Read this article to learn about the liquidity approach on quantity theory of money.

Liquidity Theory of Money:

The latest approach in this respect, which has become popular after Keynes is the “Liquidity Theory of Money”. This approach became popular in UK after the suggestions of Radcliffe Committee published in July 1959.

As a result of the Radcliffe Committee’s Report on the Working of the Monetary System in Great Britain and the views of some contemporary European monetary economists like R.S. Sayers of England, Schmolders of Germany and J.G. Gurley and E.S. Shaw of United States, a new theory has been developed, concerning the role of liquid assets on the supply of money and general economic activity popularly called the ‘Liquidity Theory of Money’.

According to this approach causal relations between money and the volume of business activity or the general price level cannot be explained under modern conditions either by the quantity theory or by the so-called income theory. Its interest in the supply of money is only due to its significance in the whole liquidity picture.


The ease with which money can be raised depends on the one hand on the composition of spender’s assets and on his borrowing power as also on the methods, mood and resources of financial institutions. Liquidity depends not only on the quantity of liquid assets available but on the borrowing power, profit expectations, hopes and moods of the general public as well. It is the whole structure of liquidity that is relevant to spending decisions.

It is, therefore, maintained that a truly complete and realistic theory of money and prices incorporates not only demand for cash or bank money but also the whole structure of liquid assets which can, in some way or the other, serve as a substitute for money to satisfy the liquidity desire of the public. In this way, Keynes ideas on money and prices have been revised, modified and generalized and extend to the whole chain of liquid assets rather than to money or near money only.

Liquidity and Liquid Assets:

Practically all monetary experts now recognize the fact of easy ‘substitutability’ between money and a wide range of financial assets as a result of which quantity of money gets a subordinate role and the ‘liquidity of the economy’ (which includes the liabilities of all types of financial institutions) comes to the forefront of the analysis. Financial experts of the Federal Reserve System emphasize the close substitutability between money and bank credit and even go to the extent of rejecting money in favour of the broader concept of the total amount of credit outstanding and make use of unstable velocity function based on credit as a component of total credit.

These experts are: S.E. Harris, J.W. Angell, W. Fellner, A.H. Hansen, A.G. Hart, R.V. Roosa, P.A. Samuelson, W.L. Smith, J. Tobin and S. Weintraub. In a narrow sense, money may be defined as a means of payment including currency and demand deposits. Obviously, all other liquid assets should be classified as ‘near money’ or ‘quasi- money’.


We may, thus, arbitrarily define near money as claims other than demand deposits, against financial institutions and central government. As such, near moneys include time deposits, various money market instruments like bills of exchange, treasury bills, gilt-edged securities, cash surrender values of life insurance policies, re-purchasable shares in savings and loan associations, travelers cheques, saving bonds, deposits of building societies, deposits of saving and other banks, postal saving deposits, savings in ‘units’ of unit trusts, shares of investment trusts and all credit instruments of the financial sector of the economy.

These near money assets are regarded liquid in the sense that their prices are relatively stable and that they are easily convertible into money proper as and when desired. In determining liquidity of assets it is the speed of conversion into the means of payment in relation to full value that should be the criterion.’

Sources of Liquidity:

The main source of liquid assets is the debt creation activities of the various sectors of the economy. Commercial banks create first grade liquid assets—demand deposits, notes, coins, etc, as also the second grade liquid assets—time and saving deposits. A good deal of liquidity is created outside the banking sector like treasury bills issued by the state treasury in the money market.

Then there are non- bank financial intermediaries such as insurance companies, building societies, saving banks, higher purchase companies, land mortgage banks, which provide liquid assets in exchange for short-term and long-term claims on the private and public sector of the economy. In fact, “financial intermediaries manufacture liquidity; they create claims which are more liquid than the securities they buy, and issue them to savers. Thus, more savings are canalized into investment activity.”


In a way, the financial intermediaries by increasing the liquidity position of the financial sector of the economy may cause a rise in the velocity of spending money, and in turn, on general business activity. The shift from quantity or supply of money to the liquidity position of business as the main determinant of aggregate demand is the central feature of the new doctrine called liquidity approach.

