Liquidity Preference Theory

This post is not necessarily a blog entry or op-ed, but rather a brief stream of consciousness on Keynes Liquidity Preference Theory. Why do I want to write about this topic? I think it’s fascinating, and the implications of the Federal Reserve’s recent quantitative easing(QE3) can be observed within Keynes framework (a blog entry for another day.)

What is Liquidity Preference Theory? Essentially it expounds upon the demand for money. We can observe an equilibrium in the market for money easily by using Keynes method. The framework revolves around three basic factors: the supply of money, interest rates, and the demand for money.

The opportunity cost of holding money is the interest rate. By holding money, you are giving up on the interest rate you could be receiving from a variety of investment options. When the interest rate goes up, your opportunity cost rises, thus decreasing the demand for money. Individuals respond to incentives. When the interest rate rises, people will be less likely to hold funds. The opposite concept also applies. When the interest rate falls, the demand for money rises. People just want to keep their capital. That process is essentially what liquidity preference is all about. Just like the name implies, individuals will have a preference to maintain liquidity(cash/money.)

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A Basic Look at the Euro’s Recent Appreciation

The Foreign Exchange Market

According to The Wall Street Journal, “The euro rose to $1.2985 late Thursday from $1.2894 late Wednesday. The euro rose as high as $1.3001 Thursday, its highest point against the dollar since May 9.” Why in the world is this happening? Isn’t it bad when the dollar weakens? In this article, I want to address the Foreign Exchange Rate(FOREX) process for “dummies” and why the Euro has been appreciating.

For the purpose of understanding FOREX rates, I will only discuss two basic reasons why the dollar has depreciated recently, European Central Bank activity and the Federal Reserve’s recently announced Quantitative Easing three(QE3.)

According to The Wall Street Journal, “The euro has rallied 6% against the dollar since early August on optimism that the European Central Bank can relieve financial stresses in struggling Euro-Zone countries.” Unless you live under a rock, you should be aware that the Euro-Zone has recently been experiencing extreme economic difficulty. Why would Central Bank activity boost the value of the Euro? Simply, foreign investors seek out stable countries with strong economic performance to invest their capital. Investors are beginning to have more confidence in the Euro-Zone, thus investing money into various financial instruments. For the purposes of your understanding, think “Investor confidence in a country= increased demand for countries currency= appreciation of said country’s currency.” This simple concept is one explanation for the US dollars recent depreciation in the FOREX market.

Today, the Federal Reserve announced another round of Quantitative Easing (QE3.) What is this? To fully understand, we need to discuss a few concepts first. The interest rate heavily relies on what is known as the money supply. The money supply is what it sounds like, the amount of money circulating through banks and financial institutions. The more money there is, the lower the interest rate. Higher interest rates signify a smaller money supply. In theory, when interest rates are low, people will borrow more money. This borrowing leads to positive economic activity, boosting GDP and reducing unemployment. Follow me so far? Quantitative easing is simply when the Federal Reserve purchases a massive amount of bonds to increase the money supply. This purchase leads to lower interest rates, which in theory is good for the economy. That’s why on the news you may constantly hear about how the Federal Reserve wants to extend low interest rates. They think it will be beneficial for the economy. However, this process actually weakens the dollar. Foreign investors have no desire to invest in low yield financial instruments. Low yields are great for borrowers, but terrible for investors. Investors will seek out other countries to invest their funds in. Thus, other currencies appreciate relative to the dollar.

There is far more to discuss on this topic, but I hope this little discussion has shed some light on current financial events.  It’s important to understand the world around you! Please let me know if you have any questions.

Why Doesn’t America Just Use The Barter System Again?

Want my cow?

I was recently browsing the web and came across a discussion about America going back to the barter system. The author of the discussion ranted, “let’s get rid of big evil business, money, oil, and go back to horse and buggy and the barter system !” This actually sounds like a decent idea at first. Many Americans long for a more simple government and financial system. Big business is public enemy number one to the common blue collar worker. But would reverting to the barter system actually do anything to address America’s ongoing problems?

