The Interest Rating to Develop a Theory of Liquidity Preference Essay

The Interest Rating to Develop a Theory of Liquidity Preference - Essay Example When the economy is doing well, the corporate cash flows rise above what is required to pay the debt off. This leads to speculative euphoria where this act of borrowing and lending goes on and reaches a point where the borrowers are no longer able to pay off the debt. As borrowers are no longer able to pay back, it leads to financial crises where banks do not have liquidity. As a result of the borrowers’ default, banks further tighten their lending, which means that even deserving borrowers that could pay back do not get access to capital in such circumstances. According to Minsky, these swings are a part of a free market economy and cannot be avoided unless there is the provision of a government enforced the regulation. Mishkin, on the other hand, focused on the role of asymmetric information in the financial system. This essentially means that one party in the transaction has less information than the other party. For example, a lender is not aware of the potential ways in which the borrower is going to use the money, but in case the money is lost, it is always the lender who is at the losing end. This asymmetric information creates two problems, namely the adverse selection and the moral hazard. Adverse selection is a trend in which lenders choose borrowers who can pay a higher interest, knowing that they can pay higher interest because their business is riskier and hence there is a greater chance of losing the money on the part of the lender. The interest rate on such investments is quite exaggerated to reflect the risk premium. Moral hazard occurs when the borrowers may choose to invest the money in activities that are undesirable from the lenders’ point of view or else they simply do not work. As this loss is to be borne by the lenders, they will refrain from lending thus causing a financial crisis. Mishkin concentrates on interest rates to develop a theory of liquidity  preference.