Rate of interest

Rate of interest: Liquidity Preference Theory:

Any business progress has to take into consideration a crucial factor that influences the current supply of money, that is, interest. The rate of interest is the other major determinant which influences aggregate investment. However, the Keynesian theory of employment starts with the rate of interest. Interest affects employment and investment. Keynes submitted his well-known liquidity preference theory of interest to elucidate the obligation, justification and significance of interest. The concept of liquidity preference is an extraordinary contribution of Keynes. According to Keynes, the rate of interest is “the prize for parting with liquidity for a particular period”.

Liquidity preference means to the cash holdings of the people. Liquidity refers to cash. Why do people contain cash? It is since money is the most liquid asset and people favor to keep their money in the form of cash. Keynes provides three motives for the liquidity preference of people. They are:

1) Transaction motive
2) Precautionary motive and
3) Speculative motive

In order to carry on everyday transactions, people favor to carry on cash. It is managed by the   transaction motive. To meet unforeseen expenses such as rapid medical expenses, people carry on cash. It is determined by defensive motive. To take benefit of market movements of prices of shares, bonds, and so on people carry on cash and in this situation the speculative motive examines their cash holdings. ‘Speculative motive refers to the object of securing gain from knowing better than the market what the prospect will bring forth’ (By Keynes).

Liquidity preference based on rate of interest. Higher the rate of interest, the people would like to take benefit and so will part with their money. Thus we can say that higher the rate of interest, lower will be the liquidity preference of the people. On other hand, lower the rate of interest, higher will be the liquidity preference.

According to Keynes, the liquidity preference is much stable as it depends on human habits that remain similar. Liquidity preference associates to the demand for money. It is significant to note that it persuades the demand side in determining the price of wealth. The other side is the supply of money that based on government monetary policy and credit making by commercial banks.

Briefly acknowledged, the Keynesian investment function provides immense significance to the rate of interest. When the rate of interest stays constant, then the investment rises with an augment in the business confidence concerning the future.

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