Europa Science & Commerce Academy

Q. No. 20:

Critically examine the liquidity preference theory of interest.

Economics Notes

Answer: INTRODUCTION: The concept of liquidity preference was presented by J. M. Keynes. In this theory the procedure of determination of rate of interest is discussed. Interest is the price paid by borrower to the lender for the use of loan able funds during a certain period. This theory expresses negative relationship between rate of interest and liquidity preference. INTEREST: According to Batch: Interest is the price paid for the use of money or credit. Definition: According to J. M. Keynes: The rate of interest is determined by the intersection of liquidity preference and supply of money in the country. Liquidity Preference: Liquidity preference means: The demand for money or desire of public to hold cash. Liquidity preference depends upon following motives 1) Transaction Motive 2) Precautionary motive 3) Speculative motive 1) Transaction Motive: Transaction motive related to the demand for money to meet the current domestic and business requirements. The demand for money by individuals can be explained by two ways. According to Consumers According to Producers The demand for money to hold cash depends upon levels of income. If level of income is high, demand for money for transaction purpose will be greater. If level of income is low, demand for money for transition motive is low. 2) Precautionary Motive: Precautionary motive means the desire of the people to hold cash for unexpected needs. These unexpected needs can be personal or business emergencies. It includes danger of unemployment, sickness, accidents, etc. it also depends upon level of income. If income will increase, demand for money for precautionary motive will increase and vice versa. 3) Speculative Motive: The demand for money for speculative motives depends upon the future changes in the rate of interest. If rate of interest increases, demand for money for speculations will fall and vice versa. Demand for Money (Md): Md = f(Y, i) Demand for money is a function of income and rate of interest.. Md = Mtd + Msd Mtd = Transitory demand for money Mtd = f(y) Msd = Speculative demand for money Msd = f(i) Here we assume that income will remain same therefore.
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Md = f(i) Schedule: Rate of Interest i Md 2% 1000 4% 600 6% 300 8% 200 Diagram:
y-axis

Economics Notes

8% 6% 4% 2%

200

400 600 800 Demand for Money

1000

x-axis

Explanation: The above schedule and diagram shows negative relationship between rate of interest liquidity preference. Supply of Money (MS): Supply of money includes currency notes in circulation, demand deposits, credit, etc, it is set by the govt. and monetary authorities MS has no relation with rate of Interest. This is the reason that supply of money curve is perfectly inelastic. Diagram: Rate of Interest

y-axis i1

MS

a i2 b i3 0
Supply of Money

c
(x-axis)

Determination of Rate of Interest: There are two cases of determination of rate of interest.
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Economics Notes

CASE I: LP changes while MS remains same. This can be explained with the help of diagram. Diagram:

Rate of Interest

y-axis i1 i2 i3 0

MS E1 E2 E3
M Md & MS

LP1 LP2 LP3

(x-axis)

Explanation: In the diagram Md & MS are measured along x-axis, while rate of interest is taken on y-axis. Basic equilibrium takes place at point E where LP curve interests MS curve. As a result, Oi is determined as rate of interest while OM is the equilibrium level of money. If demand for money increases, LP curve shifts upward as LPi. New equilibrium takes place at Ei where LP1 = MS. Rate of interest increases from Oi. Due to decrease in Md, LP curve shifts downward as LPo. New equilibrium point Eo shows that rate of infest falls from Oi to Oio. Diagram:

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Economics Notes

Rate fo Interest

Y-axis Mso Ms Ms1

io i ii

EO E E1 LP

Explanation: In the above diagram Md & Ms are measured along x-axis while rate of interest is taken on y-axis. Equilibrium takes place at point E where LP=Ms. Oi is the equilibrium rate of interest & OM is the equilibrium level of money. Due to increase in supply of money Ms shifts to right as Ms1. Here rate of interest is Oi1 at equilibrium E1. When supply of money falls Ms shifts to left as Ms o. As a result, rate from the above discussion it is conclude that interest is determined where LP and MS are equal. CRITICISM: The following are the points: 1) Ignores real factors: Keynes explain the determination of rate of interest in terms of monetary forces. Real forces like productivity of capital and savings by the people etc. are ignored. They also play an important role in creating Md. 2) Rate of Interest Is Not Independent: According to Keynes rate of interest is independent of demand for investment, while rate of interest is not determined independently. It depends upon marginal efficiency of capital and expected production. 3) Different Rate of Interest: Liquidity preference theory does not explain the existence of different rate of inters prevailing in the market. 4) Short run Analysis: This theory explains the procedure of determination of rate of interest in short run. It gives no idea about long run. 5) Ignoring MFC: Keynes ignored marginal efficiency of capital and expected yield which play an important role in determination of rate of interest.

M MS Md & Ms

M1

(x-axis)

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Economics Notes

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