Liquidity preference theory of interest

Liquidity preference theory (i.e., Keynesian theory) of interest:

Usually people prefer to hold a portion of their assets in the form of cash. Cash is a liquid benefit. According to Keynes, interest is the prize for parting with liquidity for a particular period of time. In another words, it is the prize for not hoarding.

According to Keynes, people encompass liquidity preference for three motives. They are:

1. Transaction motive;
2. Precautionary motive; and
3. Speculative motive.

The transaction motive refers to the wealth held to finance day to day spending. Defensive money is held to meet an unexpected expenditure.

Keynes states speculative motive as “the object of securing profit from knowing better than the market what the future will fetch forth.”

Out of the three motives, speculative motive is more significant in determining the rate of interest. Keynes supposed that the amount of money held for speculative motive would differ inversely with the rate of interest.

Keynes view was that the rate of interest was determined by liquidity preference on one hand and the supply of money on the other.

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 Figure: Diagrammatic example of Liquidity preference Theory of interest

In figure above Liquidity preference is illustrated by L and the supply of money is symbolized by M and the rate of interest is indicated by r. Rate of interest is determined by the intersection of L& M curves. There will be raise in the rate of interest to r1, when there is an augment in demand for money to L1 or by a reduction in the supply of money to M1.

Criticism:

Keynesian theory is a common theory of interest and it is far superior to the earlier theories of interest. However critics say that Keynes has over-emphasized liquidity preference factor in the theory of interest. Furthermore, only whenever a person has savings, the question of parting with liquidity occurs. In terms of Jacob Viner, “without saving, there can be no liquidity to surrender. Rate of interest is the return for “saving without liquidity”.

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