Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:

Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:

Demand for Money:

For the second determinant, the demand for money, Keynes coined a new term “liquidity preference” by which his theory of interest is commonly known. Liquidity preference is the desire to hold cash. The money in cash “lulls our disquietude” and the rate of interest which is demanded in exchange for it is a “measure of the degree of our disquietude.”

Supply of Money:

Of the two determinants of the rate of interest, the supply of money refers to the total quantity of money in the country for all purposes at any time. Though the supply of money is a function of the rate of interest to a degree, yet it is considered to be fixed by the monetary authorities, that is, the supply curve of money is taken as perfectly inelastic.

According to Keynes, there are three motives behind the desire of the people to hold liquid cash:

(1) The transaction motive,

(2) The precautionary motive and

(3) The speculative motive.

(1) Transactions Motive: According to Keynes, the transactions demand for money depends only on the real income and is not influenced by the rate of interest. There will however be changes in the transactions demand for money depending upon the expectations of the income, of recipients and businessmen. They depend upon the level of income, employment and prices, the business turnover, the normal period between the receipt and disbursement of income, the amount of salary or income, and on the possibility of getting a loan.

(2) Precautionary Motive:

The precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs.

Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals.

Speculative Demand for Money:

The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices). The notion of holding money for speculative motive was a new and revolutionary Keynesian idea.

Total Demand of Money:

If the total liquid money is denoted by M, the transactions plus precautionary motive by M. and the speculative motive for holding 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).

Liquidity trap:

A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Common characteristics of a liquidity trap are interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels

Criticisms of Keynes’s Liquidity Theory of Interest:

The Keynesian theory of interest has been severely criticised by Hansen, Robertson, Knight, Hazlitt, Hutt and others. It has been variously characterized as “a college bursar’s theory”, “at best an inadequate and at worst a misleading account, and “pre-classical, mercantilist, and man-in-the-street economics.”

(1) College Bursar’s Theory

(2) Inadequate and Misleading Theory

(3) Falls into Methodological Fallacy

(4) Money as a Store of Wealth is Barren

(5) Inconsistent Theory etc.

Conclusion:

The Keynesian theory of interest is not only indeterminate, but is also an inadequate explanation of the determination of the rate of interest. It treats the interest rate as a purely monetary phenomenon and by neglecting the real factors makes the theory narrow and unrealistic.