Liquidity Preference Theory of Interest
The liquidity preference theory of interest was developed by J. M. Keynes in his book "General Theory of Employment, Interest and Money' published in 1936 AD. This theory is also popularly known as Keynes on the theory of interest.
According to keyness "interest is the reward parting with liquidity for a specific period of time. for him, interest is purely a monetary phenomenon. This theory states that interest rate is determined by the intersection of demand for and supply of money.
1. Demand for Money
There are three motives for the demand for money. they are as follows.
i.Transaction motive:
Money is demanded in day-to-day transactions. This type of demand for money is income elastic but interest inelastic. This implies that there is a positive relationship between income and transaction demand for money but transaction demand for money does not depend upon interest rate.
ii. Precautionary motives:
precautionary motive refers to the people's desire to hold cash balances in order to meet emergencies and unforeseen crises such as sickness accidents, unemployment, etc. This type of demand for money is also income elastic and interest inelastic.
iii. Speculative motive :
speculative demand for money refers to the demand for hoarding certain cash in reserve to make speculative gains out of the purchase and sells of bonds and securities through future changes in the rate of interest. There is a negative relationship between the rate of interest and bond price.
2. Supply Of Money
supply of money is determined by the central bank and it is assumed to be constant or fixed in the short run. This implies that money Supply is interest inelastic i.e change in interest rate does not affect money supply.
When demand for money and supply of money is equal, the interest rate is determined which is explained graphically as follows
In the figure, Dm curve represents the demand for money curve which is downward sloping due to the negative relationship between interest rate and money demand.SM curve represents the money supply curve which is vertical (or parallel to Y-axis) because it is assumed to be fixed in the short run. These two curves interest each other at point E where equilibrium occurs. hence, the equilibrium amount of money is OM and the rate of interest is or. if the central bank increases the money supply the supply of money curve SM shifts to S1M1. this causes the rate of interest to fall from OR to OR1.
Criticisms
1. Real factors ignored:
This theory has completed ignored the influences of real factors in the determination of interest.
2. Elements of saving ignored:
Keynes ignored the elements of saving but without previous saving, there can not be liquidity to part with.
3. Short period analysis:
This theory is a short-run analysis of the determination of the rate of interest, it does not tell how the interest rate is determined in long run.
4. Productivity of capital :
productivity of capital is ignored in this analysis.
5. Variation of interest rate not explained:
This theory can not explain why interest rates vary from person to person, place to place, and for different periods.