Keynes’ Liquidity Preference Theory of Interest Rate Determination/Keyne's theory on demand for money.

What is Liquidity Preference?

“Liquidity preference is the preference to have an equal amount of cash rather than claims against others.” -Prof. Mayers

 

Keynes’ Liquidity Preference Theory of Interest Rate Determination

According to liquidity preference theory, interest is determined by the demand for and supply of money. It is determined at a point where supply of money is equal to demand for money. The determinants of the equilibrium interest rate in the classical model are the ‘real’ factors of the supply of saving and the demand for investment. On the other hand, in the Keynesian analysis, determinants of the interest rate are the ‘monetary’ factors alone. Keynes’ analysis concentrates on the demand for and supply of money as the determinants of interest rate. According to Keynes, the rate of interest is purely “a monetary phenomenon.” Interest is the price paid for borrowed funds. People like to keep cash with them rather than investing cash in assets. Thus, there is a preference for liquid cash. People, out of their income, intend to save a part. How much of their resources will be held in the form of cash and how much will be spent depend upon what Keynes calls liquidity preference, Cash being the most liquid asset, people prefer cash. And interest is the reward for parting with liquidity. However, the rate of interest in the Keynesian theory is determined by the demand for money and supply of money.

 

Demand for Money:

To Keynes, money is not only a medium of exchange, but also a store of wealth. Now, there arises a question, why people want to hold cash? Demand for money is not to be confused with the demand for a commodity that people ‘consume’. But since money is not consumed, the demand for money is a demand to hold an asset.

The desire for liquidity or demand for money arises because of three motives:

(a) Transaction motive

(b) Precautionary motive

(c) Speculative motive

 

(a) Transaction Demand for Money:

According to Peterson, “The transactions motive relates to the need to hold some quantity of money balances (either currency or demand deposits) to carry on day to day economic dealings”. Most of the people receive their incomes by the week or month while the expenditure goes on every day. Therefore, a certain amount of ready money is kept in hand to make daily payments. Not only individuals and households need money to meet daily requirements, but business firms also need it to meet daily transactions like the payment of wages, purchase of raw-materials and to pay for the cost of transport, etc.The demand for money for transactions purposes depends upon various factors like income, the general level of business activity, and the interval at which income is received. For instance, if income is received after a long interval of time, a larger proportion of income will have to be kept in ready cash.

Similarly, where goods are available on credit, less amount of ready cash is needed. Thus, as a general rule, it can be said that the transactions demand for money is income elastic and may be expressed as

(L_t) = f(Y)

Money is needed for day-to-day transactions. As there is a gap between the receipt of income and spending, money is demanded. Incomes are earned usually at the end of each month or fortnight or week but individuals spend their incomes to meet day-to-day transactions. Since payments or spending are made throughout a period and receipts or incomes are received after a period of time, an individual needs ‘active balance’ in the form of cash to finance his transactions. This is known as transaction demand for money or need- based money—which directly depends on the level of income of an individual and businesses. People with higher incomes keep more liquid money at hand to meet their need-based transactions. In other words, transaction demand for money is an increasing function of money income.

 

(b) Precautionary Demand for Money:

Every individual and firms keep their savings in liquid form for rainy days. Some part of the income is saved to provide for contingencies as illness in the family, a journey that may be required to be undertaken under compelling circumstances, some guests may arrive, some money is to be kept apart for some such event as birth or marriage, some friend or relative may require financial assistance.For all such purposes, the person would like to keep money in liquid form or semi-liquid form, e.g., in savings bank. Liquidity preference for such motive is not as high as for the transaction motive. Nevertheless, there is some liquidity preference for precautionary motives. Future is uncertain. That is why people hold cash balances to meet unforeseen contingencies, like sickness, death, accidents, danger of unemployment, etc. The amount of money held under this motive, called ‘Idle balance’, also depends on the level of money income of an individual. People with higher incomes can afford to keep more liquid money to meet such emergencies. This means that this kind of demand for money is also an increasing function of money income.

This fact can be expressed in the form of an equation as:

L_p = f(Y)

According to Keynes, demand for money for precautionary motives depends on income. Keynes denotes M₁, the combined demand for these two motives. Thus,

M₁ = L_t+ Lp = f(Y)

In Figure, vertical line AB represents the demand for precautionary and transactionary motives. It signifies the fact that demand for money for these two purposes remains OA irrespective of any change in rate of interest.

 

(c) Speculative Demand for Money:

If a man has money that he can spare even after satisfying his consumption needs and after building funds sufficient to meet contingencies, he would like to invest money in such a way that brings him profits. In this case he would not be very keen for keeping his money in liquid form. The liquidity preference is low in such cases. A high rate of interest can bring some money kept for precautionary motive for lending, but it will hardly be possible to bring out the money kept for transactional motive for lending. The more the money that is kept for the first two motives, the higher will be the rate of interest in the society and vice-versa.

