Liquidity Preference Theory of Interest was propounded by J. M. Keynes. According to him interest is purely a monetary phenomena. People prefer to keep their cash as cash itself because if they apart with it there is risk. So people desire to hold cash. The desire to hold cash is called liquidity preference. If people lend money they part with their money for certain time. Until the data of repayment they cannot use that money lent for their personal use. As a result, they suffer from several disadvantages. Unless this inconvenience or sacrifice is rewarded, they do not part with their liquidity.
To make people part with cash, there must be a reward. Interest is the attraction which makes the people to part with their cash. Thus, Keynes says that
interest is the reward for parting with liquidity for a specific period.
Interest is determined by supply and demand for money. According to Keynes interest is determined by supply and demand for money. Keynes says that demand for money arises due to the following three reasons:
1. Transactions Motive : People receive their incomes monthly or weekly. But they spend Money almost every day. So, people hold some cash to make day to day purchases. Similarly business men also hold some money to meet daily expenditure.
2. Precautionary Motive: People hold some amount of cash in liquid form in order to meet some unforeseen expenditure like marriages, medical expenses, children’s education etc. Similarly, businessmen also hold some cash to meet unforeseen and unexpected expenses.
3. Speculative Motive : Some people hold calls with a view to make profit, from further changes in the rate of Interest. Generally given the expectations about the changes in the rate of interest in future, less money will be held under the speculative motive at a higher current or prevailing rate of interest and more money will be held at a lower current rate of interest. Thus, the demand for money under the speculative motive is a function of the current rate of interest. When the rate of interest is high the liquidity preference will be low and vice-versa.
So, the liquidity preference curve or demand curve for money slopes downward from left to right.
Supply of money : The total supply of money depends upon the policies of Government or the note issuing authority. At any particular point time supply of money is fixed. So, the supply curve of money is vertical line to X axis as shown in the below diagram:
The rate of interest will be such that the demand for money is equal to the supply of money. If the supply is more than demand, interest will fall and vice-versa. The rate of interest at which both the supply and demand for money are equal is the equilibrium rate of interest. This can be shown with the help of the following diagram:
In the diagram LPC represents liquidity preference. It shows the demand for money. The liquidity preference curve LPC, intersects the supply curve MS at point E. Here the rate of interest is OR. Suppose liquidity rises from LPC to LPC1, it intersects the supply curve of money (MS) at point E1. As a result, rate of interest increases from OR to OR1.
Criticisms Or Limitations of Liquidity Preference Theory Of Interest:
This theory has been criticized on the following grounds:
1. Real factors: Keynes says that rate of interest is purely a monetary phenomena. He says that, rate of interest is determined by the demand for money and the supply of money. But critics point out that real factors like productivity of capital, saving and investments also play an important role in the determination of the rate of interest.
2. Savings : According to Keynes, interest is paid to make people part with cash. Some critics point out that interest is reward of saving. Without savings there is no possibility of formation of liquidity. Keynes ignored the sacrifice involved in savings.
3. Causes of demand for Money : Critics point out that the demand for money arises not only from the three main motives mentioned by Keynes but also from several other factors not stressed by him.
4. Meaning of Money: Keynes does not specify whether money means only cash or it include bank deposits also.
5. Level of Income : Some critics point out that Keynes did not take income which determine the liquidity preference into consideration. Whenever income changes, the liquidity preference also changes. Thus, Keynes theory of interest is also indeterminate as classical theories.
6. Liquidity preference: Keynes theory of interest is entirely depend on the assumption of Liquidity preference of the people. If there is no liquidity preference, this theory will not hold good.
7. Long period : Keynes theory is applicable only to a short period. His theory is not applicable to the long period.
8. Different rates of Interest : Keynes theory does not explain the different rates of interest prevailed in the market.
