Shri Vile Parle Kelavani Mandal’s

Narsee Monjee College of Commerce and Economics (Autonomous)

ECONOMICS
FY BCom(hons)
SEMESTER II

Theoretical Implications of Keynes’ Liquidity Preference Theory in India

Manashi Agarwal, A005, 45202220120, 7205220636

Other member details

Manashi Agarwal – A005,45202220120, 7205220636
Shreyanshi Agarwal- A006, 45202220065,7903754877
Anisha Agarwalla- A007, 45202220090, 9864735389
Megha Agarwal- A008, 45202220140, 7999470674

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 DECLARATION

I, Manashi Agarwal, declare that this project/assignment titled ‘Theoretical Implications of Keynes’
Preference Liquidity Theory in India’ is entirely my own work and any additional sources of information have
been duly cited.
All the sources published or unpublished from which I have quoted or drawn reference have been referenced
fully in the bibliography list as instructed by my teacher. I understand that failure to do so will lead to
plagiarism and any similarity found with other work elsewhere will result in severe disciplinary action.
I acknowledge it is my responsibility to keep myself updated with the schedule of viva (if any) and I will make
myself available during the same.

Manashi Agarwal

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 INDEX

Sl. No Particulars PAGE NUMBER

1. List Of Tables And Figures 4

2. Introduction 5

3. Background 10

4. Research Objectives 11

5. Research Methodology 11

6. Analysis and Interpretation 12/31

7. Conclusion 32

8. Refrences 33

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 LIST OF TABLES AND FIGURES

Sl. No Particulars PAGE NUMBER

1. Graph 1 6

2. Graph 2 7

3. Chart 1: borrowing profile of centre and states 13

4. Chart 2:Issuance profile of SDL’s 14

5. Table 1:Ownership Patterns of state government securities 16

6. Graph 3 28

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INTRODUCTION
In his well-known book, Keynes proposed a theory of money demand, which plays an important role in his
monetary theory. It's also worth noting that Keynes used the term "liquidity preference" to describe money
demand. A person's "liquidity preference," as defined by Keynes, determines how much of his income or
resources he will keep in the form of ready money (cash or non-interest-paying bank deposits) and how much
he will part with or lend. Liquidity preference refers to the general public's desire to hold cash.

Aggregate Demand For Money: Keynes’s View

The portion of M retained for transactions and a precautionary motivation is referred to as M1, and the portion
maintained for a speculative reason is referred to as M2 if the entire demand for money is represented by Md.
Md is therefore equal to M1 plus M2. Keynes contends that, unless the interest rate is extremely high, the
money held for transactions and precautionary purposes, or M1, is totally interest-inelastic. The amount of
money maintained as M1, or for transactional and precautionary purposes, is primarily a consequence of
income and business transaction volume as well as the contingencies arising from the management of personal
and business affairs. This can be expressed as follows in a functional form: Where Y stands for income and
L1 for the demand function, M1 = L1(Y)...(i), and M1 for money kept or requested as a result of the
transactions and preventative measures.

Revenue is a function of the money kept for transactional and precautionary purposes, according to the
aforementioned function. Yet, as previously explained, the amount of money sought for speculative purposes,
or M2, is essentially a function of the interest rate, according to Keynes. M2 = L2 (r...)...(ii), where r is the

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interest rate and L2 is the demand function for the speculative drive. Md can be calculated if total money
demand equals M1 plus M2.
Md = L1(Y) + L2 (r)
The overall demand for money, according to Keynes' theory, is thus an additive demand function with two
distinct components. L1(Y) represents the demand for money as a result of transactions, and financial affluence
has a growing relationship with precautionary intentions. The second component of money demand is L2(r),
which represents speculative money demand. It is a decreasing function of interest rates and is affected by
them. Keynes' additive theory of the money demand function is now widely rejected by mainstream
economists. Money, it has been noted, represents a single asset rather than a collection of assets. The same
unit of currency can be used for multiple purposes and held for multiple reasons.
Hence, it is impossible to segregate the need for money into segments that are independent of one another.

Liquidity Preference Curve: Smooth curve which slopes downward from left to right.

