Interest Rates, Yield Curves and Term Structure of Interest Rates A fundamental fact noted in the capital market is that the prices of bonds and securities change inversely with the change in the rate of interest. Clearly, greater is the turnover of business and the income there from, greater is the amount of cash a business firm will keep to satisfy its precautionary motive. People under speculative motive hold money in order to secure profit from the future speculation of the bond market. PreserveArticles.com is a free service that lets you to preserve your original articles for eternity. Liquidity Preference Theory of Interest Rates. e. 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. Liquidity Preference Theory This theory essentially says that investors are biased towards investing in short term bonds. The Central Bank of the country may increase money supply to lower the rate of interest. Bonds’ and securities’ prices will go up and the rate of interest will go down till people want to hold the amount or cash, bonds and securities equal to their supply. Keynes’s Liquidity – Preference Theory of Interest Rate! There are three reasons for which money is demanded. Unless we consider as equally important the different types of financial investments including money, we have no way of explaining the co-existence of different rates of interest. Keynes assumed that people hold either cash or bonds as wealth. The amount of money under the precautionary motive depends on the individual’s condition, economic as well as political which he lives. Any one of these two may change to bring about a change in the rate of interest. TOS For them, therefore, bonds and securities are attractive since they expect capital gains from them and cash is less attractive: the demand for cash is, therefore, low. Disclaimer Copyright, Share Your Knowledge The purpose of this theis is to make an analysis of the liquidity preference theory of interest. If at all they surrender this liquidity they must be paid interest. 4. 3. That is why the speculative motive is important in the sense that speculative motive is interest elastic. In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. 800/- giving its owner a capital loss of Rs. Whenever income changes, the liquidity preference also changes. He concentrated his attention on the rate of interest as a monetary phenomenon and thereby gave us valuable insights into the process of adjustment in the money and capital markets for bringing about changes in the interest rate. Fourthly, the liquidity-preference theory, through its ‘liquidity trap hypothesis’ stresses the limitation of monetary and banking policy and its ineffectiveness during the period of depression. The speculative motive for money thus becomes a link between the present and the future. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time. It is this liquidity preference which makes people demand money to hold, or to have an equal amount of cash rather than claims against others. Both these motives form the first component of the demand for money and both are income-elastic. All the articles you read in this site are contributed by users like you, with a single vision to liberate knowledge. They shift-from cash to bonds as they expect the rate of interest to change. Keynes, thus, presented a comprehensive analysis of the monetary sector. A particular amount of cash, therefore, has to be kept for making purchases. Likewise firms also need cash to meet their current needs like payment of wages, purchases of raw materials, transport charges etc. Keynes has propounded the theory of interest known as the liquidity preference theory. 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. For Keynes the existence of a margin between the liquidity of cash and the rate of interest is the essence of what interest is all about. This preference according to Keynes is popularly called liquidity preference. If the rate of interest is high peoples demand for money (liquidity preference) is low. The supply of money is different from the supply of ordinary commodity. An increase in the demand for money leads to a rise in the late of interest, a decrease in the demand for money leads to a fall in the rate of interest. Introduction to Keynes’s Liquidity – Preference Theory of Interest Rate: The Demand for Money or Liquidity Preference: Merits of Keynes’s Liquidity-Preference Theory. Therefore, the supply function of money is a straight line parallel to the ordinate (Y) axis, as is shown in Fig. We may write the total liquidity preference like this: L1 (y) + L2 (r). The richer a community the greater the demand for transaction motive. The keenness of the desire to hold money measures the extent of our anxiety about uncertainties of the future. 7.3. According Keynes rate of interest is demand by the supply of and demand for money. Keynes proposes two theories of liquidity preference (i.e. The supply of money is controlled by the govt. He expressed the opinion that every person who has saving has to decide how he is to keep his saving: in the form of ready money which does not bear any interest or lend it to buy interest-bearing claims like bonds and securities? According to Keynes, the equilibrium rate of interest is determined at the point where the given supply of money is equated to the level of liquidity preference. Disclaimer Much of the controversy is an anachronism since there are more potent fiscal policies available to maintain, as a primary economic goal, high levels of income, employment, and output. John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. Keynes’ theory of interest is known as liquidity preference theory of interest. What are the Criticisms of liquidity preference Theory? The equilibrium rate of interest is fixed at that point where supply of and demands for money are equal. According to Keynes, the interest rate is not given for the saving i.e. 