Hence, both the loanable funds theory and the liquidity preference theory represents a partial equilibrium analysis of the determinants of the rate of interest. Privacy Policy3. The more quickly an asset is converted into money the more liquid it is said to be. If the demand for bond increases, its price will rise. The price level. This liquidity premium is said to be positively related to maturity. We can have the community’s total demand for money or liquidity preference schedule by adding the demand for active (La) and idle balances (Li ) together. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. Liquidity is an attribute to an asset. The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model). In Fig. The liquidity preference theory is based on the premise that all investors prefer short-term horizon because long-term horizon carries higher interest rate risk. MD (LP) = MS. ADVERTISEMENTS: In Fig. Interest is a reward for parting with liquidity and is given to the wealth holder who surrenders control over money (liquidity) in exchange for a … In a liquidity trap situation, the rate of interest cannot fall below a certain low figure. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. So, in order to see how the rate of interest is determined it is necessary to consider the demand for money. In this article we will discuss about the liquidity preference theory of interest. The classical economists believe that money was only held for purposes of making transactions and bridging the time period between income receipts. The liquidity preference theory of interest explained. Keynes ignored real factors like productivity of capital and thriftiness as determining the interest rate. In the construction of the total demand curve for money only the speculative demand is assumed to vary and the other two sources of demand for money are assumed to remain constant. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Any deviation from it will not last for long. Moreover, the people who take decision regarding the purchase of commodities are the same people who take decision regarding the purchase of bonds. These bonds pay a fixed annual sum and are bought and sold on the securities market. Share Your Word File b.) In this theory, liquidity is given preference, and investors demand a premium or higher interest rate on the securities with long maturity since more time means more risk associated with the investment. In fact, a fall in the rate of interest leads to an increase in investment and an increase in investment, in its turn, leads to an increase in national income through the investment multiplier. Long period : Keynes theory is applicable only to a short period. The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market (also known as real output in goods and services market plus money market). Based on the three motives for holding money Keynes considered in his liquidity preference theory of the demand for real money balances, what variables did he think determined the demand for money? The market price and the rate of interest, i.e., earnings yield, or fixed interest bonds is therefore inversely related. The total demand curve for money is downward sloping due to speculating component much varies inversely with the rate of interest. Rothbard states "The Keynesians therefore treat the rate of interest, not as they believe they do—as determined by liquidity preference—but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system. M. M M is an exogenous policy variable chosen by a central bank, such as the Federal Reserve. A liquidity premium is the term for the additional yield of an investment that cannot be readily sold at its fair market value. The theory of liquidity preference assumes there is a fixed supply of real money balances. 6. Also learn about the possibility of zero rate of interest. Liquidity Preference. View FREE Lessons! But one of the components of total money demand known as speculative demand is assumed to depend on rate of interest. When bond prices are low (and interest rates therefore are high) speculators will anticipate a rise in bond prices and therefore a capital gain. [4], This article is about liquidity preference in macroeconomic theory. His theory is not applicable to the long period. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. General theory, theories market price and the current rate of interest, Keynes treated national does! Investors prefer short-term horizon because long-term horizon carries higher interest rate could occur as a schedule of liquidity! Includes study notes, research papers, essays, articles and other allied information submitted by like. 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