A barter system is characterized by the trading of goods between two separate entities. I trade you some berries for a shell necklace. This seems like a fair and efficient method of payment, until you examine the situation more closely. There are a variety of problems that make the barter system archaic and inefficient.

One of these problems is what economists call a “double coincidence of wants.” What in the heck is that? Simply, it means that I may have those berries to trade for your necklace, but you don’t want them! I may have to search for an item you want, necessitating multiple transactions with many different individuals. Having a standardized commodity as a currency minimizes transaction costs. You may not realize it, but the dollar makes your life a lot easier!

Another problem with the system is the need for an enormous amount of different prices. How many shells equal a vegetable? How many cars equal medical care? Let’s take a look at a hypothetical country that uses the barter system.

In Williamsland, there are 1000 goods people trade with each other. With a standardized currency, like the United States has today, there would be… 1000 different prices! The standardized currency allows for simple pricing of a variety of products. Here is how many prices would be necessary in Williamsland:

1000(999)/2 = 499,500

There would be nearly half a million different prices! I don’t know about you, but that does not sound like the ideal marketplace to me. Financial innovation in the modern era has allowed the world to become more efficient. So sorry all of you who want to travel back in time 500 years; you would be making your life much harder!

The Free Market?

Beware…

The concept of an inherently perfect and stable financial market has been the leading ideology among economists for decades. This romanticized view of a magical self-policing market is pervasive. The Efficient Market Hypothesis and Adam Smith’s “Invisible Hand” concept promote the idea that stocks are priced perfectly and the market will best regulate itself. However, with the recent financial crisis, economists have been forced to reassess their views. Why did this perfect market crumble?The stability of the market is of paramount importance to America. The recent market devastation has led to the obliteration of retirement funds, increased foreclosures, and high unemployment. America’s global security depends on a powerful economy. A financial crisis of this magnitude cannot be allowed to occur again. This fall was in part due to inadequate regulation and blind faith in quantitative mathematical derivatives. The invisible hand that was supposed to guide the market became a sleight of hand that engaged in deceptive practices. Lack of proper financial regulation is an issue that must be addressed.

The view of a perfect market is backed with impressive looking mathematical equations. One of these equations is known as Value at Risk (VaR). This equation is used to measure risk and is viewed as a nearly perfect formula. However, this formula did not predict the Asian financial Crisis of 1997 or the Russian default on debt of 1998. Long-Term Capital Management crumbled and lost over 4 billion dollars during the Russian default due to faith in complex math. Mathematics should not be treated as absolute truth. This same math was used to rationalize corrupt practices that led to the American financial crisis.

Years of market deregulation by the government created an environment ripe for risk fraught capital ventures and unethical games. The repeal of the Glass-Steagall Act in 1999 removed the separation between investment and commercial banks. Investment banks used their depositors’ money from commercial banks to partake in risky trading. Investment banks had improper leverage. The actions of investment banks such as Bear Sterns and Lehman Brothers directly led to the financial crisis.

Recent regulatory provisions such as the Dodd-Frank Act and Sarbanes-Oxley Act are not perfect but begin to address fundamental problems present in a deregulated market. The selfish actions of a few elite bankers should not be allowed to completely wreck the lives of millions of hard working Americans. Economic busts permeate into the well-being of every industry and demographic. The elderly cannot afford the cost of living. Students cannot afford the high tuition costs required to attend a university. The success of the economy directly relates to the success of every individual. The solution to this problem is to pass proper regulation. Politicians need to look past self-interest and hyper-partisanship to properly protect the American public.

The economic damage caused by a market unfettered by proper regulation has been staggering. This is not to say that the government should become an all-powerful puppet master. There must be a proper balance between free market capitalism and appropriate regulation. Predatory lending and unethical practices should be monitored and corrected. The assumption that the market will run smoothly on its own is oversimplified.