If the current rate is low, people expect it to rise in the future or expect the prices of securities to fall. Since both the transactions and the precautionary motives for holding cash depend upon income, Keynes put them together. This is the essence of Keynes’s theory. This feature has important implications for public policy which we need not discuss here. If the prices of bonds and securities are expected to rise speculative will like to buy them. Since bonds and security-holders are expected to suffer a capital loss, people are more attracted to cash; therefore, they demand a larger amount of cash. The equilibrium rate of interest is determined at that level. Disclaimer Copyright, Share Your Knowledge In other words, if he keeps his saving in the form of cash he enjoys the advantage of liquidity of his saving. Money under the above three motives constitute the demand for money. It refers to easy convertibility. Take, for example, the rate of interest Or1. According to Keynes, the interest rate is not given for the saving i.e. Whenever income changes, the liquidity preference also changes. Everybody likes to hold assets in form of cash money. The amount of cash needed for current transactions by a particular household depends upon its size of income, the interval of time after which income is received and the mode of payment. The classical economists' conclusion that nominal income is determined by movements in the money supply rested on their belief that _____ could be treated as ____. In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. Similarly the liquidity preference may change given the supply of money. It is a demand curve for money and slopes from left down to the right as shown in Fig. Liquidity Preference Theory of Interest Rates. PreserveArticles.com is an online article publishing site that helps you to submit your knowledge so that it may be preserved for eternity. Keynes’ theory of interest is known as liquidity preference theory of interest. Any one of these two may change to bring about a change in the rate of interest. That is, the interest rate adjusts to equilibrate the money market. the demand for money): the first as a theory of interest in Chapter 13 and the second as a correction in Chapter 15. If at all they surrender this liquidity they must be paid interest. He called the demand for money ‘liquidity preference’. Thus according to Keynes interest is the price paid for surrendering their liquid assets. The supply of money is different from the supply of ordinary commodity. We thus reach the conclusion that Keynes’s theory has also got its shortcomings. d. Efficient Markets Theory of Interest. PreserveArticles.com is a free service that lets you to preserve your original articles for eternity. Liquidity preference is actually a choice between many types of assets. The Liquidity Preference Theory has a goal of remaining liquid and in order to remain most liquid people should not borrow money, so the interest rate is the cost for having to borrow money and not remaining liquid. On the other hand, when they feel that the prices of bonds and securities are going to fall in the near future, they get detracted away from them and demand more cash. Due to certain reasons to be explained shortly, every person likes to hold cash or wants to be liquid. He also said that money is the most liquid asset and the more quickly a… When the rate of interest rises, the prices of bonds and securities fall and with a fall in the rate of interest, bond and security prices go up. Change in the rate of interest thus takes place whenever there is disequilibrium between people’s demand for and supply of either cash or bonds or securities. In Keynes’s liquidity-preference theory, the demand for money by the people (their liquidity preference level) and the supply of money together determine the rate of interest. The changes in the demand for money for holding it to satisfy the speculative motive are due to the future uncertainty of the rate of interest; change in expectations about its future course causes a change in the speculative demand for money now. Thus, M1 +M2 = L1 =f (Y), which means that the demand for money on account of the two motives, called L1, is a function of income. Share Your PPT File, The Classical Theory of Rate of Interest (With Diagram). 7.3. On the other hand, if he purchases interest-bearing securities, he gets some income in the form of interest but these claims are not liquid like money. According Keynes rate of interest is demand by the supply of and demand for money. An individual for his day to day transaction demand money. Similarly, businessmen also hold cash to safeguard against the uncertainties of their business. Our mission is to liberate knowledge. 1,000falls to Rs. These three motives constitute the components of the demand for money. People keep cash with them to speculate on the prices of bonds and securities which change inversely with the rate of interest. The greater is the turnover of business and income from it, the greater is the amount of cash needed to meet it. 2. According to Keynes interest is purely a monetary phenomenon because rate of interest is calculated in terms of money. The supply of money is not influenced by the rate of interest. There are three reasons for which money is demanded. Thus they lack liquidity. Similarly we also find that if the market rates of interest falls from 4 per cent per annum to 2 1/2 per cent per annum, the market price of the bond of a face value of Rs. This is the essence of Keynes’s theory. Privacy Policy3. of the liquidity preference theory of interest. Keynes was no doubt correct