LESSON- 17

KEYNES LIQUIDITY PREFERENCE APPRAOCH:

Objectives:

After studying this lesson, you will be able to understood,

 The definition of demand for money given by Keynes

 The different motives for demand for money
 The Transactions, Precautionary and Speculative motives for money
 The difference between Transactions demand for money, Precautionary demand for
money and speculative demand for money
 The total demand for money

17.1 Introduction

17.2 Keynes Liquidity Preference Approach

a) Transactions demand for money

b) Precautionary demand for money

c) Speculative Demand for money

d) Total demand for money

17.3 Derivation of LM Curve

17.4 Summary

17.5 Glossary

17.6 Model Questions

17.7 Further Readings

17.1 Introduction

Keynes propounded a theory of demand for money in his general theory which occupies an
important place in his monetary theory. In other words his demand for money is called as
liquidity preference. How much of his income or resources will a person hold in the form of
ready money and how much will he part with or lend depends upon what calls his ‘liquidity
preference’. Liquidity preference means the demand for money to hold or the desire of the public
to hold cash.

17.2 Keynes Liquidity Approach to Demand for Money

Keynes suggested three motives which led to the demand for money in an economy they are: the
transactions motive, Precautionary motive and Speculative motive.

The Transactions demand for money:

The transactions demand for money arises from the medium of exchange function of money in
making regular payments for goods and services. According to Keynes, it relates to ‘the need of
cash for the current transactions of personal and business exchange’. Further, he stated that the
changes in transactions demand for money depending upon the changes in income. Therefore,
the transactions demand for money is a direct proportional and positive function of the level of
income, and is expressed as :
Lt = f(ky) where Lt is the transactions demand for money, k is the proportion of income which is
kept for transactions purposes, and y is the income.
This equation is illustrated in the following diagram;
Regarding the rate of interest and transactions demand for money, Keynes made the Lt function

interest inelastic. But he did not stress the role of the rate of interest in this part of his analysis,

and many of his popularizers ignored it altogether. In recent years, two post Keynesian

economists WJ Baumol and James Tobin have shown that the rate of interest is an important

determinant of transactions demand for money. they have also pointed out that the relationship

between transactions demand for money and income is not linear and proportional . Rather

changes in income lead to proportionately smaller changes in transactions demand. The modern

view is that the transactions demand for money is a function of both income and interest rates

which can be expressed as:

Lt = f(Y,r) because, as the rate of interest starts rising over and above certain level the
transactions demand for money becomes interest elastic. It is because the higher rates of interest
will attract some amount of transactions balances into securities. So the backward slope of Y
curve shows that at still higher rates, the transaction demand for money declines. When there is a
rise in income level, the level of decline in transactions balances at the same rate of interest is
comparatively low. Thus, the transactions demand for money varies directly with the level of
income and indirectly varies with the rate of interest.

The Precautionary demand for money:

The precautionary motive relates to “ the desire to provide for contingencies requiring sudden
expenditures and for unforeseen opportunities of advantageous purchases”.
Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals
hold some cash to provide for illness, accidents and other unforeseen contingencies. Similarly,
businessmen keep cash in reserve to tide over unfavourable conditions or to gain from
unexpected deals. The precautionary demand for money depends upon the level of income, and
business activity, opportunities for unexpected profitable deals, availability of cash, the cost of
holding liquid assets in bank reserves etc. Keynes held that the precautionary demand for money,
like transactions demand, was function of the level of income. But the post-Keynesian
economists believe that like transactions demand, it is inversely related to high interest rates.

The speculative demand for money:

The speculative demand for money is for ‘securing profit from knowing better than the market
what the future will bring froth’ Individuals and businessmen having funds, after keeping enough
for transactions and precautionary purposes, like to make a speculative gain by investing in
bonds. Money held for speculative purposes is a liquid store of value, which can be invested at
an opportune moment in interest – bearing bonds or securities.

