Change in the rate of interest thus takes place whenever there is disequilibrium between people’s demand for and supply of either cash or bonds or securities. It is obvious “that the demand and supply of ever)’ type of asset has just as much right to be considered as the demand and supply of money. 5. It refers to easy convertibility. We turn to the analysis of these three motives first and then with some remarks about the supply of money study the determination of the rate of interest as Keynes taught us. Given the supply of money at a particular time, it is the liquidity preference of the people which determines rate of interest. This shows that the price of the bond of Rs. d. Efficient Markets Theory of Interest. Thus according to Keynes interest is the price paid for surrendering their liquid assets. When the rate of interest rises, the prices of bonds and securities fall and with a fall in the rate of interest, bond and security prices go up. Share Your PPT File, The Classical Theory of Rate of Interest (With Diagram). Transaction motive refers to the demand for money for current transactions by households and firms. The aggregate supply of money in a community at any time is the sum of money stock of all the members of the society. According to Keynes interest is purely a monetary phenomenon because rate of interest is calculated in terms of money. 200. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. For this purpose people want to keep some cash with them. At the equilibrium interest rate, the quantity of real money balances demanded equals the quantity supplied. The perfectly elastic position of the liquidity preference curve indicates that people will hold with them as inactive balances of any amount of money that they will have. In other words, the interest rate is the ‘price’ for money. Money is a given stock at a moment of time. Any one of these two may change to bring about a change in the rate of interest. Rather his great emphasis on the influence of hoarding on the rate of interest constituted an invaluable addition to the theory of interest as it had been developed by the loanable fund theorists who incorporated much of Keynes’s ideas into their own theory to make it more complete.” Nevertheless, Keynes’s theory remains a distinct theory on its own in so far as it is entirely monetary. There is an excess demand for money (cash) to the tune of SM2 which the people would try to satisfy from the sale of bonds and securities whose prices would consequently fall. It is horizontal towards the right hand side. The economic theory which argues that the risk-free interest rate is determined by the interaction of the demand for funds and the supply of funds is known as the: Select one: a. People under speculative motive hold money in order to secure profit from the future speculation of the bond market. John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. The amount of money under the precautionary motive depends on the individual’s condition, economic as well as political which he lives. Unbiased Expectations Theory— (Irving Fisher and Fredrick Lutz): The expectation of the future … The equilibrium rate of interest is fixed at that point where supply of and demands for money are equal. As D.H. Robertson has pointed out, “the fact that the rate of interest measures the marginal convenience of holding idle balance need not prevent it from measuring also the marginal inconvenience of abstaining from consumption.” With these brief remarks we now return to the study of the main merits of Keynes’s theory. This bond is thus an income-yielding asset of 40 rupees per year. This feature of the liquidity function is called the ‘liquidity trap’ since it shows that at a particular low rate of interest, people possess an insatiable demand for money. An individual for his day to day transaction demand money. Although Hawtrey thought that the idea of liquidity preference was an important contribution to monetary theory, he rejected the idea that liquidity preference is the essence of interest. Share Your PDF File Given the supply of money at a particular time, it is the liquidity preference of the people which determines rate of interest. If people expect the rate to rise in future—that is, they expect the prices of bonds and securities to fall—they would be induced now to keep more cash with them. The central Bank’s action may not lower the rate of interest at all. These are the transactions, precautionary and speculative motives. The supply of money is not influenced by the rate of interest. of the liquidity preference theory of interest. where L2 is the speculative demand for money and it is a function of the expected changes in the rate of interest. D. Hamberg remarks justifiably: “Keynes did not forge nearly as new a theory as he and others at first thought. 1,000/- earning a fixed rate of interest of 4 per cent per annum. In other words, if he keeps his saving in the form of cash he enjoys the advantage of liquidity of his saving. The rate of interest on the demand side is governed by the liquidity preference of the community arises due to the necessity of … Unless we consider as equally important the different types of financial investments including money, we have no way of explaining the co-existence of different rates of interest. The Central Bank of the country may increase money supply to lower the rate of interest. In his theory of the rate of interest, Keynes considered the demand for money- liquidity preference—to be composed of the speculative demand for it only because the demand for cash balances arising out of the other two motives is comparatively insignificant in the determination of the rate of interest in the short run. Or if the rate of interest is already very low and the liquidity preference curve is infinitely interest- elastic (liquidity trap situation), the Central Bank’s increased money supply may entirely go to meet the demand for idle balances which in this situation is insatiable. The liquidity preference constitutes the demand for money. Everybody has an innate desire to hold his saving in the form of cash rather than in the form of interest or other income-bearing assets. Thus the theory explains that the rate of interest is determined at a point where the liquidity preference curve equals the supply of money curve. The demand for liquidity arises due to three motives. 