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Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory

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  • Markus Pasche

    () (Friedrich Schiller University Jena, School of Economics and Business Administration)

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 boundedly 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.

Suggested Citation

  • Markus Pasche, 2009. "Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory," Jena Economic Research Papers 2009-085, Friedrich-Schiller-University Jena.
  • Handle: RePEc:jrp:jrpwrp:2009-085
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    Keywords

    liquidity preference; portfolio choice; self-confidence; self-consciousness; fundamental uncertainty; bounded rationality; Keynes; Knight;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
    • B31 - Schools of Economic Thought and Methodology - - History of Economic Thought: Individuals - - - Individuals

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