ii. It assumes that the decision to borrow and invest depends entirely on interest. This is not thecase, for business expectations play more important role in the decision to invest. Thus ifbusiness expectations are high, investors will borrow and invest, even if the rate of interest ishigh and if business expectations are low investors will not borrow and invest even if the rate ofinterest is low.iii. It assumes that the decision to save depends entirely on the rate of interest. This is not true forpeople can save for purposes other than earning interest, e.g. as precaution against expectedfuture events like illness or in order to meet a certain target (this is called target savings) orsimply out of habit.
b. The Keynesian Theory
Also called the
Monetary Theory of Interest
, was put forward by the Lord John MaynardKeynes in 1936. In the theory, he stated that the rate of interest is determined by the supply ofmoney and the desire to hold money. He thus viewed money as a liquid asset, interest being thepayment for the loss of that liquidity.Keynes formulated derived from three motives for holding money, namely:
Speculative.Thus Keynes contended that an individual’s aggregate demand for money in any given period will bethe result of a single decision that would be a composite of those three motives.
a. Transactions demand for money
Keynes argued that holding money is a cost and the cost is equal to the interest rate foregone.People holding money as assets could also buy Government bonds to earn interest. But money’smost important function is as medium of exchange. Consumers need money to purchase goods andservices and firms need money to purchase raw materials and hire factor services. People thereforehold money because income and expenditure do not perfectly synchronize in time. People receiveincome either on monthly, weekly, or yearly basis but spend daily, therefore money is needed tobridge the time interval between
receipt of income
disbursement over time
.The amount of money that consumers need for transactions will depend on their
spending habits,time interval after which income is received
Therefore holding habit and IntervalConstant, the higher the income level the more the money you hold for transactions. Keynes thusconcluded that transactionsdemand for money is Interest Inelastic.