Keynes’ Liquidity Preference Theory of Rate of Interest was propounded by John Maynard Keynes in his famous book The General Theory of Employment, Interest and Money. According to Keynes, the rate of interest is not determined by savings and investment, as explained by classical economists, but by the demand for and supply of money.
Keynes defined the rate of interest as the reward for parting with liquidity. Liquidity means holding wealth in the form of cash or money which can be easily used for transactions. People prefer liquidity because money provides security, convenience, and flexibility. Therefore, interest is the price paid for giving up this liquidity.
Concept of Liquidity Preference
Liquidity preference refers to the desire of people to hold money instead of investing it in bonds or other interest-earning assets. People hold money for various reasons, and this preference for holding money plays a crucial role in determining the rate of interest.
According to Keynes, individuals allocate their wealth between money (which gives liquidity but no interest) and bonds (which give interest but are less liquid). The higher the preference for liquidity, the more money people want to hold, and the higher the rate of interest required to persuade them to part with money.
Motives for Holding Money
Keynes identified three main motives for holding money. These motives explain why people demand money and form the basis of liquidity preference.
The first motive is the transaction motive. People need money to carry out day-to-day transactions such as buying goods and services. This demand for money depends mainly on the level of income and the volume of business activity. As income increases, transaction demand for money also increases. This part of money demand is not very sensitive to changes in the rate of interest.
The second motive is the precautionary motive. People hold money to meet unforeseen contingencies such as medical emergencies, accidents, or unexpected expenses. Like transaction demand, precautionary demand for money also depends on income levels and economic conditions. It is also relatively insensitive to changes in the rate of interest.
The third motive is the speculative motive, which is the most important from the examination point of view. People hold money under the speculative motive to take advantage of future changes in the rate of interest and bond prices. When interest rates are high, bond prices are low, and people expect interest rates to fall in the future. In such a situation, they prefer to hold bonds rather than money. When interest rates are low, bond prices are high, and people expect interest rates to rise in the future. To avoid capital loss, they prefer to hold money instead of bonds.
Thus, speculative demand for money is inversely related to the rate of interest and plays a key role in determining the interest rate in the economy.
Supply of Money
In Keynes’ theory, the supply of money is assumed to be fixed and controlled by the central bank. It is determined by monetary authorities such as the Reserve Bank of India and does not depend on the rate of interest.
The supply of money includes currency with the public and demand deposits with banks. Since the supply of money is fixed at any point in time, it is represented by a vertical line in a diagrammatic explanation.
Determination of Rate of Interest
According to Keynes, the rate of interest is determined at the point where the demand for money (liquidity preference) equals the supply of money.
The demand for money curve slopes downward due to the speculative motive. At higher rates of interest, people prefer to hold bonds rather than money, so demand for money is low. At lower rates of interest, people prefer to hold money, so demand for money increases.
The intersection of the money demand curve and the money supply curve determines the equilibrium rate of interest. If the rate of interest is higher than the equilibrium level, demand for money will be less than supply, leading people to buy bonds. This increases bond prices and reduces the rate of interest. If the rate of interest is lower than equilibrium, demand for money exceeds supply, leading people to sell bonds, lowering bond prices and raising the rate of interest. Thus, the equilibrium rate of interest is stable.
Liquidity Trap
One of the most significant contributions of Keynes is the concept of the liquidity trap. A liquidity trap occurs when the rate of interest falls to a very low level, and people expect it to rise in the future. In such a situation, people prefer to hold all additional money in cash rather than investing in bonds.
Under a liquidity trap, the demand for money becomes perfectly elastic, and monetary policy becomes ineffective. Even if the central bank increases the supply of money, it does not lead to a fall in the rate of interest or an increase in investment. This situation is particularly relevant during deep recessions or economic depressions.
Criticism of Liquidity Preference Theory
Although Keynes’ theory is widely accepted, it has certain limitations.
One criticism is that Keynes overemphasised the role of money and ignored the role of savings in determining the rate of interest. Critics argue that savings and investment also influence interest rates in the long run.
Another criticism is that the assumption of a fixed money supply is unrealistic, as modern central banks actively adjust money supply and interest rates.
Some economists also argue that the theory explains only short-term interest rates and not long-term rates, which are influenced by additional factors such as inflation expectations and government borrowing.
Importance for Banking and Monetary Policy
For banking professionals, Keynes’ Liquidity Preference Theory is extremely important. It helps in understanding how interest rates respond to changes in money supply and liquidity conditions. Central banks use this theory while formulating monetary policy, especially during economic slowdowns.
In India, RBI’s liquidity management tools such as repo rate, reverse repo rate, open market operations, and liquidity adjustment facility are closely linked to liquidity preference and interest rate behaviour.
Conclusion
In conclusion, Keynes’ Liquidity Preference Theory explains the determination of the rate of interest through the demand for and supply of money. The rate of interest is viewed as the reward for parting with liquidity, rather than as a reward for saving. The theory highlights the importance of speculative demand for money and introduces the concept of liquidity trap.