Interest is regarded by Keynes as a purely monetary phenomenon in the sense that the rate of interest is determined by the interaction of the demand for and supply of money.
The demand for liquidity together with supply of money determines the interest rate. Interest is the reward paid for parting with liquidity, i.e., giving up the cash balances held.
Thus, the rate of interest according to Keynes is determined by the intersection of the supply schedule of money (the total quantity of money) and the demand schedule for money (the liquidity preference).
The demand for money is a demand for liquidity the liquidity preference schedule. The concept of liquidity preference implies the preference of the people to hold wealth in the form of liquid cash rather than in other non-liquid forms like bonds, securities, bills of exchange, land, gold, etc.
The demand for money, according to Keynes, is thus demand to hold money - cash balances.
The composite demand for money is divided into two principal demands, namely (i) demand for money as a medium of exchange (active cash balance), and (ii) demand for money as a store of wealth (idle cash balance).
Now the demand for money as a medium of exchange is motivated by the necessities of transactions and precaution, while the demand for money as a store of wealth is prompted by speculation.
Thus, there are three motives which lead to liquidity preference: (1) the transactions motive, (2) the speculative motive, (3) the precautionary motive.
In the liquidity function, however, it is postulated by Keynes that the demand for money is positively correlated with income an increase in the level of incomes implies a rise in the demand for money, and vice versa.
On the other hand, it is negatively correlated with the rate of interest a rise in the rate of interest reduces the demand for money or, in other words, an increase in the demand for money leads to a rise in the rate of interest, and vice versa.
To express in symbolic terms:
Let, L stand for the total demand for money.
Liquidity preference arising from speculative motives may symbolically be expressed as L 2 , as distinguished from L 1 , i.e., demand for money under transactions plus precautionary motives. L is income-determined and interest-inelastic, whereas L 2 is interest-elastic and income-determining.
L = L 1 + L 2
Now, let M be the total supply of money, M 1 the total quantity of money held by people for transactions and precautionary motives. M 2 the quantity of money held for speculative purposes, Y be the level of income and r be the rate of interest. Then we have:
M 1 = L 1 (y) (1) (Liquidity function relating to transactions and precautions demand for money).
M 2 = L 2 (r) (2) (Liquidity function relating to speculative demand).
The complete liquidity function is:
M = M 1 + M 2 = L 1 (y) + L 2 (r) or if
L = L 1 + L 2 ,
M = L(r,y) then,
M = L(r,y) tells us that the total quantity of money in existence at any time equals the quantity of money held which depends on the rate of interest and the level of income.
The equation, M = M 1 + M 2 is a convenient reminder that the total demand for money is in fact subdivided into a partial demand for "active" money and a partial demand for "idle" money or what is the same thing, into the demand for money as a "medium of exchange" and the demand for money as a "store of wealth." [M = L (r,y)].
Liquidity Preference Schedule:
The liquidity preference schedule expresses the financial relation between the amount of money demanded for all liquidity motives and the rate of interest. The demand for money or the liquidity function can be conveniently explained diagrammatically.
In the liquidity function is generally downward sloping; indicating that the amount of money demanded for liquidity purposes is a decreasing function of the rate of interest. For, the community is ordinarily willing to hold more money at a low rate of interest than at a high rate of interest.
It shows that when there is an upward shift in the entire liquidity function as (LP 1 , LP 2 , LP 3 ) owing to change in the level of income affecting the community's expectations regarding the advantages of holding liquid assets, the amount of money demanded for liquidity purposes increases from OQ 1 to OQ 2 at the prevailing rate of interest OR.
Determination of Interest Rate:
According to the liquidity preference theory, the equilibrium rate of interest is determined by the interaction between the liquidity preference function (the demand for money) and the supply of money, as represented. In the OR is the equilibrium rate of interest.
The theory further states that any change in the liquidity preference function (LP) or change in money supply or change in both respectively cause changes in the rate of interest.
If given the money supply, the liquidity preference curve (LP) shifts from LP 1 to LP 2 implying thereby an increase in demand for money; the equilibrium rate of interest also rises from R 1 to R 2 .
Similarly, assuming a given liquidity preference function (LP), when the money supply increases from M 1 to M 2 , the rate of interest falls from R 1 to R 2
The following major criticisms have been levelled against the liquidity preference theory of interest:
1. Prof. Hansen maintains that the Keynesian theory of interest rate, like the classical theory, is indeterminate. In the Keynesian version, the liquidity preference function will shift up or down with changes in the level of income.
Particularly, L 1 (i.e., liquidity preference for transactions and out of precautionary motives), being the function of income, we already know the income level. And, to know the level of income, we must know the rate of interest.
Thus, Keynes' criticism of the classical theory applies equally to his own theory. It is interesting to note here that Professor Hansen considers the loanable funds version as well as the liquidity preference theory, inadequate.
But, in his view, loanable funds formulation and the Keynesian formulation, taken together, do supply us with an adequate theory of interest.
2. According to Hazlitt, the Keynesian theory of interest is one-sided since it ignores the real factors in the determination of the rate of interest.
Keynes considered interest to be a purely monetary phenomenon and refused to believe that real factors like productivity and time preference had any influence on the rate of interest.
Similarly, the classicists also were wrong in considering interest purely as a real phenomenon, and ignoring the monetary factors.
3. Keynes ignored the element of saving when he considered interest as a reward for parting with liquidity. Professor Jacob Viner points out that "Without saving there can be no liquidity to surrender.
The rate of interest is the return for saving without liquidity." Hence, it is incorrect to ignore the impact of the saving factor in the determination of the rate of interest.
4. The liquidity preference version is clearly wrong. It goes directly contrary to the facts that it presumes to explain.
According to the theory, the rate of interest should be the highest at the bottom of a depression when, due to falling prices or rising value of money, people have strong liquidity preference.
On the contrary, the rate of interest is found to be the lowest at the bottom of a depression.
5. The concept of liquidity preference in the theory of interest is vague and confusing. For instance, if a man holds funds in the form of time-deposits, he will be paid interest on them; therefore, he is getting both, i.e., interest-cum-liquidity.
6. For some critics, Keynes' liquidity preference theory of interest is too narrow in scope.
In their view, the desire for liquidity an important factor in determining the rate of interest arises not only from the three main motives (transactions, precautionary and speculative) mentioned by Keynes, but also from several other factors not stressed by him.
7. Some critics opine that interest is not a reward for parting with liquidity as stressed by Keynes. In their view, interest is the reward paid to the lender for the productivity of capital. Ac such, interest is paid because capital is productive.
8. In Keynesian theory, the rate of interest is regarded independent of the demand for investment funds. Critics point out that this is unrealistic.
The cash balances of the entrepreneurial class are largely influenced by their demand for capital for purpose of investment.
The demand for capital being dependent upon the marginal productivity of capital, the rate of interest is not determined independently of the marginal efficiency of capital or the demand for investment funds.
9. Keynesian theory concentrates only on the short run and ignores the long period. But, for capital investment, it is a long-term rather than a short- term rate of interest which is really significant.