Keynes is of the view that income and not the rate of interest is the equilibrating force between saving and investment. People have desire for liquidity (i.e., the liquidity preference or to desire to hoard money) and interest is reward for parting with liquidity. The policy implication of the liquidity trap is that the rate of interest cannot be lowered any more and the monetary policy becomes ineffective in the liquidity trap region of the liquidity preference schedule. … The lending system of ancient Babylon was evidently quite sophisticated. In economics, we look at the marginal cost and marginal benefit analysis. The liquidity preference curve LPC, intersects the supply curve MS at point E. Here the rate of interest is OR. The theory is also called the monetary theory of interest. Keynes argued in the General Theory of Employment, Interest and Money (1936) that velocity (V) can be unstable as money shifts in and out of ‘idle’ money balances reflecting changes in people’s liquidity preference… Given that ; Expectations Theory ; Given that we want to invest for two years, we should be indifferent between either strategy. In practice, however, Keynes treats the rate of interest as determining liquidity preference. Given the level of income, the demand for money and the current rate of interest are inversely related; as the rate of interest falls, the demand for money increases. Share Your PDF File In this article we will discuss about:- 1. Thus, interest is paid because capital is productive. This means that changes in the interest rate have very little effect on investment. had any influence on the rate of interest. An increase in the liquidity preference implies an increased desire of the people to sell bonds to get more cash, as a result of which bond prices will fall and interest rates will rise. Liquidity preference theory is a classical model that proposes that an investor should mandate a higher interest rate or premium on securities with long-term maturities that are prone to high risk. Demand for Money 3. Interest has been defined as the reward for parting with liquidity for a specified period. Money is most liquid of all assets which helps in making day to day transactions. But there is always a limit (set by the liquidity trap) to this cheap money policy. Debts were transferable, hence should be paid to the bearer rather than a named creditor. When prices decline, both consumers and producers have a tendency to postpone their purchases and keep large amounts of money with them. Similarly, at a lower rate of interest Oi2, the demand for money will be more than the supply of money (i2 d2 > i2 s2). TOS4. [1], According to Keynes, demand for liquidity is determined by three motives:[2]. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. It does not tell how the rate of interest is determined in the long run. INTRODUCTION THE AIM OF this paper is to reconsider critically some of the most im- portant old and recent theories of the rate of interest and money and to formulate, eventually, a more general theory … Keynes refused to believe that the real factors like productivity, time preference, etc. 0%. The demand for speculative motive is a function of rate of interest and an inverse relationship exists between the two (L2 = f(i)). In the security market, changes in the prices of bonds reflect themselves in the changes in the liquidity preference of the people. (c) In this theory, rate of interest is determined by the demand and supply of money. The LP curve represents liquidity preference curve. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. Further, according to Keynes, rate of interest is determined by liquidity preference or demand for money to hold and the supply of money known as Liquidity Preference Theory. explanation is known as the theory of liquidity preference because it posits that the interest rate adjusts to balance the supply and demand for the economy’s most liquid asset – money. The theory of liquidity preference implies that: A) as the interest rate rises, the demand for real balances will fall. have been assumed to be perfect substitutes with bonds. (a) In a recession, interest rates are already very low and the demand for holding money for speculative motive has become almost infinite (perfectly elastic LP curve). It further implies that the rate of interest cannot be lowered any more. The level of liquidity preference, Keynes wrote, depends upon a number of … (i) if the interest rate is below the equilibrium level, then the quantity of money people want to hold is less than the quantity of money the Fed has created. Thus, changes in money supply may cause negligible changes in the interest rates. For example, if a man holds his funds in the form of time deposits or short-terms treasury bills, he will be paid interest on them. Thus, the demand for active balances (L1 = Lt + Lp) is a constant (k = kt + kp) function of income (Y) and can be symbolically written as-. One is Keynes’ liquidity preference, the other is the loanable funds theory.Keynes, in his theory, had asserted that r was a purely monetary phenomenon. Keynes, in his book, General Theory of Employment, Interest and Money, has developed a monetary theory of interest as opposed to the classical real theory of interest. Any deviation from this equilibrium rate of interest will be unstable. Share Your Word File Clay receipts or drafts were issued to those who deposited grain or other commodities at royal palaces or temples. "[3], Criticism emanates also from post-Keynesian economists, such as circuitist Alain Parguez, professor of economics, University of Besançon, who "reject[s] the keynesian liquidity preference theory ... but only because it lacks sensible empirical foundations in a true monetary economy". the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. It refers to the demand for holding certain amount of cash in reserve to make speculative gains out of the purchase and sale of bonds through future changes in the rate of interest. According to this theory, the rate of interest should be the highest at the bottom of depression when, due to falling prices, people have great liquidity preference. 3 at 3% rate of interest. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. from M2M2 to M3M3) will not reduce the rate of interest anymore because of liquidity trap. The determination of the rate of interest can be better explained in the shop. Figure 7 shows that given the demand for money (LP curve), as the supply of money decreases (shift from MM to M1M1), the rate of interest rises (from Oi to Oi1) and as the supply of money increases (shift from MM to M2M2), the rate of interest falls (from Oi to Oi2). (ii) The theory admits two assets (money and bonds) whose nominal value is fixed. According to the critics, the liquidity preference theory is of limited value from supply side. It is referred to as a monetary theory because of the following reasons: (a) According to Keynes, interest, which is a payment for the use of money, is a monetary phenomenon. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. Main points of criticism are discussed below: Hazlitt attacked the liquidity preference theory of interest on the ground that it considered interest as a purely monetary phenomenon and ignored the influence of the real factors on the determination of the rate of interest. (d) The rate of interest cannot be reduced beyond the lower limit set by the liquidity trap. 4. Keynes considers monetary policy to be ineffective during recession. Both the curves intersect at point E which indicates that Oi is the equilibrium rate of interest. Thus, Keynes denied the fact that changes in money supply may influence the economy through direct mechanism. The demand for money for speculative motive (L2) is highly sensitive to and is a negative function of the rate of interest (i); as the current rate of interest rises, the demand for money for speculative motive decreases and vice versa. Given the supply of money at a particular time, it is the liquidity preference of the people which determines rate of interest. Keynes theory is also called a demand-for-money theory. With Hicks, the Keynesians admit that r is determined by the interaction of monetary and non-monetary (real) forces. An important feature of the LP schedule is that if the rate of interest falls to a very low level (say i0). The demand for transactions and precautionary motives, which is more or less stable, depend upon the level of income and is interest-inelastic (L1 = k(Y)). reserves of liquidity in money balances the lower will tend to be the velocity of circulation of money. Thus the liquidity theory provides no solution; it cannot tell the rate of interest unless we already know the income level, the investment level and the interest rate itself. All other non-monetary assets (such as, equities, physical commodities, etc.) 100 yields a fixed amount of Rs. With an increase in the level of income, the demand for money curve shifts upwards (e.g. According to liquidity preference theory of interest the rate of interest is determined by the demand for liquidity and supply of liquidity. The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. If the rate of interest rises to 4% the price of the bond must fall to Rs. This completely ignores the influence of inflation on portfolio decisions. b. The concept of liquidity preference is confusing, vague and makes Keynes’ theory of interest self- contradictory. Like the classical theory of interest, Keynes’ liquidity preference theory is also indeterminate. Similarly, if people feel that in future the rate of interest is going to fall (or bond prices going to rise), they will reduce the demand for money meant for speculative purpose. His theory argued there was a relationship between interest rates and the demand for money. As a result, rate of interest increases from OR to OR1. If you think about it intuitively, if you are lending your money for a longer period of time, you expect to earn a higher compensation for that. But, the critics point out that the liquidity preference arises not only from these three motives, but also from several other factors. Supply of money refers to the total quantity of money in the country for all purposes at a particular time. On average, either strategy gives the same return. The demand for money for transactions motive mainly depends on the size of money income; the higher the level of money income, the greater the demand for transactions motive and vice versa. Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. Moreover, the net increase in financial assets in the government budget may directly influence consumption and investment without necessarily changing the interest rate. Rate of interest, like the price of any other commodity, is determined by the demand and supply of money. The theory argues that consumers prefer cash over the other asset types for three reasons (Intelligent Economist, 2018). People receive income in periods that do not correspond to the times they want to spend it. Share Your PPT File, Gold Standard: Features, Functions, Working, Rules, Merits and Demerits. Keynes’ theory of interest is known as liquidity preference theory of interest. Thus, he gets both liquidity and interest. The Liquidity preference theory implies that monetary expansion or contraction by the authorities will have an uncertain effect on the economy because the demand for money function has been assumed unstable due to the uncertain nature of the speculative demand for money. Most business companies have a tendency to accumulate and hold money balances in order to finance their plans for business expansion. For example, a bond with the price of Rs. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The rate of interest is the return for saving without liquidity.”. In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. Without previous saving, there cannot be liquidity (cash balances) to part with. b. According to them, interest is the reward paid to the lender for the productivity of capital. For the households, unexpected economic circumstances affect their decision to keep money for precautionary motive. we can also call this theory as Liquidity Preference theory. It is definitely better than the classical theory in some regards: (a) Keynes’ theory is more realistic because he gives importance to money in his theory and considers rate of interest as a monetary phenomenon. 13. They can be persuaded to give up some part of their cash if adequate reward is offered. Keynes's liquidity preference theory implies that velocity O A. is constant O B. is zero in the long-run. People desire to have money in order to take advantage from knowing better than others about the future changes in the rate of interest (or bond prices). 