in giving importance to money in his theory but then he completely disregarded all other factors. As money are highly liquid people to hold money with than in form of Cash. In such a situation the demand to hold cash diminishes. He also provided a link between the monetary and the real factors and thus paved the way for an integrated, determinate theory of the rate of interest which J.R. Hicks could ultimately formulate. Keynes, thus, presented a comprehensive analysis of the monetary sector. Clearly, greater is the turnover of business and the income there from, greater is the amount of cash a business firm will keep to satisfy its precautionary motive. The reason is that the interest rate is the opportunity cost of Or if the rate of interest is already very low and the liquidity preference curve is infinitely interest- elastic (liquidity trap situation), the Central Bank’s increased money supply may entirely go to meet the demand for idle balances which in this situation is insatiable. Prof. Fisher’s Time Preference Theory: Fisher’s Time Preference Theory is the modified theory of … He concentrated his attention on the rate of interest as a monetary phenomenon and thereby gave us valuable insights into the process of adjustment in the money and capital markets for bringing about changes in the interest rate. The liquidity preference curve becomes quite perfectly at a very low rate of interest. One thus has liquidity preference. Content Guidelines 2. An increase in the demand for money leads to a rise in the late of interest, a decrease in the demand for money leads to a fall in the rate of interest. 1,000/- bearing 40 rupees income per annum will rise to Rs. Keynes propounded his theory of interest called the Liquidity Preference Theory. The exponents of the loanable funds theory duly incorporated the liquidity preference idea into their theory through their analysis of hoarding and dishoarding. If there is no liquidity preference, this theory will not hold good. It is horizontal towards the right hand side. There would be equilibrium in the bonds and securities market at this rate where the demand for and supply of cash would also be equal. Despite some flaws in Keynes’s treatment of money and the rate of interest, we cannot minimize the importance of Keynes’s valuable contribution to the apparatus and policy about rate of interest. In advanced countries, of which Keynes was writing, people like to hold cash for the purchase of bonds and securities when they think it profitable. 3. Hence, liquidity preference theory requires as a pre-condition of saving-investment equality, already postulated by classical economists. 4. The total supply of money is fixed at a particular point of time. We may define the income period as the (typical) time interval elapsing between the dates at which mem- Theories of interest rate determination are very important in economics. The supply of money is controlled by the govt. 3. In this figure, rate of interest is shown on the ordinate axis and the demand for money on the co-ordinate axis. The speculative motive for liquidity- preference thus introduces a dynamic element in the Keynesian theory. Households and business concerns need some money for precautionary purposes because they have to take precaution against unforeseen contingencies like sickness, fire, theft and unemployment. For this purpose people want to keep some cash with them. Before publishing your Article on this site, please read the following pages: 1. If the expectations of the public change and cause an upward shift of the liquidity schedule or curve, the rate of interest may remain where it is. This preference according to Keynes is popularly called liquidity preference. It does not give any place to such real factors as productivity and thrift. The differences between the two term-structure of interest rate models, expectations hypothesis and liquidity preference theory, are hard to miss. Money supply depends upon the currency issued by the government and the policy followed by the Central Bank of the country. For them, therefore, bonds and securities are attractive since they expect capital gains from them and cash is less attractive: the demand for cash is, therefore, low. This inverse relationship between the market rate of interest and the price of a bond or security can be accounted for and illustrated like this. Unless we consider as equally important the different types of financial investments including money, we have no way of explaining the co-existence of different rates of interest. The liquidity preference constitutes the demand for money. Secondly, Keynes’s theory of the interest rate is more general than the classical theory in that it is applicable not only to full-employment economy but also to the state of less than full employment. TOS4. Fourthly, the liquidity-preference theory, through its ‘liquidity trap hypothesis’ stresses the limitation of monetary and banking policy and its ineffectiveness during the period of depression. The speculative motive for money thus becomes a link between the present and the future. The equilibrium rate of interest is fixed at that point where supply of and demands for money are equal. The fact that prices of bonds change inversely with rate of interest is clear. It is obvious “that the demand and supply of ever)’ type of asset has just as much right to be considered as the demand and supply of money. Where the demand for money is equal to supply of money. