Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums: Inflation premium 2% Liquidity premium 1% Maturity risk premium 2% Default risk premium 2% Based on these data, the real risk-free rate of return is: a. (b) There is no need to distinguish between money and real rates because every change in the money rate of interest is regarded as an equivalent change in the real rate of interest. The transactions demand for money is not influenced by the rate of interest; it is interest-inelastic. This means that changes in the interest rate have very little effect on investment. Symbolically, the speculative demand for money is expressed as: The community’s total demand for money (L) consists of – (a) the demand for active balances, i.e., the transactions demand for money, plus the precautionary demand for money (Lt = Lt + Lp), (b) the idle balances, i.e., the speculative demand for money (L2). Without previous saving, there cannot be liquidity (cash balances) to part with. On the demand side, the rate of interest is governed by the liquidity preference of the community and on the supply side, it is controlled by the total stock of money as fixed by the monetary authority. As a result, rate of interest increases from OR to OR1. For example, if a man holds his funds in the form of time deposits or short-terms treasury bills, he will be paid interest on them. In this theory, liquidity is given preference, and investors demand a premium or higher interest rate on the securities with long maturity since more time means more risk … Liquidity trap is an important feature of the speculative demand for money function. 100 yields a fixed amount of Rs. 0%. Keynes’ liquidity preference theory not only provides explanation for the determination of and changes in the rate of interest, but also is of great significance in Keynes’ general theory of income and employment. Speculative demand for money refers to the demand for holding certain amount of cash in reserve to make speculative gains out of the purchase and sale of bonds and securities through future changes in the rate of interest. (b) It lays more stress on the store of value function of money and related it with future expectations. Today we are discussing the Keynesian theory of interest rate. (b) Idle cash balances – consisting of speculative demand for money. The demand for money for transactions motive mainly depends on the size of money income; the higher the level of money income, the greater the demand for transactions motive and vice versa. Thus, the demand for active balances (L1 = Lt + Lp) is a constant (k = kt + kp) function of income (Y) and can be symbolically written as-. But empirical studies have shown doubts about the validity of the assumption of unstable liquidity preference function. The stronger the desire for liquidity, the higher the rate of interest and weaker the desire for liquidity, the lower the rate of interest. 4. from M2M2 to M3M3) will not reduce the rate of interest anymore because of liquidity trap. Thus, all the three motives together give the total demand for money Thus. LP to LP2 in Figure 6). Figure 6 shows that given the supply of money (MM curve), as the demand for money increases (shift from LP to LP1), the rate of interest rises (from Oi to Oi1) and as the demand for money decreases (shift from LP to LP2), the rate of interest falls (from Oi to Oi2). "[3], Criticism emanates also from post-Keynesian economists, such as circuitist Alain Parguez, professor of economics, University of Besançon, who "reject[s] the keynesian liquidity preference theory ... but only because it lacks sensible empirical foundations in a true monetary economy". According to Keynes, the interest rate is not given for the saving i.e. (a) In a recession, interest rates are already very low and the demand for holding money for speculative motive has become almost infinite (perfectly elastic LP curve). Content Guidelines 2. Apart from transactions motive, people hold additional amount of cash in order to meet emergencies and unexpected contingencies, such as, sickness, accidents, unemployment, etc. Title: The Liquidity Preference theory of interest 1 The Liquidity Preference theory of interest. 3. Thus the liquidity theory provides no solution; it cannot tell the rate of interest unless we already know the income level, the investment level and the interest rate itself. speculative motive: people retain liquidity to speculate that bond prices will fall. Keynes, in his book, General Theory of Employment, Interest and Money, has developed a monetary theory of interest as opposed to the classical real theory of interest. In this article we will discuss about:- 1. On average, either strategy gives the same return. The liquidity preference theory is a short period analysis since it explains the determination of interest rate in the short period. This theory assumes that the demand for real money balances L ( r , Y ) depends negatively on the interest rate (because the interest rate is the opportunity cost of holding money) and positively on the level of income. Share Your PPT File, Gold Standard: Features, Functions, Working, Rules, Merits and Demerits. People desire to have money in order