LIQUIDITY PREFERENCE THEORY OF INTEREST

• LIQUIDITY PREFERENCE
  THEORY OF INTEREST
  MACRO ECONOMICS/BUSINESS ECONOMICS UPDATED
• MACRO ECONOMICS
• LIQUIDITY PREFERENCE THEORY OF INTEREST

1. GIVEN A THEORY OF ‘ LIQUIDITY PREFERENCE THEORY ‘  BY LORD KEYNES IN HIS BOOK “ THE GENERAL THEORY OF EMPLOYMENT,INTEREST AND MONEY”
2. INTEREST IS THE PRICE OF SERVICES OF MONEY. INTEREST IS A MONETARY PHENOMENON.
3. KEYNES” INTEREST IS THE REWARD FOR PARTING WITH LIQUIDITY FOR A SPECIFIED PERIOD.
4. ACCORDING TO KEYNES” THE RATE OF INTEREST IS THE PREMIUM WHICH IS TO BE OFFERED TO INDUCE THE PEOPLE TO HOLD WEALTH IN SOME FORM OTHER THAN HOARDED MONEY.
5. INTEREST IS THAT REWARD WHICH IS PAID TO A PERSON FOR PARTING WITH LIQUIDITY FOR A SPECIFIED PERIOD.

•  MAIN POINTS OF LIQUIDITY PREFERENCE THEORY OF INTEREST

a)    INTEREST IS MONETARY PHENOMENON BECAUSE IT IS DETERMINED BY DEMAND FOR AND SUPPLY OF MONEY

b)    SUPPLY OF MONEY DEPENDS MONEY IN CIRCULATION AND BANK DEPOSIT IN A COUNTRY

c)    EACH INDIVIDUAL OR FIRM NEEDS HARD CASH FOR DAY TODAY TRANSACTIONS FOR MEETING EXIGENCIES ETC

d)    THEY ARE READY TO PAY PRICE FOR SECURING LOAN

e)    ON THE OTHER HAND WHO POSSESS LIQUIDITY PREFER TO LENDING

f)     IT MEANS THEY PREFER TO HOLD MONEY IN CASH FORM TO LENDING OTHER

g)    THIS PREFERENCE IS CALLED LIQUIDITY PREFERENCE

h)    FOR PARTING LIQUIDITY ONLY IF THEY ARE GIVEN REWARD IN THE FORM OF INTEREST

• DEFINITION OF INTEREST
• KEYNES.” INTEREST IS THE REWARD FOR PARTING WITH LIQUIDITY FOR  SPECIFIED PERIOD.
• THIS DEFINITION INDICATE THAT PEOPLE CAN HOLD THEIR WEALTH IN DIFFERENT FORM SUCH AS MONEY,DEBENTURES,GOVERNMENT SECURITIES ETC.
• THE RATE OF INTEREST IS THE PREMIUM WHICH IS TO BE OFFERED TO INDUCE THE PEOPLE TO HOLD WEALTH IN SOME FORM OTHER THAN THE HOARDED MONEY
• INTEREST IS THAT REWARD WHICH IS PAID TO A PERSON FOR PARTING WITH LIQUIDITY FOR SAPECIFIED PERIOD
• DETERMINATION OF INTEREST
• DETERMINED AT POINT WHERE DEMAND FOR MONEY AND SUPPLY OF MONEY IS EQUAL
• DEMAND FOR MONEY

1. MEDIUM OF EXCHANGE: MONEY HELPS IN BUYING GOODS AND SERVICES
2. STORE OF WEALTH:-HELPS IN TIDE OVER FUTURE DIFFICULTIES AND INDULGE IN SPECULATIVE ACTIVITIES. MONEY IS DEMANDED FOR TRANSACTION.PRECAUTIONERY AND SPECULATIVE MOTIVE

·         DEMAND FOR MONEY IS EXPRESSED IN TERMS OF LIQUIDITY PREFERENCE

• MOTIVES FOR HOLDING LIQUIDITY
• TRANSACTION MOTIVE: - INDIVIDUALS AND FIRM NEEDS MONEY TO MEET THEIR DAILY TRANSACTIONS. IT IS BECAUSE THERE IS TIME INTERVAL BETWEEN RECEIPT OF THEIR INCOME AND THEIR EXPENDITURE. THE AMOUNT OF CASH KEPT FOR THIS PURPOSE DEPENDS UPON :

a)    SIZE OF INCOME

b)    THE TIME GAP BETWEEN THE RECEIPT OF MONEY

c)    MODE OF EXPENDITURE

o    DEMAND FOR TRANSACTION MOTIVE DEPENDS UPON THE LEVEL OF INCOME

o    Lt=f(Y)

• PRECAUTIONARY MOTIVE:-HAVE TO FACE SEVERAL EXIGENCIES OF FUTURE. EVERY INDIVIDUAL DESIRES TO HOLD SOME CASH BALANCES TO PROVIDE FOR SICKNESS,UNEMPLOYMENT AND ACCIDENTS ETC . FIRMS WOULD LIKE TO HOLD CASH FOR SUDDEN BREAKDOWN OF MACHINERY,LOSSES ETC

o    DEMAND FOR TPRECAUTIONARY MOTIVE DEPENDS UPON THE LEVEL OF INCOME

o    LP=f(Y)

