Liquidity Theory of Money

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Subject: Economics

Class: M.A.
Semester: III
Name of the Paper:
Monetary Economics

Topic:
Liquidity Theory of Money

Keywords: Radcliffe-Sayers, Gurley-Shaw, non-banking financial intermediaries

Dr. Rajesh Pal


Professor and Head
Department of Economics
Faculty of Social Sciences
Mahatma Gandhi Kashi Vidyapith
Varanasi-02.
Email: [email protected]

Disclaimer: Although the author has made every effort to ensure that the information and knowledge
provided in this chapter is correct and accurate in regard to the subject matter covered. The matter of this
chapter is taken from the author’s book entitled “Issues and Concepts of Economics (2016),” published by
Adhyayan Publishers and Distributors, New Delhi. The author possesses the copyright of his book. The
author assumes no responsibility for errors, inaccuracies, omissions, or any other inconsistencies herein
and hereby disclaim any liability to any party for any loss, damage, or disruption caused by errors or
omissions, whether such errors or omissions result from negligence, accident, or any other cause.

Self-Declaration: The content is exclusively meant for academic purposes and for enhancing teaching
and learning. Any other use for economic/commercial purpose is strictly prohibited. The uses of the
content shall not distribute, disseminate or share it with anyone else and its use is restricted to
advancement of individual knowledge. The information provided in this e-content is authentic and best as
per my knowledge.

Copyright © 2020 by Rajesh Pal.

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Liquidity Theory of Money
Learning Objectives

After learning this chapter, you will be able to:

• Know the meaning of liquidity.


• Understand the difference between money assets and near money assets.
• Explain the two versions of liquidity theory of money.
• Express the importance of non-banking financial intermediaries.
• Distinguished between the Radcliffe-Sayers and Gurley-Shaw versions of liquidity theory
of money.

Introduction

Liquidity theory of money is looked upon as advanced theory over quantity theory of money and
income theory of money. This theory has rejected both quantity theory and income theory of
money. According to this theory, it is neither quantity of money in circulation nor national
income determines the price level or general economic activity in an economy. On the contrary
the theory looks upon general liquidity as the sole determinants of the price level or the
economic activity in a country.

Liquidity Theory of Money

To understand the general liquidity, we have to make a distinction between money and near
money. The distinction between money and near money is based on the degree of liquidity.
Money in a narrow sense is a means of payment, which serves as a medium of exchange,
measure of value, a store of value, and a standard for deferred payments. It is the most liquid
assets; it includes currency/cash (C) and demand deposits (withdrawable by cheques) of
commercial banks (DD), as

M = C + DD (i)

Where, M refers to money; C refers to currency; and DD represents demand deposits of


commercial banks, which is withdrawable by cheques.

The narrow concept of money is called money assets (referring to assets, which functions
as money). According to broad concept of money,

Money = Money assets + Near money assets (referring to assets, which can be converted
into money on a short notice like fixed money. Near money comprise all those assets held by the
public, which are not directly used by the public as a means of payment, but are looked upon as a
near substitute of money. For example, time and saving deposits of commercial banks,
government security, treasury bills, bills of exchange, traveller’s cheques, post-office national

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saving certificate, debentures, surrender value of life insurance policies, and units issued by the
Unit Trust and various other credit instruments customarily used in the money market.

According to this theory, it is non-banking financial intermediaries, which provide a link


between liquidity and monetary policy. This theory states that aggregate public expenditure
particularly in advanced country is not only affected by currency and demand deposits of
commercial banks but also by near money as well. Near money play an important role in
determining expenditure of the public. It is on account of this that the liquidity theory of money
accords an important status to near money as a determinant of the price level in a country.
Hence, it is suggested by the modern economists that central bank should control both
commercial banks as well as non-banking financial intermediaries. There are two versions of
liquidity theory of money: (i) Radcliffe-Sayers’ version of the liquidity theory, and (ii) Gurley-
Shaw version of the liquidity theory.