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. LIQUIDITY PREFERENCE THEORY Definition (also called liquidity preference hypothesis) Observation that, all else being equal, people prefer to hold on to cash (liquidity) and that they will demand a premium for investing in non-liquid assets such as bonds, stocks and real estate. Both these motives form the first component of the demand for money and both are income-elastic. The purpose of this theis is to make an analysis of the liquidity preference theory of interest. Introduction to Keynes’s Liquidity – Preference Theory of Interest Rate: The Demand for Money or Liquidity Preference: Merits of Keynes’s Liquidity-Preference Theory. The perfect interchangeability of all units of money makes it impossible for the liquidity- preference theory to account for the phenomenon of diverse rates on the various parts of the credit market.”. 6. We may define the income period as the (typical) time interval elapsing between the dates at which mem- The speculative motive for liquidity- preference thus introduces a dynamic element in the Keynesian theory. If the rate of interest is high peoples demand for money (liquidity preference) is low. Our mission is to liberate knowledge. The speculative motive for money thus becomes a link between the present and the future. Therefore, the supply function of money is a straight line parallel to the ordinate (Y) axis, as is shown in Fig. In this figure, rate of interest is shown on the ordinate axis and the demand for money on the co-ordinate axis. Controlling in Management # Meaning, Definition, Types, Process, Steps and Techniques. LIQUIDITY PREFERENCE, INTEREST, AND MONEY 49 money rests; it is therefore necessary to analyze closely each source of demand and the factors that determine it. The changes in the demand for money for holding it to satisfy the speculative motive are due to the future uncertainty of the rate of interest; change in expectations about its future course causes a change in the speculative demand for money now. It does not give any place to such real factors as productivity and thrift. Firstly, Keynes’s theory is a monetary rather than a real theory. As water is liquid and it can be used for anything at will, so also money can be converted to anything immediately. The LP curve represents liquidity preference curve. Keynes’s liquidity-preference theory has some distinct merits over the classical theory. Keynes assumed that people hold either cash or bonds as wealth. The supply of money in existence consists of legal tender money, bank money and credit money. The rate of interest on the demand side is governed by the liquidity preference of the community arises due to the necessity of keeping cash for meeting certain requirements. It is a demand curve for money and slopes from left down to the right as shown in Fig. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity.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. 7.4 by the straight line SS. Before publishing your Articles on this site, please read the following pages: 1. Money commands universal acceptability. Everybody likes to hold assets in form of cash money. Clearly, greater is the turnover of business and the income there from, greater is the amount of cash a business firm will keep to satisfy its precautionary motive. theory, liquidity, interest, preference, explained. It ought into spotlight the role of money in the determination of the rate of interest. Keynes’s theory is to this extent much more dynamic and as such more realistic. Households need cash so as “to bridge the interval between the receipt of income and its expenditure.” Between the periods of receiving pay packets, house-holders have to enter into transactions for meeting their daily needs. Rate of interest would rise till it is at the level Or. Fourthly, the liquidity-preference theory, through its ‘liquidity trap hypothesis’ stresses the limitation of monetary and banking policy and its ineffectiveness during the period of depression. He did not agree with the neoclassical view that the rate of interest is determined in part by the marginal revenue productivity of capital due to its influence on the demand for investment. PreserveArticles.com is an online article publishing site that helps you to submit your knowledge so that it may be preserved for eternity. “Liquidity preference is the preference to have an equal amount j ^ of cash rather than claims against others.” -Prof. Mayers Determination of Interest: According to liquidity preference theory, interest is determined by the demand for and supply of money. The classical theory was devoid of any monetary influence because classicals would consider money only as a veil or a medium of exchange: the store of value function was entirely ignored. The total supply of money is fixed at a particular point of time. There is an excess supply of cash