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Finally, unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. Transaction motive refers to the demand for money for current transactions by households and firms. The classical theory was devoid of any monetary influence because classicals would consider money only as a veil or a medium of exchange: the store of value function was entirely ignored. According Keynes rate of interest is demand by the supply of and demand for money. A particular amount of cash, therefore, has to be kept for making purchases. where L2 is the speculative demand for money and it is a function of the expected changes in the rate of interest. Classical Theory of Interest Rates. Popular Course in this category Credit Risk Modeling Course Thus according to Keynes interact is purely a monetary phenomenon. According to liquidity preference theory, the opportunity cost of holding money is the inflation rate False When the interest rate increases, the opportunity cost of holding money decreases, so the quantity of money demanded decreases. According to Keynes the first two motives for liquidity preference namely the transaction and precautionary are interest inelastic. The transaction demand for money is closely connected with the concept of the income period. There is an excess supply of cash of the amount of M1S which people do not want to hold or which they like to invest in bonds and securities. 1,600. 200. Thus, the amount of cash which the people wish to hold for speculative motive depends upon the expected change in the rate of interest. The liquidity preference constitutes the demand for money. LIQUIDITY PREFERENCE THEORY Definition (also called liquidity preference hypothesis) Observation that, all else being equal, people prefer to hold on to cash (liquidity) and that they will demand a premium for investing in non-liquid assets such as bonds, stocks and real estate. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity.The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. Introduction to Keynes’s Liquidity – Preference Theory of Interest Rate: The Demand for Money or Liquidity Preference: Merits of Keynes’s Liquidity-Preference Theory. 7.4 by the straight line SS. 800/- giving its owner a capital loss of Rs. The shape of liquidity preference curve is accounted for in Keynes’s analysis like this: When the market rate of interest is high, people expect it to fall in future and the prices of bonds and securities to go up. We turn to the analysis of these three motives first and then with some remarks about the supply of money study the determination of the rate of interest as Keynes taught us. It is here that the Keynesian liquidity preference theory assumes an altogether different role in the determination of income, output and employment from that given to the loanable funds theory by the neoclassical. We may write the total liquidity preference like this: L1 (y) + L2 (r). Likewise, if the money supply is less than the demand for it, the rate of interest will rise. We can write, therefore, that M2 -g(Y), where,M2 is the demand for money due to precautionary motive and g(y) shows it to be a function of income. 800/- newly floated by a company will bring 40 rupees per annum while the old bond of the face value of Rs. Thus liquidity preference will be more at lower interest rates. He did not agree with the neoclassical view that the rate of interest is determined in part by the marginal revenue productivity of capital due to its influence on the demand for investment. The supply of commodity is a flow whereas the supply of money is a stock. The determination of the rate of interest can be better explained in the shop. According to Keynes, the equilibrium rate of interest is determined at the point where the given supply of money is equated to the level of liquidity preference. Keynes has propounded the theory of interest known as the liquidity preference theory. Rather his great emphasis on the influence of hoarding on the rate of interest constituted an invaluable addition to the theory of interest as it had been developed by the loanable fund theorists who incorporated much of Keynes’s ideas into their own theory to make it more complete.” Nevertheless, Keynes’s theory remains a distinct theory on its own in so far as it is entirely monetary. According to the liquidity preference theory of the term structure of interest rates, an increase in the yield on long-term corporate bonds versus short-term bonds could be due to _____. All the articles you read in this site are contributed by users like you, with a single vision to liberate knowledge. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities … 4. The Keynesian liquidity preference schedule relates the various rates of interest to the levels of demand of money. Both these motives form the first component of the demand for money and both are income-elastic. As water is liquid and it can be used for anything at will, so also money can be converted to anything immediately. This made it possible to build up a theory of income. There is disequilibrium in the money market. In his theory of the rate of interest, Keynes considered the demand for money- liquidity preference—to be composed of the speculative demand for it only because the demand for cash balances arising out of the other two motives is comparatively insignificant in the determination of the rate of interest in the short run. Supply of money cannot be privately increased like that of commodities. At the equilibrium interest rate, the quantity of real money balances demanded equals the quantity supplied. hoarding. He expressed the opinion that every person who has saving has to decide how he is to keep his saving: in the form of ready money which does not bear any interest or lend it to buy interest-bearing claims like bonds and securities? Share Your PDF File Our mission is to provide an online platform to help students to discuss anything and everything about Economics. It is on these motives that the level of demand for money or liquidity preference depends. 