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. Discussing the shape of the liquidity preference curve, Keynes went a step farther to highlight a peculiar feature of it. PreserveArticles.com is an online article publishing site that helps you to submit your knowledge so that it may be preserved for eternity. Content Guidelines 2. It is “the reward for parting with liquidity for a specific period.” In other words, rate of interest was to Keynes the reward for accepting a claim like bond and security in lieu of money. theory, liquidity, interest, preference, explained. 7.3. Keynes states in his Liquidity Preference theory that there are three motives that drive people’s desire for liquidity. Liquidity Preference Theory of Interest: J.M. This made it possible to build up a theory of income. Before publishing your Article on this site, please read the following pages: 1. It should be noted that the liquidity preference due to transactions and precautionary motives is dependent on the level of income while that for speculative motive is a function of the expected changes in the rate of interest. It does not give any place to such real factors as productivity and thrift. There would be equilibrium in the bonds and securities market at this rate where the demand for and supply of cash would also be equal. The demand for money has a negative slope because of the inverse relationship between the speculative demand for money and the rate of interest. One thus has liquidity preference. of the liquidity preference theory of interest. Given the demand for money when supply of money rises, rate of interest falls to OR. The central Bank’s action may not lower the rate of interest at all. The equilibrium rate of interest is determined at that level. Thus the theory explains that the rate of interest is determined at a point where the liquidity preference curve equals the supply of money curve. The total supply of money is represented by a vertical line Ms. Keynes’s liquidity-preference theory has some distinct merits over the classical theory. The determination of the rate of interest can be better explained in the shop. At any other rate money demand would be either more or less than money supply. Liquidity means shift ability without loss. The differences between the two term-structure of interest rate models, expectations hypothesis and liquidity preference theory, are hard to miss. Interest is not compensation to the saver for the abstinence he has undergone or time preference he has. Secondly, Keynes’s theory of the interest rate is more general than the classical theory in that it is applicable not only to full-employment economy but also to the state of less than full employment. In figure 7 .4 money supply is given as OS and the level of liquidity preference by the curve LPC. Keynes ignores saving or waiting as a means or source of investible fund. It should be noted that the money supply and the level of liquidity preference are entirely independent and the two arc brought together only by changes in the rate of interest. Suppose a person purchases a bond of the face-value of Rs. Suppose the rate of interest is Or2 at which money demand is OM2 while the supply is OS. The liquidity preference constitutes the demand for money. In other words, the interest rate is the ‘price’ for money. Hence, the rate of interest is neither a purely monetary phenomenon nor a purely real phenomenon. Money is the most liquid asset and people generally have liquidity preference, i. e., a preference for holding their wealth in the form of cash rather than in the form of interest or other income yielding assets. Content Guidelines On the other hand, when they feel that the prices of bonds and securities are going to fall in the near future, they get detracted away from them and demand more cash. 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. These are the transactions, precautionary and speculative motives. Interest has been defined as the reward for parting with liquidity for a specified period. If there is no liquidity preference, this theory will not hold good. This curve represents the demand for money at various rate of interest. The perfect interchangeability of all units of money makes it impossible for the liquidity- preference theory to account for the phenomenon of diverse rates on the various parts of the credit market.”. This bond is to give an income of 40 rupees per year to its owner, whatever its market value. Money is a given stock at a moment of time. The fact that prices of bonds change inversely with rate of interest is clear. Thus they lack liquidity. This was the position during depression. When the rate of interest rises, the prices of bonds and securities fall and with a fall in the rate of interest, bond and security prices go up. People are paid weekly or monthly while they spend day after day. Take, for example, the rate of interest Or1. Money is the most liquid assets. Since bonds and security-holders are expected to suffer a capital loss, people are more attracted to cash; therefore, they demand a larger amount of cash. The level of liquidity preference, Keynes wrote, depends upon a number of considerations which can be classified into three broad motives for liquidity. