Keynesian Theory of Interest Rate Determination

Liquidity Preference Theory of Interest Rate

The Liquidity Preference Theory of Interest was introduced by J.M. Keynes in his book “The General Theory of Employment, Interest and Money.” Keynes rejected the classical view that interest is a reward for saving. According to him, interest is the reward for parting with liquidity.

Meaning of Liquidity Preference Theory

Liquidity Preference refers to the desire of people to hold money in liquid form for various purposes. People demand money because it is the most liquid form of asset and can be used anytime.

Determination of Rate of Interest

According to Keynes, the rate of interest is determined by the interaction between Liquidity Preference (Demand for Money, $M_d$) and the Supply of Money ($M_s$).

• Demand for Money ($M_d$) depends on people’s desire to hold money.
• Supply of Money ($M_s$) is fixed by the central bank (RBI).
• The equilibrium interest rate is determined where $M_d = M_s$.

Key Ideas of the Theory

1. Interest is treated as the price paid for using money.
2. The rate of interest is determined by the demand and supply of money.
3. Supply of Money consists of money in circulation plus bank deposits in a country. It is generally fixed by the monetary authority (RBI).
4. Demand for Money arises because people want to keep money in liquid form for use at any time.
5. Individuals and firms need cash for daily expenses and emergencies.
6. People who need money are ready to pay interest, and people who have money will lend it only when rewarded with interest.

Motives of Demand for Money (According to Keynes)

1. Transaction Motive

People hold money to carry out day-to-day transactions like buying goods, paying bills, or meeting regular expenses. This demand depends on three factors:

• Size of income
• Frequency of income received
• Spending habits or mode of expenditure

2. Precautionary Motive

People hold money to face future uncertainties like illness, accidents, emergencies, business risks, or unexpected expenses. This demand also depends directly on income and is not affected by the rate of interest. Formula: $L_p = F(y)$

3. Speculative Motive

People hold money to take advantage of future investment opportunities. After fulfilling transaction and precautionary needs, the extra cash is kept for speculative purposes such as buying shares or bonds at the right time. This demand depends on the rate of interest; the lower the interest, the more money people hold in hand instead of investing. Formula: $L_s = F(roi)$