GRAPH 1

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 GRAPH 2

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Total liquid money is denoted by M, the transactions plus precautionary motives by M1 and the speculative
motive by M2, then
M = M1 + M2.
Since M1 = L1 (Y) and
M2 = L2 (r),
The total liquidity preference function is: M = L (Y, r).
The supply of money assumed fixed by the monetary authorities.
Hence the money supply curve is: perfectly inelastic curve.

DETERMINATION OF THE RATE OF INTEREST:

The interest rate is set when the supply of money equals the demand for money.
The vertical line QM represents money supply, and the horizontal line L represents total money demand.
Both curves intersect at E2, which determines the equilibrium rate of interest OR.
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If the rate of interest deviates from this equilibrium, the rate of interest is adjusted and equilibrium E2 is re-
established

At point E1, the supply of money OM exceeds the demand for money OM1. As a result, the rate of interest
will begin to fall from OR1 until the equilibrium rate of interest OR is reached. Similarly, at the OR2 interest
rate level, the demand for money OM2 exceeds the supply of money OM. As a result, the interest rate OR2
will begin to rise until it reaches the equilibrium rate OR.

If the monetary authorities increase the supply of money while keeping the liquidity preference curve L
constant, the interest rate will fall.

Given the supply of money, the rate of interest will rise if the demand for money rises and the liquidity
preference curve shifts upward.

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BACKGROUND

The Reserve Bank of India is India's central bank (RBI). Its primary mission is to manage and coordinate
India's monetary policy. It was established in 1935. On the board of directors that manages RBI is a governor
chosen by the government. The main objectives of the RBI are to maintain price stability, promote economic
growth, supervise foreign exchange reserves, and monitor financial institutions. In addition to acting as a bank
for the government and bankers, the RBI also prints money. In order to safeguard the stability and soundness
of all Indian banks, public and private, it monitors them all and takes the necessary action. Furthermore, RBI
creates and implements monetary policies that influence interest rates, liquidity, and inflation. In sum, RBI
plays a key role in the economy.essential function in preserving the nation's financial stability and
economic expansion.

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RESEARCH OBJECTIVES

1. To study the keynesian theory

2. To study the liquidity preferences of keynesian theory
3. Keynesian liquidity preference in India
4. To study the demand and supply curves of liquidity in India

RESEARCH METHODOLOGY AND RESEARCH DESIGNS

The macro-level analysis in this study of Theoretical Implications of Keynes’ Liquidity Preference Theory in
India is based on secondary data sources on the official websites of the RBI and other official government
websites from 2018-19 to 2022-23.
Reference Span:
This study's reference period runs from the years 2008–09 through 2022–23.
Sources Of Data

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This analysis has made use of secondary data that was gathered from official government websites. This
information was gathered by the government through a nationwide poll.

ANALYSIS:
INTRODUCTION
Market borrowing has become a crucial source of funding for state governments' resource shortfalls. The
National Small Savings Fund (NSSF), special securities issued to it, loans from banks and other financial
institutions, state provident funds, deposits and advances, and own reserves are some of the borrowing options
available to state governments. In the past, loans from the Center were the main source of funding for states.
The channel, however, lost significance as a result of changes in the financial markets and nations' capacity to
borrow on their own behalf, and it was shut down in May 2005. Since then, states have issued state government
securities or state development loans(SDLs) in an effort to move more and more towards market-
based funding.

SIZE OF STATE MARKET BORROWING

Debt consolidation While state borrowing has increased in recent years, the government of India's borrowing
from markets has remained steady (Chart 1). In comparison to the borrowings of the Centre, which climbed
from 261000 crore in FY 2008-09 to 588000 crore in FY 2017–18, a CAGR of 9%, the gross market
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borrowings of states increased from 118140 crore in FY 2008–09 to 419100 crore in FY 2017–18, at a CAGR
of 15%. State borrowings totaled 478323 crores in FY 2018–19, while centre borrowings declined
to 571000 crores.

