Banks and Liquidity Preference

Consider a simple economy with three sectors: households, firms and government.  There are two assets: government bills and loans to firms.  Firms can hold bills, but we'll assume their holdings are generally zero.  All loans to firms are made by households.  The national balance sheet looks like this.

	Households	Firms	Government
Loans	L	- L
Bills	B		- B

(To avoid needing to include money as a separate asset class, we'll assume here that the bills are used as the medium of exchange.  This could be through direct physical exchange.  Alternatively, all bills could be held in individual accounts in a central registry with households and firms making payments by instructing the registry to transfer ownership interests.)

For simplicity, we will assume that firms wish to invest as much as they can and are limited only by the amount that households are prepared to lend.  Household behaviour can then be split into two decisions that are strictly independent. 

First, they make a decision that determines the total addition to their holdings of financial assets.  It is usual to think of this as being a decision about how much they spend on consumption, given their income expectation and other factors.  The accumulation of financial assets - saving - is the residual.

Secondly, they make a decision which determines the split between making additional loans and acquiring additional bills.  It will be useful to think of this as being a decision about the amount of additional loans they want to make.  We can imagine that bills are riskless and households have no limits on how many they hold, but that loans to firms carry default risk and households wish to manage their exposure.

It is crucial to recognise that these are two separate decisions.  Households can decide to spend less on consumption, without changing their decision about how much to lend to firms.  Likewise, they can decide to lend more to firms, without changing their decision about how much to consume.  Putting this latter point another way, a household decision to save more is not a pre-condition of an increase in loans to firms.

Each decision affects expenditure independently.  We have assumed that firms will spend all they can borrow, so the decision to lend affects expenditure directly.  As we have noted, this is not dependent on a decision by households to consume less.  So although, for the economy as a whole, investment must equal income less consumption, both investment and consumption are separately determined, making income the thing that needs to adjust.

If we were instead to assume that there was just one decision and the amount to be loaned to firms had to be exactly equal to the amount saved, then we would have the sort of situation conjured up by loanable funds imagery.  We could imagine that the amount to be loaned was determined by the amount households decided to save.  This might be the case in a simple barter model where saving could only be undertaken by retaining real goods

How do banks fit into this picture?  The answer is all to do with the lending decision and not the saving decision.  If the amount to be loaned to firms is still decided entirely by households, then banks are mere conduits - what people often mean when they question whether banks are just intermediaries.  On the other hand, if part or all of that decision falls to banks, then they immediately become an active part of the process.

We can illustrate this by adding banks into our balance sheet in two different ways.  In the first (shown below), banks hold the loans and households hold deposits at the bank instead. 

	Households	Firms	Banks	Government
Deposits	D		- D
Loans		- L	L
Bills	B			-  B

We need to make two further assumptions here.

a) that households decide between bills and deposits in the same way that they did between bills and loans; and

b) that banks accept any amounts deposited, which they then automatically lend out.

In this case, we can see that the lending decision still rests entirely with households, notwithstanding that banks are making the actual loans.  This is a true banks-as-simple-intermediaries model.

Alternatively, we might add in banks as shown below:

	Households	Firms	Banks	Government
Deposits	D		- D
Loans		- L	L
Bills			B	- B

In this scenario, a decision by households to increase holdings of deposits is the same as a decision to save.  There is no way for households to do one and not the other.  Rather than making two separate decisions, households now only get to make one.  The split between loans and bills - essentially the decision to lend - is in the hands of banks.  So, now, bank behaviour is crucial.

In reality, we are somewhere between these  two situations.  Bank decisions on lending are important, but household decisions matter too.  A major factor in the financial crisis was non-banks (households, here) trying to switch from bank debt (deposits) to government securities (bills).

Once we start to consider separate objectives for households and banks, we need to start bringing interest rates into the picture (or rather interest rate differentials).

We can see here the critical importance of portfolio decisions and how they are made.  This basic idea is really what liquidity preference is about in Keynesian and post-Keynesian economics.  Liquidity preference is perhaps an unfortunate term because, although liquidity is an important element, we need to look at aspects of portfolio preference that go beyond that.