Question

According to the book “The General Theory of Employment, Interest, and Money, John Maynard Keynes purposed the theory of liquidity preference to explain the factors that determine an economy’s interest rate. (i) State the definition of the theory of liquidity preference. (ii) How does the theory of liquidity preference explain downward-sloping aggregate-demand curve? Explain your answer in both words and diagrams.

Answer 1

Answer (i)-According to Keynes, money is the most liquid asset. The definition of Liquidity Preference states that the demand for an supply of money (liquidity) determines the interest rate in the economy. He describes the liquidity preference theory in terms of three motives that determine the demand for money-

The transactions motive, which states that individuals have a preference for liquidity in order to have sufficient cash on hand for basic day-to-day transactions such as buying groceries, paying rent etc.

The precautionary motive relates to an individual's preference for additional liquidity in the unavoidable event that or unexpected problem or cost arises that requires cash. These cost include unforeseen costs like house or car repairs, accidents, illness, injury etc.

The speculative motive is related to stakeholders who spaculate about the rise and fall in interest rates. It states that when the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate.

Answer (ii)-Money demanded for transaction, precautionary and spaculative motives constitutes demand for money, or liquidity preference. Liquidity preference means the amount of cash people like to keep with them at a particular time. The higher the liquidity preference, given the supply of money, the higher will be the rate of interest; and vice versa

According to Keynes, demand for money for speculative motive together with the supply of money determines the rate of interest. The supply of money is determined by the policies of the Government and the Central Bank of the country. In the figure below, how the equilibrium between the liquidity preference for speculative motive (downward sloping money demand curve) and the supply of money curve determines the rate of interest is depicted-

The MD is the money demand/ liquidity preference curve for speculative motive. OM2 is the quantity of money supply available for satisfying liquidity preference for speculative motive. Rate of interest will be determined where the speculative demand for money is equal to, the (fixed) supply of money OM2 i.e. MD=M2 . It is clear from the figure that speculative demand for money is equal to OM2 quantity of money at Or rate of interest. Hence or is the equilibrium rate of interest. As the money demand curve slopes downwards, interest rate falls. There is an inverse relation between rate of interest and demand for money.