CHART 1: BORROWING PROFILE OF CENTRE AND STATES

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CHART 2: ISSUANCE PROFILE OF SDL’s

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PROFILE OF INVESTORS TO SDL ISSUANCES

Institutions like commercial banks, insurance firms, and provident funds make up the majority of SDL
investors (PFs). Commercial banks' purchases of SDLs have gradually decreased, with their stake falling from
52% in FY 2007–08 to 34% at the end of March 2019. The percentage of insurance companies and provident
funds has significantly increased (Table 1). More than half of SDL ownership was held by insurance firms
(33%) and pension funds (PFs) (22%), who are primarily investors who keep the bonds until maturity. Few
overseas institutional investors have participated in the SDL market. Investment limits were raised gradually
to reach 2% of the total market capitalization in order to encourage the involvement of foreign portfolio
investors (FPIs). stock remaining after March 2018. Due to a lack of transparency and the absence of high
frequency data on state finances and state government activities, the FPI limit usage of SDLs for the quarter
ending March 2018 was a pitiful 12% of the limit notwithstanding the increase in investment limits.

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TABLE 1: OWNERSHIP PATTERNS OF STATE GOVERNMENT SECURITIES (share in percent)

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SDL VALUATION
State government securities are valued using the Yield to Maturity (YTM) method with a standard markup of
25 basis points above the yield of the central government assets of equal maturity, according to the RBI's
master circular on the valuation of investments, issued July 1, 2015. A 50 basis point markup is applied to the
value of UDAY bonds issued by various state governments. Because of the valuation standards that enable
boosting the price of SDL on banks' books and the protection from market risks provided by the Held to
Maturity (HTM) dispensation, banks investing in SDLs are reluctant to trade. The RBI has recently proposed
that the securities issued by each state government be valued using observed prices, with an emphasis onto
make sure that the bond holdings of banks accurately represent their current market value. This action might
deter banks from making passive investments and raise SDL trading volume.
The market now relies on FBIL's estimation of SDLs. When applicable, the approach uses trading SDL prices
with the necessary adjustments for non-traded securities.

SDLS AND REPO MARKET

SDLs became eligible for repo transactions in April 2007 under the RBI's Liquidity Adjustment Facility
(LAF). Also, they are acceptable as collateral for loans made through market repo. Although though SDLs
have a small proportion compared to other products like central government securities and treasury bills,

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trading in the repo market with SDLs as collateral has improved. SDLs now account for 13.56% of the repo
market, up from 0.87% in FY 2008-09 and 0.87% in FY 2008-09. SDL trading in basket repos is minuscule
because most of the trade is centred in baskets containing treasury bills and central government assets. Over
time, trading of SDLs in special repos has expanded, with average daily volumes rising from 271 crore in FY
2012–13. 5947 crore in the fiscal year 2018–19.

MOTIVE
Motives for Liquidity Preference are:
1. THE TRANSACTION MOTIVE
It claims that people prefer liquidity because it ensures they have enough money on hand to cover their
fundamental daily necessities. To put it another way, stakeholders have a strong demand for liquidity to meet
their short-term responsibilities, such as paying their rent or mortgage or for groceries. Increased living
expenses translate into a greater requirement for money/liquidity to cover those basic demands.
2. PRECAUTIONARY DEMAND FOR MONEY
Given the uncertainty of the future, caution is required. The need for people to keep cash on hand in case of
unanticipated circumstances is referred to as a precautionary incentive for holding money.

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 3. SPECULATIVE DEMAND FOR MONEY
According to Keynes, the precautionary and transactional incentives are strongly income elastic but
comparatively interest inelastic.
As a function of the quantity of income (Y), the amount of money held under these two motives
(M1) is stated as
M1 = L1 (Y)
According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower
the rate of interest, the higher the speculative demand for money.
Algebraically, the speculative demand for money is:
M2 = L2 (r) Where, L2 is the speculative demand for money, and r is the rate of interest.
When higher interest rates are offered, investors give up liquidity in exchange for higher rates. As an example,
if interest rates are rising and bond prices are falling, an investor may sell their low paying bonds and buy
higher-paying bonds or hold onto the cash and wait for an even better rate of return.

