Liquidity Preference Theory of Interest

In his renowned book The General Hypothesis of Employment, Interest, and Money, Keynes advanced this theory. The Keynesian theory of interest is another name for this hypothesis. The following claims form the foundation of this theory:

• The compensation for withholding liquidity for a predetermined amount of time is interest.
• The relationship between the supply and demand for money determines interest rates.
• The only purely financial phenomenon is interest.

According to Keynes, the rate of interest is the compensation for withholding liquidity for a predetermined amount of time. His theory states that the relationship between the supply and demand for money determines the rate of interest at the equilibrium point.

Demand for money

Money is in high demand, as is keeping cash on hand. Liquidity preference is the term used to describe the public's desire to hold cash. The three reasons that Keynes highlighted for the public's demand for liquid cash are briefly described below:

• Transactions Motive: The term "transaction motive" refers to the amount of cash that a person must carry at all times in order to conduct both personal and professional transactions. People keep cash on hand to bridge the gap between their outgoing expenses and incoming income. The income motive is what we refer to as. The businessmen also needed to have cash on hand to cover their immediate expenses, such as paying for transportation, labor, and raw goods. The business motive is what we refer to as.
• Precautionary motive: The term "precautionary motive" describes people's need to keep funds on hand in case of unforeseen catastrophes or contingencies, such as illness, accidents, unemployment, etc. People keep some cash on hand to cover unforeseen expenses like illness, accidents, and unemployment. Businessmen similarly maintain money in reserve to profit from unforeseen agreements or to weather unpleasant circumstances. High income elasticity characterizes the transaction and preventive motives while being somewhat interest inelastic.
• Speculative Motive: A need for maintaining a particular amount of cash in reserve to generate speculative gains from the purchase and selling of bonds and securities based on potential changes in interest rates is referred to as speculative demand for money. The demand for speculative motivations is mostly influenced by bond prices and interest rates. But their relationships to one another are inverse. People will purchase bonds to sell if bond prices rise as expected in the future (i.e., as expected, the rate of interest would decline). However, if bond prices are anticipated to decline soon (i.e., if an increase in interest rates is anticipated), then consumers will sell bonds to prevent losses. According to Keynes, when interest rates are high, there is a low level of speculative demand for money, and vice versa when interest rates are low. For instance, a bond that costs Rs. 100 yields a fixed sum of Rs. 3 at a 3% interest rate. If the interest rate increases to 45, the bond's price must decrease to Rs. 75 in order to still produce the same fixed income of Rs. 3.

Supply of Money

The entire amount of money available in the nation at any given time for all uses is referred to as the money supply. The government or the nation's monetary authority determines and controls the supply of money, as opposed to the demand for it. Also, it is perfectly inelastic represented by a vertical straight line.

Determination of the Rate of Interest

Liquidity preference theory of interest

The rate of interest is set at the equilibrium level, where the supply and demand of money are equal, much like the price of any good. The vertical line in the illustration, QM, represents the supply of money, while the letter "L" represents the overall demand for money. At the equilibrium point E2where OR as the equilibrium rate of interest is established, the demand for money and supply of money intersect. A change in the interest rate will be made if there is any divergence from this equilibrium point. E2 will once more be established as the equilibrium point.

The supply of money OM is larger than the demand for money OM1 at point E1. Thus, from OR1 until the equilibrium rate of interest OR is reached, the rate of interest will begin to decline or drop. The demand for money is higher than the supply of money at the OR2 level of interest rate. As a result, until it reaches the equilibrium rate, the rate of interest OR2 will start climbing.

OR

The rate of interest will fall or decrease if the money supply is raised by the monetary authority or the government but the liquidity preference curve L remains the same. Given the supply of money, the interest rate will rise if the demand for money rises and the liquidity preference curve goes upward.

Criticisms:

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

• It is anticipated that the level of income will be provided; the preferred level of liquidity will be determined by the interest rate. But the level of income affects the preference for liquidity.
• It is a common misconception that the demand for investment capital determines the rate of interest. The demand for capital and subsequent investment of different people have a substantial impact on their cash balances.
• The rate of interest is not solely a financial phenomenon, as has been noted. The determination of the interest rate is heavily influenced by actual variables like capital production and consumer thriftiness.
• The rate of interest is not solely determined by liquidity preference. Other variables play a role in the rate of interest by changing the supply and demand for investable funds.
• The occurrence of many interest rates that are prevalent in the market at the same time is not explained by the liquidity preference theory.
• Keynes disregards waiting or saving as a way to generate investable capital. Giving up liquidity in the absence of any savings is pointless.
• Only the short-run interest is explained by the Keynesian hypothesis. It provides no indication of the long-term interest rates.
• Like the traditional and loanable money theories, Keynes' theory of interest is illogical. We are unable to predict how much funding will be available for money unless we know how much the transaction demand for money is.

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan