Liquidity: Its Origins and Implications in an Uncertain Multiperiod World with Limited Borrowing

By Miller, Edward | American Economist, Spring 1994 | Go to article overview

Liquidity: Its Origins and Implications in an Uncertain Multiperiod World with Limited Borrowing


Miller, Edward, American Economist


Most monetary and macroeconomic theory contains an implicit assumption that all assets and liabilities are traded in perfect markets with equal borrowing and lending rates. This paper will show that significant changes must be made in our standard theories when borrowing and lending rates differ. The frequent and important case where individuals cannot borrow against their human capital can

be handled by noting that inability (or unwillingness) to borrow is operationally equivalent to an infinite borrowing rate. The more general case of borrowing rates exceeding lending rates thus includes the inability to borrow against certain types of future income, such as income from human capital.

A monetary theory which assumes perfect financial markets with borrowers able to borrow unlimited amounts at the lending rate upon demand (and without transaction costs) is logically inconsistent. In such a world, the free and ready availability of credit makes liquidity a free good and holding noninterest paying money irrational. Since everything can be financed by credit, the optimal strategy is to invest all monetary balances and to use credit for working balances. Any monetary income is used upon its receipt to reduce the outstanding credit balances.

Most attempts to derive a theory of consumption and saving from individual behavior use two-period models in which there is an exchange of present consumption for future consumption at a specified date [10]. Yet observation suggests that most individuals view the key decision as being a trade-off between current consumption or saving. Saving is retaining purchasing power for consumption at an indefinite and unspecified future time. The decision to save is the decision to retain the option, through asset holding, of choosing a date for future consumption.

In this essay a simple state of nature model will be used in which the consumer chooses between consumption now and retaining purchasing power for future use. The model has been developed elsewhere [8] and will be used here to explore the implications of different types of assets for macroeconomic equilibrium. It differs from other models with uncertain future income in being multiperiod and in having higher borrowing rates than lending rates. In such a model, the marginal utility of consumption is equated to the marginal utility of purchasing power held for future use. This leads to a model in which liquid asset holdings enter into the consumption function and are not cancelled out by liabilities of equal amount.

It will be shown here that allowing for the option on consumption aspect of holding purchasing power does not make a difference if unlimited borrowing is possible at the lending rate. However, if the consumer cannot borrow unlimited amounts at the rate at which he lends, liquidity does have value for him. An analysis of the choice between consumption now and an option on consumption gives different conclusions than the traditional analysis of the optimal choice between consumption at two times.

When the consumer can both borrow and lend at the going interest rate, the condition for consumer equilibrium between period (n - 1) consumption and period n consumption is simple. Let i be the interest rate. In equilibrium he will have borrowed (or lent) sufficient amounts in period n - 1 and in the relevant state of nature to assure that the marginal utility in period n - 1 is equal to the period n marginal utility multiplied by (1 + i). With any other relationship between the marginal utilities of consumption in the two periods, the consumer could increase his welfare by changing his level of saving. This could not be an equilibrium.

Thus, with equal lending and borrowing rates, the marginal utility of current consumption must (adjusted for interest) equal the marginal utility of next period's consumption. The consumer gains no additional utility beyond time preference from being able to spend funds early; he cannot benefit from increased liquidity and the ability to shift consumption to an earlier time. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Liquidity: Its Origins and Implications in an Uncertain Multiperiod World with Limited Borrowing
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.