Keynes’ Liquidity Preference and other theories of interest

(This article elucidates Keynes’ Liquidity Preference Theory of Rate of Interest, Money Demand Determination of Rate of Interest: Equilibrium in the Money Market, Effect of an Increase in the Money in Money Demand or Liquidity Preference Curve, The Liquidity Preference Theory, proposed by John Maynard Keynes, explains interest rate determination based on people’s preference for liquidity. The book “The General Theory of Employment, Interest, and Money,” written by J.M. Keynes was published in 1936. According to the Liquidity Preference Theory, the interest rate determination is based on people’s preference for liquidity.)

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3. The current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates.

Money market equilibrium:

An increase in the interest rate reduces the quantity of money demanded. A reduction in the interest rate increases the quantity of money demanded. The demand curve for money shows the quantity of money demanded at each interest rate. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied. All other things unchanged, a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real GDP and the price level.

Effect of An Increase in Money Demand:

When there is an increase in the price level, the demand for money increases. Conversely, when there is a decrease in the price level, the demand for money decreases. “An Increase in Money Demand” shows an increase in the demand for money. Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences.

The Keynes’ Liquidity preference theory aims to explain the following;

 1) How interest rates are determined.

2) The key premise is that people naturally prefer holding assets in liquid form i.e. in a manner that it can be quickly converted into cash at little cost.

According to J. M. Keynes, the interest rate, just like the price of any commodity, is determined by the forces of demand for and supply of money in the money market. The theory discusses the determination of the interest rate by using the supply of money and demand for money in the money market of a country.

Supply of money: The money supply is the total currency and other liquid assets in a country’s economy on the date measured. The money supply includes all cash in circulation and all bank deposits that the account holder can easily convert to cash.

Demand for money: Liquidity preference denotes the desire of the public to hold cash. Keynes considers that People hold money (M) in liquid cash for three motives: transactions, precautionary, and speculative.

Transactions Motive: The transaction motive relies on the demand for money or the need for cash for the current transactions of individual and business exchanges. Individuals hold cash to bridge the gap between the receipt of income and its expenditure. This is called the income motive. Businesses hold cash to meet their working capital such as payments for raw materials, transport, wages, etc. This is called the business motive.

Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for unforeseen contingencies. People hold some cash to meet exigencies like treatment of illness, accidents, unemployment, and other unforeseen contingencies. Likewise, businessmen keep cash in reserve to take advantage of a deal in an unfavorable market situation.

Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other. Bond prices can move higher as interest rates move lower, people will buy bonds to sell when the price later actually rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses.

Keynes holds that the transaction and precautionary motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M1) is a function (L1) of the level of income (Y) and is expressed as M1 = L1 (Y).

According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and the lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for speculative money M2=L2 (r) Where L2 is the speculative demand for money, and r is the rate of interest.

Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M1, and the speculative motive by M2, then;

M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity preference function is expressed as M = L (Y, r).

The other determining factor of investment is the rate of interest. Investment and employment can be increased by lowering the rate of interest. The rate of interest is determined by the demand for money and the supply of money. When the supply of money increases, the demand for money decreases, and the interest rate falls.  Therefore, whenever the Central Bank releases more money for circulation, the demand for money decreases and that leads to a lower interest rate. On the demand side is the liquidity preference (LP) schedule. The higher the liquidity preference, the higher the rate of interest that will have to be paid to cash holders to induce them to part with their liquid assets, and vice versa. Since Liquidity Preference (LP) depends on the psychological attitude to liquidity on the part of speculators about future interest rates, it is not possible to lower the liquidity preference to bring down the rate of interest.

Equality of Investments and Savings:

In the Keynesian analysis, the equilibrium level of employment and income is determined at the point of equality between saving and investment. Saving is a function of income, i.e. S=f (Y). It is defined as the excess of income over consumption, S=Y–C, and income is equal to consumption plus investment.

Thus Income (Y) = consumption (C) plus investment (I) i.e. Y=C+I

Income (Y) minus consumption (C) = Investment, i.e. Y-C=I

Since Income minus consumption= Savings, Y-C=S

Therefore, I=S

So the equilibrium level of income is established where saving equals investment. 

Criticisms: Keynes’s theory of interest has been criticized on the following grounds:

1. Critics pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest. Had the capital not been productive, no one would have demanded it and, hence, paid no interest on capital.

2. Keynes considers that People hold money in liquid cash for three motives: transactions, precautionary and speculative, and “interest is a reward for parting with liquidity. According to the critics, Liquidity preference is not the only factor governing the rate of interest. There are several other factors that influence the rate of interest by affecting the demand for and supply of investible funds. Practically, liquidity preference depends on money, the rate of savings, the propensity to consume, the marginal efficiency of capital,, etc. All these factors are completely ignored by Keynes.

3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time. As time changes, we find changes in the liquidity preference which leads to changes in the interest rate. Thus Keynes’ liquidity preference theory suffers from the drawback that it ignores the time element.

 4. Keynes ignores saving or waiting as a means or source of investible funds. To part with liquidity without there being any savings is meaningless. The person who has no savings, how can he part with liquidity? According to Prof. Jacob Viner, “There can be no liquidity without saving.” Prof. D.H. Robertson has also expressed similar views.

5. The Keynesian theory only explains interest in the short run. It gives no clue to the rates of interest in the long run.

6. Keynes’s theory of interest, like the classical and loanable funds theories, is indeterminate. Most economists have pointed out that like the classical and the neo­classical theories of interest, the liquidity preference theory is also indeterminate. According to Keynes, the rate of interest is determined by the speculative demand for money and the supply of money available for speculative purposes. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is.

7. .According to Keynes, the rate of interest hangs on liquidity preference. The greater the liquidity preference, the higher the rate of interest; the smaller the liquidity preference, the lower the rate of interest. However, this is not true, during the depression, people had high liquidity preferences, and yet the market rate of interest was low. Similarly, in times of inflation, people’s liquidity preference is low but the rate of interest is high. These facts contradict Keynes’s theory.

8. .Keynes assumes that the choice always lies between liquid cash and liquid bonds. The theory is, therefore, an all-or-nothing theory. In reality, however, various investable assets, differing in liquidity, are available in the market. A person who has some savings does not want to either hold in cash or invest it in illiquid bonds. Instead, he keeps some cash, some liquid assets, and some illiquid assets. Keynes has thus unnecessarily separated the liquid from the illiquid asset for the determination of the interest rate.

9. According to critics, Keynes’s theory of interest applies only to advanced countries where money is widely in circulation and the money market is well organized. It is only in such countries that people can choose among different types of securities. It does not apply to backward countries where the choice of assets is limited. It cannot be applied to a barter economy.

However, Keynes’s liquidity preference theory in modern economics occupies an important place because it takes into account monetary factors in determining interest rates. There is always less than full employment in an economy. It is with the help of liquidity preference theory that full employment can be restored.

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1. THE CLASSICAL THEORY OF THE RATE OF INTEREST
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