, which shows the ineffectiveness of standard monetary policy.

Tags: Liquidity preference, Monetary theory, Portfolio, Strong uncertainty, Kahn

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