Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory

22 Pages Posted: 18 Dec 2010

Date Written: 2009

Abstract

One of Keynes' core issues in his liquidity preference theory is how fundamental uncertainty affects the propensity to hold money as a liquid asset. The paper critically assesses various formal representations of fundamental uncertainty and provides an argument for a more bounded rational approach to portfolio choice between liquidity and risky assets. The choice is made on the basis of individual beliefs which are subject to mental representations of the underlying economic structure. Self-consciousness arises when the agent is aware of the fact that beliefs are dispersed among agents due to the absence of a 'true'? model. Responding to this fact by increasing liquidity preference is rationalized by the higher ex post performance of choice. Moreover, we analyze the case that the portfolio is partially financed by debt. It is explored how fundamental uncertainty affects the volume of the portfolio and hence money and credit demand as well as the probability of debt failures.

Keywords: Liquidity preference, portfolio choice, self-confidence, self-consciousness, fundamental uncertainty, bounded rationality, Keynes, Knight

JEL Classification: G11, D81, E41, B31

Suggested Citation

Campanella, Edoardo, Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory (2009). Economics Discussion Paper No. 2009-48. Available at SSRN: https://ssrn.com/abstract=1726751 or http://dx.doi.org/10.2139/ssrn.1726751

Edoardo Campanella (Contact Author)

World Trade Organization (WTO) ( email )

Rue de Lausanne 154
Geneva 21, CH-1211
Switzerland

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