Explain Keynes liquidity preference theory of interest?

What is Keynesian liquidity preference theory?

J.M Keynes in his book "The general theory of employment, interest and money” in 1936, propounded his theory of interest called the liquidity preference theory. Keynes considered rate of interest to be purely monetary phenomenon and determined by the demand for money and the supply of money.

The Desire or preference to hold cash on money rather than other assets is called as liquidity preference. The rate of interest is directly related to the liquidity preference and higher the liquidity preference higher will be the rate of the interest. Liquidity preference theory of interest was given by J.M. Keynes.

According to Keynes people like to hold cash for three reasons or motives which are discussed below-

(i)Transaction motive: Transaction motives refer to the demand for money for current transaction by firms and households. The demand for money for transaction motives depends on the level of income. As the level of income increases transaction demand for money also increases and vice versa. Symbolically-

Tdm =f(Y)

Tdm =Transaction demand for money

f(Y)= function of income

(ii) Precautionary motive: Sometimes people hold cash balances to meet unforeseen contingencies, like sickness, death, accidents, danger of unemployment, etc. The amount of money held under this motive, is called 'Idle balance', also depends on the level of money income of an individual. People with the higher incomes can afford to keep more liquid money to meet such emergencies and thus the relationship between precautionary demand for money (Pdm) and the volume of income is normally a direct one, Symbolically-

Pdm = f(Y)

(iii)Speculative motive: The speculative demand for money is for securing profit from knowing better than the market what the future will bring forth and after keeping enough for the transaction and precautionary purposes individual and the Businessman have funds to make a speculative gain by investing in bonds. Estimated interest rates are associated with interest rates and therefore speculative interest rates can be summarized by -

Sdm = f (r)

Money Supply: The supply of money in a particular period depends upon the policy of the central bank of a country and Money supply curve, Sm, has been drawn perfectly inelastic as it is institutionally given.

Keynes liquidity preference theory of interest explain with the help of a Figure:

Determination of Interest Rate: Keynes said that the rate of interest is determined by the demand for money and the supply of money. In the following figure, OM is the total amount of money supplied by the central bank and at point E demand for money becomes equal to the supply of money and thus, the equilibrium interest rate is determined at OR. Now let us suppose that the rate of interest is greater than OR. In such a situation, the supply of money will exceed the demand for money. People will purchase more securities. As a result, its price will rise and interest rate will fall until demand for money becomes equal to the supply of money. 

On the other hand, if the rate of interest becomes less than OR the demand for money will exceed supply of money and people will sell their securities. Price of securities will decline and rate of interest will rise until we reach point E. Thus, the rate of interest is directly determined by the monetary variables only.

Criticisms (Limitations) of Keynes liquidity preference theory of interest:

The Keynes liquidity theory  of interest has been criticized on the following grounds-

1. Real factors: Keynes says that rate of interest is purely a monetary phenomenon. But he critics that real factors like productivity of capital, saving and investments also play an important role in the determination of the rate of interest.

2. Causes of demand for Money:  This critics point out that demand for money arises not only from the three main motives mentioned by Keynes but also from several other factors not stated.

3. Meaning of Money: Keynes does not specify whether money means only cash or it include bank deposits also.

4. Liquidity preference: Keynes theory of interest is entirely depend on the assumption of Liquidity preference of the people. If there is no liquidity preference then this theory will not hold good.

5. Long period: Keynes theory is applicable only to a short period. His theory is not applicable for the long period of time.