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. He called the demand for money ‘liquidity preference’. Hence, liquidity preference theory requires as a pre-condition of saving-investment equality, already postulated by classical economists. 3. This shows that the price of the bond of Rs. #2 – Liquidity Preference Theory 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. 1,600. Keynes propounded his theory of interest called the Liquidity Preference Theory. 6. With a fall in money supply rate of interest rises. It is horizontal towards the right hand side. The demand for liquidity arises due to three motives. A. declining liquidity premiums B. an expectation of an upcoming recession C. a decline in future inflation expectations This is because Keynes held that rate of interest does not bring about equality of saving and investment; in his view it is income that does so. According to Keynes the first two motives for liquidity preference namely the transaction and precautionary are interest inelastic. In symbols we can write, M1 = f (Y), where M1 is the transaction demand for money and f(Y) shows it to be a function of income. Thirdly, Keynes’s theory helped integrate the theory of money to the general theory of output and employment. d. Efficient Markets Theory of Interest. Today we are discussing the Keynesian theory of interest rate. 7. Similarly, businessmen also hold cash to safeguard against the uncertainties of their business. Theories of interest rate determination are very important in economics. We can write, therefore, that M2 -g(Y), where,M2 is the demand for money due to precautionary motive and g(y) shows it to be a function of income. Transaction motive refers to the demand for money for current transactions by households and firms. The three motives for keeping liquid are the transaction motives, the precautionary motive and the speculative 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. 200. This bond is thus an income-yielding asset of 40 rupees per year. This feature of the liquidity function is called the ‘liquidity trap’ since it shows that at a particular low rate of interest, people possess an insatiable demand for money. Thus we see that the Keynesian explanation of the determination of the rate of interest was all in terms of monetary factors. The supply of money is determined by the central bank of a country. Keynes’s Liquidity-Preference Theory is not necessarily at conflict with the classical or neoclassical theory. Keynes gave the primary role to the speculative motive for holding money and did not include the first two motives in his theory of the rate of interest. Share Your Word File In such a situation the demand to hold cash diminishes. where L2 is the speculative demand for money and it is a function of the expected changes in the rate of interest. If people expect the rate to rise in future—that is, they expect the prices of bonds and securities to fall—they would be induced now to keep more cash with them. The Liquidity Preference Theory has a goal of remaining liquid and in order to remain most liquid people should not borrow money, so the interest rate is the cost for having to borrow money and not remaining liquid. In this figure, rate of interest is shown on the ordinate axis and the demand for money on the co-ordinate axis. Keynes pointed out that it is not the rate of interest which equates saving with investment but this equality is brought about through income changes. People demand to hold money with them to meet the unforeseen contingencies. Similarly we also find that if the market rates of interest falls from 4 per cent per annum to 2 1/2 per cent per annum, the market price of the bond of a face value of Rs. In his theory of the rate of interest, Keynes considered the demand for money- liquidity preference—to be composed of the speculative demand for it only because the demand for cash balances arising out of the other two motives is comparatively insignificant in the determination of the rate of interest in the short run. Supply of money, at a particular time, is given to the economy by the government and the credit-creating power of the banks. 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 _____. We turn to the analysis of these three motives first and then with some remarks about the supply of money study the determination of the rate of interest as Keynes taught us. LIQUIDITY PREFERENCE THEORY Definition (also called liquidity preference hypothesis) Observation that, all else being equal, people prefer to hold on to cash (liquidity) and that they will demand a premium for investing in non-liquid assets such as bonds, stocks and real estate. He did not agree with the neoclassical view that the rate of interest is determined in part by the marginal revenue productivity of capital due to its influence on the demand for investment. It is on these motives that the level of demand for money or liquidity preference depends. 1,000falls to Rs. In his book The General Theory of Employment, Interest and Money, J.M. The rate of interest on the demand side is governed by the liquidity preference of the community arises due to the necessity of … Keynes’s theory is to this extent much more dynamic and as such more realistic. Likewise, if the money supply is less than the demand for it, the rate of interest will rise. Obviously the transaction demand for money depends upon income. As water is liquid and it can be used for anything at will, so also money can be converted to anything immediately. Welcome to EconomicsDiscussion.net! Given the supply of money at a particular time, it is the liquidity preference of the people which determines rate of interest. According Keynes rate of interest is demand by the supply of and demand for money. Now suppose the market rate of interest rises to 5 per cent per annum. Keynes was of the opinion that factors like abstinence and time preference have nothing to do with the payment of rate of interest. Further, by including marginal efficiency of capital as the major determinant of investment, Keynes freed the rate of interest from the onerous tasks given to it in the classical theory. The changes in the demand for money for holding it to satisfy the speculative motive are due to the future uncertainty of the rate of interest; change in expectations about its future course causes a change in the speculative demand for money now. 4. 