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Liquidity Preference

Liquidity preference in macroeconomic theory 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 (1936) 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. Interest rates, he argues, cannot be a reward for
savings as such because, if a person hoards his savings in cash, keeping it under his mattress say,
he will receive no interest, although he has nevertheless, refrained from consuming all his current
income. Instead of a reward for savings, interest in the Keynesian analysis is a reward for parting
with liquidity.

According to Keynes, demand for liquidity is determined by three motives:

1) The transactions motive:

People prefer to have liquidity to assure basic transactions, for their income is not constantly
available. This demand basically arises in order to make current payments and because of
money as a medium of exchange. 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:

Precautionary motive for holding money refers to the desire of the people to hold cash balances
for unforeseen contingencies. People hold a certain amount of money to provide for the danger
of unemployment, sickness, accidents and other uncertain perils. In other words, people prefer to
have liquidity in the case of social unexpected problems that need unusual costs. The amount of
money demanded for this motive depends on the psychology of the individual and the condition
in which he lives. The amount of money demanded also grows with the income.

3) The speculative motive:

People retain liquidity to speculate that bond prices will fall. When the interest rate decreases
people demand more money to hold until the interest rate increases, which would drive down the
price of an 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). John Maynard Keynes, in laying out
speculative reasons for holding money, stressed the choice between money and bonds. If agents
expect the future nominal interest rate (the return on bonds) to be lower than the current rate
they will then reduce their holdings of money and increase their holdings of bonds. If the future
interest rate does fall, then the price of bonds will increase and the agents will have realized a
capital gain on the bonds they purchased. This means that the demand for money in any period
will depend on both the current nominal interest rate and the expected future interest rate (in
addition to the standard transaction motives captured by Y).
The Liquidity Preference Curve

The liquidity-preference relation can be represented graphically as a schedule of the money


demanded at each different interest rate. The supply of money together with the liquidity
preference curve in theory interact to determine the interest rate at which quantity of money
demanded equals the quantity of money supplied.

Here is a diagram to illustrate the "liquidity preference" idea.

In the diagram, we show the quantity of money on the horizontal axis and the interest rate on the
vertical axis. For example, if the rate of interest is Ra, people want to hold Ma of money, whereas
if the rate of interest were to go down to Rb, people would increase their demand for monetary
assets to Mb.

The Fed can use this relationship, in reverse, to influence the interest rate. Suppose the Fed sets
the total quantity of money at Ma. Then people will try to shift their assets out of the less liquid
accounts into liquid money accounts as long as the rate of interest is less than Ra, or in reverse, to
buy non-liquid assets whenever the rate of interest is greater than Ra. Since they cannot all shift
their assets at once -- the total quantity of assets of each kind is known -- their competition for
liquid or non-liquid assets will drive the interest rate to Ra. We may say that Ra is the
"equilibrium interest rate" with a money supply of Ma. If the Fed wants to push interest rates
down to Rb, they would increase the money supply to Mb.
There are two points of controversy about this.

• There may be a lower limit to how far the Fed can push the interest rates down. In the
diagram, the demand for money increases without any limit as the interest rate falls
toward Rt. Thus, no matter how much the Fed increases the money supply, it could never
push the interest rate below Rt. Rt is called "liquidity trap." Some economists have
questioned the possibility of a "liquidity trap;" but others observe that the Japanese
economic system, in the late 1990's, behaved very much like it was at the "liquidity trap"
interest rate level. In any case, interest rates can never go lower than zero, and Japanese
interest rates in the late 1990's were sometimes so low that the zero lower limit would be
relevant.

• The Fed can use the liquidity preference relationship to influence interest rates only to the
extent that the relationship is stable, or at least predictable. But some economists believe
that it is very unstable and unpredictable -- a source of trouble rather than a means of
control. In the fall of 1998, with the collapse of a major "hedge fund," and again just
before January 1 2000, the Fed believed that there would be bid increases in liquidity
preference. Indeed, for a short period in 1998, it seemed as if the U. S. economy had a
liquidity trap at an interest rate of several percent. But because they predicted these
changes, the Fed adjusted the money supply to keep the interest rates more nearly stable,
and they were successful on the whole.
Determination of Rate of Interest:
Equilibrium in Money Market

The rate of interest, according to J.M. Keynes, is determined by demand for money (liquidity
preference) and supply of money.

The factors that determine demand for money are the level of nominal income and the level of rate of
interest. The supply of money, at a given time, is fixed by the monetary authority of the country.

So, the rate of interest is determined when demand for money is equal to the supply of money where
the money market is in equilibrium. There will be disequilibrium if the rate of interest is either higher
or lower than the equilibrium rate of interest.

