Liquidity preference theory

J.M. Keynes hence this theory is known as also Keynesian theory of interest propounded liquidity preference theory of interest. According to Keynes’ the rate of interest is determined by the demand for and supply of money or cash. Keynes’ theory based on Liquidity preference is called monetary theory of the rate of interest as against the classical real theory of rate of interest. It is so called because money plays on active role in it.

According to Keynes interest is a payment for the use of money. In word, “Interest is the reward paid for parting with Liquidity for a specific time.”

Liquidity preference means the demand for money to hold as cash or desire of the public to hold cash.

People who have surplus money can either keep it in the form of ready cash (liquidity) or they may invest it in fixed income yielding assets like bonds and securities on which people each a rate of interest. They purchase stocks and shares on which they get dividend. They may spend on immovable property liked houses on which they get rent.

For an example, people’s wealth on the form of bond, Securities, stock shares and houses mentioned above may not be useful in urgent need of people or owner, for this, these assets must be converted into money or cash first. Then such cash amount may be useful to purchase goods and services people desire to Loose. All this may take long process in this regard to sell the fixed assets immediately or urgently is not possible. So, it would be better for people hold cash, which is only the liquid asset. The common motive of people for holding cash is to avert the up coming unforeserh risk or perils on the other hand the cash held by people may be purchased by paying them interest.

Interest, according to Keynes, is the reward, which must be paid to overcome liquidity. The higher the liquidity (desire of people to hold cash), the higher is the reward (interest), which must be paid. Hence, interest is a reward for parting with the liquidity.

According to Keynes. Under this theory rate of interest is determined by the interaction between demand for and supply of money. Demand for money arises from three motives; (i) The transaction motive, (ii) Precautionary Motive & (Iii) Speculative Motive) .

(i)         Transaction Motive

In this regard, demand for cash is made for the current transaction of individual and business exchange. Keynes had divided the motive of this demand into two parts (a) income motive.

Individuals hold cash in order “to bridge the interval between the receipts of income and its expenditure”. This is called the income motive.

Most of the people receive their income by the week or the month, while they have to fulfill their day-to-day needs by making day-to-day expenditure. For this reason, people hold some-portion of income as cash to make-current payments. The amount of such cash depends on the size of income, the interval at which the income is received and the methods, of payments in the locality.

(b)        Business Motive

The businessman and the entrepreneur also have to hold cash out of their income to pay for raw materials, pans port facility, wages and salaries and to meet all other current expenses on the causes of business. This Keynes calls the Business. Motive for holding money.

The size of the cash holding under this motive depends on the size of the turn-ver of businessmen.

(ii)        Precautionary Motive

Precautionary motive for holding money refers to the desire of the people to keep cash balance for some up comity misfortunes. People keep cash balance to overcome the unforesech situations of unemployment, sickness, accidents and some other unexpected dangerous situations. The amount of money to held under this situation and on the condition they are living. The combined some o balances held for transaction and precautionary motive, Keynes termed as ‘active balances. The demand for active balance can be referred to as L1 and thus L1 = f (y). According to Keynes L1 is the directly proportionate to the level of national income (y) .

(iii)      Speculative Motive

The idea of speculative motive is an original idea of Prof. Keynes.

The aim of holding cash to east more income in future on the basis of change in the bond prices and interest rate is defined as speculative demand.

Here all securities and other such papers providing a fixed rate of interest over a period of time are called bonds or bond papers.

Under speculative motive of money demand, people hold cash to invest in interest bearing bonds or securities if they get an opportunity to earn profit in the future. Money held this motive is a Liquid store of value.

Bond prices and the rate of interest are inversely related to each other. Low bond prices reflect high interest rate and high bond prices reflect low interest rates. Here bond caries a fixed rate of interest. For example, if a bond of the value of Rs. 100 carries 4% interest and the market rate of interest rises to 8% as a result the value of this bond falls to Rs. 50 in the market. Contrarily if the market rate of interest falls to 2%, the value of the bond will rise to Rs. 200 in the market. Thus analyzing the profitable-situation individual or businessman can invest in bonds.

Individual & businessmen thus can gain by purchasing bonds worth Rs. 100 each at the market price of only Rs. 50 each (at the 8% interest rate) and sell them again when they interest rate.)

Thus it is dear that businessmen purchase bonds at lower prices and sell them at higher prices to make profit in the bond market.

The injection of businessmen’s money into bond’s and withdraw of their money from bonds market are completely influenced by the expected change in bond prices and interest rate, prevailed in the market.

Hence, According to Keynes, expectation about changes in band prices or in current market rate of interest determines the size of speculative demand for money. Thus, there is inversely but direct relationship between current rate of interest and speculative demand for money (cash balances). It means, higher the rate of interest, lower the speculative demand for money and vice versa. Symbolically L2 = f (i), whose L2 is the demand for money for speculative motive and i is the rate o interest the curve of demand for, speculative motive is down ward sloping from left right shown as below.

It is remarkable that at a very low rate of interest such as 2%, the speculative demand for money becomes perfectly elastic. This portion of the curve is also called liquidity pap. This is because at the very Low rate of interest people like to keep money in cash but not to invest in bonds because purchasing bonds will mean, certain loss.

Demand for speculative motive can be explained by the following figures.

In the figure, LP is the Liquidity preference demand curves, which slopes downward. This means there is inverse relation between rate of interest (measured on OY axis) and speculative demand for money [measured on OX axis]. As rate of interest decreases from or to OR’ the demand for money increase from OM to OM’ similarly when rate of interest falls from OR’ to OR” demand for money increases from OM to OM’ we level of OR”, which is the lowest level of rate of interest the demand for liquid money is perfectly elastic. This is shown by E” to LP portion in the above figure where LP curve becomes quite flat. This portion is called the liquidity trap. In this situation people don’t pay interest on investing money in cash. They are influenced by the future expectation of the change in bond price and rate of interest.

