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Liquidity Preference

Motives and Criticism

Theory:

The Liquidity Preference Theory was propounded by the Late Lord J.


M. Keynes.
According to this theory, the rate of interest is the payment for parting
with liquidity.
Liquidity refers to the convenience of holding cash. Everyone in this
world likes to have money with him for a number of purposes. This
constitutes his demand for money to hold.
The sum-total of all individual demands forms the demand for money
for the economy. On the other hand, we have got a supply of money
consisting of coins plus bank notes plus demand deposits with banks.
The demand and supply of money, between themselves, determine the
rate of interest.

Motives for Liquidity:


Money may be demanded to satisfy a number of motives.
These are:
(i) Transactions Motive:
We get income only periodically. We must keep some money with us
till we receive income next, otherwise how can we carry on
transactions? Transactions motive also includes business motive. It
takes some time before the businessman can sell his product in the
market. But he must pay wages to the workers, cost of raw material,
etc., now. He must keep some cash for the purpose.

(ii) Precautionary Motive:


Everyone lays by something for a rainy day. Some money must be kept
to meet unforeseen situations and emergencies.
(iii) Speculative Motive:
Future is uncertain. Rate of interest in the market continues changing.
No one can guess what turn the change will take. But everybody hopes,
and with confidence, that his guess is likely to be correct. It may or
may not be so. Some money, therefore, is kept to speculate on these
probable changes to earn profit.

Interest-rate Determination:
Money demanded for all these motives or purposes constitutes
demand for money, or liquidity preference. Liquidity preference
means how much cash people like to keep with them at a particular
time. The higher the liquidity preference, given the supply of money,
the higher will be the rate of interest; and vice versa. Further, given
the liquidity preference, the larger the supply of money, the lower will
be the rate of interest, and the smaller the supply of money, the higher
the rate of interest.
According to Keynes, the demand for money, i.e., the liquidity
preference, and supply of money determine the rate of interest. It is in
fact the liquidity preference for speculative motive which along with
the quantity of money determines the rate of interest.We have
explained above the speculative demand for money. As for the supply
of money, it is determined by the policies of the Government and the

Central Bank of the country. The total supply of money consists of


coins plus notes plus demand deposits with banks.
We see, thus, that according to liquidity preference theory, the rate of
interest is purely a monetary phenomenon. Productivity of capital has
very little, though indirect, say in determining the rate of interest.
How the rate of interest is determined by the equilibrium between the
liquidity preference for speculative motive and the supply of money is
shown in Fig. 34.4.

In part (a) of the figure, LPS is the cur of liquidity preference for
speculative motive. In other words, LPS curve shows the demand for
money for speculative motive. To begin with, OM 2 is the quantity of
money available for satisfying liquidity preference for speculative
motive. Rate of interest will be determined where the speculative
demand for money is in balance with, or equal to, the (fixed) supply of
money OM.2It is clear from the figure that speculative demand for
money is equal to OM2quantity of money at or rate of interest. Hence
or is the equilibrium rate of interest.

Assuming no change in expectations, an increase in the quantity of


money (via open-market operations) for the speculative motive will
lower the rate of interest. In part (a) of the figure, when the quantity of
money increases from OM1 to OM2, the rate of interest falls from Or to
Or, because the new quantity of money OM ; is in balance with the
speculative demand for money at Or rate of interest. In this case, we
move down the LPS curve. Thus, given the schedule or curve of
liquidity preference for speculative motive, an increase in the quantity
of money brings down the rate of interest.
It is worth mentioning that shifts in liquidity preference schedule or
curve can be caused by many other factors which affect expectations
and might take place independently of changes in the quantity of
money by the Central Bank. Shifts in the liquidity preference curve
may be either downward or upward, depending on the way in which
the public interprets a change in events.
If some change in events leads the people on balance to expect a
higher rate of interest in the future than they had previously
anticipated, the liquidity preference for speculative motive will
increase, which will bring about an upward shift in the curve of
liquidity preference for speculative motive and will raise the rate of
interest.
In part (b) of Fig. 34.3, assuming that the quantity of money remains
unchanged at OM2, with the rise of the liquidity preference curve from
LPS to LPS, the rate of interest rises from Or to Or, because at Or,
the new speculative demand for money is in equilibrium with the
supply of money OM2. It is worth noting that when the liquidity

preference speculative motive rises from LPS to LPS, the amount of


money hoarded does not rise; it remains as OM; as before. Only the
rate of interest rises from Or to Or to equilibrate the new liquidity
preference for speculative motive with the available quantity of money
OM 2.
Thus, we see that Keynes explained interest in terms of purely
monetary forces and not in terms of real forces like productivity of
capital and thrift, which formed the foundation-stones of both
classical and loanable fund theories. According to him, demand for
money for speculative motive together with the supply of money
determines the rate of interest.
Moreover, according to Keynes, interest is not a reward for saving or
thriftiness or waiting, but for parting with liquidity. Keynes asserted
that it is not the rate of interest which equalises saving and
investment, but this equality is brought about through changes in the
level of incomes.

