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Monday, 9 May 2011

Critically examine the Liquidity Preference Theory of Interest

Liquidity Preference Theory :-
This theory was offered by J.M Keynes. According to him interest is the reward for parting with liquid control over cash for a specific period. According to Keynes people divide their income into two parts, saving and expenditure. People can keep their saving in cash or they can lend it to others. Now question can be asked that why people hold the money in a liquid form? Keynes has given three motives for holding the money in liquid form.


1. Business Motive :-
A businessman or employer keeps a certain amount of cash in hand in order to meet the daily needs.

2. Precautionary Motive :-
People hold a certain amount of money in cash in order to meet the unexpected expenses like diseases and accidents.

3. Speculative Motive :-
If the people expect a rose in the rate of interest in the future, they will try to hold the money in cash. In order to lend it in future when the rate of interest is high people hold less money in the form of cash, if the rate of interest is low then people hold more money in the form of cash. It can be explained by the following diagram.

Explanation :- When rate of interest is OK people hold only "OM" amount of money. On the other hand when rate of interest is low "OL" then people prefer to hold "ON" amount of money.


It has been assumed that supply of money remains fixed. It is determined by government.

Determination of the Rate of Interest :-
The rate of interest is determined by the demand ans supply forces. At that point where both are equal, That rate of interest will be fixed.

Explanation :- According to this schedule when rate of interest is 6% demand for money and supply is same (60 Lakh). So in the market 6% rate of interest will be fixed.

Explanation :- In this diagram supply of money is 60 lacs which is fixed by the monetary authorities. The demand curve DD cuts the supply curve at the point "E". So the rate of interest is 6%.

Crticism :-
This theory has been criticized on the following grounds :

1. Short Run :-
This theory is applicable only in the short run, while it falls to guide that how rate of interest is determined in the long run.

2. Quantity of money is not clear :-
Sometimes Keynes includes the credit money in supply and sometimes excluded it.

3. Marginal efficiency of capital :-
Rate of interest is influenced by the marginal efficiency of capital but this theory ignores it.

4. Distinction between productive unproductive :-
The money may be used for the productive purpose or for the unproductive Keynes calls it the reward of parting liquidity.


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