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Keynes Liquidity Preference Theory of Interest

 Keynes  Liquidity Preference Theory of Interest
  • Earnings no Invariable but Variable
  • One of the solemn imperfections of the classical thesis is that it presumes the level of earnings to be given and considers interest as a symmetry device amidst the demand for investable money and the supply of funds through savings.

    As per Keynes, earnings are a variable and not an invariable and the parity amidst saving and investment is brought about by variations in earnings and not by changes in the rate of interest.

  • Saving – Investment Schedules are not at liberty
  • In this thesis, the two determinants of interest rate the demand and supply curves of saving are treated at liberty to each other. It means that if there is variation in demand, the demand curve for savings can move up or below th curve I devoid of causing a variation in the supply curve.

    However, as per Keynes, the two curves are not at liberty to each other. If for example, an invention moves the investment curve upward, earnings will mount and it will tend to huger savings and thus moves the supply curve too. Likewise, a movement in the supply curve will fetch a variation in the demand curve.

  • No Mechanical Parity Among Symmetry and Market Rates
  • As per classical view, the market and the symmetry rates of interest are always equal. Any inconsistency among the two is only a provisional phenomenon which would vanish in the long run. Keynes nevertheless, does not consider the inconsistency among the two as accidental and provisional.

    It can be due to the retrenchment or enlargement of bank credit. An enlargement of bank credit by enhancing the supply of loanable money fetches about a drop in the market rate of interest below the symmetry rate and contra. Therefore, there is no mechanical equality of the market and symmetry rate of interests.

Keynes’ Liquidity Preference Theory of Interest

  • Supply of Money
  • Of the two determinants of the rate of interest the supply of money denotes to the aggregate quantity of funds in the nation for all uses at any phase. Though the supply of money is a function of the rate of interest to a scale, yet it is regarded to be fixed by the fiscal authorities, the supply curve of money is considered as perfectly inelastic.

  • Demand for Money
  • For the next determinant, the demand for money, Keynes phrased a new terminology “liquidity preference” by which his hypothesis of interest is generally understood. Liquidity preference is the desire to keep cash. The huger the liquidity preference the huger will be the rate of interest that will have to be paid to the holders of cash to persuade them to part with their liquid possessions. The lower the liquidity preference the lesser will be the rate of interest that will be paid to cash holders.

  • Transactions Motive
  • The transactions motive associates to “the need of cash for the current transactions of personal and business exchanges.” It is moreover subdivided into the earnings and trade motives. The earnings motive is meant to bridge “the interval among the phase of incurring business expenses and that of the receipt of the sale proceeds.” If the phase among the incurring of expenditure and receipt of earnings is small, less cash will be held by the people for recent transactions and contra.

Criticisms

  • Indeterminate Thesis
  • The Keynesian thesis, like the classical thesis of interest is undefined. Keynes emphasizes that the liquidity preference and the volume of money determine the rate of interest. But this is not correct for the reason that a new liquidity preferences curve will have to be represented at each level of earnings.

  • Incomplete Thesis
  • Hicks, Somers, Lerner, Hansen and others opine that the rate of interest along with the level of earnings is determined by four aspects: (1) The investment demand function (MEC), (2) The saving function (or the consumption function), (3) The liquidity preference function and (4) The volume of money function. Though all these rudiments are found in the Keynesian analysis, yet Keynes does not fetch them in his interest rate thesis.

  • Bewilderment Concerning Association Among Interest Rate and Volume of money
  • There is bewilderment in Keynes’ analysis about association among rate of interest and amount of money. On the one hand, he says that the demand for money is inversely dependant on the rate of interest and on the other hand, he tells, that the symmetry rate of interest is inversely dependant upon the amount of money. Throughout his study, Keynes does not make any difference among the two proposals and often uses them in an indistinguishable behaviour. This is a basic error in Keynes’ scrutiny for the former association possess true for an individual and the latter for the market.

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