Question

Explain the critically discuss liquidity preference theory of interest. Can interest rate by zero. Give reason for your answer.

Answer 1

According to Keynes interest is not reward for hoarding but reward f for parting with liquidity for specified period. It is price which equilbrate the desire to hold cash with the available quantity of cash. Supply of cash is determined by monetary authority. While demand for money arises due to precautionary motive, speculative motive and transactions motive. Transactions motive refers to need of cash for carrying out personal and business transactions. Precautionary motive refers to desire to provide for contingencies. Speculative motive is for securing profit from knowing better than the market what the future will bring forth. Speculative demand varies inversely with interest rate and transanction and precautionary are functions of income. Equilbrium will occur when demand for money is equal to supply. This theory has been criticised because it splits demand for money arbitrarily into three components whereas people demand money in general.. It does not explain what determines normal and actual interest rate. Robertson therefore calls it misleading. No monetary change has direct and permanent effect on interest rate. It assumes a definite functional relationship between them. Keynes holds money as a store of wealth is barren. Hunt clearly says money is as productive as all other assets. According to this theory rate of interest should be highest at bottom of depression because liquidity preference is strongest at that time due to falling prices. But facts are opposite.. As vines further says without saving there can't be liquidity to part with.