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Presentation by :Bhagyashree .H.

Topic: Keynes liquidity preference theory
of interest rate
MA-2nd year economics



Keynes liquidity preference theory of

interest rate

The concept was first developed by John
Maynard Keynes in his epoch-making
book the general theory of employment,
interest and money(1936).
The rate of interest is purely monetary
phenomenon and is determined by
demand for money and supply of money.
The thoery explains determination of the
interest rate by the supply of money and
demand for money.


Keynes defined interest as:Interest is

the reward for parting liquidity for a
specified period or to sacrifice

According to the theory, the interest

rate adjusts to balance the supply and
demand for money.

According to Keynes, rate of interest is

determined by liquidity preference or
demand for money to hold and the

Money is the most liquid asset

and people generally like to keep
their assets in cash. Therefore if
they are ask to surrender this
liquidity, they must be paid a
reward. This reward is paid in the
form of interest. Greater the
desire for liquidity, higher shall be
the rate of interest demanded for
parting with liquidity.

Three motives for people holding

Transactions motive (arising from
medium of
function):positively related to
Precautionary motive: positively
related to
Y(income), Negatively related to
Speculative motive (arising from

Keynes theory of interest

According to keynes, the rate of interest is

determined by demand for money (liquidity
preference) and supply of money.

In keynesian sense demand for money is the

demand to hold money. An increase in the
demand for money shall, lead to rise in the
rate of interest, and a decrease in the demand
for money shall, lead to a fall in the rate of
interest . The liquidity preference governs the
rate of interest, it, in its own turn, is also
governed by the rate of interest. Higher the
rate of interest ,the lower shall be the liquidity

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 moneyholdings of all the members of the
community. Supply of money is a factor
which is always in the hands on state
monetary authority. Through its control
of supply on money ,it can influence the
rate on interest which, in its turn, affects
the liquidity preference .Higher the
supply of money, the lower shall be the
rate of interest, lower the supply of
money, higher shall be the rate of

Keynes theory of interest

In the diagram, 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 decreases as the rate of
interest rises. There is an inverse relationship between
the rate of interest and the liquidity a
lower rate of interest, people find it more profitable to
old their savings in the form of cash balances (liquidity
preferences) than at a higher rate of interest . This is the
reason why the LP curve slopes downwards to the right.
The QM represents the total mount of money which is
assumed to be constant and as such inelastic vis--vis
the interest rate . That is why the curve QM is vertically
At Os2 rate of interest, the supply o f 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 supply of money are both

At a higher rate of interest ,i.e., at Qs3 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 on interest the
liquidity preference of the people declines,
because people wish to take advantage of the
At a lower
rate of interest,
by lending
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
(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 of the supply of money
in existence.

Effect of an increase in money supply

on the rate of interest

ON is the quantity of money available. The
Rate of interest will be determined where the
demand for money is in balance or equal to
the fixed supply of money ON. Demand of
money is equal to ON quantity of money at Or
rate of interest . Or is the equilibrium rate of
interest. Assuming no change in expectations
and nominal income, an increase in the
quantity of money will lower the rate of
interest. When the quantity of money
increases from ON to ON. The rate of interest
falls from Or to Or1 because the new quantity
of money ON1 is in balance with demand for
the money at Or1 rate of interest.

Increase in money supply leads to the

fall in the rate of interest. With initial
equilibrium at Or, When the money
supply is expanded from ON to ON1 ,
There emerges excess supply of money
at the initial Or rate of the interest. The
people would react to this excess
quantity of money supplied by buying
bonds. As a result, The bond prices will
go up which implies that the rate of
interest will decline. This is how the
increase in money supply leads to the
fall in rate of interest.


Keynes liquidity preference theory of interest has

been criticized on the ground that it furnishes too
narrow an explaination 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
factor not stressed by him.
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 the other words,
interest is paid because capital is productive.
Keynes, theory of interest , according to critics, is of
limited value from the supply is not always
possible to reduce the rate of interest by increasing
the supply of money. If the liquidity preference of the

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