Discussion Paper

No. 2009-48 | November 11, 2009
Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory

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.
 

Submitted to the special issue
Managing Financial Instability in Capitalist Economies
 

JEL Classification

B31 D81 E41 G11

Cite As

Markus Pasche (2009). Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory. Economics Discussion Papers, No 2009-48, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2009-48

Assessment



Comments and Questions


Anonymous - Referee Report 1
December 15, 2009 - 10:55

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Markus Pasche - Reply to report #1
December 18, 2009 - 10:57

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Anonymous - Report
December 28, 2009 - 10:23

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Anonymous - Reply to report
February 17, 2010 - 12:52

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Anonymous - Referee Report 2
January 06, 2010 - 10:58

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Markus Pasche - Reply to Report #2
February 17, 2010 - 09:51

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