2. PreserveArticles.com: Preserving Your Articles for Eternity, Brief note on Liquidity Preference Theory of Interest, Brief Notes on the Keynes’ Liquidity Preference Theory of Interest. Despite some flaws in Keynes’s treatment of money and the rate of interest, we cannot minimize the importance of Keynes’s valuable contribution to the apparatus and policy about rate of interest. The amount of cash which an individual will require to keep in his possession depends on two factors (i) the size of personal income and (ii) the length of the time between pay-days. Popular Course in this category Credit Risk Modeling Course If the current rate is low, people expect it to rise in the future or expect the prices of securities to fall. Whether it is an individual or a firm, for both the amount of cash money needed to satisfy their precautionary motive depends upon their income more than anything else. It ought into spotlight the role of money in the determination of the rate of interest. Firstly, Keynes’s theory is a monetary rather than a real theory. The speculative motive for liquidity- preference thus introduces a dynamic element in the Keynesian theory. The transaction demand for money is closely connected with the concept of the income period. The amount of cash needed for current transactions by a particular household depends upon its size of income, the interval of time after which income is received and the mode of payment. To part with liquidity without there being any saving is meaningless. Under speculative motive people want to keep each with them to take advantage of the charges in the price of bonds and securities. Households and business concerns need some money for precautionary purposes because they have to take precaution against unforeseen contingencies like sickness, fire, theft and unemployment. The classical theory was devoid of any monetary influence because classicals would consider money only as a veil or a medium of exchange: the store of value function was entirely ignored. 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. The exponents of the loanable funds theory duly incorporated the liquidity preference idea into their theory through their analysis of hoarding and dishoarding. This feature has important implications for public policy which we need not discuss here. We have already discussed the classical theory of interest rate. The classical theory being static in nature did not consider the uncertainty about the rate of interest and its influence on the present. Other costly assets like gold and landed property may be valuable but they cannot be shifted at will. hoarding. But this will take place only if the level of liquidity preference remains where it is. 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 supply of money is not influenced by the rate of interest. The greater is the turnover of business and income from it, the greater is the amount of cash needed to meet it. The reason is that the interest rate is the opportunity cost of Liquidity preference: Keynes theory of interest is entirely depend on the assumption of Liquidity preference of the people. Or if the rate of interest is already very low and the liquidity preference curve is infinitely interest- elastic (liquidity trap situation), the Central Bank’s increased money supply may entirely go to meet the demand for idle balances which in this situation is insatiable. Purpose. If the expectations of the public change and cause an upward shift of the liquidity schedule or curve, the rate of interest may remain where it is. Thus, Keynes theory of interest is also indeterminate as classical theories. In other words, the demand for money is inversely related to the expected changes in the rate of interest. According to the theory of liquidity preference, the supply and demand for real money balances determine what interest rate prevails in the economy. In other words, if he keeps his saving in the form of cash he enjoys the advantage of liquidity of his saving. For all these misfortune, he demands money to hold with him. The supply of money in existence consists of legal tender money, bank money and credit money. D. Hamberg remarks justifiably: “Keynes did not forge nearly as new a theory as he and others at first thought. Liquidity preference is actually a choice between many types of assets. This is the essence of Keynes’s theory. Keynes was no doubt correct in giving importance to money in his theory but then he completely disregarded all other factors. There is disequilibrium in the money market. Before publishing your Articles on this site, please read the following pages: 1. It is a monetary phenomenon in the sense that rate of interest is determined by the supply of and demand for money, Keynes defined interest as the reward for parting with liquidity for specified time. Thus according to Keynes interact is purely a monetary phenomenon.
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