The liquidity preference theory of interest explained

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According to Keynes interest is purely a monetary phenomenon because rate of interest is calculated in terms of money. It is a monetary phenomenon in the sense that rate of interest is determined by the supply of and demand for money, Keynes defined interest as the reward for parting with liquidity for specified time.

What is liquidity preference:-

Liquidity means shift ability without loss. It refers to easy convertibility. Money is the most liquid assets. Money commands universal acceptability. Everybody likes to hold assets in form of cash money. If at all they surrender this liquidity they must be paid interest. As water is liquid and it can be used for anything at will, so also money can be converted to anything immediately.

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Other costly assets like gold and landed property may be valuable but they cannot be shifted at will. Thus they lack liquidity. As money are highly liquid people to hold money with than in form of Cash. This preference according to Keynes is popularly called liquidity preference. Thus according to Keynes interest is the price paid for surrendering their liquid assets. Greater the liquidity preference higher shall be the rate of interest. The liquidity preference constitutes the demand for money.

According Keynes rate of interest is demand by the supply of and demand for 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. The demand for liquidity arises due to three motives.

Demand for money:

(a) The transaction motive:-

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An individual for his day to day transaction demand money. A man has to buy food and medicines in his day to day life. For this purpose people want to keep some cash with them. The amount of cash which an individual will require to keep in his possession depends on two factors (i) the size of personal income and (ii) the length of the time between pay-days. The richer a community the greater the demand for transaction motive.

(b) The precautionary motive:

People demand to hold money with them to meet the unforeseen contingencies. An individual may become unemployed; he may fall sick or may meet serious accident. For all these misfortune, he demands money to hold with him. The amount of money under the precautionary motive depends on the individual’s condition, economic as well as political which he lives. Thus the demand for money under this motive depends on size of income, nature of the person and farsightedness.

(c) Speculative motive:

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Under speculative motive people want to keep each with them to take advantage of the charges in the price of bonds and securities. People under speculative motive hold money in order to secure profit from the future speculation of the bond market. If the prices of bonds and securities are expected to rise speculative will like to buy them. In such a situation the demand to hold cash diminishes. Thus liquidity preference will be more at lower interest rates.

Money under the above three motives constitute the demand for money. An increase in the demand for money leads to a rise in the late of interest, a decrease in the demand for money leads to a fall in the rate of interest. According to Keynes the first two motives for liquidity preference namely the transaction and precautionary are interest inelastic. That is why the speculative motive is important in the sense that speculative motive is interest elastic.

Supply money:

The supply of money is different from the supply of ordinary commodity. The supply of commodity is a flow whereas the supply of money is a stock. The aggregate supply of money in a community at any time is the sum of money stock of all the members of the society. The supply of money is controlled by the govt. The supply of money in existence consists of legal tender money, bank money and credit money. The supply of money is determined by the central bank of a country. The total supply of money is fixed at a particular point of time. The supply of money is not influenced by the rate of interest.

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Equilibrium rate of interest:

The rate of interest is determined by the demand for money and supply of money. The equilibrium rate of interest is fixed at that point where supply of and demands for money are equal. If the rate of interest is high peoples demand for money (liquidity preference) is low. The liquidity preference function or demand curve states that when interest rate falls, the demand to hold money increases and when interest rate raises the demand for money, diminishes. The determination of the rate of interest can be better explained in the shop.

In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. The LP curve represents liquidity preference curve. This curve represents the demand for money at various rate of interest. The total supply of money is represented by a vertical line Ms. The equilibrium rate of interest is determined at that level. Where the demand for money is equal to supply of money. Given the demand for money when supply of money rises, rate of interest falls to OR. With a fall in money supply rate of interest rises. Similarly the liquidity preference may change given the supply of money. When liquidity preference shifts upward, given the supply money at the level on the rate of interest rises to the level OQ. Thus according to Keynes interact is purely a monetary phenomenon.

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