The liquidity preference theory of Interest has been propounded by J.M. Keynes. According to him, “Interest is the reward for parting with liquidity.” In the words of Keynes interest is a monetary phenomenon. Liquidity means the convenience of holding cash. Liquidity preference means desire to hold cash. This is inherent in human nature. Everyone in this world likes to have money with him for a number of purposes. This constitutes his demand for money to hold.
According to Keynes, demand for money or liquidity preference is based on three motives.
1. Transactions Motive:
People like to hold some cash in order to meet their daily expenses in the interval between the receipt of income and its expenditure. Businessmen have also to meet routine expenses of transport, raw materials, wages etc. The cash held by people under this motive depends upon the level of income and business activity. The transactions motive is income elastic, but interest inelastic.
2. Precautionary Motive:
Every one lays something against a rainy day Future is always uncertain. Hence people require cash to meet unforeseen contingencies like unemployment, sickness, accident etc. the demand for precautionary motive depends on the level of income and nature of the people. This motive is also income elastic, but interest inelastic.
3. Speculative Motive:
This motive relates to the demand for money to earn profits. Future is uncertain and unpredictable. Rate of interest in the market continues changing. No one can guess what turn the change will take. But everybody hopes with confidence that his guess is likely to be correct. It may or may not be so. Some money therefore is kept to speculate on these probable changes to earn profit. The demand for cash for the two motives is limited and is not affected much by the rate of interest. Speculative demand for money and interest are inversely related. At higher rate of interest people keep less cash, purchase more bonds, and vice versa. At a very low rate of interest, the liquidity preference of the people is unlimited. This implies that people lend nothing and keep everything in cash. This is what Keynes calls Liquidity Trap.