Liquidity Preference Theory of Keynes

Liquidity Preference Theory of Keynes:

Keynes expounded his own theory of interest which may be called the monetary theory of interest as opposed to the classical theory which might be termed as the real theory of interest. According to Keynes, interest is purely a monetary phenomenon because the rate of interest is calculated in terms of money. It is also a monetary phenomenon in the sense that it is determined by the demand for and the supply of money. Keynes defines interest as the reward paid for parting with liquidity for a specified time. Money is the most liquid asset and people generally like to keep their assets in cash. Therefore, if they are asked to surrender this liquidity, they must be paid a reward. This reward is paid in the form of interest. The greater the desire for liquidity, the higher shall be the rate of interest demanded for parting with liquidity.

Now, the rate of interest, like the price of an ordinary commodity, is determined by the demand and supply of money. The rate of interest on the demand side is governed by the liquidity preference of the community. The liquidity preference of the community arises due to the necessity of keeping adequate cash for meeting certain requirements of the community. Keynes discusses these requirements under three heads, namely:

• The Transaction Motive.
• The Precautionary Motive.
• The Speculative Motive.

The demand for money arising under these three motives constitutes the aggregate demand for money. Further, it is to be remembered that the demand for money in the Keynesian sense is the demand to hold money. Money under the above three motives is actually held in cash in the hands of the public and the community demand for money shall increase or decrease, according as the community wishes to hold more or less cash in its hand. An increase in the demand for money (i.e., an increase in liquidity preference) shall, ceteris paribus lead to a rise in the rate of interest, and vice versa, a decrease in the demand for money (i.e., a decrease in the liquidity preference) shall, ceteris paribus, lead to a fall in the rate of interest. An increase in demand is not always followed by a rise in the rate of interest. If for instance, an increase in the demand for money is also followed by an increase in the quantity of money in the same proportion, the rate of interest shall not be affected at all. While the liquidity preference governs the rate of interest, in its own turn, is also governed by the rate of interest. The higher the rate of interest, the lower shall be the liquidity preference; the lower the rate of interest, the higher shall be the liquidity preference.

The rate of interest, on the supply side, is determined by the supply of money available in the economy. The supply of money is different from the supply of a commodity. While the supply of a commodity is a flow, the supply of money is a stock. This is true because money is not being continuously produced and consumed in the same way as commodities are. Further, it should be remembered that the supply of money is the supply of money to hold, and the aggregate supply of money in a community at any time is the sum of all the money holdings of all the members of the community. Unlike the demand for money, the supply of money is completely amenable to government control. The liquidity preference of the community cannot be directly controlled by the State. But the supply of money is a factor that is always in the hands of the state.

In most countries, the control of the supply of money has been entrusted to the monetary authority which happens to be the Central Bank itself. The monetary authority may not be able to influence liquidity preference directly, because it falls outside its preview. But through its control of the supply of money, it can influence the rate of interest, which in its turn, affects the liquidity preference. The supply of money has the same effect on the rate of interest as the supply of an ordinary commodity has on its price. The higher the supply of money, ceteris paribus, the lower shall be the rate of interest; vice versa, the lower the supply of money, ceteris paribus, the higher shall be the rate of interest. An increase in the supply of money is not always followed by a fall in the rate of interest. If, for instance, an increase in the supply of money is also followed by an equivalent increase in the demand for money, the rate of interest shall not be affected at all. Nevertheless, control of the supply of money is a potent weapon in the hands of the State whereby it can increase investment and employment by lowering the rate of interest. While the supply of money affects the rate of interest, it, in its turn, is not affected by the rate of interest unless the monetary authority issues more money to counter the high rate of interest, because the supply of money is in the hands of the government.

Keynes’ theory of interest can also be illustrated with the help of the diagram as shown below.

• In the above figure, LP is the liquidity preference curve. It represents the demand for money. The demand for money varies with the interest rate. It increases as the rate of interest falls, and it decreases as the rate of interest rises. There is, thus, an inverse relationship between the rate of interest and the liquidity preference. At a lower rate of interest, people find it more profitable to hold their savings in the form of cash balances (liquidity preference) than at a higher rate of interest. This is the reason why the LP curve slopes downward to the right.

• The QM curve represents the total amount of money which is assumed to be constant and as such inelastic vis-a-vis the interest rate. That is why the curve QM is vertically straight.

• At the OS₂ rate of interest, the supply of money which people wish to hold (liquidity preference) is OQ, and the supply of money in existence is also OQ. Thus, the liquidity preference and the supply of money are both equal. OS₂ or PQ is, therefore, the equilibrium rate of interest, because at this rate both the demand and supply of money are in equilibrium with each other.

• At a higher rate of interest, i.e., at the OS₃ rate of interest, people wish to hold less money (OQ₁) and invest the balance, i.e., Q₁Q money. It is, thus, clear that at a higher rate of interest, the liquidity preference of the people declines, because people wish to take advantage of the higher interest rate by lending their surplus funds to others.

• At a lower rate of interest, i.e., OS₁ people wish to hold more money, i.e., their liquidity preference increases from OQ to OQ₂ because now they lose more by lending money to others.

• If there is an increase in liquidity preference, i..e, if the LP curve shifts to the right (in the form of LP₁), assuming that the supply of money remains constant, the rate of interest also increases from PQ to L₁Q.

• If, on the contrary, the supply of money increases from OQ to OQ₂ (assuming that the liquidity preference remains the same), the rate of interest will decline from OS₂ to OS₁.

Thus, according to Keynes, the rate of interest equates the liquidity preference of the community with the amount or supply of money in existence.