Monday, August 24, 2009

Liquidity Preference

One of the functions of money is that it serves as a liquid asset. Since money is generally accepted as a medium of exchange and as a store of value, hence it is most liquid of all assets. Whenever people want liquidity, they hold their wealth in the form of money. In fact people can hold their wealth in the form of real asset like houses, shops, factories, etc claims of money like bonds or debentures and money. Holding of wealth in the form of real asset or goods and in the form of claims of money yield income to its possessor. But holding of wealth in form of money does not give any income and still people like to hold money or prefer liquidity. There are many motives for holding money or liquidity preference. But all the motives are not equally important for all classes of people. Keynes has given three main motives for holding money or liquidity preference. They are discussed as under.

1. TRANSACTION MOTIVE

The transaction motive relates to demand for money for current payments. People like to hold some cash in order to meet their expenses in the interval between the receipt of income and its expenditure. Business men also want to hold some cash for current payments. For instance they have to buy raw material at regular interval and have to pay for the repair of the machinery and plants etc. from time to time. Money held by the people under this motive depends upon the level of income and business activity.

2. PRECAUTIONARY MOTIVE

Besides holding money for meeting the current needs, people would like to keep some money with them to meet certain unforeseen expenditures and contingencies such as danger of unemployment, sickness, accident etc. Money held under this motive will depend on the financial position and the nature of individual. The quantity of money held to satisfy the precautionary motive will vary widely with individuals and business according to their degree of financial conservatism, the nature of their enterprise, their access to the credit market and the stage of development of organised markets for quick conversion of earning assets such as stock and bonds into cash.

3. SPECULATIVE MOTIVE

Speculative motive relates to the demand of money to take advantage of the fluctuation in the rate of interest. The demand for holding money for the first two motives is limited and is not affected much by the rate of interest. Thus the demand for holding money or bonds etc for the speculative motive is greatly influenced by the change in the rate of interest. When the rate of interest is low but is expected to rise in the future, an individual will hold more money or bonds etc in the hope of taking advantage of the rise in the rate of interest. The opposite will happen if the rate of interest is high but is expected to fall in near future. It is here that liquidity preference is connected with the rate of interest People’s choice to hold their wealth in the form of money or bonds etc will depend upon the present rate of interest and their anticipation regarding the future rate of interest. When the rate of interest is very low people will prefer to keep their wealth in the form of money rather than in bonds and securities. It is so because they know that income from bonds etc will be low and keep with them more cash or money. Further they anticipate rise in the rate of interest and hence they prefer to hold money to take advantage of higher interest rates rather than bonds and securities. On the other hand a higher rate of interest will include people to keep their wealth in the form of bonds and securities because income from them would be quite handsome. Thus speculative motive for holding money refers to speculation in future prices of money claims i.e. bonds, shares etc.

Besides the above three main motives, there are some other motives for holding money also these motives for holding money are deflationary motive, convenience motive, and business expansion motive. Holding money for speculation in future prices of goods and services is called deflationary motive. Business motive refers to the holding money for future transaction. Holding money for sake of convenience is called convenience motive.

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