to take advantage from knowing better than others about the future changes in the rate of interest (or bond prices). Shifts in the demand for money function (LP curve) are caused by the changes in the level of income. Variations of Interest Rates not Explained: This theory cannot explain why interest rates vary from person to person, from place to place and for different periods. For other uses, see, The General Theory of Employment, Interest and Money, "Man, Economy, and State with Power and Market", Money Creation, Employment and Economic Stability: The Monetary Theory of Unemployment and Inflation, Organisation for Economic Co-operation and Development,, Creative Commons Attribution-ShareAlike License. explanation is known as the theory of liquidity preference because it posits that the interest rate adjusts to balance the supply and demand for the economy’s most liquid asset – money. TOS4. In Man, Economy, and State (1962), Murray Rothbard argues that the liquidity preference theory of interest suffers from a fallacy of mutual determination. The policy implication of the liquidity trap is that the rate of interest cannot be lowered any more and the monetary policy becomes ineffective in the liquidity trap region of the liquidity preference schedule. Interest has been defined as the reward for parting with liquidity for a specified period. It is for economists like Hicks and Hansen to remove these short­comings and to combine real and monetary factors together and formulate a complete and determinate theory of interest. Rate of interest, being a monetary phenomenon, establishes equilibrium in the monetary sector, i.e., between demand and supply of money. According to the classical economists, the rate of interest is determined by the decision as to how much should be saved and consumed out of a given income level. Symbolically, the transactions demand for money can be stated to be function of money income: where, Lt represents the transactions demand for money, kt represents the fraction of money income society desires to hold in cash, and Y represents money income. Liquidity preference or the demand for money is of special significance in Keynes’ theory of interest. The theory is also called the monetary theory of interest. The liquidity preference theory ignored the effect of inflation and is based on the assumption of actual or expected price stability. Both the curves intersect at point E which indicates that Oi is the equilibrium rate of interest. D) as the interest rate rises, income will rise. By increasing money supply, the monetary authorities can reduce the rate of interest and thus encourage investment. Some critics point out that interest is not the reward for parting with liquidity as stressed by Keynes. In daily life, the individual or business income and expenditures are not perfectly synchronised. Similarly, at a lower rate of interest Oi2, the demand for money will be more than the supply of money (i2 d2 > i2 s2). Speculative demand for money or demand for idle balances is the unique Keynesian contribution. In Keynes’s liquidity-preference theory, the demand for money by the people (their liquidity preference level) and the supply of money together determine the rate of interest. For the households, unexpected economic circumstances affect their decision to keep money for precautionary motive. (b) In recession, investment plans are greatly curtailed and the demand for business loans is very low because of depressed profit expectations. Thus, changes in money supply may cause negligible changes in the interest rates. (i) if the interest rate is below the equilibrium level, then the quantity of money people want to hold is less than the quantity of money the Fed has created. An important feature of the LP schedule is that if the rate of interest falls to a very low level (say i0). The prices rise because of a number of factors like the rise in labour costs, bottlenecks in production process, etc. Money being a medium of exchange, the primary demand for money arises for making day-to- day transactions. In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. Given the supply of money at a particular time, it is the liquidity preference of the people which determines rate of interest. Thus, according to Hansen, “Keynes’s criticism of the classical theory applies equally to his own theory”. Changes in the demand for money and the supply of money lead to corresponding changes in the rate of interest. He also said that money is the most liquid asset and the more quickly an asset can be … The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. Similarly, if people feel that in future the rate of interest is going to fall (or bond prices going to rise), they will reduce the demand for money meant for speculative purpose. Moreover, the net increase in financial assets in the government budget may directly influence consumption and investment without necessarily changing the interest rate. 3. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. Keynes believed that interest is not the reward for hoarding but it is the reward for parting with liquidity. Supply of money refers to the total quantity of money in the country for all purposes at a particular time. It means that at this extremely low rate of interest, people have no desire to lend money and will keep the whole money with them. The liquidity preference theory goes directly contrary to the facts that it presumes to explain. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. People receive income in periods that do not correspond to the times they want to spend it. Keynes gives three reasons for holding cash, i.e., the transactions motive, the precautionary motive, and the speculative motive. Thus, the lower the interest rate, the more money demanded (and vice versa). It is influenced by political and not by economic factors. This will cause the rate of interest to fall back to its equilibrium level (Oi). (d) According to this theory, the rate of interest can be controlled by the monetary authority. Holding of money in the form of cash is the most convenient way of keeping one’s savings. Keynes's liquidity preference theory implies that velocity O A. is constant O B. is zero in the long-run. Significance of Liquidity Preference Theory of Interest 7. For example, a bond with the price of Rs. (i) The assumption of price stability has two implications: (a) Money has the absolutely certain yields of zero per cent; its opportunity cost can be measured by the money interest rate; and changes in the money rate indicate relative excess or scarcity of money supply. It refers to the extremely low level of interest rate at which people have no desire to lend money and will keep the whole money with them. A major rival to the liquidity preference theory of interest is the time preference theory, to which liquidity preference was actually a response. Other Liquidity Preference Motives Ignored: Keynes’ analysis of the liquidity preference is narrow in scope. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. B) as the interest rate rises, the demand for real balances will rise. Liquidity preference theory propounds that not all assets can be traded without a transaction cost and so money holding is positive even when interest paid out is greater than zero. Given that ; Expectations Theory ; Given that we want to invest for two years, we should be indifferent between either strategy. The reason for liquidity preference or holding wealth in cash is that future is uncertain and full of risks and cash provides protection against future risk and uncertainties. Liquidity Management: Theory # 2. The lending system of ancient Babylon was evidently quite sophisticated. The Shift-Ability Theory : The shift-ability theory of bank liquidity was propounded by H.G. perfectly elastic portion of the liquidity preference curve), the increase in the supply of money will not reduce the rate of interest any more. Purchase of other assets (securities, commodities etc.) O C. As interest rates rise people will reduce their money holdings and therefore velocity will decrease OD. Most business companies have a tendency to accumulate and hold money balances in order to finance their plans for business expansion. On the contrary, a fall in the liquidity preference means an increased desire of the people to buy bonds at current prices, thus raising the bond prices and lowering the interest rates. The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities, this causes the yield curve to be upward-sloping. Any deviation from this equilibrium rate of interest will be unstable. According to Jacob Viner, “Without saving there can be no liquidity to surrender. This relationship is shown by the downward sloping LP schedule in Figure 5. 6. According to this theory, the rate of interest should be the highest at the bottom of depression when, due to falling prices, people have great liquidity preference. b. This completely ignores the influence of inflation on portfolio decisions. But, in fact, the interest rate is the highest at the peak of a boom. Thus, the community’s total demand for money depends upon the level of income and the rate of interest: The liquidity preference schedule or demand for money curve expresses the functional relationship between the amount of money demanded for all the three motives and the rate of interest. But further increase in money supply (e.g. Given the level of income, the demand for money and the current rate of interest are inversely related; as the rate of interest falls, the demand for money increases. The theory argues that consumers prefer cash over the other asset types for three reasons (Intelligent Economist, 2018). It refers to the demand for holding certain amount of cash in reserve to make speculative gains out of the purchase and sale of bonds through future changes in the rate of interest. Keynes theory of interest is more general than the classical theory. Neo-Keynesian economists like Hicks, Lerner and Hansen are of the opinion that loanable funds formulation and the Keynesian liquidity preference formulation taken together do supply us with an adequate theory of the rate of interest. have been assumed to be perfect substitutes with bonds. Thus, the rate of interest cannot be known without first having the knowledge of income level.

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