6. 3. The central Bank’s action may not lower the rate of interest at all. Content Guidelines The rate of interest is determined by the demand for money and supply of money. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. Keynes’s Liquidity-Preference Theory is not necessarily at conflict with the classical or neoclassical theory. On the other hand, if they expect the rate of interest to fall—that is, the bond and security prices to rise—they would be induced to have more bonds and securities rather than cash. Keynes's liquidity preference theory indicates that the demand for money is a function of both income and interest rates. Keynes proposes two theories of liquidity preference (i.e. Fifthly, Keynes amply made it clear that interest is not and income is the equilibrating mechanism between saving and investment. LIQUIDITY PREFERENCE, INTEREST, AND MONEY 49 money rests; it is therefore necessary to analyze closely each source of demand and the factors that determine it. The perfectly elastic position of the liquidity preference curve indicates that people will hold with them as inactive balances of any amount of money that they will have. Much of the controversy is an anachronism since there are more potent fiscal policies available to maintain, as a primary economic goal, high levels of income, employment, and output. Keynes gave the primary role to the speculative motive for holding money and did not include the first two motives in his theory of the rate of interest. That is, D m = T dm + P dm + S dm. Therefore, the market value of the old bond will fall to Rs. It should be noted that the money supply and the level of liquidity preference are entirely independent and the two arc brought together only by changes in the rate of interest. Interest is not compensation to the saver for the abstinence he has undergone or time preference he has. Further, by including marginal efficiency of capital as the major determinant of investment, Keynes freed the rate of interest from the onerous tasks given to it in the classical theory. Today we are discussing the Keynesian theory of interest rate. The total supply of money is represented by a vertical line Ms. Privacy Policy They shift-from cash to bonds as they expect the rate of interest to change. The richer a community the greater the demand for transaction motive. It ought into spotlight the role of money in the determination of the rate of interest. This bond is thus an income-yielding asset of 40 rupees per year. People keep cash with them to take advantage of the changes in the price of bonds and securities in the capital market. A fundamental fact noted in the capital market is that the prices of bonds and securities change inversely with the change in the rate of interest. 7. Money is a given stock at a moment of time. Firstly, Keynes’s theory is a monetary rather than a real theory. The amount of cash which an individual will require to keep in his possession depends on two factors (i) the size of personal income and (ii) the length of the time between pay-days. Since the speculative demand for money depends upon the expected future changes in the rate of interest, we can write. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time. Suppose the rate of interest is Or2 at which money demand is OM2 while the supply is OS. These are the transactions, precautionary and speculative motives. This curve represents the demand for money at various rate of interest. Bonds’ and securities’ prices will go up and the rate of interest will go down till people want to hold the amount or cash, bonds and securities equal to their supply. Liquidity means shift ability without loss. In his book The General Theory of Employment, Interest and Money, J.M. 800 when the market rate of interest rises from 4 to 5 per cent per annum. 5. Liquidity Preference Theory of Interest: J.M. Thus the theory explains that the rate of interest is determined at a point where the liquidity preference curve equals the supply of money curve. It should be noted that the liquidity preference due to transactions and precautionary motives is dependent on the level of income while that for speculative motive is a function of the expected changes in the rate of interest. Supply of money, at a particular time, is given to the economy by the government and the credit-creating power of the banks. In Keynes’s liquidity-preference theory, the demand for money by the people (their liquidity preference level) and the supply of money together determine the rate of interest. The economic theory which argues that the risk-free interest rate is determined by the interaction of the demand for funds and the supply of funds is known as the: Select one: a. 1,000/- earning a fixed rate of interest of 4 per cent per annum. theory, liquidity, interest, preference, explained. For all these misfortune, he demands money to hold with him. A. declining liquidity premiums B. an expectation of an upcoming recession C. a decline in future inflation expectations The amount of cash needed for taking this precaution will depend upon an individual’s psychology, his views about the future and the extent to which lie wants to ensure protection against such unforeseen events. Keynes’s Liquidity – Preference Theory of Interest Rate! Thus, at high current rates of interest, liquidity preference is low. Greater the liquidity