Supply of Money

The supply of money is determined by the central Bank of any country. Total supply of money is notes, coins issued by the central bank and the total bank money in a country. As supply of money is only determined by central bank. It is constant for a period of times, and so supply curve is vertically straight lined or parallel to OY axis Supply of money is not influenced by the change in rate of interest. Hence money supply curve is completely interest-inelastic. If the total supply of money increases the supply curve shirts-right.

Supply of money at constant level.

From the figure, on OY and OX axes respectively rate of interest and quantity of money are measured from the figure. It is clear that money supply is fixed at OM quantity. It is not influenced even the rate of interest changes from OR to OR­1. Here MS is supply curve of total money supply.

Determination of Rate of Interest

Rate of interest is determined by the demand for money and demand for supply. Here, how the rate of interest is determined by the equilibrium between the liquidity preference for speculative motive and the supply of money is shown.

Equilibrium between Demand for and Supply of money

In the above figure, MS and LP are the more Y supply and liquidity preference curves respectively. LP is the demand for money for speculative motive. Rate of interest is determined at point money for speculative motive (LP) interests each other. The corresponding equilibrium rate of interest and quantity of money are or and OM respectively.

Shift in supply curve

In the same figure, the effect of change in money supply is presented. When money supply increased by central bank from Ms to Ms’ [Holding LP curve constant], there is new equilibrium point at E.’ At this point the increased money supply curve M’S’ intersects Liquidity preference curve. At the new equilibrium point, corresponding rate of interest and quantity of money is or’ and OM’. This clears he that the increase in more Y supply by central bank through open market decreases the level of rate of interest’ prevailed in the economy. Similarly another result can be experienced when LP curve shits.

Shifts in Liquidity Preference Curve

If these are a change in the expectations regarding the future rate of interest, the whole curve for speculative motive will change accordingly. If people expect the rate of interest to be higher [i.e. bond prices to be lower[ in future, the speculative demand for money will increase and the whole liquidity preference curve for speculative motive will shift upward. Consequently the rate of interest will be increased which is shown in the figure below.

Effect of increase in LX on rate of interest

In the figure above, when the money supply is constant the increase in liquidity preference results the increase in interest rate, as liquidity preference curve LP shits to L’P’. These is new equilibrium at point E’ where new shifted L’P’ curve and MS curve intersects to each other. As a result, interest rate increased and determined at OR’ level while amount of money is constant at only OM level.

According to Keynes, interest is monetary phenomenon and the rate of the interest is determined by the intersection of demand for money and supply of money. From the above analysis of Keynesian liquidity preference theory of interest these things are clear. Given the supply of money the rate of interest rises as the demand for money increases and falls as the demand for money decreases. Similarly given the demand for money, the rate of interest falls as the supply of money increases and rises as the supply of money decreases. The rate of interest can’t be reduced beyond the Lower Limit set by the Liquidity trap.

Criticisms:

Keynes’ liquidity preference theory of interest has been crudely criticized by economists like A1 + Hansen, Henery Hazlitt, Jacob Viner and Hut etc. on the following grounds, Keynes liquidity preference theory of interest has been criticized.

(1)   Real factors ignored

According to the economist Hazlitt, Keynes has ignored the influence of the real factors on the rate of interest determination Keynes refused to believe that real factors such as productivity, time preferences had any influence on the rate of interest. As his theory is based on pure monetary phenomenon, Keynes’ liquidity preference theory is also called on sided theory.

(2)   Element of Saving Ignored

In the definition of Keynesian liquidity preference theory of interest, Keynes defined that interest is the reward for parting with Liquidity. Here, Keynes ignored the element of saving. Without previous saving there can’t be liquidity to part with. According to Jecob Viner, without saving there can be no liquidity to surrender. The rate of interest is the return for saving without Liquidity.”

(3)   Short-period Analysis

Since the theory only explains the determination of rate of interest in the short period of time. It does not explain how the rate of interest is determination in the long run.

(4)   Variation of Interest Rates not explained

The theory cannot explain why interest rates very from person to person, from place to place and for different periods.

(5)   Importance of Productivity Ignored

According to some critics’ interest is not the reward for parting with Liquidity as expressed by Keynes? According to them, interest is the reward paid to the Lender for the productivity of capital. Hence, interest is part for the existing power of capital to be productive.

(7)   Self- Contradictory

The concept of Keynes’ liquidity theory of interest is confusing vague and self- contradictory. For example, if a man holds his cash as in the form of time deposits or invest on Treasury bill then he will be paid interest on them. Hence he gets liquidity along with interest.

(8)   Other liquidity preference motives ignored

According to Keynes the desire for liquidity arises only due to three motives such as transaction motive, pre centenary motive. But critics point out that the liquidity preference arises not only for the three motives but also for other motives such as deflationary motive, business expansion motive and convenience motive.

(9)   Indeterminate Theory

According to Keynes rate of interest is determined by liquidity prefer he and the supply of money. While the liquidity of preference depends on the level of income itself depends on the investment, which ultimately depends on rate of interest. Thus, according to Hansen, “Keynes’s criticism of the classical theory applies equally to his own theory!’ Thus, Keynes liquidity theory of interest is in determinate.

(10) Less effective from supply side

According to the liquidity preference theory of interest, money supply is constants. If supply of money increases, rate of interest will decrease but it is not always possible to reduce the rate of interest by increasing the money supply. In the region of liquidity trap, the increase in the supply will not reduce the rate of interest any more.

 

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