Interest Rates, Liquidity Preference And Inflation

Article of the Week from Fixing the Economists

by Philip Pilkington

On my post about Austrian and Marxian capital theory a commentator left a fairly predictable ‘Austrian comment’ which denied that they assume perfect foresight in their theory of interest rates and investment, gave a confused story about accounting identities (apparently if consumption rises then by identity profits fall; someone tell the NIPA crowd that they have it all wrong!) and insisted that I knew nothing about Austrian economics.

In the midst of this torrent of wrongness, however, the commentator made one interesting point that I haven’t heard before. He said that inflation and particularly hyperinflation proved the Keynesian liquidity preference of interest rates wrong. Here is the argument laid out in clear form.

1. Keynesian liquidity preference theory states that when liquidity preference rises interest rates will also rise as people hold onto liquid assets.
2. In a high inflation/hyperinflation environment we would expect liquidity preference to fall because the value of liquid assets is being eroded.
3. But in high inflation/hyperinflation environments we typically see interest rates rise together with the inflation.

Some sharp readers will roll their eyes at this. “Come on Phil, why are you dealing with this rubbish?” they will ask:

“Obviously in times of high inflation/hyperinflation central banks will raise the overnight rate of interest to stabilize real interest rates.”

Yes, of course this is the answer I gave to our Austrian friend and it is pretty obvious to anyone who deals with real world economic problems (as opposed to attending self-reinforcing libertarian meetings the purpose of which is to buttress a political ideology).

However, I thought that this incident might give me an opportunity to clear up some misconceptions about liquidity preference theory. You see, when we have a central bank setting the overnight rate of interest then the liquidity preference theory must be modified somewhat. Basically we must recognize that central banks have control over the interest rates but — and this is an enormous ‘but’ for anyone interested in financial markets — they do not control the spread between other interest rates and the overnight rate. This spread is dictated by liquidity preference.