Saturday, August 22, 2009

Liquidity Preference Theory

Keynes expounded his own theory of interest which many be called the monetary theory of interest as opposed to the classical theory which might be termed as the Real Theory of Interest. According to Professor Keynes, interest is purely a monetary phenomenon, because the rate of interest is calculated in terms of money. It is also monetary phenomenon in the sense that it is determined by the demand for and the supply of money. Professor Keynes defines interest as “the reward paid for parting with liquidity for a specified time.” Money is the most liquid asset and people generally like to keep their assets in cash. Therefore if they are asked to surrender this liquidity, they must be paid a reward. This reward is paid in the form of interest. Greater the desire for liquidity higher shall be the rate of interest demanded for parting with liquidity.
The rate of interest, like the price of an ordinary commodity is determined by the demand for and supply of money. The rate of interest on the demand side, is governed by the liquidity preference of the community. The liquidity preference of the community arises due to the necessity of keeping community. Keynes discusses these requirements under three heading.
(i) Transaction Motive
(ii) The precautionary Motive and
(iii) Speculative Motive.
The demand for money arising under these three motives constitutes the aggregate demand for money. It must be keep in mind that the demand for money in Keynesian sense the demand to hold money. Money under these three motives is actually held in cash in hands of the public, and the community’s demand for money shell increase or decrease, according to the community’s desires to hold more or less cash in hands. An increase in the demand for money (i.e. an increase in liquidity preference) shall lead to arise in the rate of interest. A decrease in the demand for money (i.e. decrease in liquidity preference) shall lead to fall in the rate of interest. An increase in the demand for money is not always followed by a rise in the rate of interest. If for instance, an increase in the demand for money is followed by an increase in the quantity of money in the same proportion, the rate of interest shall not be affected at all. While the liquidity reference governs the rate of interest, in it own town, it is also governed by the rate of interest. Higher the rate of interest, the lower shall be liquidity preference, lower the rate of interest, the higher shall be the liquidity preference.
The rate of interest on supply side is determined by the supply of money in the economy. The supply of money is different from the supply of commodity. While the supply of commodity is a flow, the supply of money is a stock. Further supply of money is the supply of money to hold and the aggregate supply of money in community at any time is the sum of all money holdings of all members of the community. Unlike the demand for money, the supply of money is completely amenable to government control. The liquidity preference of the community cannot be directly controlled by the sale. But supply of money is the factor which is always in the hands of the state. In most countries the control of supply of money has been entrusted to the Central bank. The Central Bank may not be able to influence liquidity preference directly. But through its control of supply of money, it can influence the rate of interest which in its turn affects the liquidity preference. Higher the supply of money, the lower shall be the rate of interest, lower the supply of money higher shall be the rate of interest. An increase in supply of money is not always followed by a fall in the rate of interest. If for instance an increase in the supply of money is also followed by an equivalent increase in the demand for money, the rate of interest shall not be affected at all. While the supply of money affect the rate of interest, it is in turn not affected by the rate of interest unless the monetary authority issues more money to counter the high rate of interest, because the supply of money is in hands of the government.

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