Liquidity preference theory (Keynesian theory) of interest

Liquidity preference theory (Keynesian theory) of interest.

Generally people prefer to hold a part of their assets in the form of cash. Cash is a liquid asset. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. In other words, it is the reward for not hoarding.

According to Keynes, people have liquidity preference for three motives. They are 1. Transaction motive; 2. Precautionary motive; and 3. Speculative motive.

The transaction motive refers to the money held to finance day to day spending. Precautionary money is held to meet an unforeseen expenditure.

Keynes defines speculative motive as 'the object of securing profit from knowing better than the market what the future will bring forth.' Of the three motives, speculative motive is more important in determining the rate of interest. Keynes believed that the amount of money held for speculative motive would vary inversely with the rate of interest.

Keynes was of the view that the rate of interest was determined by liquidity preference on the one hand and the supply of money on the other.

In fig.  Liquidity preference is shown by L and the supply of money is represented by M and the rate of interest is indicated by r. Rate of interest is determined by the intersection of L and M curves. There will be increase in the rate of interest to r₁, when there is increase in demand for money to L₁ or by a decrease in the supply of money to M₁.

Criticism : Keynesian theory is a general theory of interest and it is far superior to the earlier theories of interest. But critics say that Keynes has over - emphasized liquidity preference factor in the theory of interest. Moreover, only when a person has savings, the question of parting with liquidity arises. In the words of Jacob Viner, 'without saving, there can be no liquidity to surrender. The rate of interest is the return for 'saving without liquidity'.