Suppose, the rate of interest is higher than the equilibrium rate of interest, then an excess supply will
emerge in the market which will cause people to buy more buy more bonds and replace some of the
money in their portfolios with bonds. Since the total money supply remains fixed, it can not be reduced
by buying bonds by individuals. The bonds buying spree would lead to the rise in the prices of bonds
which will lead to a fall in the rate of interest. Due to this, quantity demanded of money increases to be
once again equal to the given supply of money and the excess supply of money is entirely eliminated
and the money market is in equilibrium.

On the other hand, if the rate of interest is lower than the equilibrium rate of interest, an excess demand
for money will emerge in the market. As a reaction to this excess demand, people would like to sell
their bonds in order to obtain a greater quantity of money for holding at a lower rate of interest. The
stock of money remaining fixed, the attempt by the people to hold more money balances at a rate of
interest lower than the equilibrium level through sale of bonds will only cause bond prices to fall. The
fall in bond prices implies a rise in the rate of interest. Thus, the quantity demanded for money
decreases to become equal to the given supply of money and equilibrium in the money market is
attained.
Effect of an Increase in Money Supply
Rate of interest will be determined where demand for money is equal to the supply of money. An
increase in the money supply will (through buying securities by the central bank of the country from
the open market) will lower the rate of interest.

This is because, with an initial equilibrium at Or, when the money supply is expanded from ON to
ON’, there emerges an excess supply of money at the initial Or rate of interest. The people would
react to this excess money supplied through buying bonds. As a result, bond prices would go up
which implies that the rate of interest would decline. This is how the increase in money supply leads
to the fall in the rate of interest.

Effect of Shifts in Money Demand Curve


or Liquidity Preference Curve
The position of the money demand curve depends on two factors:

1) The level of nominal income :- With an increase in nominal income, money demand for
transactions and precautionary motives increase causing an upward shift in the money demand
curve.
2) The expectations about the changes in bond prices in the future which implies changes in the rate
of interest in the future:- If some changes in events leads the people to expect a higher rate of
interest in future than they had previously supposed, the money demand for speculative motive
will increase which will bring about an upward shift in the money demand curve or liquidity
preference curve and this will raise the rate of interest.

Thus, Keynes explained interest in terms of purely monetary forces and not in terms of real
forces like productivity of capital and thrift. According to him, demand for money for
speculative motive together with the supply of money will determine the rate of interest. He
agreed that the marginal revenue product of capital tends to become equal to the rate of interest
but the rate of interest is not determined by the marginal revenue productivity of capital.

Moreover, according to him, interest is not a reward for saving but for parting with liquidity.
Keynes asserted that it is not the rate of interest which equalizes saving and investment but this
equality is brought about by the changes in the level of income.
Critical Appraisal of Keynes Liquidity
Preference Theory of Interest
1) Keynes ignored the role of real factors in the determination of interest:

Keynes makes the rate of interest independent of the demand for investment funds. In fact, it
is not so independent. The cash balances of businessmen are largely influenced by their
demand for capital investment which depends on the marginal revenue productivity of capital.
Therefore, rate of interest is not independently determined by the marginal efficiency of
capital and investment demand. When there will be an increase in the investment demand due
an increase in the MEC, the rate of interest will go up. But Keynesian theory does not account
for this. Similarly, Keynes ignored the availability of savings on the rate of interest. For
instance, if the propensity to consume of the people increases, savings would decline. As a
result, supply of funds in the market will decline which will raise the rate of interest.

2) Keynes theory is indeterminate

When the income increases, liquidity preference curve shifts to the right and given the supply
of money, new equilibrium rate of interest will be obtained. Thus, at different levels of
income, there will be different liquidity preference curves and as a result, different
equilibrium rates of interest. Thus, we can not know the rate of interest unless we the liquidity
preference curve and also, we can not know the liquidity preference curve unless we know
the level of income. However, we can not know the level of income unless we first know the
rate of interest. This is because, rate of interest influences investment which in turn
determines the level of income. Thus, Keynes theory is indeterminate, that is, we are not able
to arrive at a single determinate rate of interest; rate of interest varies as the income varies.

3) No liquidity without savings

According to Keynes, interest is a reward for parting with liquidity and in no way a
compensation and inducement for saving. But without saving, the funds can not be available
to be kept as liquid and there will be no basis of surrendering liquidity if one has not already
saved money. Jacob Viner rightly maintains, “Without saving there can be no liquidity to
surrender.” Therefore, the rate of interest is vitally connected with saving which is neglected
by Keynes in the determination of interest.

It follows from above that Keynesian theory of interest is not without flaws. But the
importance Keynes gave to liquidity preference as a determinant of interest is correct. A valid
and an adequate explanation of interest must incorporate this important factor of demand for
money to hold.