According to Keynes, it is expectations about changes in bond prices or in the current market
rate of interest that determine the speculative demand for money. In explaining the speculative
demand for money, Keynes had a normal or critical rate of interest in mind. If the current rate of
interest is above the critical rate of interest, businessmen expect it to fall and bond price to rise.
They will, therefore, by bonds to sell them in future when their prices rise in order to gain
thereby. A t such times, the speculative demand foe money would fall, conversely, if the current
rate of interest happens to be below the critical rate businessmen expect it to rise and bond prices
to fall.

Thus, the speculative demand for money is a decreasing function of the rate of interest. The
higher the rate of interest, the lower the speculative demand for money, and the lower the rate if
interest, the higher the speculative demand for money. It can be expressed algebraically as Ls = f
®, where Ls is the speculative demand for money and r is the rate of interest. Thus, the
Keynesian speculative demand for money function is highl6y volatile, depending upon the
behaviour of interest rates.
The Total Demand for Money:

According to Keynes, money held for transactions and precautionary purposes its primarily a
function of the level of income, Lt = f(Y), and the speculative demand for money is a function of
rate of interest, Ls = f®. Thus the total demand for money is a function of both income and
interest rate.
L = f (Y,r)

Where L represents the total demand for money. Thus the total demand for money can be
derived by the lateral summation of the demand function for transactions and precautionary
purposes and the demand function for spec8ulative purposes, as illustrated in figures

Panel A of the figure shows OT, the transactions and precautionary demand for money at Y level

of income and different rates of interest. Panel B shows the speculative demand for money at

various rate of interest. It is an inverse function of the rate of interest. For instance, at r6 rate of

interest it is OS and as the rate of interest falls to r2, the Ls curve becomes perfectly elastic.

Panel C shows the total demand curve for money L which is a lateral summation of LT and Ls

curves: L = LT + Ls. Total demand for money also becomes perfectly elastic showing the

position of liquidity trap.

17.3 Derivation of LM Curve

The LM curve can be derived from Keynesian theory from his analysis of money market
equilibrium. According to Keynes, demand for money to hold depends on Transaction and
speculative motive. It is the money held for transactions motive which is the function of income.
The demand for money also depends on the rate of interest which is the cost of holding the
money. This is because by holding money rather then lending it and buying other financial
assets, one has to forego interest. The intersection of the various money demand curves
corresponding to different income levels with the supply curve of money fixed by the monetary
authority would give us the LM curve. LM curve related the level of income with the rate of
interest which is determined by money market equilibrium corresponding to different level of
demand for money. The LM curve tells what the various rates of interest will be ( given the
quantity of money and family of demand curves of money) at different levels of income. But the
money demand curve or what Keynes called liquidity preference curve alone cannot tell us what
exactly the rate of interest will be.

17.4 Summary

Keynes in his theory stated that the demand for money arises for three motive; transactions
motive, precautionary and speculative motive. According to Keynes the total demand for money
means total cash balances which may be of two types: active and Idle balances. The former
comprises transactions and precautionary demand and the later comprise speculative demand.
Both the transaction and precautionary demand are positively associated with the changes in the
money income but change in rate of interest no role to play in determining transaction and
precautionary demand. Speculative demand for money is negatively associated with the changes
in the rate of interest. Finally Keynes held that the total demand for money is determined by both
interest and income.

17.5 Glossary
Liquidity
Transactions demand
Precautionary demand
Liquidity trap
Active balances
Idle balances

17.6 Model Questions

Short answer type questions
1. Define the term liquidity preference?
2. Explain the Keynes theory of Speculative demand for money?
3. what is meant by total demand for money?
4. what is liquidity trap?
5. Derive the LM Curve?
Essay type Questions
1) Critically evaluate the Keynes liquidity preference theory?
2) Discuss liquidity preference theory of money, explain how is it superior
than classical theory of demand for money?

17.7 Suggested Readings

Ackley Gardner : Macro economic theory

Ward R A: Monetary theory and policy
Rana & Verma : Macro economic analysis
Hajela TN: Monetary economics
Ghatak : Monetary economics in developing economies