Keynes’ Liquidity Preference Theory of Rate of Interest

The Liquidity Preference Theory of interest rates, also known as Keynesian theory of interest rates, was developed by John Maynard Keynes, one of the most influential economists of the 20th century. According to this theory, the interest rate is determined by the demand for and supply of money, and the preference of individuals for liquidity. The theory is based on the idea that individuals prefer to hold their wealth in liquid form, such as cash, rather than in illiquid forms, such as bonds or other financial assets.

Keynes argued that the demand for money was determined by the level of economic activity and the level of income in the economy. When the economy is in a state of recession or depression, the demand for money increases because people want to hold more liquid assets due to uncertainty about their future income. On the other hand, when the economy is in a state of expansion, the demand for money decreases because people are more willing to invest in productive assets.

The supply of money is determined by the monetary authority, such as the central bank, through its control over the money supply. The central bank can increase or decrease the supply of money through its monetary policy tools such as open market operations, discount rate changes, and reserve requirements.

According to the Liquidity Preference Theory, the interest rate is determined by the equilibrium between the demand for and supply of money. If the demand for money is high relative to the supply of money, the interest rate will be high. Conversely, if the supply of money is high relative to the demand for money, the interest rate will be low.

The Liquidity Preference Theory suggests that there is a natural rate of interest that equilibrates the demand for and supply of money. The natural rate of interest is the interest rate that would exist in a perfectly competitive economy with no inflation or deflation. The actual interest rate will fluctuate around the natural rate of interest based on changes in the demand for and supply of money.

The Liquidity Preference Theory has important policy implications. Keynes argued that in times of economic recession or depression, monetary policy should be used to increase the money supply and lower interest rates in order to stimulate economic activity. In contrast, during times of economic expansion, monetary policy should be used to decrease the money supply and raise interest rates to prevent inflation.

Overall, the Liquidity Preference Theory of interest rates is an important contribution to economic theory and continues to influence monetary policy decisions today.