Sunday, June 7, 2009


What can be done to reduce liquidity preference?

The present situation is of a deflationary type because there is a very strong liquidity preference (by banks, investors and households). This is preventing a pickup in credit and in purchases of risky assets. What can be done to lessen the liquidity preference once interest rates have been lowered to zero?

− try to create inflation expectations (quantitative monetary policy, currency depreciation) to cause investors and banks to switch from cash to assets that provide a hedge against inflation (real estate, productive capital, etc.);

− increase the return on risky assets (through fiscal policy, for example), because the return on risk-free assets cannot be reduced further (despite some far-fetched proposals to introduce negative interest rates).

Policies discouraging the holding of liquid assets are more effective than policies of creating additional liquidity, although they are similar in certain respects (inflation expectations).

It must also be recognised that if banks are faced with a fall in credit demand, it is only on the investor side that action can be taken.

If, moreover, there are fears of excessive monetary creation and expected inflation, the most advisable policy is therefore to increase the returns on risky assets via incentive policies.

To see full report: FLASH ECONOMICS