LIQUIDITY MANAGEMENT HYPOTHESIS: THEORETICAL FOUNDATIONS, EMPIRICAL TESTS, AND APPLICATIONS (CREDIT RESERVES, MONEY DEMAND)

This study explores the role of liquidity in decision making under uncertainty. Expected Utility Maximization hypothesis is used to develop a rigorous theoretical model that explains the demand for liquidity in the form of cash and credit reserves (defined as unused credit or borrowing power) as primarily a risk response. The model also shows that the reservation price or the liquidity value that a risk-averse decision maker (DM) places on his cash or credit reserves mainly depends upon his degree of risk aversion, the liquidity and liquidity-risk characteristics of his portfolio, and the pattern of his random cash demands. Furthermore, a theoretical simulation experiment reveals a surprisingly complex structure for the liquidity value curves and furnishes a rich set of potentially testable hypotheses regarding their shapes and behavior. Finally, the theoretical framework is extended to rigorously formulate a 'Liquidity Management Hypothesis' according to which a risk-averse DM maximizes his expected utility by allocating his resources in such a way that at the optimum he holds a least-cost combination of his liquidity reserves in the form of cash and credit.; The analytical framework developed here also promises to be useful in the theoretical investigation of many interesting problems. For instance, when applied to the standard theory of production, the model clearly brings out the crucial significance of financial variables in analyzing the optimal decisions of a firm facing capital constraints and uncertain product price and cash demands and thus represents a promising first step towards achieving a meaningful integration of the standard production theory and the modern theory of finance.; Firm-level financial data on U.S. and Thailand farmers are used to test various hypotheses about the shapes and behavior of their liquidity value curves for credit reserves. On the whole, the empirical results, within the limitations of the data used, are fairly consistent with the theoretical predictions. Significantly, the liquidity value curves for the U.S. and Thai farmers are found to be surprisingly similar in shape suggesting general applicability of the Liquidity Management Theory in widely different cultural, geographical, and economic settings.