Liquidity Preference Theory of Interest by Keynes
Keynes bases his approach to the desire for money on two crucial functions. They are:
- The means of trade
- Store of value
Total Cash Balances = The active cash balance (transaction demand and precautionary demand) + the idle cash balance (Speculative Demand of Money)
It has to do with how individuals and businesses need a positive cash flow for their ongoing activities. Everyone keeps money on hand to close the gap between the receipt of income and expenditure. Many requests, for this reason, are based on the amount and frequency of an individual's income.
In this article, we will discuss the liquidity preference theory of Keynes. Let's begin.
According to Keynes, the supply and demand for money determine the rate of interest. Since the real theory of the classical is different from this theory, we refer it to as the monetary theory of interest.
Supply of Money: The total amount of money available in the nation at any given time for all uses is considered one of the two factors determining the interest rate. For monetary authorities, the supply of money is taken to be fixed, or totally inelastic, even if it is partially a function of the rate of interest.
Demand for Money: Keynes introduced the term "liquidity preference," by which his theory of interest is generally known, to describe the second determinant, the demand for money. Liquidity is the preference for holding cash. The amount of interest required in exchange for cash "measures the degree of our disquietude," while the amount of cash itself "lulls our disquietude." The premium that must be paid to persuade people to retain wealth in a form other than cash hoarding, in Keynes' words, is the rate of interest. The interest rate that must be provided to cash holders to persuade them to leave with their liquid assets will increase as the liquidity preference rises. Cash holders' interest rates will decrease in proportion to their preference.
Keynes asserts that people want to maintain liquid currency for three reasons:
(1) the transaction motive,
(2) the precautionary motive, and
(3) the speculative motive.
1. Transactional Motive:
The "need for cash for the current transactions of household and business exchanges" is the transaction motive. It is further separated into commercial objectives. The business motive is the "interval between the time of incurring business charges and that of the receiving of the sale revenues," much like the income motive is "meant to bridge the interval between the receipt of income and its disposal." People will hold less cash on hand for current transactions if there is a short period between incurring expenses and receiving revenue, and the opposite is true. However, based on the expected income, the beneficiaries, and the businesspeople, there will be adjustments in the money demands for transactions. Factors, including income level, employment, influenced them, pricing, business turnover, the typical time between receiving and disbursing revenue, the size of the wage or income, and the likelihood of getting a loan. The demand for money to complete the transaction rises with income level and vice versa.
Transaction motive is not impacted by the interest rate. i.e., inelastic interest rates Lt = Kt(Y), where Y stands for income, Kt is the fraction of money society (households or businesses) wants to hold, and Lt represents the transaction demands of money.
2. Precautionary motive:
We refer the desire of people and businesses to keep money on hand in case of unforeseen contingencies to as the precautionary reason for holding money. Both private individuals and business owners maintain cash on hand to cover unforeseen expenses. People keep some cash on hand to cover unanticipated events like illness, accidents, unemployment, and other emergencies. Businessmen similarly hoard funds to profit from unforeseen opportunities or weather adverse circumstances. "Money held for the sake of caution is rather like water held back in a water tank." The amount of money needed as a precaution relies on several factors, including income level, business activity, the potential for unforeseen profitable agreements, accessibility to cash, the cost of maintaining liquid assets in bank reserves, etc. According to Keynes, income is highly elastic, while transactions and precautionary impulses are relatively uninteresting and inelastic.
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3. Speculative motives:
It refers to the sum of money that individuals wish to keep in a liquid state to profit from market swings resulting from potential future changes in bond prices or interest rates. This goal involves using the money to trade bonds for speculative returns. After setting aside enough for transactions and safety measures like profiting from bond investments, people and business owners have money. A liquid store of value, money held for speculative purposes can be invested in interest-bearing bonds or assets at the right time.
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According to Keynes, the speculative demand for money is determined by predictions about changes in bond prices or the present market rate of interest. The speculative demand for money is the declining function of the interest rate to the issue of expectations about a safe future interest rate. The speculative desire for money decreases with an increase in interest rates and increases with a decrease in interest rates. We expressed algebraically the speculative demand for money as L2 = f(i), where f is the speculative demand for money and i is the interest rate.
However, the speculative demand for money becomes fully elastic at a very low-interest rate, like 2%. One of the key characteristics of the L curve is that it becomes fully elastic when the interest decreases to a very low level. People won't lend money to one another because of the exceptionally low-interest rate, which means they will keep all of their money in cash rather than invest in bonds when interest rates are extremely low. It further suggests that the interest rate cannot be cut. A LIQUIDITY TRAP is a name for this characteristic of liquidity preference.
The Overall Need for Money
If L stands for the entire amount of liquid money, L1 for the transactions plus the precautionary motive, and L2 for the speculative holding motive, then L = L1 + L2. We represent the total liquidity preference function as L = L(Y, r) since L1 = L1 (Y) and L2 = L2 (r). L2 is inactive or passive money, whereas L1 is money that is in circulation. Even though the function of income is L1 and the function of interest is L2, we cannot keep them in watertight containers. At high-interest rates, even L1 exhibits interest elasticity. Transferring money from unused balances means the demand for L1 can be met if it rises.