KEYNESIAN THEORY OF MONEY AND INTEREST

(Note- This lecture is compiled from the book of Macroeconomics by L.N. DUTTA for
teaching purpose only)

To the classicals, interest is a real phenomenon, determined by savings and investment

which, in tum, depend on such real factors as future time preference and productivity of
capital, respectively. To Keynes, interest is a monetary phenomenon determined by
demand for and supply of money.

There are three main motives for which individuals and business community
wish to hold money in cash.
These are: (a) transaction motive, (b) precautionary motive and (c) speculative motive.
Of these, the first — the transaction motive is the same as the transaction demand for money
of the classical. The precautionary motive — the motive to meet with emergency needs of
individuals and businesses —is the additional element to the demand for money. The third,
i.c., speculative motive is special to Keynes” list of the demand for money. In fact, this
motive is ‘crucial’ insofar as its relation with rate of interest is concerned.

Thus, there are two main categories of demand for money:

transaction demand (including precautionary demand) and speculative demand.
This can functionally be written as follows:

L1=L1(Y) and L2=L2(r)

where, L1, refers to transaction demand and L2, speculative (or, asset) demand, Y
and r are, respectively, the level of income and rate of interest. Further, since L,
is positively related to the level of income and L, is negatively related to the rate
of interest.

CORRECTION- IN 2nd FIGURE ON Y AXIS ITS “r” not “Y”

Keynes’ theory of interest is known as the “liquidity preference’ theory.

Liquidity preference refers to the demand for money since individuals and the community
prefer liquidity (or money in its most liquid form(cash) are the same as to why people
demand money.

Now, since total demand for money can be lumped together as L= L1 + L2. we can express in
functional form as L = L(Y, r), that is, total demand for money depends on both the level of
income and the rate of interest.

Keynes defined interest as the ‘reward for parting with liquidity’. This means
that people generally have preference for cash or liquidity because this is the
most secure form of money holding. When sacrifice this most liquid form of money holding
they must be rewarded with an incentive for doing this in the form of interest. Now, when
this incentive (ie. interest rate) is lower as compared to some normal rate people generally
have in their mind, they have greater preference for liquid money. Similarly, when the
interest rate is higher, people have smaller preference for liquid money.

Now the question is what is the alterative to liquidity preference? L, is also known as the
“asset demand" for money since money serves as an asset in addition to being a medium of
exchange.

To understand the logic of this asset demand and its relationship with the rate of interest, we
assume that there are several alternative financial assets such as bonds, equities and a variety
of other alternative assets.
However, Keynes assumed that there is a single alternative to cash holding viz., ‘bonds”. So,
people who wish to hold money as an asset have two options: either they can keep money in
which case they get no reward at all, or they can buy “bonds”. In the latter case, there is a
‘return” attached with bond holding. This return is of two kinds:
(a) interest rate applicable to each bond and (b) capital gain/loss in case of rise/fall in the
price of bonds.
The price of bond is, however, inversely related to the rate of interest, that is, if the rate of
interest rises the price of bond falls and if the rate of interest falls, the price of bond rises. The
inverse relationship con be illustrated with an example:

Example-

Supposing a bond worth Rs 1000 with 5 per cent rate of interest on its face
value is issued by the government or any private company with a view to raising
capital from the market. Now somebody buys this bond which carries an annual
yield of Rs 50 (5% of 1000 = 50). This means that the purchaser of this particular
bond will continue to receive an annual return of Rs 50 so long as he holds the
bond. In case be sells it to some other person, the new purchaser will continue to
enjoy the advantage. Now, if the rate of interest fall to 4%, for instance, which
is applicable to all newly issued bonds, the price of existing bond rises since,
at the old price of Rs 1000 it is not able to produce an an annual yield of Rs 50. In
fact, now, its price rises to Rs 1250 (Rs 1250 x 4% = Rs 50).

Hence, the relationship between price of bond, rate of interest and its annual payment (known
as coupon payment) can be expressed as:

b(r)=c/b(p)

where, c = annual coupon payment, b(p) = price of bond and b(r) = bond rate of
interest. Clearly, if b(r) falls, c being fixed, b(p) rises and conversely, if b(r) rises,
b(p), falls.
The other kind of return attached with bond holding is the ‘expected capital
gain”. This depends upon the future price of the bond. [f the price of bond rises
in future, bond holders stand to gain if they sell it in the market. On the other
hand, if the price falls they stand to lose. Thus, capital gain or loss is uncertain
and depends upon the behaviour of the market rate of interest. Most bond holders
would expect the yield on bonds (interest rate) to remain at low level so that they
can be capital gainers. The coupon payment is, however, a constant annual sum
regularly received by the bond holder.
Now, when the price of bond becomes higher (interest rate lower) people
will be buying less bonds and hold more money. The opposite happens when
the interest rate is higher (or, bond price lower) — people's preference will
swing towards buying more bonds and keeping less money in cash. This inverse
relationship, therefore, explains also the inverse relationship between the rote of
interest and the demand for money (downward sloping speculative demand for
money.

Liquidity Trap

However, what is more important and relevant in the context of Keynesian

theory of interest is not only the current rate of interest but the expected future
rate of interest. With movement of interest rate upward or downward, the bond
holders form a certain expectation about future interest rates for, expected
future price of bonds). For instance, when interest rate is increasing, holders of
bonds might consider a particular rate to be highest and expect the future rate
to be decreasing thereafter. Similar perception might prevail when interest rate
is moving downward and reaches a certain level which the bond holders/asset
holders would consider minimum. Their expectation, in such a situation, would
be a movement upward of the interest mite in future. Based upon such a state
of expectation about future movement of interest rate, the bond holders would
either prefer to hold money or bond. For instance, when the current interest rate is
regarded as the highest, wealth holders would tend to hold maximum amount of
bonds, since they would expect future rate of interest to be on the lower side. By
doing so, they can reap maximum capital gains by selling their bonds at higher
prices. Conversely, when current interest rate is regarded as the lowest (highest
bond price) they would like to hold most of their wealth in money because they
expect the rate of interest to rise in the next move (bond price to fall) so that
they can, then, buy bonds and subsequently gain from bond holding. This latter
situation of falling interest rate to the minimum is known as “liquidity trap"
when the demand for money is infinitely large. It must be noted, however, that all
bond holders do not have the same “state of expectation” about future movement
of bond prices. Had it been so, at lowest price of bond, there would be very high
demand for bonds which would raise their prices in the bond market. Opposite
would be the case when bond price reaches the highest (expected) level.

Aug far as the supply of money is concerned, Keynes assumed that supply of money is
“institutionally” determined - by the central banking authority at a point in time. So, supply
of money is said to be exogenously or autonomously determined.
Figure shows the rate of interest on the vertical axis and demand and supply of money on the
horizontal axis. The vertical line L1, represents the transaction demand for money, which is
insensitive to interest rate.
The speculative demand for money, L2, is, however, inversely related to the rate of interest,
hence it is downward sloping. However, when interest rate reaches Orm, — considered as
minimum, the demand for money, L2, is infinitely clastic. Hence,
L2 curve is horizontal at this minimum rate of interest. This is the situation of
‘Liquidity trap’.