Monetary policy that influences the total volume of money supply is inadequate unless it aims at influencing the total volume of liquidity in the economy that goes beyond the supply of money,, because the aggregate expenditures are influenced not only by currency and deposit money but also by ‘near money’ assets. Hence, it is generally agreed that there should be a reorientation of monetary policy so that both banking and non-banking financial institutions are effectively controlled and the general liquidity position of the economy is regulated.

The aim of monetary policy under liquidity approach is to attack the general liquidity position of business and of banks. Therefore, what is important is not the price index or the volume of money but a proper assessment of the general liquidity position, general business confidence, profit expectations, hopes and moods, etc. It was in this background that the liquidity approach to the theory of money was developed by the Radcliffe Committee and advocated by Prof. R.S. Sayers in England usually called ‘Radcliffe-Sayers Thesis’.

Radcliffe-Sayers Thesis:

The essence of Radcliffe-Sayers thesis is that the supply of money—the quantity that the central bank can directly influence—is not the main plank of monetary action. The supply of money no doubt plays an important part in the spending decisions of the public but these are also influenced considerably by the various alternatives of raising funds either by selling an asset or by borrowing.

According to the Radcliffe Committee “decisions to spend on goods and services—the decisions that determine the level of total demand—are influenced by the liquidity of the spenders…The spending is not limited by the amount of money in existence, but it is related to the amount of money people think they can get hold of whether by disposal of capital assets or by borrowing.” In other words, the vital factor in the decision to spend is the ‘general liquidity’ of the whole economy rather than the money supply.

Instead of interest-elasticity of the liquidity preference function, importance is given in the Radcliffe Model to the likelihood of shifts in this function. It does not treat the demand for liquidity as identical with the demand for money. The ready availability of interest-yielding money substitutes makes the demand for liquidity broader. Such near money substitutes as time-deposits, savings, loan, shares and treasury bills are virtually as liquid as such and in addition yield an interest return.

The growth of highly competitive and liquid money markets and the growth of non-bank financial intermediaries provide earning liquid assets in large quantity. They have increased the velocity manifold. To the extent of the availability of these money substitutes, the expansion in income or the expectation of rise in the interest rate may fail to increase the demand for cash for the transaction and speculative motives.

The ‘Radcliffe-Liquidity’ version emphasizes the basic point that the causal relations existing between money and the general level cannot be entirely explained either by the quantity theory of money or by the so-called income theory of money. It is neither income nor the quantum of money but liquidity which provides the most vital link between general business activity (price level) and monetary conditions.

The central place of monetary action is not the supply of money, for the demand for money is not the quantity of it that the central bank can influence, but the structure of interest rates or the state of liquidity of the whole economy—the quantity of money gets a subordinate role and the liquidity of the whole economy which includes the liabilities of all types of financial institutions comes to the forefront of the analysis. On the whole, it could be said that the ‘Radcliffe-Sayers Thesis’ as also the ‘Gurley-Shaw Analysis’ combine the main elements of the liquidity scheme paving the way for a ‘Liquidity Theory of Money’ which is based on a wider concept of liquidity than the mere cash liquidity of banks.


Thus, under the circumstances enumerated above, with both the segments of the demand for money susceptible to leftward shifts, monetary policy confined to regulating the supply of money is not likely to be as successful in stemming inflation as the Keynesian Model would like us to believe. Since the significant variable is not the supply of money, but rather the supply relative to demand, the flexibility of demand makes control of the supply alone, an unreliable instrument to affect the level of general business activity (price level).

The Radcliffe approach during severe inflation is not to restrict the supply of money alone but to strike hard more directly and rapidly at the overall liquidity of spenders. A combination of control of bank advances, of capital issues and of consumer credit has been advocated in this connection. These results do not depend as in the Keynesian Model on the short-term interest-elasticity of the demand for money, but rather on shifts in that demand.

In the words of the Radcliffe Report, “the factor which monetary policy should seek to control and influence is far beyond the supply of money”. It is nothing less than the state of liquidity of the economy as a whole. It is, thus, Radcliffe Monetary Theory, rather than the orthodox Keynesian Theory, which poses the most fundamental challenge to the Modern Quantity Theory of Money.