Radcliffe-Sayers’ version of the Liquidity Theory

The Radcliffe Committee Report on the Working of the Monetary System (1959)1 emphasis on
monetary policy aspects while Sayers emphasis on theoretical aspects of the liquidity theory; the
combined analysis of liquidity theory of both Radcliffe committee and Sayers are sometimes
called Radcliffe-Sayers’ thesis. This thesis emphasis that the aggregate demand or the level of
economic activity is influenced by the public expenditure, which in turn is not only influenced by
the quantity of money in circulation and demand deposits but also by the general liquidity of the
economy. The general liquidity is influenced by the interest rate. The liquidity theory, thus,
accords an important place to the interest rate. It is the interest rate, which determines the
expenditure of public via general liquidity. Any change in the interest rate affects general
liquidity. For example, change in interest rate affects lending activities of the commercial banks
and non-banking financial intermediaries (NBFIs). An increase in the interest rate decreases
general liquidity, which leads to fall in public expenditure and ultimately fall in the price level
and vice versa. Thus, to control over the economy, we have to control the interest rate and
regulate the functioning of non-banking financial intermediaries besides commercial banks. In a
nut shell, this theory states that quantity of money, though play an important role in determining
the price level yet it is near money assets (i.e., general liquidity), which determines the price
level. According to this theory, monetary policy cannot succeed unless it is supported by fiscal
policy.

Gurley-Shaw version of the liquidity theory

Gurley and Shaw have divided the total quantity of money under two heads such as, inside
money and outside money.2 Inside money is based on the debt of endogenous economic units. It
is money created within the private sector against some private debt. It consists of financial
claims by one class of individuals and firms on others within the economy. Outside money on
the other hand is money is based on the debt of a unit (the government) exogenous to the system.

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Thus, it is currency issued by government, gold, foreign and government securities. It is the
liability of the government as a debtor and the claim of the private sector as a creditor.

When a country progresses economically, changes in financial structure are observed.


Financial assets or claims are generally divided under the two heads of primary (direct) securities
ans secondary (indirect) securities. The primary securities are financial claims against real sector
units, for examples, bills, bond, and equities etc. They are created by real sector units as ultimate
borrowers for raising funds to finance their deficit spending. The secondary securities are
financial claims issued by financial institutions or intermediaries against themselves to raise
funds from the public. The examples are such diverse financial assets are the Reserve Bank
currency, bank deposits, life insurance policies UTI units and bonds etc. Gurley and Shaw have
divided the total quantity of money into two parts viz; inside money and outside money. As per
the Gurley and Shaw, it is in the non-banking financial companies (NBFCs) that provide
liquidity and safety to financial assets and help in transferring funds eventual lenders to decisive
borrowers for industrious purpose. As per them, the savings deposits of NBFCs are similar to the
demand deposits of commercial banks; so for NBFCs it is not complex to change their savings
into cash. If the central bank wishes to control surplus liquidity in the fiscal system only through
the decrease in supply of money, it will not get success for the reason that the savings deposits of
NBFCs can be converted into cash. Hence, Gurley-Shaw version of the liquidity theory
emphasise that the credit control weapons of central bank should apply not only to the
commercial banks, but also to the NBFCs/NBFIs. In this context, Gurley-Shaw thesis has
advocated the application of variable-cash-reserve ratio to the NBFIs in the same manner as it is
applicable to the commercial banks.

When NBFCs increases rates of interest on their savings deposits, the public decreases its
demand for money, which in turn decreases the market rate of interest. Fall in market rate of
interest leads to increase in public expenditure, which in turn leads to increase the price level.
Therefore, NBFCs make strict fiscal policy less effective. Likewise, NBFCs can make an
expansionary fiscal strategy unproductive by decreasing liquidity. Unlike, Radcliffe Report,
Gurley and Shaw argue that the central bank’s control over NBFCs must be comprehensive for
an effective fiscal strategy.