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IMPLICATIONS OF LIQUIDITY PREFERENCE THEORY

❖ RATE OF INTEREST AND SUPPLY OF MONEY

Under Keynesian economics, the monetary authority is expected to stimulate employment by pursuing a cheap
money policy, i.e., lowering interest rates by increasing the supply of money.
The idea behind an easy money policy is that increasing the total supply of money (all else being equal)
increases the money available for speculative motive (M2), causing a fall in interest rates and stimulating
investment, which in turn increases income.
How effective monetary stimulus is determined by how much the interest rate falls in response to an increase
in M2 (the elasticity of the L% function); how responsive investment is to a fall in the interest rate (the
elasticity of the schedule of marginal efficiency of capital); and how much a given increase in investment
increases income (the size of the investment multiplier)." Such a monetary management policy, however, has
significant limitations. The rate of interest will fall if the quantity of money increases (other things remaining
constant); however, this will not happen if the liquidity preference increases more than the quantity of money.
Similarly, a decrease in the rate of interest will increase investment and employment (all else being equal), but
this may not be the case if the marginal efficiency of capital declines faster than the rate of interest. Monetary
policy may be rendered ineffective in breaking the economic deadlock when an economy is in the grip of a
chronic depression, when liquidity preferences are high and profitability expectations are low. As a result,
monetary policy based on Keynes' liquidity preference analysis suffers from significant practical constraints.

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 ❖ EXPECTATIONS AND THE RATE OF INTEREST
The importance of expectations is another implication of the liquidity preference theory of interest rates.
Indeed, our understanding of the LP theory is incomplete unless we consider the role of expectations,
particularly individual and business firm expectations about the future economic values of bonds and
securities. Certain fundamental characteristics of the asset and speculative demand for money can be properly
understood through the use of expectations. As previously stated, uncertainty about the future is the primary
reason why some people prefer to hold cash rather than income-producing assets.
This is reasonable, but insufficient. The fundamental reasons why individuals and businesses switch from cash
to debt or bonds, and vice versa, are expectations about future economic values. Only in relation to notions of
what constitutes a normal level of bond prices or interest rates do future price expectations and the behaviour
that results from such expectations have meaning. Given the concept of a normal rate, wealth holders anticipate
that the current rate will fall as it returns to normal.
At this high rate, asset holders will abandon cash in favour of bonds. If asset holders expect the current rate to
remain low, they anticipate a rise in the rate as it returns to normal. As a result, they avoid bonds in favour of
cash. Equilibrium will be reached when bearish market expectations are balanced by bullish market
expectations. The inclusion of both the bond market and future value expectations into our analysis provides
a much more complete explanation of the shape of the asset demand curve.

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The Radcliffe Committee Report points out that the expectations in the movement in interest rate could
have two types of effects:

(i) The incentive effect-

The incentive effect refers to expected changes in interest rates, that is, the cost of money influencing the cost
of holding goods stocks—whether commodities or capital goods. With the expectation of an increase in
interest rates, the stockholder or investor would like to cut back due to the increased cost of holding the stocks
or starting the venture.
This is an interest incentive effect that considers the cost of money in holding goods, etc. However, the
Radcliffe Committee observes that the cost of money is relatively small in comparison to other production
costs and that it has little or no effect on holders or investors' plans to change. Because capital investment is
frequently determined by material costs and labour availability rather than interest rates.

ii) The general liquidity effect-

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The general liquidity effect, on the other hand, refers to the expected behaviour of lenders rather than
borrowers. It refers to the liquidity position of near money asset holders as a result of changes in the value of
such financial assets. As a result of the expected effects of changes in interest rates on the prices of such assets,
lenders' behaviour changes, which may influence credit availability in the money market.
As a result, when interest rates rise, lenders discover that the value of their financial assets has decreased,
making them less willing to lend more money to borrowers. According to the report, evidence suggests that
the general liquidity effect of interest rates carries slightly more weight than the interest incentive effect.
Another consequence of Keynes' liquidity preference theory is that bond prices are inversely related to interest
rates. In other words, bond prices and interest rates move in opposite directions, so when interest rates fall,
bond prices rise, and vice versa when interest rates rise.
Assume a bond pays a fixed income of Rs. 50 per year at 5% interest and sells in the market for Rs. 1,000. If
the interest rate falls to 4%, the price of the bond will rise to Rs. 1,250 in order to earn an annual income of
Rs. 50. Similarly, if the rate of interest rises to 6% the price of the bond will fall to about Rs. 850 to give us a
fixed income of about Rs. 50.
The formula for the same is:
Bt + iBt = Bt (1 + i) = Bt + 1
where B is the bond's purchase price, I is the interest rate, and Bt +1 is the bond's redemption value one year
after purchase. As a result, if the bond's purchase price is Rs. 100 and the interest rate is 6%, the redemption

