Liquidity Preference Theory: Keynes' Interest Rate Model

The Liquidity Preference Theory of Interest

The Liquidity Preference Theory, presented by J.M. Keynes in 1936, is a highly regarded theory. According to Keynes, the rate of interest is a purely monetary phenomenon. It represents the reward for relinquishing liquidity for a specific period.

Thus, similar to the price of a commodity, the rate of interest is determined by the demand for and the supply of money. Therefore, it is necessary to introduce the concepts of demand for money and supply of money.

The supply of money refers to the stock of money in circulation and is a fixed quantity at a particular point in time. It is the sum of currency (notes and coins) and commercial bank deposits. It remains fixed in the short run because it is determined and controlled by the central bank of a country.

Therefore, it plays a passive role in interest rate determination. By contrast, the demand for money plays an active role in determining the equilibrium rate of interest. Therefore, a background knowledge of demand for money is essential in order to understand Keynes’ theory.

1. Transactions Motive

Individuals and business firms hold money in order to carry out day-to-day transactions.

Each individual or firm experiences a time gap between receipts (income) and payments (expenditure) and will need to hold money to cover this gap.

The average amount held will depend primarily on the system of payments, i.e., on the frequency of the receipts. For example, if a weekly paid person receives Rs. 300 a week and spends it all by the next pay-day, their average cash holding is Rs. 150, i.e., the amount they had at the beginning (Rs. 300) and the amount they have at the end (zero), divided by 2. If they receive a monthly salary of Rs. 1,200 then, assuming that their spending habits do not alter, their average cash holding will rise to Rs. 600, i.e., (Rs. 1200 + 0) ÷ 2.

The amount of cash held for transactions and precautionary purposes also depends on incomes and prices. If income increases, then more money will be held. Similarly, if prices rise, more money will be required to purchase the same amount of goods and services.

2. Precautionary Motive

People and business firms hold some money as a reserve to meet unforeseen contingencies, such as sickness or accidents, or the need to take advantage of an opportunity to buy something which is being offered at a specially reduced price for only a limited period, e.g., during a sale.

3. Speculative Motive

The classical economists considered it irrational for people to hold wealth in the form of money other than that held for transactions and/or precautionary purposes. This is because any money left over could be invested in interest-earning assets like bonds. Keynes, however, argued that it was not necessarily irrational to hold idle money balances.

He pointed out that at times it might be preferable to hold idle money (cash) than to buy government securities (bonds). If a person holds money, they lose interest but do not suffer capital loss (due to a fall in the value of their assets) either. In fact, it costs money to hold money. Therefore, the rate of interest is called the opportunity cost of money holding. By holding money, an individual loses the opportunity to earn interest.