Question

Using Keynes liquidity preference theory, explain the link of demand for money with economic variables?

Answer 1

Keynes’ Theory of Demand for Money:

It is also worth noting that for demand for money to hold Keynes used the term what he called liquidity preference. How much of his income or resources will a person hold in the form of ready money (cash or non-interest-paying bank deposits) and how much will he part with or lend depends upon what Keynes calls his “liquidity preference.” Liquidity preference means the demand for money to hold or the desire of the public to hold cash.

Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:

Liquidity preference of a particular individual depends upon several considerations. The ques­tion is: Why should the people hold their resources liquid or in the form of ready money when he can get interest by lending money or buying bonds?

The desire for liquidity arises because of three motives:

(i) The transactions motive,

(ii) The precautionary motive, and

(iii) The speculative motive.

The Transactions Demand for Money:

1. the transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending

Precautionary Demand for Money:

Precautionary motive for holding money refers to the de­sire of the people to hold cash balances for unforeseen contingencies. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents, and the other uncertain perils. The amount of money demanded for this motive will depend on the psychology of the individual and the conditions in which he lives.

Speculative Demand for Money:

The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices). The notion of holding money for speculative motive was a new and revolutionary Keynesian idea.

Money held under the speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of money meant for a different purpose. The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate.

Demand for Money: Keynes’ View:

If the total demand of money is represented by Md we may refer to that part of M held for transactions and precautionary motive as M1 and to that part held for the speculative motive as M2. Thus Md= M1 + M2. According to Keynes, the money held under the transactions and precautionary motives, i.e., M1, is completely interest-inelastic unless the interest rate is very high.

The amount of money held as M1, that is, for transactions and precautionary motives, is a function of the size of income and business transactions together with the contingencies growing out of the conduct of personal and business affairs.

this in a functional form as follows:

M1 = L1(Y) …(i)

where Y stands for income, L1 for demand function, and M1 for money demanded or held under the transactions and precautionary motives. The above function implies that money held under the transactions and precautionary motives is a function of income.

On the other hand, according to Keynes, money demanded for speculative motive, i.e., M2 as explained above, is primarily a function of the rate of interest.

This can be written as:

M2 = L2(r) …(ii)

Where r stands for the rate of interest, L2 for demand function for speculative motive.

Since total demand of money Md = M1 + M2, we get from (i) and (ii) above

Md = L1(Y) + L2(r)