Criticism of Liquidity Preference Theory of Keynes

Criticism of Liquidity Preference Theory of Keynes:

Prof. Hansen has pointed out, the Keynesian theory of interest is not free from criticism. He says that the Keynesian theory suffers from the same weakness as Keynes himself pointed out in the classical theory; namely, indeterminateness. The rate of interest is determined by the liquidity preference and the supply of money. Now liquidity preference itself is determined by the income level, and liquidity preference cannot itself be known unless the income level is known, and the rate of interest plays an important part in the determination of the income level. The Keynesian theory, in Prof. Hansen’s view, is, therefore, as confusing as the classical theory.

Prof. Henry Hazlitt has criticized Keynes’ theory of interest on the following grounds.

Firstly, it is pointed out that the main fallacy in the Keynesian theory of interest lay in ignoring or denying the determining influence of the real factors on the rate of interest. Keynes considered interest to be a purely monetary phenomenon and refused to believe that real factors like productivity and time preference had any influence on the rate of interest. The classical economists, he says, were equally wrong in considering interest to be a purely real phenomenon, determined and influenced by real factors alone. The truth, as pointed out by that well-known Swedish economist, Porf. Knut Wicksell was that both sets of factors, real and monetary had to be recognized and reconciled in any complete theory of interest. So from this point of view, Keynes’ theory of interest appeared to be one-sided, and in the words of Prof. Hazlitt, was “a preclassical mercantilistic and man-in-the-street economics”.

Secondly, it is not helpful to explain the interest rate as “the reward for parting with liquidity” any more than it would be to explain the price of tomatoes or a house as “the reward” to the buyer for parting with cash for them. Without previous savings, moreover, there can be no “liquidity” to part with. Saving is the necessary means to obtain the funds to be invested at interest. As Prof. Jacob Viner has put it, “Without saving there can be no liquidity to surrender. The rate of interest is the return for saving “without liquidity”. As such, the element of saving cannot be ignored in any theory of interest.

Thirdly, it is said that Keynes’ liquidity preference theory is clearly wrong. It goes directly contrary to the facts that it presumes to explain. If Keynes’s theory were right, the rate of interest would be the highest precisely at the bottom of a depression, when due to falling prices people’s preference for liquidity is the strongest. But it is precisely at the bottom of a depression that the rate of interest is the lowest. And if Keynes’ theory of interest were correct, the rate of interest would be the lowest at the peak of a boom when due to all-around confidence the liquidity preference of the people is the weakest. But it is precisely at the peak of a boom that the interest rate is the highest.

Fourthly, it is pointed out that the use of the term liquidity preference itself is neither helpful nor necessary. It throws considerably more confusion and considerably less light on the problem of interest. Besides being vague, it also has the effect of making Keynes’ theory self-contradictory. For example, if a man holds his funds in the form of time deposits or short-term Treasury Bills, he is being paid interest on them; therefore, he is getting interest and “liquidity” too.

Besides the above criticisms, Keynes’ theory of interest has also been criticized on the following grounds:

Firstly, Keynes’ liquidity preference theory of interest has been criticized on the ground that it furnishes too narrow an explanation of the rate of interest. It links the desire for liquidity to three main motives. The critics, however, point out that the desire for liquidity arises not only from the three main motives mentioned by Keynes but also from several other factors not stressed by him.

Secondly, some critics point out that interest is not the reward for parting with liquidity as stressed by Keynes. On the contrary, interest is the reward paid to the lender for the productivity of capital. In other words, interest is paid because capital is productive.

Thirdly, Keynes’ theory of interest, according to critics, is of limited value from the supply side. It is not always possible to reduce the rate of interest by increasing the supply of money. If the liquidity preference of the people also increases in the same proportion in which the supply of money is increased, then the rate of interest shall remain unaffected.

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