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price is Rs. 106. Assume the redemption price of the bond is Rs. 106, and the interest rate is also Rs. 6%—the
current purchase price of the bond—Bt is:

Now, assume the interest rate on bond falls from 6 per cent to 4 per cent per annum, during the current year,
while the rate of interest on the old bond remains—at 6 per cent. The new purchase price of the old bond
(assuming the yield on old bond at Rs. 6) will be:

It is, therefore, clear that as the rate of interest falls, bond prices rise and vice versa. Hence, the price of a bond
and the rate of interest are inversely related. Changes in the prices of bonds in the organized securities markets
reflect themselves in the changes in the liquidity preference of the people. A decline in liquidity preference is
reflected in an increased desire on the part of the public to buy bonds at current prices raising the prices of
bonds and lowering the rate of interest.

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On the other hand, an increase in the liquidity preference is reflected in an increased desire on the part of the
public to sell bonds to get more cash, as a result of which prices of bonds will fall and interest rates will rise.
Thus, we find an inverse relationship between the prices of bonds and the interest rates.

❖ LONG-TERM VERSUS SHORT-TERM RATE OF INTEREST

The distinction between short-term and long-term interest rates is an important implication of Keynes' liquidity
preference theory. Interest is paid to the owner of wealth who gives up control of money (liquidity) in exchange
for a debt, bond, or security. The interest rate (reward for parting with liquidity) varies according to the length
and maturity of the debt. Daily loans will have a different interest rate than weekly, monthly, or yearly loans.
Because the speculative demand for money changes so quickly, the short-term rate of interest is more
vulnerable to violations than the long-term rate of interest. The long-term rate of interest is relatively stable
because, over time, conflicting expectations cancel each other out, leaving very little influence on the rate of
interest. However, in Keynes' theory, real investment in long-term capital assets is important, and the long-
term rate of interest on loans, bonds, and securities used to finance these investments is of primary importance.
The short-term and long-term interest rates both move in the same direction. If long-term interest rates tend to
rise while short-term interest rates do not, interest earnings will differ.

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 ❖ THE LIQUIDITY TRAP
A close examination of the liquidity preference schedule in the figure reveals another important implication
of the liquidity preference theory by demonstrating the behaviour of the demand for idle cash balances in
response to an interest rate decline. It demonstrates that as the interest rate falls (from Or "to Or' to Or), the
LP curve becomes increasingly elastic, until it becomes perfectly elastic.
It demonstrates that as the demand for money becomes perfectly elastic, the interest rate becomes more
difficult to lower and becomes increasingly resistant to further reduction. For example, after or rate of interest,
no further interest rate reduction may be possible. The reason for this is the growing risk of losing interest
income at lower interest rates. Furthermore, the low interest rate does not adequately compensate for the
additional costs and inconvenience of purchasing bonds.
Furthermore, there is reason to believe that if bond prices change at all, they will fall. For all of these reasons,
the liquidity preference curve becomes perfectly elastic, indicating that no further reduction in interest rates is
possible simply by increasing the quantity of money; for example, in Fig. 20.7, no further reduction in interest
rates is possible after Or, even if the amount of money is increased from OM to OM", the rate of interest
remains constant (Or = P"M" - P'"M'").

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When this stage is reached, the demand for money has become absolute, in the sense that everyone prefers to
hold money over bonds or securities yielding Or (interest) or less. Bond prices will not rise because bonds and
securities are no longer purchased with additional money (A/"A/'"), and the interest rate will remain at Or.
Assume a Rs. 1,000 security generates a fixed annual income of Rs. 20 at a low interest rate of 2%.
Now, suppose the rate of interest changes from 2% to 3%, as a result of this, the value of security will fall to
about Rs. 670 (because this sum will bring the fixed income of Rs. 20 a year) thereby causing a loss of Rs.
330. It is to avoid such a loss in the value of bonds and securities that people like to keep more cash at a low
rate of interest.
This is because people are more or less convinced that the rate of interest has fallen to the minimum and do not expect it to fall
further. If at all they expect any change, it is in the upward direction (as from 2% to 3% in the above example), causing a fall in
the prices of bonds. It is, therefore, clear that on account of psychological and institutional rigidities, the rate of interest becomes
sticky (near-about the level of 2% and does not or cannot) fall to zero or become negative.

