Liquidity Preference Theory of Interest:
J.M. Keynes in his epoch-making book the General Theory of employment, Interest and
Money, has put forward a new theory of interest. According to him:
"Interest is not the price for waiting. It is not the remuneration necessary to call forth saving
because a man may save money, bury it in his backyard and get nothing from it in the way of
interest. Interest is the reward for surrendering liquidity, i.e., a reward for dispensing with the
convenience of holding money immediately available".
Interest is, thus, the reward for parting with liquid control over cash for a specific period, or we
say:"Interest is the payment for parting with the advantages of liquid control of money
balance".
Here, a question can be asked as to why the need for liquidity arises when people can earn
interest by lending their ready money. Keynes has given three distinct motives of demand for
money or holding money in liquid form.
Demand for Money:
The main components of demand for money are as under:
Transaction motive.
Precautionary motive.
Speculative motive.
(a) Transaction motive. Transaction demand for money refers to the demand for money to
hold cash balances for day to day transactions. The transaction motive relates to the
desire of households and firms to keep a certain amount of cash in hand in order to bridge
the interval between the receipt of income and expenditure. The transaction demand for
money depends upon size of income.
Formula: In symbols we can write:
L1 = F(y)
Here:L1 is the transaction demand for money and F(y) shows it to be a function of income.
(b) Precautionary motive. The precautionary motive relates to the desire of households and
business concerns to hold a certain portion of the total ready money in cash in order to meet
certain unforeseen or unexpected expenses like fire, theft etc. This demand for money depends
upon size of income.As transaction and the precautionary motives for holding cash depend upon
income, as they are income elastic, Keynes has put them together. It is expressed in symbols us:
L2 = F(y)
1
Which means that the liquidity preference on account of the two motives called L2 is a function
of income.
(c) Speculative motive. The speculative motive relates to the desire of the households and firms
to keep a portion of their resources in ready cash in order to take advantage of changes in the
interest rates. If people expect a rise in the rate of interest in the future, they will try to hold
money in cash in order to lend it in the future. Conversely, if they expect a fall in the rate of
interest, they will at once like to invest money now in order to avail themselves of the advantages
of high rate of interest. Thus, we find that an expected rise in rate of interest stimulates liquidity
preference and an' expected fall has the opposite effect. It is written in symbols as:
L3 = F(r)
The liquidity preference for speculative demand for money is a function of expected changes in
the rate of interest.
We have discussed in all the three factors which exercise powerful influence on the people's
desire to hold money. The first two factors, i.e. the transaction motive and the precautionary
motive are not very much influenced by; the changes in the rate of interest, but the third factor,
viz, speculative motive is very sensitive to the changes in the interest rate. The major portion of
money which people want to hold in the form of cash in fact is meant for speculative purposes.
When the rate of interest in a community is high, people hold less money in the form of cash
because by lending it to other, they earn a sufficient amount of money. Conversely if the rate of
interest is low, people will not be very anxious to lend money. So the total money held by
individuals and business firms will be high. In short, the demand for money to hold in cash under
speculative purposes is a function of the current rate of interest. It increases as the interest rate
falls and decrease as the interest rate rises. We can say that demand for money for speculative
motive is a decreasing function of the rate of interest as is shown in the fig.
Diagram/Curve:
2
In fig, along OX is measured the demand for money which people want to hold in the form of
cash and along OY is shown the rate of interest. FG is the liquidity preference curve which
slopes downward from left to right. When rate of interest is high, i.e. OL, the demand for money
to hold in the form of ready money or cash is OS only. When the interest rate falls to OH, then
the demand for money to hold in cash increases to ON.
Supply of Money:
The supply of money depends upon the currency issued by the central bank or the policy
followed by the government of the country. The supply of money consists of currency and
demand deposits. In the short run, the supply of money is assumed to be constant.
Determination of the rate of interest
According to J.M. Keynes- The rate of interest is determined at a where demand for money is
equal to the supply of money.
Md = Ms
Md = Total demand for money.
Ms = supply of money.
In the figure, the rate of interest as determined by the interaction of the forces of demand and
supply of money is OR, if there is any deviation from this interest rate, it will not be stable. For
example, if the interest rate is OR1 it will lead to more supply of money (by PQ) than its demand.
This will lead to fall in the interest rate. The interest rate OR2 is also not stable. Here demand for
money is more than its supply by P/Q1. This will lead to rise in interest rate.
