But empirical studies have shown doubts about the validity of the assumption of unstable liquidity preference function. In Figure 5, LP curve represents demand for money and MM curve represents supply of money. Determination of Rate of Interest 5. Keynes's liquidity preference theory implies that velocity O A. is constant O B. is zero in the long-run. d. 3%. Criticisms 8. The liquidity preference theory ignored the effect of inflation and is based on the assumption of actual or expected price stability. The determination of the rate of interest can be better explained in the shop. Welcome to EconomicsDiscussion.net! Interest has been defined as the reward for parting with liquidity for a specified period. Thus, the community’s total demand for money depends upon the level of income and the rate of interest: The liquidity preference schedule or demand for money curve expresses the functional relationship between the amount of money demanded for all the three motives and the rate of interest. 6. In this theory, liquidity is given preference, and investors demand a premium or higher interest rate on the securities with long maturity since more time means more risk … Figures 6 and 7 illustrate the influence of changes in demand for and supply of money on the rate of interest. Rate of interest, being a monetary phenomenon, establishes equilibrium in the monetary sector, i.e., between demand and supply of money. 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. Variations of Interest Rates not Explained: This theory cannot explain why interest rates vary from person to person, from place to place and for different periods. The transactions demand for money is not influenced by the rate of interest; it is interest-inelastic. The normal yield curve reflects higher interest rates for 30-year bonds, as opposed to 10-year bonds. Thus, Keynes denied the fact that changes in money supply may influence the economy through direct mechanism. (b) Rate of interest is calculated in terms of money. Meaning of Liquidity Preference: Without previous saving, there cannot be liquidity (cash balances) to part with. from M2M2 to M3M3) will not reduce the rate of interest anymore because of liquidity trap. involves some kind of risk, cost of inconvenience. For example, during inflation, high money interest rates may be mistaken as an effect of a decrease in money supply, whereas in reality they may- indicate low real rates of interest due to inflation. Supply of money refers to the total quantity of money in the country for all purposes at a particular time. (d) The rate of interest cannot be reduced beyond the lower limit set by the liquidity trap. 8. According to Keynes, the rate of interest is determined by the decision as to how much saving should be held in money and how much allocated to bond purchase. Liquidity preference means the desire of the community to hold cash. In Man, Economy, and State (1962), Murray Rothbard argues that the liquidity preference theory of interest suffers from a fallacy of mutual determination. Figure 6 shows that given the supply of money (MM curve), as the demand for money increases (shift from LP to LP1), the rate of interest rises (from Oi to Oi1) and as the demand for money decreases (shift from LP to LP2), the rate of interest falls (from Oi to Oi2). The Demand for … People receive income in periods that do not correspond to the times they want to spend it. 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. Thus, all the three motives together give the total demand for money Thus. Share Your PDF File c. 2%. According to him, the rate of interest is determined by the demand for and supply of money. 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 liquidity preference theory recognises only two types of assets: (a) Money – which yields nothing exclusively; (b) Bonds – which pay an explicit rate of interest. The equilibrium rate of interest is determined by the intersection of the demand for money function and the supply of money function. According to Keynes, the precautionary demand for money (Lp), like the transactions demand (Lt), is also a constant (kp) function of the level of money income (Y), and is insensitive to the changes in the rate of interest-, Keynes lumps the transactions and the precautionary demands for money together on the ground that both are fairly stable functions of income and both are interest-inelastic. O C. As interest rates rise people will reduce their money holdings and therefore velocity will decrease OD. Before publishing your Articles on this site, please read the following pages: 1. In his definition of interest as a reward for parting, with liquidity, Keynes ignored the element of saving. The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities, this causes the yield curve to be upward-sloping. Demand for money means the desire of the people to hold their wealth in liquid form (i.e., to hold cash). (b) Idle cash balances – consisting of speculative demand for money. The liquidity preference theory goes directly contrary to the facts that it presumes to explain. According to this theory, interest is a monetary phenomenon and the rate of interest is determined by the demand for and supply of money. The important implications of the liquidity preference theory are given on the next column: Keynes’ liquidity preference theory of interest highlights the importance of money in the determination of the rate of interest. Keynes gives three reasons for holding cash, i.e., the transactions motive, the precautionary motive, and the speculative motive. (ii) However, Keynes’ theory is not without merits. Suppose liquidity rises from LPC to LPC1, it intersects the supply curve of money (MS) at point E1. Demand for speculative motive is essentially related with the rate of interest and bond prices. But further increase in money supply (e.g. But we cannot know income level without first knowing the volume of investment and the volume of investment requires the prior knowledge of rate of interest. 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.

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