Compare and contrast the Keynesian Liquidity Preference and the Asset Demand Theories of

the rate of interest.

In the 1930s, Keynes’s General Theory of Employment, Interest, and Money sparked a debate
on the equivalence or otherwise of the classical Loanable Funds Theory and Keynes’ Liquidity
Preference Theory. Below, the controversy between these two theories and why Keynes
challenged the loanable funds theory will be explored. Finally, interest rate determination in
the Asset Demand and Liquidity Preference theories will be illustrated and their results in
different scenarios compared.

According to classical theory the interest rate is determined by the intersection of investment
demand and saving schedules (Hansen, 1951). A theory called the Loanable Funds theory,
formulated by Knut Wicksell, built upon the classical theory and prominent economists like
Ohlin, Robertson and Myrdal also contributed. According to the Loanable Funds theory, the
interest rate must equate the demand for and supply of loanable funds. The supply of
loanable funds includes savings, additions to savings from current income and dissavings from
past income.

Nowadays, the asset demand theory explains the demand for assets, including loanable
funds, bonds and other non-monetary assets. According to this theory, there are four
determinants of asset demand: wealth, expected returns relative to other assets, risk (relative
to other assets) and liquidity (relative to other assets). Therefore, this theory illustrates the
response of the quantity demanded of an asset to changes in these determinants (Mishkin,
Matthews, & Giuliodori, 2013). In short, the quantity demanded of an asset is positively
related to wealth, liquidity (relative) and expected return (relative) and negatively related to
risk (relative), assuming that people are risk-averse.

Based on the asset demand theory, the supply and demand curves for bonds can be
constructed (Figure 2). The demand curve for bonds is downward sloping because an increase
in the price of bonds decreases the interest rate (due to the inverse relationship between
price and the interest rate) and also the rate of expected return, which reduces the quantity
of bonds demanded, ceteris paribus. The upward sloping supply curve shows the positive
relationship between price and the quantity of bonds supplied. As price increases, the interest
rate falls, making it less costly for firms to borrow and increasing the quantity of bonds
supplied. When the demand and supply curves intersect, the resulting rate of interest is “the
‘price’ which brings into equilibrium the demand for resources to invest with the readiness to
abstain from present consumption” (Keynes, 1936).

Keynes did not agree with the loanable funds theory (asset demand theory) as it ignored the
liquidity preference of people, that is, the form in which savings are stored (Keynes, 1936). In
his General Theory, Keynes proposed the Liquidity Preference theory which is meant to fill in
the gap left by the loanable funds theory. (Bibow, 2000) tries to illustrate that “Keynes’
Treatise disequilibrium analysis already proves that what was to become loanable funds
theory later on is, indeed, logically inconsistent”. In the liquidity preference theory, it is
assumed that wealth can either be stored as money or else as bonds, which earn a rate of
interest. Therefore, in this theory, the interest rate is not the ‘price’ which equates the
demand and supply for bonds, but “the reward for parting with liquidity, [is] a measure of the
unwillingness of those who possess money to part with their liquid control over it” (Keynes,
1936). In other words, the interest rate is the opportunity cost of holding money, as by holding
money instead of bonds one will forego the interest rate.

In Keynes’ theory, the equilibrium interest rate (i*) is determined by the intersection of the
supply and demand for money (Figure 1). It can be derived that equilibrium in the money
market results in equilibrium in the bond market. In this respect, this theory would eventually
arrive at the same interest rate as in the asset demand theory. The demand for money is
downward sloping as when the interest rate rises, the opportunity cost of holding money
increases and less money is demanded. The money supply is assumed to be perfectly inelastic
as it is set by the central bank.

In the liquidity preference theory, when the interest rate is lower than the equilibrium
interest rate, there is an excess demand for money as the opportunity cost of holding money
goes down (Figure 1). Therefore, people will sell bonds to earn more money, which will
decrease the price of bonds and increase the interest rate. This will continue until the excess
demand for money is eliminated. In the asset demand theory, more people want to sell bonds
than to buy when the price is higher than the equilibrium (Figure 2). This excess supply will
cause the price of bonds to fall (and the interest rate will increase) until the excess supply is
eliminated. Therefore, one can say that an excess demand in the money market means that
there must be an excess supply of bonds in the bond market. Indeed, according to (Tsiang,
1956), the two theories are identical, and they would determine the same rate of interest if
both sets of demand and supply functions are formulated correctly in the ex ante sense.

