LIQUIDITY PREFERENCE THEORY

In macroeconomic theory liquidity preference refers to the demand for money considered as liquidity. The concept was first developed by John Maynard Keynes in his book the general theory of employment, interest and money to explain determination of the interest rate by the supply and demand for money.

The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. He argues that interest rate cannot be a reward for saving as such because, if a person holds his saving in cash, keeping it under his mattress he will receive no interest. Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. According to him, the rate of interest is determined by the demand for and supply of money.

Liquidity preference means the desire of the public to hold cash. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive.

1: Transaction motive: people prefer to liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income. The higher the income the more money demanded for carrying out increased spending.

2: The precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.

3: speculative motive: people retain liquidity to speculate that bond price will fall. When the interest rate decreases people demand more money to hold until the interest rate decreases, which would drive down the price of as existing bond to keep its yield in line with the interest rate. Thus the lower the interest rate, the more money demanded and vice versa.

According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as

M₂ = L₂ (r)

Where, L₂ is the speculative demand for money, and

r is the rate of interest.

Geometrically, it is a smooth curve which slopes downward from left to right.

Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M₁ and the speculative motive by M₂, then

M = M₁ + M₂. Since M₁ = L₁ (Y) and M₂ = L₂ (r), the total liquidity preference function is expressed as M = L (Y, r).

Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line.

Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money.  In the following figure, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curve intersects at E₂ where the equilibrium rate of interest OR is established.

If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E₂ will be re-established.

At the point E₁ the supply of money OM is greater than the demand for money OM₁. Consequently, the rate of interest will start declining from OR₁ till the equilibrium rate of interest OR is reached. Similarly at OR₂ level of interest rate, the demand for money OM₂ is greater than the supply of money OM. As a result, the rate of interest OR₂ will start rising till it reaches the equilibrium rate OR.

It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise.

Criticisms: Keynes theory of interest has been criticized on the following grounds:

1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest.

2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds.

3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time.

4. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless.

5. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run.

6. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is.