The Radcliffe-Sayers thesis stands in sharp contrast to the positions taken both by Keynesians and Monetarists. First, Radcliffe Thesis views the money supply as relatively unimportant in determining spending. Second, the transmission mechanism envisaged by Radcliffe Committee is much different from those of Keynesians and Monetarists.


According to Radcliffe Committee a change in money supply has little or no effect on interest rates and investment (Keynesian Mechanism); or on the type of portfolio adjustment (Monetarist Mechanism), ‘third, expectations play an important role in Keynesian and Monetarists Models in determining interest rates—but Radcliffe Committee says these expectations are based on past experience rather than what authorities say.

Thus, the Radcliffe-Sayers thesis suggests two alternatives, namely:

(a) Imposition of ‘liquidity controls’ over a wide range of financial institutions and

(b) Achievement of a control through the ‘liquidity effect’ of changes in the rate of interest.


However, (a) is difficult to administer as most of the financial intermediaries except commercial banks are usually outside the control of the central bank and even if they are brought within the scope of its regulation there is always the possibility of the new financial institutions coming up and there would be no end to this process. The other alternative (b) above is also ruled out as it may cause serious disruptions in the financial sector. As such, the Radcliffe-Sayers thesis considers monetary policy as subordinate to fiscal policy in normal times and advocates its use in inflationary situation only.

It may not be, however, forgotten that Radcliffe-Sayers’ thesis that the factor which the monetary policy should try to control is not the supply of money but the state of liquidity of the whole economy—has evoked a good deal of debate. Dr. Balogh considers this approach to be very haphazard. The Radcliffe Committee never defines the liquidity concept and its relationship to spending motivation. The new and fuzzier concept is substituted for the quantity of money.

Sir Oscar Hobson considers money to be the crucial factor. According to him, obsession with liquidity structure has inhibited the Committee from knowing or speaking its mind normally on practical issues of monetary control. Mr. Jasay considers the Radcliffe approach to be an utterly muddled one, indicating a stock-flow muddle, a liquidity muddle and an interest rate muddle.

Mr. J.G. Gurley notices confusion everywhere: “in the role of the money supply, in the concept of liquidity, in the analysis of non-banking intermediaries, in the discussion of interest rate determination and so on. Despite this criticism, the committee has made an important contribution to the understanding and shaping of future monetary policies by emphasizing the structure of liquidity or the structure of interest rates as the chief factors of monetary control—it, however, never meant that the supply of money was unimportant in any case.”

The Gurley-Shaw Thesis:

In contrast to the monetarists, J.G. Gurley and E.S. Shaw believe that money and the behaviour of commercial banks have unduly been given more importance in the Keynesian model. According to them money is only one of a number of financial assets and commercial banks constitute only one of the various types of financial intermediaries. They contend that quantity theory of money analysis should be extended to include other large number of financial assets and institutions.

Financial intermediaries are defined as financial institutions which serve as middlemen between savers and borrowers. Since most other financial institutions like mutual saving banks, credit unions, insurance companies, pension funds, chit funds, savings and loan associations, etc., also accept deposits and advance loans—these should be treated as financial intermediaries like commercial banks. These financial intermediaries benefit both savers and borrowers because deposits with them also earn interest, are more liquid than many other assets and are relatively risk free.


Again, borrowers like individuals, firms, and government also gain from their existence. Gurley and Shaw argue that the assets of non-bank financial intermediaries have increased more rapidly in recent years than the assets of commercial banks and this trend and the role of financial intermediaries have undermined the effectiveness of monetary policy based on the control of money supply created by the banks alone.

The main claim of these authors to fame is through their discovery of and emphasis on the fact that in a growing economy, along with the process of economic growth in real terms there is a proliferation of financial institutions, banks, saving institutions and so forth and their insistence that this fact makes a difference to monetary analysis. In support of this contention they have produced a large theoretical framework, in which they develop the theme that financial intermediaries are important and in the course of their analysis they develop a variety of theoretical models.

They have pointed out to the liabilities of non-bank financial intermediaries and their implications on the analysis for monetary theory and policy. According to them, on account of this development monetary theory and policy cannot be correctly analyzed without reference to the financial structure of the economy. Just as in the Radcliffe-Sayers thesis the whole liquidity of the economy is important, in the same way, in the Gurley-Shaw thesis the entire financial structure of the economy becomes significant, thereby making the velocity function both complex and unstable.

