Question

What is Keynesian Liquidity Preference Theory of Interest in Economics? Illustrate in detail.

Critically explain this Liquidity Preference Theory of Interest .

Answer 1

Keynesian Liquidity Preference Theory -

This Theory was developed by the most famous economist of twentieth century, Prof. J.M. Keynes in his book "The General Theory of Employment, Interest and Money." We have already explained in early part of this chapter that according to Keynes, interest is a reward for parting with liquidity. Now we shall make a detailed study of this theory.

Every person has a natural tendency to keep his money in liquid form and when that money is lent, the liquidity is reduced. Hence, unless some incentive or reward is given for parting with liquidity, people would not like to forego their liquidity.

Now the question arises as to why a person wants to keep his money in liquid form. Keynes identified three reasons or motives for this purpose.

(i) Transaction Motive

(ii) Precautionary Motive, and

(iii) Speculative Motive

Now we shall explain them in detail:

(i) Transaction Motive -

People keep their money in liquid form so that they can make purchases of goods and servies and can make payment in cash. This can be divided into two categories.

a) Income Motive

b) Business Motive

(a) Income Motive -

People get their income at certain time interval e.g. a month, a week, a quarter or annually. However, they have to make payment for their requirements on almost a daily basis. Hence, they have to keep cash with them in order to be able to meet their expenses during this time interval, say, a month. The average holding of cash with them will be half of their initial cash balance. This can be explained with an example. Suppose a person's monthly expenditure is $6000 per month. He will then keep $6000 with him on the first day of the month and spend $200 per day, so that this amount will be totally exhausted by the end of the month. In such a situation the average cash balance with him over the month shall be 6000/2 = 3000. If the same income is received on a quarterly basis he would be required to keep $18000 with him at the beginning of a quarter, out of which he can spend     $200 per day for the next 90 days. The average cash balance in such a situation would be 18000/2 = $9000. This shows that longer the time interval in receiving the income, the greater shall be the demand for money for transaction purposes.

(b) Business Motive -

The second purpose of transaction motive is for business purposes. In every business, expenses start as soon as a business is initiated, but the receipt of income takes place after some time. During this time interval a businessman is required to keep cash with him, so that he can meet these expenses. Even after starting a business, there is no synchronization between receipt of cash and expenditure. Hence, a businessman will have to keep some cash with him to make necessary payments so that business activities are not hindered.

(ii) Precautionary Motive -

Every person keeps some extra cash with him, in addition to his requirement for transaction purposes. This is called precautionary purpose'. This money is kept to meet future contingencies or unanticipated expenses. For example, a person's requirement for transaction is $6000 p.m., but he would like to keep $7000 with him. This extra sum of $1000 is kept by him to meet certain unanticipated expenses like the treatment of illness of family member, arrival of guests, additional expenses on education, demands by friends etc., Similarly, businessmen also keep some extra cash over and above what is needed for transaction purposes.

(iii) Speculative Motive -

After meeting his requirement of transaction and precautionary motives, the money left with a person is used by him to give loans to others. This is called speculative motive. The money kept for speculative motive is given as a loan on interest. If the rate of interest is high, people give a larger amount of money as a loan and keep minimum cash with themselves. As against this, if the rate of interest is low they tend to keep their money is cash with themselves, so that it can be lent when interest rate rises in future.

The money required for all the above purpose i.e. transaction motive, precautionary motive and speculative motive is called the total demand for money, which can be expressed as follows.

                                                   L = T +P+S

Out of the above i.e. the money demanded for transaction motive (T) and precautionary motive (P) is dependent on income and is not affected by rate of interest, while the demand for money for speculative motive is dependent on rate of interest, i.e., if interest rate rises demand is reduced and if interest rate decreases the demand for money increases.

The total demand for money i.e. liquidity preference can be expressed as follows.

                                                 L = L (y) + L (r)

Here L(y) is liquidity preference for transaction and precautionary motive dependent on income and L (r) is the demand for money for speculative motive dependent on rate of interest.

 

Criticism of Liquidity Preference Theory -

Keynesian theory of interest, like his other theories, was a revolutionary approach because it was based on entirely different hypothesis. It was called a monetary theory because it was dependent on monetary factors. However, this theory was criticised on the following grounds.

1. Indeterminate:

Keynes had criticised the loanable funds theory on the basis that it was indeterminate. The same thing applies to Keynesian theory. Keynes, had conceived the demand for money on the assumption of constant income. However, the reality is that the change of income also affects demand for money.

2. Ignoring the Real Factors:

Keynes had completely ignored the real factors like investment, saving, consumption and believed that it is purely a monetary phenomenon. Many other economists believe that these real factors have an important role to play in interest rate determination. Another important fact in this regard is that no liquidity is possible without saving. Only when we save a part of our income, that liquidity can come.

3. Contradictory Experiences:

It has often been seen that during a period of slump people have a high liquidity preference, but interest rates are low and during boom liquidity preference is low although interest rates are high. These facts are contradictory to Keynesian Theory, because according to this theory if liquidity preference is high, interest rate should also be high and vice versa. Thus, actual experiences are contradictory to the theory.

 

 

This Theory was developed by the most famous economist of twentieth century, Prof. J.M. Keynes in his book 'The General Theory of Employment, Interest and Money.