• M₁= L_t+L_P  =f(Y)

• SPECULATIVE MOTIVE

1. SPECULATIVE MOTIVE IS MOTIVE OF EARNING PROFIT FROM KNOWING BETTER THAN THE MARKET WHAT THE FUTURE WILL BRING FORTH.
2. PEOPLE WOULD LIKE TO HOLD CASH WITH THEM SO THAT THEY MAY EARN PROFIT ON ACCOUNT OF CHANGE IN THE RATE OF INTEREST. DEMAND FOR MONEY FOR SPECULATIVE MOTIVE IS INTEREST ELASTIC.
3.  L_{s =}  f (r)

• DIAGRAM
• EXPLANATION
• 
  
• DEMAND FOR MONEY FOR SPECULATIVE MOTIVE IS SHOWN. CD IS THE DEMAND CURVE FOR MONEY FOR SPECULATIVE MOTIVE. IT SLOPES DOWNWARD FROM LEFT TO RIGHT AND AFTER POINT L IT BECOMES PARALLEL TO X AXIS. IT MEANS DEMAND FOR MONEY FOR SPECULATIVE MOTIVE IS INVERSELY RELATED TO RATE OF INTEREST. WHEN RATE OF INTEREST FALLS BELOW 2% THEN PEOPLE WILL HAVE NO INDUCEMENT TO LEND MONEY RATHER THEY WILL PREFER TO HOLD THE SAME IN CASH FORM WITH THEMSELVES. THIS SITUATION IS CALLED LIQUIDITY TRAP
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• TOTAL DEMAND
• DIAGRAM
• 
• 
  
• SUPPLY OF MONEY

1. MONEY IN CIRCULATION:- THE QUANTITY OF CURRENCY NOTES AND COINS IS DETERMINED BY CENTRAL BANK OF THE COUNTRY.
2. KEYNES SUPPLY OF MONEY DEPENDS UPON MONEY CIRCULATION AND BANK DEPOSITS IN A COUNTRY. LIQUIDITY PREFERENCE OR DEMAND FOR MONEY REMAINING CONSTANT INCREASE IN SUPPLY OF MONEY LOWERS THE RATE OF INTEREST AND DECREASES IN SUPPLY OF MONEY RAISES THE RATE OF INTEREST.
3. EQUILIBRIUM RATE OF INTEREST: DEMAND FOR MONEY AND SUPPLY IS EQUAL
4. MD(  L_P ) = MS
5. 
   

•  
• SUPPLY OF MONEY
• 
• MS IS THE SUPPLY CURVE OF MONEY AND LP IS THE LIQUIDITY PREFERENCE AND IT INTERSECT AT E. OR WILL BE THE EQUILIBRIUM RATE OF INTEREST
• CHANGE IN DEMAND FOR MONEY OR LIQUIDITY PREFERENCE
• D
  
  
• DETERMINARION OF RATE OF INTEREST
• DIAGRAM
• 
• 
  
• LIQUIDITY PREFERENCE REMAINING THE SAME
• CHANGES IN THE SUPPLY OF MONEY WILL BRING
• ABOUT A CHANGE IN THE INTEREST RATE
• INVERSE RELATION BETWEEN THE SUPPLY OF
•  MONEY AND RATE OF INTEREST
• CHANGE IN THE SUPPLY OF MONEY
• LIQUIDITY TRAP
• WHEN RATE OF INTEREST FALLS BELOW A PARTICULAR LIMIT ,PEOPLE WILL NOT PART WITH LIQUIDITY,THEY WILL REFUSE TO LEND MONEY. L_P= f(r,Y)
• 

• MEANING OF LIQUIDITY TRAP

1. LIQUIDITY TRAP MEANS THAT WHEN RATE OF INTEREST FALLS BELOW A PARTICULAR LIMIT,PEOPLE WILL NOT PART WITH LIQUIDITY. THEY WILL DECLINE TO LEND THE MONEY.BY LENDING MONEY OR BY INVESTING IT IN BONDS AND SECURITIES THEY HAVE TO SUFFER SOME INCONVENIENCE AND INCUR SOME EXPENSES. SO THE RATE OF INTEREST MUST BE AT LEAST BE SUCH AS TO COMPENSATE THESE INCONVENIENCE AND EXPENSES
2. IF THE RATE OF INTEREST FALLS BELOW THIS MINIMUM,DEMAND FOR MONEY WOULD BECOME ABSOLUTE,THAT IS INSENSITIVE TO THE RATE OF INTEREST.

• CRITICISM

1. INDETERMINATE:LIQUIDITY PREFERENCE CAN NOT KNOWN UNLESS RATE OF INTEREST IS KNOWN, WITHOUT THE KNOWLEDGE OF INCOME,IT IS POSSIBLE TO KNOW THE RATE OF INTEREST.
2. MORE EMPHASIS ON MONETARY FACTORS:IGNORED THE EFFECT OF REAL FACTORS
3. SAVING IGNORED:IGNORED THE SAVING
4. ONLY A SHORT PERIOD OF ANALYSIS
5. UNREALISTIC ASSUMPTIONS: WRONG ASSUMPTION OF HOLDING OF WEALTH IN CASH OR IN BONDS
6. LIQUIDITY IS RELATED TO OTHER MOTIVES