preference higher shall be the rate of interest. TOS Everybody has an innate desire to hold his saving in the form of cash rather than in the form of interest or other income-bearing assets. Keynes pointed out that it is not the rate of interest which equates saving with investment but this equality is brought about through income changes. His arguments offer ample scope for criticism, but his final conclusion is that liquidity preference is a function mainly of income and the interest … Keynes’s theory is to this extent much more dynamic and as such more realistic. Other costly assets like gold and landed property may be valuable but they cannot be shifted at will. “Liquidity preference is the preference to have an equal amount j ^ of cash rather than claims against others.” -Prof. Mayers Determination of Interest: According to liquidity preference theory, interest is determined by the demand for and supply of money. In other words, the interest rate is the ‘price’ for money. Therefore, the supply function of money is a straight line parallel to the ordinate (Y) axis, as is shown in Fig. Controlling in Management # Meaning, Definition, Types, Process, Steps and Techniques. 1,000/- will also be bringing in 40 rupees. An individual may become unemployed; he may fall sick or may meet serious accident. c. Loanable Funds Theory of Interest. Interest Rates, Yield Curves and Term Structure of Interest Rates Money commands universal acceptability. This speculative propensity of the people can be satisfied only with cash and it depends upon expected changes in the prices of bonds and securities. Keynes assumed that people hold either cash or bonds as wealth. To part with liquidity without there being any saving is meaningless. Interest has been defined as the reward for parting with liquidity for a specified period. Thus, Keynes theory of interest is also indeterminate as classical theories. According to the quantity theory of money demand interest rates have no effect on the demand for money. This was the position during depression. The third and most important motive of the demand for money is the speculative motive. This is because Keynes held that rate of interest does not bring about equality of saving and investment; in his view it is income that does so. Although Hawtrey thought that the idea of liquidity preference was an important contribution to monetary theory, he rejected the idea that liquidity preference is the essence of interest. Given the demand for money when supply of money rises, rate of interest falls to OR. Discussing the shape of the liquidity preference curve, Keynes went a step farther to highlight a peculiar feature of it. If people expect the rate to rise in future—that is, they expect the prices of bonds and securities to fall—they would be induced now to keep more cash with them. we can also call this theory as Liquidity Preference theory. 5. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. Keynes’s liquidity-preference theory has some distinct merits over the classical theory. John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. According to this theory, “Interest is the reward for parting with liquidity for a specific period.” In other words, it can be said that interest is the reward for parting with liquidity. The perfect interchangeability of all units of money makes it impossible for the liquidity- preference theory to account for the phenomenon of diverse rates on the various parts of the credit market.”. Households need cash so as “to bridge the interval between the receipt of income and its expenditure.” Between the periods of receiving pay packets, house-holders have to enter into transactions for meeting their daily needs. This is because the liquidity preference on account of transaction motive and precautionary motives is stable and almost interest-inelastic while that for the speculative motive is specially sensitive to changes in the rate of interest. Thirdly, Keynes’s theory helped integrate the theory of money to the general theory of output and employment. ‘Or’ is the equilibrium rate of interest, for at this rate the amount of money demanded is equal to its supply. For Keynes the existence of a margin between the liquidity of cash and the rate of interest is the essence of what interest is all about. The classical theory being static in nature did not consider the uncertainty about the rate of interest and its influence on the present. Likewise firms also need cash to meet their current needs like payment of wages, purchases of raw materials, transport charges etc. In figure 7 .4 money supply is given as OS and the level of liquidity preference by the curve LPC. Given the supply of money at a particular time, it is the liquidity preference of the people which determines rate of interest. People under speculative motive hold money in order to secure profit from the future speculation of the bond market. Welcome to EconomicsDiscussion.net! Copyright. Share Your Word File People are paid weekly or monthly while they spend day after day. This shows that the price of the bond of Rs. Rate of interest would rise till it is at the level Or. Suppose a person purchases a bond of the face-value of Rs. Keynes ignores saving or waiting as a means or source of investible fund. This bond is to give an income of 40 rupees per year to its owner, whatever its market value. Before publishing your Articles on this site, please read the following pages: 1. The liquidity preference function or demand curve states that when interest rate falls, the demand to hold money increases and when interest rate raises the demand for money, diminishes.