Criticism:
Keyness theory, too, has come in for considerable criticism:
(i) Firstly, it has been pointed out that the rate of interest is not a
purely monetary phenomenon. Real forces like productivity of capital
and thriftiness also play an imp i.ant role in the determination of the
rate of interest.
(ii) Keynes makes the rate of interest independent of the demand for
investment funds. In fact, it is not so independent. The cash-balances
of the businessmen are largely influenced by their demand for savings

for capital investment. The demand for capital investment depends


upon the marginal revenue productivity of capital. Therefore, the rate
of interest is not determined independently of the marginal
productivity of capital or marginal efficiency of capital, as Keynes calls
it.
(iii) Liquidity preference is not the only factor governing the rate of
interest. There are several other factors which influence the rate of
interest by affecting the demand for and supply of investable funds.
(iv) This theory does not explain the existence of different rate of
interest prevailing in the market at the same time.
(v) Keynes ignores saving or waiting as a source or means of investible
funds. To part with liquidity without there being any saving is
meaningless.
(vi) The Keynesian theory explains interest in the short run only. It
gives no clue to the rates of interest in the long run.
(vii) Finally, exactly the same criticism applies to Keynesian theory
itself on the basis of which Keynes rejected the classical and loanable
funds theories. Keyness theory of interest, like the classical and the
loanable funds theories, is indeterminate.
According to Keynes, the rate of interest is determined by the
speculative demand for money and the supply of money available for
satisfying speculative demand. Given the total money supply, we
cannot know how much money will be available to satisfy the
speculative demand for money unless we know how much the
transactions demand for money is; and we cannot know the

transactions demand for money unless we first know the level of


income. Thus, the Keynesian theory, like the classical, is
indeterminate.
In the Keynesian case the supply and demand for money schedules
cannot give the rate of interest unless we already know the income
level; in the classical case the demand and supply schedules for
savings offer no solution until the income is known. Precisely the same
is true of loanable-funds theory. Keyness criticism of the classical and
loanable-funds theories applies equally to his own theory.Hansen.

ADDITIONAL NOTES
(1) Reed factors ignored:
Keynes held that interest is purely a monetary phenomenon as it is determined by the monetary
forces of supply and demand. Hazlitt criticized the theory on the ground that Keynes did not take
into consideration the real factors on the determination of the rate of interest. Keynes believed that
real factors like productivity, time preference had no influence on the rate of interest. Thus liquidity
preference is one-sided.
(2) No liquidity without saving:
Keynes held that interest is the reward for parting with liquidity. He believed that interest is the
amount of compensation for surrendering liquidity. He did not say that interest is a price for saving
without saving no ingestible funds can be crated. Thus he ignored the abstinence waiting and time
preference as the sole cause of interest payment. According Jacob Viner without saving there can be
no liquidity to surrender. Thus rate of interest and saving are related.
(3) In determinate theory:
Keynes liquidity preference theory interested is indeterminate. According to him, the rate of interest
is determined by the supply of money and liquidity preference. The position of liquidity preference
depends on the level of income. Thus the rate of interest cannot be known without knowing the
income level, on the other hand, cannot be known without knowing the volume of investment and
volume of investment can not be determined without the knowledge of interest rates. Thus liquidity
preference is indeterminate.

(4) Long period ignored:


Liquidity preference theory cannot explain the level of interest rate in the long run. He gives due
importance on short period.
(5) Contrary of facts:
Liquidity preference theory is contrary to facts. According to Keynes when liquidity preference is
high, But what is seen at the time of depression people want to have more cash balance with them.
This means the liquidity preference of the people is high but in depression rate of interest is generally
very low. This means the liquidity preference theory of interest is contrary to facts.
(6) Self contradictory:
According to Keynes interests the reward for parting with liquidity. But it is found that people who
deposited money in form of fixed depositor any other short term bills can withdraw at any time or
after a fixed period of time. Thus he gets back his liquidity and interests. He, therefore, receives
interest without parting with liquidity