Saturday, September 19, 2009

Limitations of the Liquidity preference Theory

Still, liquidity theory has important limitations. It is only a short-run approach to interest-rate determination because it assumes that income levels remain constant. In the longer run, interest rates are affected by changes in the level of income. Indeed, it is impossible to have a stable-equilibrium interest rate without also reaching an equilibrium level of income, savings, and investment. Then, too, liquidity preference considers only the supply and demand for money, whereas business, consumer, and government demands for credit clearly have an impact upon the cost of credit to these borrowers. A more comprehensive view of interest rates is needed which considers the important roles played by all actors in the financial system-businesses, households, and governments.

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