Keynes precautionary motive predicts that people with larger incomes will hold more cash as a contingency measure. The amount of money needed to protect against such unforeseen costs is not large but it is necessary. The preference for liquidity here is a sort of insurance against the inconvenience of being unable to pay for something that is needed. As with the other components of money demand, people will be reluctant to hold too much money on-hand because of the lost interest that it could be earning . Liquidity describes how an increase or decrease in the money impacts interest rates, customer expenditures, and the investments’ stability. Higher liquidity ensures growth in the value of the asset class.

Liquidity Preference is the amount of money people hold in cash. Thus the liquidity theory provides no solution; it cannot tell the rate of interest unless we already know the income level, the investment level and the interest rate itself. Thus, according to Hansen, “Keynes’s criticism of the classical theory applies equally to his own theory”. The concept of liquidity preference is confusing, vague and makes Keynes’ theory of interest self- contradictory. For example, if a man holds his funds in the form of time deposits or short-terms treasury bills, he will be paid interest on them. Precautionary demand is the demand for liquidity to cover unforeseen expenditures such as an accident or health emergency.

liquidity preference theory

Investors like to have the liquidity to ensure their short-term obligations rather than struggling or borrowing. The amount of liquidity is directly proportional to the income level. The higher the income is, the more it is used for increased spending.

Related Terms:

The transactions motive relates to the demand for money or the need of cash for the current transactions of individual and business exchanges. Individuals hold cash in order to bridge the gap between the receipt of income and its expenditure. Speculative demand is the demand to take advantage of future changes in the interest rate or bond prices. According to Keynes, the higher the rate of interest, the lower the speculative demand for money. And the lower the rate of interest, the higher the speculative demand for money. The individual decides the portion for spending and reserve for future consumption based on income.

liquidity preference theory

WealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation. The second criticism is that this theory assumes a certain level of income. The Structured Query Language comprises several different data types that allow it to store different types of information… In real-world terms, the more quickly an asset can be converted into currency, the more liquid it becomes. He holds a master’s degree in economics from Queen’s University and studied radio broadcasting at Humber College. ‚Yield‘ regards an asset’s earnings relative to its current market value.

Understanding Keynesian Liquidity Preference Theory

The aggregate demand for money or the function of liquidity preference would be the sum of all three motives transaction, precautionary and speculative). Stakeholders may also have a speculative motive.When interest rates are low, demand for cash is high and they may prefer to hold assets until interest rates rise. The speculative motive refers to an investor’s reluctance to tying up investment capital for fear of missing out on a better opportunity in the future. The transactions motive states that individuals have a preference for liquidity to guarantee having sufficient cash on hand for basic day-to-day needs. In other words, stakeholders have a high demand for liquidity to cover their short-term obligations, such as buying groceries and paying the rent or mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those day-to-day needs.

Thus, the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people are content holding the quantity of money the Fed has created. Let’s now develop the theory of liquidity preference by considering the supply and demand for money and how each depends on the interest rate. A change in the demand for money due to speculative reasons may also occur if prices of bonds/securities rise and people expect them to increase further. In Man, Economy, and State , Murray Rothbard argues that the liquidity preference theory of interest suffers from a fallacy of mutual determination. Keynes alleges that the rate of interest is determined by liquidity preference.

It means that at this extremely low rate of interest, people have no desire to lend money and will keep the whole money with them. It further implies that the rate of interest cannot be lowered any more. This feature of the liquidity preference schedule has been called the ‘liquidity trap’. Similarly, if people feel that in future the rate of interest is going to fall , they will reduce the demand for money meant for speculative purpose.

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Also, factors like psychology, uncertainty in the future, and the economy’s structure influence the portion for spending. When it comes to saving for the future, people can hold in the form of cash or investment in interest-bearing assets. At point E1, the supply of money is higher than the demand for money, and so individuals buy more securities. The interest rate begins to fall back to point-R in such situations.

As people cut back on their holdings of bonds, bond issuers find that they have to offer higher interest rates to attract buyers. Thus, the interest rate rises until it reaches the equilibrium level. If the interest rate is above the equilibrium level , the quantity of money people want to hold is less than the quantity the Fed has created, and this surplus of money puts downward pressure on the interest rate. As per him, the equilibrium interest rate is when the money demanded equals supply demand.

This study examined the demand for real money balances in Nigeria over the period 1971 to 2012. The partial adjustment coefficient indicates that 4.1 percent of the discrepancy between desired and actual real money demanded is eliminated each year in the short run. The estimated money demand function is stable, indicating the absence of structural breaks in the demand for real money balances in Nigeria.

How Does Liquidity Preference Theory Work?

We’ve updated our privacy policy so that we are compliant with changing global privacy regulations and to provide you with insight into the limited ways in which we use your data. Clipping is a handy way to collect important slides you want to go back to later. Do Minimum Wage Laws Make Labor a Fixed or Variable Cost OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR. If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E2 will be re-established.

Disadvantages of liquidity preference theory

These events include unforeseen costs like house or car repairs. Because of all the potential risks involved in investment, most portfolios hold at least some portion of their funds in very liquid assets, currency being the most liquid. Currency will of course be eroded by inflation since it pays no interest at all, but it is not tied-in to anything and can quickly be moved into some other form of investment if circumstances require it. Most investors want to match their assets with liabilities and hence choose different options according to their needs. The theory suggests that the borrowers do not shift from one maturity to another readily.

Criticisms of the Keynesian Theory of Interest

For businessmen, the expectations regarding the future prosperity and depression influence the precautionary demand for money. The precautionary demand for money depends upon the uncertainty of the future. The speculative motive relates to the desire to hold one’s resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other.

Note − In Expectation Theory the investors prefer a longer tenure bond to a shorter one. According to Liquidity Premium Theory, the rates of long-term bonds will remain higher than shorty term ones. As the cost of short-term debts is less, according to a firm’s point of view, the firm could minimize the cost of borrowings by continually refinancing the short-term debt. People choose to hold money instead of other assets that offer higher rates of return so they can use the money to buy goods and services. Because the quantity of money supplied is fixed by Fed policy, it does not depend on other economic variables. In addition to open-market operations, the Fed can influence the money supply using various other tools.

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