of the amount of M1S which people do not want to hold or which they like to invest in bonds and securities. This is because the liquidity preference on account of transaction motive and precautionary motives is stable and almost interest-inelastic while that for the speculative motive is specially sensitive to changes in the rate of interest. The exponents of the loanable funds theory duly incorporated the liquidity preference idea into their theory through their analysis of hoarding and dishoarding. Thirdly, Keynes’s theory helped integrate the theory of money to the general theory of output and employment. Purpose. This made it possible to build up a theory of income. Liquidity Preference Theory of Interest Rates. According to the liquidity preference theory of the term structure of interest rates, an increase in the yield on long-term corporate bonds versus short-term bonds could be due to _____. In other words, the demand for money is inversely related to the expected changes in the rate of interest. Liquidity Preference Theory This theory essentially says that investors are biased towards investing in short term bonds. To part with liquidity without there being any saving is meaningless. The equilibrium rate of interest is determined at that level. He called the demand for money ‘liquidity preference’. Prof. Fisher’s Time Preference Theory: Fisher’s Time Preference Theory is the modified theory of … That is why the speculative motive is important in the sense that speculative motive is interest elastic. we can also call this theory as Liquidity Preference theory. The keenness of the desire to hold money measures the extent of our anxiety about uncertainties of the future. However, the negative sloping liquidity preference curve becomes perfectly elastic at a low rate of interest. Whether it is an individual or a firm, for both the amount of cash money needed to satisfy their precautionary motive depends upon their income more than anything else. A particular amount of cash, therefore, has to be kept for making purchases. An individual may become unemployed; he may fall sick or may meet serious accident. Keynes considered rate of interest to be a purely monetary phenomenon determined by the demand for money and supply of money. But this will take place only if the level of liquidity preference remains where it is. It is on these motives that the level of demand for money or liquidity preference depends. The shape of liquidity preference curve is accounted for in Keynes’s analysis like this: When the market rate of interest is high, people expect it to fall in future and the prices of bonds and securities to go up. Keynes was of the opinion that factors like abstinence and time preference have nothing to do with the payment of rate of interest. Thus we see that the Keynesian explanation of the determination of the rate of interest was all in terms of monetary factors. This inverse relationship between the market rate of interest and the price of a bond or security can be accounted for and illustrated like this. Despite some flaws in Keynes’s treatment of money and the rate of interest, we cannot minimize the importance of Keynes’s valuable contribution to the apparatus and policy about rate of interest. hoarding. The demand for money for transactions by firms also depends upon the income, the general level of business activity and the manner of the receipt of income. Similarly, businessmen also hold cash to safeguard against the uncertainties of their business. Share Your Word File Suppose the rate of interest is Or2 at which money demand is OM2 while the supply is OS. If the expectations of the public change and cause an upward shift of the liquidity schedule or curve, the rate of interest may remain where it is. Money is the most liquid assets. The classical economists' conclusion that nominal income is determined by movements in the money supply rested on their belief that _____ could be treated as ____. If there is no liquidity preference, this theory will not hold good. According to the theory of liquidity preference, the supply and demand for real money balances determine what interest rate prevails in the economy. #2 – Liquidity Preference Theory 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 associated with the investment. Keynes, thus, presented a comprehensive analysis of the monetary sector. 800/- newly floated by a company will bring 40 rupees per annum while the old bond of the face value of Rs. If the prices of bonds and securities are expected to rise speculative will like to buy them. The fact that prices of bonds change inversely with rate of interest is clear. In figure 7 .4 money supply is given as OS and the level of liquidity preference by the curve LPC. Supply of money, at a particular time, is given to the economy by the government and the credit-creating power of the banks. A fundamental fact noted in the capital market is that the prices of bonds and securities change inversely with the change in the rate of interest. Keynes proposes two theories of liquidity preference (i.e. This speculative propensity of the people can be satisfied only with cash and it depends upon expected changes in the prices of bonds and securities. The total supply of money is represented by a vertical line Ms. PreserveArticles.com: Preserving Your Articles for Eternity, Brief note on Liquidity Preference Theory of Interest, Brief Notes on the Keynes’ Liquidity Preference Theory of Interest. Keynes propounded his theory of interest called the Liquidity Preference Theory. Classical Theory of Interest Rates. 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