According to Keynes, money is demanded because of three motives -transaction, precautionary and speculative. The first two motives provide yield of convenience and certainty. The third motive provides money yield. Keynes has termed demand for money as liquidity preference.
(i) The Transaction Motive:
People like to keep their money in liquid form (cash) to meet their day-to-day expenses during the period between the receipt and spending of their money. The necessity for liquidity on this account arises to bridge the gap between the receipt of incomes and its spending.
An individual or a firm receives income at a particular fixed time while its spending is spread over a period of time and in order to meet these expenses, as and when they arise money in cash is needed. The amount of money which an individual needs for such expenses depends upon his income. This motive for liquidity has been called by Keynes as ‘transaction motive*. Liquidity preference on account of this motive is interest-inelastic.
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(ii) The Precautionary Motive:
Besides day-to-day transactions, there are many unforeseen contingencies in the life of individuals for which they hold money. The desire of the people for holding money under the precautionary motive is devoted to fulfill the function of a store of value. It may be compared with a water tank. As there must be some water in the tank always for one does not know when and for what purpose it may be needed.
Similarly, one must have some cash always, for this may be needed at any moment for rainy days like unemployment, sickness, disablement etc. Thus, liquidity preference which exists for unforeseen exigencies of life constitutes precautionary motive. The amount needed in this way depends upon the income of the individual. Liquidity preference on this account is also interest-inelastic.
(iii) The Speculative Motive:
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The third and the last motive for liquidity preference is the desire to earn profits. Many people may think that the rate of interest in the future will be higher and in order to take advantage of this future increase in the rate of interest, they may like to keep money in the liquid form to be invested in securities when the rates of interest actually rise. In the opposite case when the feeling is that interest rates would decline, they will invest in the present thus reducing the liquidity of money with them. Keynes has called this as ‘Speculative Motive’.
Price of bonds and rate of interest are inversely related. If the rate of interest is higher, the price bond would be low and vice-versa. This can be explained with the help of an example. Say a bond of Rs. 100 has been issued which will carry 5% interest. This implies that whatever may be the price of bond but its holder will get a return of Rs. 5, essentially.
Now say the rate of interest goes upto Rs. 6, and then Rs. 83.3 as the price of bond will ensure a return of Rs. 5. On the other hand, if the rate of interest declines to Rs. 4, then Rs. 125 as the price of bond will ensure a return of Rs. 5. Therefore, it is clear when rate of interest goes up, price of bond goes down and vice-versa.
Now the question arises as to how much one should keep money in cash or should invest in bonds and securities. If one speculates that the rate of interest would be low in future (means a rise in the price of bonds), he would hold money in cash at present with a view to earn profits by investing in bonds in future.
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On the other hand, if he expects that in future rate of interest would be higher (this means a decline in the price bonds) demand for holding cash at present would decline. Thus, if the speculated rate of interest is low, the demand for money would be higher and vice-versa.
Keynes has attached the maximum importance to liquidity preference for speculative purpose. Liquidity preference for first two motives generally remains fixed. It depends upon the level of income and is interest inelastic. On the other hand, demand for money or liquidity preference for speculative motive is interest elastic, i.e., the function of interest.