7.3. Where the demand for money is equal to supply of money. In such a situation the demand to hold cash diminishes. Disclaimer Copyright, Share Your Knowledge According to Keynes, the interest rate is not given for the saving i.e. To part with liquidity without there being any saving is meaningless. In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. People under speculative motive hold money in order to secure profit from the future speculation of the bond market. It ought into spotlight the role of money in the determination of the rate of interest. 5. Firstly, Keynes’s theory is a monetary rather than a real theory. He gave the hypothesis that at extremely low rates of interest, the liquidity function (curve) becomes perfectly elastic, that is, parallel to the co-ordinate (X) axis, as is shown in the portion AB of the liquidity preference curve in Fig. There is an excess supply of cash of the amount of M1S which people do not want to hold or which they like to invest in bonds and securities. LIQUIDITY PREFERENCE, INTEREST, AND MONEY 49 money rests; it is therefore necessary to analyze closely each source of demand and the factors that determine it. On the other hand, if he purchases interest-bearing securities, he gets some income in the form of interest but these claims are not liquid like money. Privacy Policy3. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities … There is disequilibrium in the money market. Purpose. Liquidity preference is actually a choice between many types of assets. ‘Or’ is the equilibrium rate of interest, for at this rate the amount of money demanded is equal to its supply. That is why the speculative motive is important in the sense that speculative motive is interest elastic. “Liquidity preference is the preference to have an equal amount j ^ of cash rather than claims against others.” -Prof. Mayers Determination of Interest: According to liquidity preference theory, interest is determined by the demand for and supply of money. Under speculative motive people want to keep each with them to take advantage of the charges in the price of bonds and securities. The economic theory which argues that the risk-free interest rate is determined by the interaction of the demand for funds and the supply of funds is known as the: Select one: a. The amount of money under the precautionary motive depends on the individual’s condition, economic as well as political which he lives. It is horizontal towards the right hand side. Thus liquidity preference will be more at lower interest rates. Take, for example, the rate of interest Or1. According to the liquidity preference theory of the term structure of interest rates, an increase in the yield on long-term corporate bonds versus short-term bonds could be due to _____. The richer a community the greater the demand for transaction motive. It is here that the Keynesian liquidity preference theory assumes an altogether different role in the determination of income, output and employment from that given to the loanable funds theory by the neoclassical. If the rate of interest is high peoples demand for money (liquidity preference) is low. That is, D m = T dm + P dm + S dm. Liquidity means shift ability without loss. Thus, M1 +M2 = L1 =f (Y), which means that the demand for money on account of the two motives, called L1, is a function of income. His arguments offer ample scope for criticism, but his final conclusion is that liquidity preference is a function mainly of income and the interest … It does not give any place to such real factors as productivity and thrift. 1,000/- earning a fixed rate of interest of 4 per cent per annum. For all these misfortune, he demands money to hold with him. The Keynesian liquidity preference schedule relates the various rates of interest to the levels of demand of money. Rate of interest would rise till it is at the level Or. The LP curve represents liquidity preference curve. This bond is thus an income-yielding asset of 40 rupees per year. we can also call this theory as Liquidity Preference theory. Keynes has propounded the theory of interest known as the liquidity preference theory. Liquidity preference: Keynes theory of interest is entirely depend on the assumption of Liquidity preference of the people. Money is the most liquid assets. This preference according to Keynes is popularly called liquidity preference. The amount of cash needed for taking this precaution will depend upon an individual’s psychology, his views about the future and the extent to which lie wants to ensure protection against such unforeseen events. Rather his great emphasis on the influence of hoarding on the rate of interest constituted an invaluable addition to the theory of interest as it had been developed by the loanable fund theorists who incorporated much of Keynes’s ideas into their own theory to make it more complete.” Nevertheless, Keynes’s theory remains a distinct theory on its own in so far as it is entirely monetary. , expectations hypothesis and liquidity preference theory and liquidity preference of the bond of the face value Rs... Already discussed the classical theory being static in nature did not consider the uncertainty the. 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