Terminology

• Bond: A bond is a long-term debt obligation of a corporation that can generally be traded
on the market. When a company needs fund, it sells a bond. When it sells a bond, it is
actually borrowing money.
• Bond Price: Bond price = reciprocal of interest rate X coupon rate.
• Money Assets: Money assets comprise currency and demand deposits of commercial
banks, which is withdrawable by cheques.

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• Near Money Assets: Near money assets are those assets, which can be converted into
money on a short notice like fixed money. Near money comprise all those assets held by
the public, which are not directly used by the public as a means of payment, but are
looked upon as a near substitute of money. For example, time and saving deposits of
commercial banks, government security, treasury bills, bills of exchange, traveller’s
cheques, post-office national saving certificate, debentures, surrender value of life
insurance policies, and units issued by the Unit Trust and various other credit instruments
customarily used in the money market.
• Inside Money: Inside money is based on the debt of endogenous economic units. It is
money created within the private sector against some private debt. It consists of financial
claims by one class of individuals and firms on others within the economy.
• Outside Money: Outside money on the other hand is money is based on the debt of a
unit (the government) exogenous to the system.
• Financial Assets: Financial assets or claims are generally divided under the two heads of
primary (direct) securities and secondary (indirect) securities.
• Primary Securities: The primary securities are financial claims against real sector units,
for examples, bills, bond, and equities etc. They are created by real sector units as
ultimate borrowers for raising funds to finance their deficit spending.
• Secondary Securities: The secondary securities are financial claims issued by financial
institutions or intermediaries against themselves to raise funds from the public. The
examples are such diverse financial assets are the Reserve Bank currency, bank deposits,
life insurance policies UTI units and bonds etc.

Important Points

• Liquidity theory of money looks upon general liquidity as the sole determinants of the
price level or the economic activity in a country.
• There are two versions of liquidity theory of money: (i) Radcliffe-Sayers’ version of the
liquidity theory, and (ii) Gurley-Shaw version of the liquidity theory.
• The Radcliffe Committee Report on the Working of the Monetary System (1959)
emphasis on monetary policy aspects while Sayers emphasis on theoretical aspects of the
liquidity theory.
• The liquidity theory accords an important place to the interest rate. It is the interest rate,
which determines the expenditure of public via general liquidity. Any change in the
interest rate affects general liquidity.
• An increase in the interest rate decreases general liquidity, which leads to fall in public
expenditure and ultimately fall in the price level and vice versa.
• Gurley and Shaw have divided the total quantity of money under two heads such as,
inside money and outside money.

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• According to liquidity theory of money, it is non-banking financial intermediaries, which
provide a link between liquidity and monetary policy. This theory states that aggregate
public expenditure particularly in advanced country is not only affected by currency and
demand deposits of commercial banks but also by near money as well.
• As per the Gurley and Shaw, it is in the non-banking financial companies (NBFCs) that
provide liquidity and safety to financial assets and help in transferring funds eventual
lenders to decisive borrowers for industrious purpose.
• Unlike, Radcliffe Report, Gurley and Shaw argue that the central bank’s control over
NBFCs must be comprehensive for an effective fiscal strategy.
• Radcliffe-Sayers’ thesis monetary policy cannot succeed unless it is supported by fiscal
policy.

Check Your Progress

1. Explain Radcliffe-Sayers and Gurley-Shaw versions of Liquidity theory of money.


2. Distinguish between Radcliffe-Sayers and Gurley-Shaw versions of Liquidity theory of
money.
3. How is liquidity theory of money different from income theory of money and quantity
theory of money?
4. Differentiate between money assets and near money assets.
5. What is meaning of financial assets?
6. Discuss non-banking financial intermediaries.

References

1. Seth, M.L.2008. “Monetary Economics.” Lakshmi Narain Agarwal, Educational


Publishers, Agra: 185.
2. Ibid.

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