Edited by Philip Arestis and Malcolm Sawyer
Chapter 20: Liquidity Preference Theory
Jörg Bibow To ditch or to build on it? The theory of liquidity preference is probably the single most controversial of the core constituents of The General Theory. Keynes presented a ‘liquidity [preference] theory of interest’, a theory that is supposed to ﬁll the vacuum left by what he regarded as the ﬂawed ‘classical [savings] theory of interest’. In the early post-General Theory literature, the notion of liquidity preference quickly became a synonym for the demand for money. Together with a constant stock of money, liquidity preference was the factor that determined the rate of interest in the money market of Hicks’s seminal IS–LM model. The novelty of Keynes’s contribution was widely seen in the speculative motive for the demand of money only. And his revolutionary claim regarding the ﬂawed classical theory of interest that needed replacement seemed ill founded when Hicks (1939) declared that liquidity preference and classical (loanable funds) theories were ‘equivalent’. Within the broader context of developments in postwar monetary and macroeconomic thought, this was but one element in weaving (or ‘synthesizing’) Keynes’s supposedly ‘general’ theory into the essentially unshattered neoclassical mainstream by relegating the relevance of his insights to special circumstances that could potentially arise in the short run if money wages were sticky (Modigliani, 1944). Correspondingly, in policy matters, monetary policy was stylized as a short-run tool that could help stabilize the economy by controlling the supply of money – with the money neutrality postulate ﬁrmly upheld as far as the long run is...
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