Figure 1 Liquidity preference theory: Elimination of excess demand for money

Figure 2 Asset demand theory: elimination of excess supply of bonds

To compare the outcomes of these theories, suppose that the economy is going through a
business cycle expansion. Since more is being produced and income is increasing, wealth also
increases. This increases the demand for bonds at each price, shifting the demand curve to
the right. On the other hand, since there are more profitable investment opportunities, firms
want to supply more bonds at each price to obtain the necessary funds. The resulting effect
on the interest rate depends on the size of these shifts (Figure 3). However, in the liquidity
preference framework the result is not ambiguous. An increase in wealth means that people
want to hold more money and make more transactions and the demand for money increases
at each interest rate, shifting the demand curve to the right. This results in a definite increase
in the interest rate (Figure 4). Therefore, in this case, the two theories may arrive to different
conclusions.
 Figure 3 Asset demand theory: Business cycle expansion

Figure 4 Liquidity preference theory: Business cycle expansion

However, sometimes they result in the same outcome. Now suppose that inflation or the
price level in the economy is rising. Since the expected return on real assets increases relative
to bonds, the demand for bonds decreases at each price (or interest rate). This causes the
demand curve for bonds to shift to the left. On the other hand, an increase in expected
inflation decreases the real cost of borrowing, making it cheaper for firms to supply bonds;
the supply curve shifts to the right. The result is that the price of bonds falls and the
equilibrium interest rate rise (Figure 5). The liquidity preference theory assumes that there
are only two kinds of assets, money and bonds, therefore changes in the expected return of
real assets have no effect on the interest rate, unlike in the asset demand theory (Mishkin,
Matthews, & Giuliodori, 2013). An increase in inflation causes the purchasing power of people
to fall which means that they must hold more money (rather than bonds) to be able to carry
out the same transactions. This shifts the demand curve for money to the right and increases
the interest rate (Figure 6). Therefore, in the situation of a price level increase, the asset
demand theory and the liquidity preference framework yield the same results.
 Figure 5 Asset demand theory: Increase in expected inflation (increase in the price
level)

Figure 6 Liquidity preference theory: Increase in expected inflation (increase in

the price level)

Several authors have tried to reconcile these theories by giving their own reasons why they
may or may not differ. (Ackley, 1957) argues that these theories have different subject
matters; the liquidity preference theory identifies an “asset-holding equilibrium” whilst the
loanable funds theory deals with what happens in disequilibrium. On the other hand, (Snippe,
1985) argues that “the difference between Keynes’ theory and the loanable funds theory is a
matter of substance”. Others, like (Chang, 1976) maintain that it is a matter of difference
interpretations and misapplication of Walras’ law, and with respect to the liquidity preference
theory (Millikan, 1938) argues that its interpretation depends on the meaning of the term
“liquidity preference”. However, (Chang, 1976) tries “to show the equivalence of the two
theories in both static and dynamic analysis” and (Snippe, 1985) argues that “from a formal
point of view the loanable funds theory and liquidity preference theory may be considered
equivalent”.

Finally, it can be concluded that the asset demand theory and the liquidity preference
framework should theoretically arrive to the same rate of interest. However, with different
interpretations and in certain situations, they may not determine the same interest rate. The
debate on whether these two theories are equivalent and if not, which is the right one,
continues up to this day.

References

Ackley, G. (1957, September). Liquidity Preference and Loanable Funds Theories of Interest:
Comment. The American Economic Review, 47(5), 662-673. Retrieved November 23, 2017,
from http://www.jstor.org/stable/1811744

Bibow, J. (2000). The Loanable Funds Fallacy in Retrospect. History of Political Economy, 32(4), 789-
831. doi:10.1215/00182702-32-4-789

Chang, C. F. (1976, December). Liquidity Preference and Loanable Funds Theories: A synthesis.
Australian Economic Papers, 15(27), 302-307. Retrieved December 25, 2017

Hansen, A. H. (1951, August). Classical, Loanable-Fund, and Keynesian Interest Theories. The
Quarterly Journal of Economics, 65(3), 429-432. Retrieved December 25, 2017, from
http://www.jstor.org/stable/1882223

Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: Palgrave
Macmillan.

Millikan, M. (1938, June). The Liquidity-Preference Theory of Interest. The American Economic
Review, 28(2), 247-260. Retrieved November 23, 2017, from
http://www.jstor.org/stable/1806751

Mishkin, F. S., Matthews, K., & Giuliodori, M. (2013). The Economics of Money, Banking and Financial
Markets: European Edition. Harlow: Pearson.

Snippe, J. (1985, June). Loanable Funds Theory versus Liquidity Preference Theory. De Economist,
133(2), 129-150. doi:https://doi.org/10.1007/BF01676404
Tsiang, S. C. (1956, September). Liquidity Preference and Loanable Funds Theories, Multiplier and
Velocity Analysis: A Synthesis. The American Economic Review, 46(4), 539-564. Retrieved
November 23, 2017, from http://www.jstor.org/stable/1814282