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 GRAPH 3

LIQUIDITY BOOST
The RBI has pumped significant liquidity into the system via various channels. In fact, we should focus on
Reserve Money rather than what is happening at the discount window. In this case, we must distinguish
between "durable liquidity" and "temporary liquidity." The RBI's purchase of government securities from
banks increases long-term liquidity. This is more important than the short-term loans made by the RBI.
However, it should be noted that inflation has largely remained within the acceptable range. Inflation would
have been much higher if the money supply had grown in tandem with the Reserve Money. Indeed, several
members of the Monetary Policy Committee expressed satisfaction in their Minutes that inflation had

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moderated. They are, however, looking for a reason in the behaviour of individual prices. However, one reason
is the unintended moderation in the money supply. We must reach the proper conclusion.
An expansionary fiscal policy and a supportive monetary policy are required in a difficult situation such as the
one posed by Covid-19. However, the timing of when to moderate is also important. Following the 2008
financial crisis, many countries, including India, made this mistake. They maintained an expansionary policy
for an extended period of time, resulting in inflation.
The time has come to slow the growth of Reserve Money. As the economy returns to normalcy, the money
multiplier will rise in tandem with credit growth.
There are now enough excess reserves to cause money supply growth once activity picks up. Currently, the
policy rate is negative when adjusted for inflation. A continuation of this can lead to 'financial repression,'
with all of its consequences.
The increase since April 2021 is primarily due to the relaxation of mobility restrictions. No policy can be
effective as long as the lockdown remains in place. The critical year will thus be 2022-23, when policy actions
can become relevant.

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INTERPRETATION:
As per article written by Anupam Prakash, Kaustav K Sarkar, Ishu Thakur and Sapna Goel (RBI),
•The overall domestic financial resource balance – measured by the net acquisition of financial assets less net
increase in liabilities – continued to improve, turning marginally positive at 0.3 per cent of GDP in 2020-21.

• During 2020-21, household financial savings increased significantly relative to their long-term trend,
reflecting an increase in the stock of both currency and deposits, as well as increased savings in insurance
products.

• In 2020-21, the Reserve Bank's balance sheet expanded due to an increase in financial assets reflecting
unconventional monetary measures to mitigate the impact of the pandemic and ensure adequate liquidity for
the economy's smooth operation. Other financial institutions with excess inflows from households increased
their investment in government securities as demand for bank credit fell during the pandemic year.

• Non-financial corporations deleveraged their balance sheets in 2020-21, improving their net financial wealth
after years of deterioration.

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• With less reliance on external financing, particularly by Indian corporations, the rest of the world's financial
assets and liabilities grew at a slower pace in 2020-21.

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 CONCLUSION

Thus, we draw the conclusion that Keynes' hypothesis is flawed as well. Keynes was absolutely correct to
emphasise the importance of money in his theory, but he completely overlooked all other factors.
The proponents of the loanable funds theory duly included the liquidity preference principle into their theory
through their research of hoarding and dishoarding. According to D. Hamberg, Keynes did not develop a
nearly as novel theory as he and others initially thought.
Instead, the proponents of the loanable fund theory, who developed the theory of interest and significantly
incorporated Keynes's views into their own theory to make it more comprehensive, saw his emphasis on the
effect of hoarding on the rate of interest as a valuable addition.
The Keynesian liquidity preference theory has been extensively applied in India, particularly when talking
about the country's monetary policies. This strategy has been repeatedly used by India's central bank, the
Reserve Bank of India, to control the country's money supply and inflation rate. Ultimately, the Keynesian
liquidity preference theory has shaped India's economic policies and provided decision-makers with the
instruments they need to effectively manage the country's macroeconomic environment.

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 REFERENCES

• https://www.rbi.org.in/
• https://m.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=55393#
• The General Theory of Employment, Interest, and Money (1936)

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