This sort of demand for money is really Keynes’ contribution. The speculative motive refers to the desire to hold one’s assets in liquid form to take advantages of market movements regarding the uncertainty and expectation of future changes in the rate of interest. The cash held under this motive is used to make speculative gains by dealing in bonds and securities whose prices and rate of interest fluctuate inversely. If bond prices are expected to rise (or the rate of interest is expected to fall) people will now buy bonds and sell when their prices rise to have a capital gain. In such a situation, bond is more attractive than cash. Contrarily, if bond prices are expected to fall (or the rate of interest is expected to rise) in future, people will now sell bonds to avoid capital loss. In such a situation, cash is more attractive than bond. Thus, at a low rate of interest, liquidity preference is high and, at a high rate of interest, securities are attractive.

It can be expressed in the form of an equation

M₂ = f (r)

In Figure, CD is the demand curve for speculative motives. It slopes downward from left to right. But at point K, it becomes parallel to X-axis. It indicates that demand for money is inversely related to rate of interest. In other words, at higher rate of interest, demand for money for speculative motives will be low and vice-versa.

Thus,

S_dm = f (r)

Where, Y is the rate of interest.

 

Total Demand for Money:

The total demand for money (MD) in the summation of transaction, precautionary and speculative demand for money. 

MD = M₁ + M₂ = f (Y, r)

 

The demand for money has a negative slope because of the inverse relationship between the speculative demand for money and the rate of interest. However, the negative sloping liquidity preference curve becomes perfectly elastic at a low rate of interest. According to Keynes, there is a floor interest rate below which the rate of interest cannot fall. This minimum rate of interest indicates absolute liquidity preference of the people.

In Figure A transaction and precautionary demand for money is shown. AB is the demand curve which is perpendicular to X-axis. It indicates that rate of interest has no effect on it. In other words, with the increase or decrease in rate of interest demand for money remains stable.

In Figure B speculative demand for money is shown. JK is the demand curve which at point K becomes horizontal to X-axis; it signifies that rate of interest does affect the demand for money. At higher rate of interest demand for money is lower and vice-versa.

In Figure C total demand for money is shown. It is the summation of transaction, precautionary and speculative demand for money. It is DD curve which at point M becomes horizontal to X-axis. This demand curve is known as liquidity preference curve.

 

Money Supply:

By supply of money is meant the sum total of currency and bank deposits held by non-banking public. The money supply in a country is determined by the monetary authority such as the central bank. Money supply is not related to the rate of interest. The supply of money in a particular period depends upon the policy of the central bank of a country.

It is the need of the economy which will determine the quantity of money. Therefore, the supply curve of money (M) is shown as a vertical line parallel to the ordinate (Y) axis as shown in Figure.

 

Equilibrium Rate of Interest:

According to Keynes, equilibrium rate of interest is determined at a point where demand for money is equal to supply of money.

MD (LP) = MS.

In Figure  MS is the supply curve of money where LP is the liquidity preference or demand curve for money. Both these curves intersect each other at point E which determines OR rate of interest.

However, effect of change in demand for money and supply of money are explained as under:

 

Change in Demand for Money:

If the supply of money remains constant, and as the liquidity preference for money increases rate of interest also increases and vice-versa. In Fig. 10. SM is the supply of money curve. M, M₁, M₂ are the demand for money curves. Now suppose that initially M is the demand curve. Here equilibrium is restored at point E where M curve cuts MS and rate of interest is determined.

If liquidity preference increases to M₁, new equilibrium will be at E₁ and the interest rate increases to OR₁. If contrary to this, liquidity preference curve falls to M₂, equilibrium will be at point E₂ which will determine OR₂ interest rate.

Change in Supply:

If demand for money remains constant, as the supply of money increases, rate of interest decreases and vice-versa.

In Figure LP is the liquidity preference curve while MS, M1S₁ and M₂S₂ are the supply curves. In the beginning, MS is the supply curve which intersects demand curve at point E. Here equilibrium rate of interest is OR.

Now if the supply of money decreases to M₁S₁, then LP curve cuts supply curvy at E₂. The equilibrium rate of interest is OR₁. On the other hand, if supply of money increases to S₂ M₂, equilibrium interest rate falls to OR₂.

