Class XI, Principles of Economics, "Liquidity Preference Theory (Interest)"

Liquidity Preference Theory

Concept of the Theory
The liquidity preference theory was first enunciated by Lord Keynes. This theory is based on consumption and saving of an individual given a certain amount of income. According to Keynes an individual has a limited (given) amount of income which require two decisions on his part
a. How much he has to consume? And
b. How much he has to save?
The decision regarding consumption is called propensity to consume in the words of Keynes, which he spends, on consuming goods. After spending the individual has a certain proportion of his income left with him, which is his saving. Again he has to decide that weather he has to hold his saving in the form of cash or in the form of capital for earning interest. This is what Keynes has called liquidity preference. The smaller the desire to lend, the higher the liquidity preference.
Factors Governing Liquidity Preference
The liquidity preference of a particular person depends on a number of conditions. These may be:
1. Transaction Motive
The transaction motive relates to the demand for money or 5the need for cash resulting due to an individual’s current personal and business transaction and exchanges.
2. Precautionary Motive
Precautionary motive refers to the desire of the people to hold cash or sustain the saving for any unseen emergencies.
3. Speculative Motive
It relates to hold cash or resources in liquid form in order to take advantage of the market movements regarding the future changes in prices.
According to Keynes most of the people save money with speculative motive.
Determination of the Rate Interest
In the Keynesian world the demand for money or the liquidity preference and the supply of money determine the rate of interest. It is infect the liquidity preference for speculative motive, which along with the quality of money determines the rate of interest.
Criticism
The liquidity preference theory is often criticized on the following grounds:
1. The rate of interest is not a purely monetary phenomenon. One of the major criticisms made on this theory is that the rate of interest is not purely monetary phenomenon as real forces like productivity of capital etc also play an important role in the determination of the rate of interest.
2. Liquidity preference is not the only factor governing. The agreement for this statement was that there are several other factors that influence the rate of interest by the demand for and supply of investible funds
3. Keynis ignores saving or waiting as a source or means of investible fund
4. Keynis theory explains interest in the short run only and also does not explain the existence of different rates of interest prevailing in the market at the same time.