Liquidity Preference Theory of Interest | BCOM Business Economics Notes


Liquidity Preference theory of Interest

  • According to JM Keynes Rate of interest is determined by the demand for and supply of money
  • people’s demand for money refers to the desire to hold cash money and Bank deposit which can be withdrawn for a payment that can be made at any time such deposits are in the form of a current account and savings account.
  • According to Keynes people desire to hold money for liquidity preference owing to various motives. Broadly they are:
  1. Transaction motive
  2. Precautionary motive and
  3. Speculative motive
  1. Transactions motive is further subdivided into an income motive and business motive. The former refers to household and later business people. For both groups, there is a time lag between receipt and expenditure for which they require to hold cash for the transactions. the amount of money kept by them depends on their income higher the income larger the amount held under these motives does demand for transactions Motive depends on the level of income.
  2. Precautionary motive refers to the necessity to satisfy all unforeseen events in life. Like the unexpected incidents in business, people hold the cash under this motive to satisfy any unforeseen expenditure or benefit favorable market conditions to their purchases.
  3. Speculative motives is the demand for money related to the store of the value function and is based on asset demand for money people keep ready cash to take advantage of the changes in prices in financial asset financial market being on certain and subjective price fluctuation speculators purchase financial assets at a lower price and sell at a higher price thereby earn profit
  4. Demand for cash that’s liquidity preference for speculative motive is interest elastic. Rate of interest and liquidity preference for speculative motives are inversely related at a higher rate of interest less money is kept in cash and more money is kept at a lower rate of interest.
  5. As per Keynes at a very low rate of interest people prefer to keep all the money in cash as the opportunity cost of holding money is also low at this point the demand for money for speculative motives becomes perfectly elastic such a situation is called a liquidity trap.

         We now express the demand for money for transactions, precautionary and speculative motive as under: 

          Md = M1 + M2

          Md = Total demand for money (liquidity)

          M1 = Demand for money for transactions and speculative motive – M1= L (Y)

          M2 = Demand for money for speculation motive – M2 = L (r)

  • The demand for transections and precautionary motives is income elastic but interest inelastic, except perhaps at a very high rate of interest.
  • If the rate of interest is very high, people may reduce the amount of money kept for these motives and may decide to lend and earn interest. At such a high rate of interest, the opportunity cost of holding money is very high.
  • Money held for speculative motives is related to the rate of interest and in turn on the prices of bonds and securities.

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Reference: MHSB and Manan Prakashan

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