Importance of Liquidity Preference Theory in Interest

Some of the major importance of liquidity preference theory in interest rate are as follows:

1. Liquidity Trap:

By liquidity trap, we mean a situation where the rate of interest cannot fall below a particular minimum level. It means rate of interest is always positive. It cannot be zero or negative. It can be shown with the help of Figure. Along the X-axis is represented the speculative demand for money and along the Y-axis the rate of interest. The liquidity preference curve LP is downward sloping towards the right. It signifies that the higher the rate of interest, the lower the demand for speculative motive, and vice-versa. Thus, at the high current rate of interest OR, a very small amount OM is held for speculative motive. This is because at a high current rate of interest much money would have been lent out or used for Buying bonds and therefore less money will be kept as inactive balances.

If the rate of interest rises to OR₁ then less amount OM₁ will be held under speculative motive. With the further fall in the rate of interest to OR₂, money held under speculative motive increases to OM₂. It will be seen in Fig. 12 that the liquidity preference curve LP becomes quite flat i.e., perfectly’ elastic at a very low rate of interest. It is horizontal line beyond point EE₁ towards the right. This perfectly elastic portion of liquidity preference curve indicates the position of absolute liquidity preference of the people.

That is, at a very low rate of interest people will hold with them as inactive balances any amount of money they come to have. This portion of liquidity preference curve with absolute liquidity preference is called liquidity trap by some economists.

M₁, = L₁, (Y)

2. Interest is Monetary Phenomenon:

According to Keynes, interest is a purely monetary phenomenon. His theory has focused on the role of money in determining the rate of interest.

3. More Generalized:

The classical theory was a special theory applicable only to a full- employment situation. Keynes theory is more general in that it is applicable both to full as well as under employment situations.

4. Integrated Theory:

A great merit of Keynes theory is that it has integrated the theory of interest with the general theory of output and employment. Employment depends on the level of investment and inducement to invest is influenced apart from marginal efficiency of capital, by the rate of interest.

5. Integration with Price:

Keynes has integrated the theory of interest with the theory of price. The classical writers had unduly emphasized such real factors as abstinence and time preference. According to Keynes, interest is the price of money, and like the price of any commodity, it is determined by the demand for and supply of money.

6. More Practical:

The theory is of great practical significance also. The rate of interest depends on the demand for and supply of money. The supply of money is regulated by the government or the monetary authority of the country. Therefore, the government can greatly influence the rate of interest by regulating money-supply. Also through its liquidity trap hypothesis, the theory stresses the limitation of monetary authority in lowering the rate of interest beyond a certain level.

7. Inverse Relation between Interest and Price:

Another importance of Keynes liquidity preference is that bond prices are inversely related to interest rate. It means, interest rate and bond prices move in opposite direction.

8. Long Term Vs. Short Term Interest Rates:

According to Keynes, interest is a reward for parting with liquidity. The interest rate differs on debts of different lengths and maturities. The interest rate on daily loans will be different from the rates of interest on weekly, monthly and yearly loans. Debts of longer maturity’ like three, five or ten years will have different interest rates.

 

Limitations:

Even Keynes’ liquidity preference theory is not free from criticisms:

Firstly, like the classical and neo-classical theories, Keynes’ theory is an indeterminate one. Keynes charged the classical theory on the ground that it assumed the level of employment fixed.

Same criticism applies to the Keynesian theory since it assumes a given level of income. Keynes’ theory suggests that D_m and S_M determine the rate of interest. Without knowing the level of income we cannot know the transaction demand for money as well as the speculative demand for money. Obviously, as income changes, liquidity preference schedule changes—leading to a change in the interest rate.

Therefore, one cannot, determine the rate of interest until the level of income is known and the level of income cannot be determined until the rate of interest is known. Hence indeterminacy. Hicks and Hansen solved this problem in their IS-LM analysis by determining simultaneously the rate of interest and the level of income.

It is indeed true also that the neo-classical authors or the pro-pounders of the loanable funds theory earlier made attempt to integrate both the real factors and the monetary factors in the interest rate determination but not with great successes. Such defects had been greatly removed by the neo-Keynesian economists—J.R. Hicks and A.H. Hansen.

Secondly, Keynes committed an error in rejecting real factors as the determinants of interest rate determination.

Thirdly, Keynes’ theory gives a choice between holding risky bonds and riskless cash. An individual holds either bond or cash and never both. In the real world, it is the uncertainty or risk that induces an individual to hold both. This gap in Keynes’ theory has been filled up by James Tobin. In fact, today people make a choice between a variety of assets.

Conclusion:

Despite these criticisms, Keynes’ liquidity preference theory tells a lot on income, output and employment of a country. His basic purpose was to demonstrate that a capitalist economy can never reach full employment due to the existence of liquidity trap.

Though the liquidity trap has been overemphasized by Keynes yet he demolished the classical conclusion the goal of full employment. Further, his theory has an important policy implication. A central bank is incapable of reviving a capitalistic economy during depression because of liquidity trap. In other words, monetary policy is useless during depressionary phase of an economy.