Monetary policy becomes more effective, when besides controlling the quantity of money it takes into account the activities of the non-bank financial intermediaries. It is useful to note that the Gurley-Shaw thesis gave up the conventional division between commercial bank as creators of loanable funds; and financial intermediaries—as brokers of loanable funds, as being, erroneous.

They stressed that all types of financial institutions can create loanable funds. They, therefore, upheld the view that monetary authority’s regulatory powers be extended to these non-bank financial institutions also, thereby making monetary policy wider in scope as against the Radcliffe-Sayers thesis which gave only a subordinate place to monetary policy.

However, since the original statement of Gurley-Shaw thesis in the 1950s, there have been many empirical studies related to the substitutability of money and other assets. Edgar L. Feige and Douglas K. Pearce’ have surveyed these studies. Though these studies included different variables, different periods, different methodologies—they concluded that “the results are surprisingly consistent and indicate that there is a rather weak substitution relationship between money and the liabilities of non- bank financial intermediaries”. Thus, the empirical evidence does not appear to support the view that the growth of non-bank financial intermediaries has seriously undermined the effectiveness’ of monetary policy.

Liquidity in a Developing Economy:


As the financial diversification of underdeveloped countries is taking place and non-monetary sector is squeezing (as it is likely to in developing economies), the non-bank financial intermediaries assume added importance, the financial claims offered by these intermediaries become more and more acceptable to public and a new category of quasi-money assets come to the limelight. The growth of non-bank financial intermediaries had the effect of broadening and deepening the liquidity structure of advanced economies and the same effect is likely to follow in underdeveloped countries—where liquidity structure is prone to become broad based.

In a developing and growing economy as the rate of aggregate output and national income over time rises, this will require an expansion of money supply; firstly, as national income expands, the volume and number of transactions go up as also the demand for money as a medium of exchange and store of value. Further, as the income per head increases the demand for cash balances M1 and M2 also goes up. As such, there are in most economies, which are moving along their growth paths, a variety of near money assets. Therefore, in analyzing the growth of an economy, it is important to consider not only the relationships between the rate of growth of the actual quantity of money and the rate of expansion of aggregate output but also structural changes that are taking place in the financial sector and overall liquidity of the economy.

According to the various reports of the Reserve Bank of India near money and quasi-money assets have increased by many times. Near money assets amount to a little over half of money supply with the public in recent years shows that overall liquidity of Indian Economy is much more important for monetary action than merely the quantity of money. Thus, the main problem of the growing economy like India is the adjustment between the rate of growth of overall liquidity and the rates of growth of income and economic activities.

For a scientific understanding of ‘liquidity’ a distinction is sometimes made between ‘subjective liquidity’ and ‘objective liquidity’. The former depends upon personal preferences and prestige consideration, while the latter includes actual liquid assets and credit facilities available. In this sense, liquidity no longer remains a quantitative amount of cash but a quality of general business conditions. Thus, viewed from this angle the approach becomes more realistic and the monetary theory reduced by the quantity theory to the background returns to glory again by the introduction of liquidity as the missing link between money and aggregate demand.


On the whole it could be said that the Radcliffe-Sayers thesis as also the Gurley-Shaw analysis contain the main ingredients of the liquidity approach paving the way for liquidity theory of money which admits of a wider concept of liquidity than the mere cash liquidity of banks. This approach emphasizes the fact that what matters is not how much money is in circulation but whether the people are being tempted to switch from money to near money assets.

However, in the hands of German economists like Prof. Ottoviet and Prof. Schmolders the liquidity concept has become much broader than before because they extend it from mere cash and bank account (first grade liquidity) to a second and third degree of liquidity. They show that in our economies most commodities, financial claims and accounts receivable can be mobilized. They also emphasize that a tendency to increasing liquidity is a natural consequence of the development of financial system particularly in developing economies.


Liquidity theory of money approach in its wider sense is not only a better explanation and description of market and price conditions in modern economy but is also useful for a better understanding of the scope, methods and limitations of monetary policy.