3. An increase in the money supply (given the LP function) reduces the rate of interest, which (given the marginal efficiency of capital function) increases investment, which, in turn, leads to an increase in output, employment and income. The equilibrium rate of interest is determined by the intersection of the demand for money function and the supply of money function. The Liquidity Preference Theory was introduced was economist John Keynes. This fact has a great practical significance. According to Keynes, the rate of interest is determined by the decision as to how much saving should be held in money and how much allocated to bond purchase. According to him, the rate of interest is determined by the demand for and supply of money. He also said that money is the most liquid asset and the more quickly an asset can be … According to him, the desire for liquidity arises only due to three main motives, i.e., the transactions motive, the precautionary motive and the speculative motive. Interest has been considered as the reward for parting with liquidity. Significance of Liquidity Preference Theory of Interest 7. (c) It analyses some fundamental features of money and capital markets. Liquidity preference theory signifies the inverse relationship between the rate of interest and the bond prices. The emphasis in Keynes’ theory is on the desire for liquidity and not on the actual liquidity. To sum up Keynes’ theory of interest: given the liquidity preference, the rate of interest falls as the supply of money increases and rises as the supply of money decreases, given the supply of money, the rate of interest rises as the liquidity preference increases and falls as the liquidity preference decreases and the rate of interest cannot be reduced beyond the lower limit set by the liquidity trap. The stronger the desire for liquidity, the higher the rate of interest and weaker the desire for liquidity, the lower the rate of interest. Criticisms 8. 3 Expectations Theory Review. This relationship is shown by the downward sloping LP schedule in Figure 5. Figures 6 and 7 illustrate the influence of changes in demand for and supply of money on the rate of interest. Welcome to EconomicsDiscussion.net! Thus, according to Hansen, “Keynes’s criticism of the classical theory applies equally to his own theory”. It is for economists like Hicks and Hansen to remove these short­comings and to combine real and monetary factors together and formulate a complete and determinate theory of interest. For example, at a higher rate of interest Oi1, demand for money will be less than the supply of money (i1d1 < i1 s1). In a way, the term structure represents the market expectation on short-term interest rates. A major rival to the liquidity preference theory of interest is the time preference theory, to which liquidity preference was actually a response. Keynes’ liquidity preference theory not only provides explanation for the determination of and changes in the rate of interest, but also is of great significance in Keynes’ general theory of income and employment. (ii) if the interest rate is above the equilibrium level, then the quantity of money people want to hold is greater than the quantity of money the Fed has created. perfectly elastic portion of the liquidity preference curve), the increase in the supply of money will not reduce the rate of interest any more. 6. Variations of Interest Rates not Explained: This theory cannot explain why interest rates vary from person to person, from place to place and for different periods. Money being a medium of exchange, the primary demand for money arises for making day-to- day transactions. The normal yield curve reflects higher interest rates for 30-year bonds, as opposed to 10-year bonds. (ii) However, Keynes’ theory is not without merits. Rothbard states "The Keynesians therefore treat the rate of interest, not as they believe they do—as determined by liquidity preference—but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system. The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities, this causes the yield curve to be upward-sloping. Holding of money in the form of cash is the most convenient way of keeping one’s savings. 75 to yield the same fixed income of Rs. Other Liquidity Preference Motives Ignored: Keynes’ analysis of the liquidity preference is narrow in scope. This is the essence of Keynes’s theory. In this sense, the liquidity preference theory of interest is one-sided. This implies that the wealth owner holds either all bonds or all money depending upon the current or expected rate of interest. Rate of interest, being a monetary phenomenon, establishes equilibrium in the monetary sector, i.e., between demand and supply of money. The reason for liquidity preference or holding wealth in cash is that future is uncertain and full of risks and cash provides protection against future risk and uncertainties. Purchase of other assets (securities, commodities etc.) The important implications of the liquidity preference theory are given on the next column: Keynes’ liquidity preference theory of interest highlights the importance of money in the determination of the rate of interest. Liquidity trap is an important feature of the speculative demand for money function. Economics, Capital, Interest, Theories, Theories of Interest Rate Determination. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model). Changes in the demand for money and the supply of money lead to corresponding changes in the rate of interest. This will cause the rate of interest to rise and reach its equilibrium position. #2 – Liquidity Preference Theory. The theory of liquidity preference explains why the LM curve slopes upward. Demand for money: Liquidity preference means the desire of the public to hold cash. As interest rates rise, people will increase their money holdings and therefore velocity will rise. According to the classical economists, the rate of interest is determined by the decision as to how much should be saved and consumed out of a given income level. By increasing money supply, the monetary authorities can reduce the rate of interest and thus encourage investment. Thus, interest is the reward for inducing people to part with liquidity. The impact of a change in the supply of money on prices is seen via its impact on the rate of interest, the level of investment, output, employment and income. It is not always possible to reduce the rate of interest by increasing the money supply: (a) If demand for money also increases in the same proportion in which the supply of money is increased, the rate of interest will remain unaffected. Interest has been defined as the reward for parting with liquidity for a specified period. This theory assumes that the demand for real money balances L ( r , Y ) depends negatively on the interest rate (because the interest rate is the opportunity cost of holding money) and positively on the level of income. Today we are discussing the Keynesian theory of interest rate. Neo-Keynesian economists like Hicks, Lerner and Hansen are of the opinion that loanable funds formulation and the Keynesian liquidity preference formulation taken together do supply us with an adequate theory of the rate of interest. The liquidity preference theory ignored the effect of inflation and is based on the assumption of actual or expected price stability. Apart from transactions motive, people hold additional amount of cash in order to meet emergencies and unexpected contingencies, such as, sickness, accidents, unemployment, etc. Thus, the equilibrium rate of interest is determined at the level where demand for and supply of money are equal to each other. Thus, the rate of interest cannot be known without first having the knowledge of income level. While the classical theory operates only in a full employment situation, Keynes’ theory is applicable to both full employment as well as less-than-full employment conditions. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. Changes in Demand for and Supply of Money 6. (d) According to this theory, the rate of interest can be controlled by the monetary authority. (i) Undoubtedly, Keynes liquidity preference theory of interest is an incomplete and indeterminate theory and has many other short-comings. Disclaimer Copyright, Share Your Knowledge It refers to the extremely low level of interest rate at which people have no desire to lend money and will keep the whole money with them. Supply of Money 4. For businessmen, the expectations regarding the future prosperity and depression influence the precautionary demand for money. Meaning of Liquidity Preference: A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.". According to Keynes, the interest rate is not given for the saving i.e. In this theory, liquidity is given preference, and investors demand a premium or higher interest rate on the securities with long maturity since more time means more risk … According to this theory, interest is a monetary phenomenon and the rate of interest is determined by the demand for and supply of money. The liquidity preference theory goes directly contrary to the facts that it presumes to explain. Keynes alleges that the rate of interest is determined by liquidity preference. Keynes theory of interest is more general than the classical theory. Thus, as against the classical economists, Keynes puts greater emphasis on the store of value function of money. The interest rate according to Keynes is given for parting with liquidity for a particular period of time. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds (here, the term "bonds" can be understood to also represent stocks and other less liquid assets in general, as well as government bonds). Such a kind of portfolio behaviour is not observed in reality. On the contrary, a fall in the liquidity preference means an increased desire of the people to buy bonds at current prices, thus raising the bond prices and lowering the interest rates. (b) There is no need to distinguish between money and real rates because every change in the money rate of interest is regarded as an equivalent change in the real rate of interest. the transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. According to Jacob Viner, “Without saving there can be no liquidity to surrender. But further increase in money supply (e.g. According to Keynes, the rate of interest is determined by the liquidity preference and the supply of money. Thus, the demand for money for speculative motive will rise. The Shift-Ability Theory : The shift-ability theory of bank liquidity was propounded by H.G. Liquidity preference or the demand for money is of special significance in Keynes’ theory of interest. Unlike the demand for money, the supply of money is determined and controlled by the government or the monetary authority of the country and is interest-inelastic (as shown by the vertical line MM in Figure 5). For example, during inflation, high money interest rates may be mistaken as an effect of a decrease in money supply, whereas in reality they may- indicate low real rates of interest due to inflation. C) the interest rate will have no effect on the demand for real balances. Speculative demand for money or demand for idle balances is the unique Keynesian contribution. The liquidity preference theory was an attempt to displace the prevailing theory of interest (and financial asset pricing)--the loanable funds theory (also known as the classical or time preference theories) of interest. According to Keynes, the precautionary demand for money (Lp), like the transactions demand (Lt), is also a constant (kp) function of the level of money income (Y), and is insensitive to the changes in the rate of interest-, Keynes lumps the transactions and the precautionary demands for money together on the ground that both are fairly stable functions of income and both are interest-inelastic. 1%. Privacy Policy3. Rate of Interest-A Link between Monetary and Real Sector: Keynes integrates the theory of money and the theory of prices and the rate of interest is the link between the monetary sphere and the real sphere. The supply of money is different from the supply of commodities; while the supply of commodities is a flow, the supply of money is a stock. Criticisms Or Limitations of Liquidity Preference Theory Of Interest: But we cannot know income level without first knowing the volume of investment and the volume of investment requires the prior knowledge of rate of interest. 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