But while these are the core of the discussion, it is positioned in a broader view of Keynes’s economic theory and policy. Classical economists have assumed that the level of income remains constant but in actual practice we see that the change in investment also affects the level of income. Actually, this is quite contrary to the facts. The liquidity preference theory of money was propounded by J.M.Keynes in 1936 in his book 'The General Theory of Employment, Interest and Money' which stated that if the liquid money is not loaned out to someone or invested somewhere then it will cost the interest which could be earned from the money if it would be loaned out or invested. Report a Violation 11. KEYNES’ LIQUIDITY PREFERENCE THEORY OF INTEREST. Keynes considered rate of interest to be a purely monetary phenomenon determined by the demand for money and supply of money. Keynes’ Liquidity Preference Theory of Interest or The Monetary Theory of Interest. The theory assumes that the supply of money or liquidity remains constant while the demand for liquidity changes and the rate of interest is determined where LP curve cuts the SM curve. The second reason forwarded by Bohm-Bawerk is that people tend to underrate future wants. The theory is based on the fact that interest-rate risk is more on the longer maturity securities. It is also called neo-classical theory of interest. Option II: Rs. KEYNES’ LIQUIDITY PREFERENCE THEORY OF INTEREST. Sacrifice, waiting and productivity are the real factors which are also important for the determination of the rate of interest. Thus, the quantity of money issued by the central bank and its credit policy are the determinants of money supply in the country. Given the level of income at high interest rates, liquidity preference refers to the total demand for money (M 1 +M 2) and at low interest rates the demand for speculative motive (M 2) alone. For example, an increase in the supply of long-term securities will tend to reduce their price and hence raise their yield (rate of interest), without affecting the rate of interest on short-term securities. When the demand for liquidity changes keeping the supply of liquidity constant the change in LP and the rate of interest will move in the same direction as given in Diagram 10. At this rate of interest at the given level of income total savings are equal to total investment (S=I) and the total demand for and total supply of money are also equal. The higher the impatience to spend money in the present, that is, the higher the preference of individuals for present enjoyment of to future enjoyment of them, the higher have to be the rate of interest to induce them to lend money. The people whose incomes are high are likely to have their present wants more fully satisfied. (2) Abstinence or Waiting Theory of Interest. Keynes’ theory based on Liquidity preference is called monetary theory of the rate of interest as against the classical real theory of rate of interest. The rate of interest is determined at the point where the IS curve intersects the LM curve. Projects: From OBOR to SCO - … Keynes proposes two theories of liquidity preference (i.e. Thus, a change in the expectations leads to a change in the term structure of interest rates. IS curve represents the equilibrium in real sector and LM curve represents the equilibrium in monetary sector. Keynes has developed a monetary theory of interest as opposed to the classical real theory of interest. The result will be a flat yield curve as shown in Figure 14C. This theory was propounded by Lord Keynes in (1936), according to him the theory seeks to explain the level of interest rate with regards to the interaction of two important factors: the supply of money and desire of savers to hold their savings in cash or near cash. Liquidity cannot be possible without saving. It shows the equilibrium between saving and investment (SI) on the one hand and equilibrium between liquidity and supply of money (LM) on the other. It means there is direct relationship between rate of interest and supply of capital. Investment is needed for capital goods and other infrastructures. (1) Productivity Theory of Interest. The rate of interest will increase with the increase in demand for liquidity keeping the supply of liquidity constant. Under the Theory of Liquidity Preference, an investor faced with two assets offering the same rate of return Rate of Return The Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. There is inverse relationship between the rate of interest and demand for liquidity preference. Saving depend on the level of income of individuals, households and the government. He has to wait for the return of loan. IS curve show the relationship between different levels of income and rates of interest in which the related saving and investment are in equilibrium. Rates of interest are at the highest when the prosperity is at its highest level. For example, the commercial banks may not consider purchasing a 30-year bond but may be willing to consider any maturity upto ten years. (vi) If the market rates of interest are expected first to rise in the immediate future and fall later on, this will provide a hump-backed yield curve as shown in Figure 14D. The theory of loanable funds has been criticised on the following grounds: The theory has taken a wrong and unrealistic concept of hoarding. Liquidity Preference Theory of Interest – The theory, propounded by Keynes, that the interest rate is set in the market for money where the demand for money balances interacts with the central bank’s supply of liquidity. The Liquidity Preference Theory of Interest was propounded by : (1) J.M. LP increases with the increase in the level of income and thereby the rate of interest increases. Loanable funds are demanded by such consumers who are spending more than their current incomes. (2) Savings and investment are not interest elastic. Mr. Keynes's liquidity-preference theory of interest is that the interest rate is determined by liquidity preference and the quantity of money. • Everybody likes to hold assets in form of cash money. According to this theory, the rate of interest is the payment for parting with liquidity. Introduction to Keynes’s Liquidity – Preference Theory of Interest Rate: In his book The General Theory of Employment, Interest and Money, J.M. Interest is the cost for the demand for loanable funds. (a) He can invest for the whole two years, or. LP shows the demand for liquidity and SM shows the supply of money or liquidity. (ii) The theory implicitly assumes that the authorities are not capable of influencing the term structure by public debt management and changes in the supply of credit. Therefore, premium must be added to the return of longer-term maturities to attract the risk-averse buyers. At the higher level of income saving will be high and rate of interest will be low while at the lower level of income the saving will be low and the rate of interest will be high. SS is the saving schedule or supply of capital. Similarly, an increase in the supply of short-term securities will tend to reduce their price and thus the rate of interest on these short-term securities will rise, without affecting the interest rate on long-term securities. Everyone in this world likes to have money with him for a number of purposes. For example, if the current rate of interest on two-year loans is 9%, the investment of Rs. Contrary to it, the level of investment, income and savings are also affected. The rate of interest is another major determinant that influences aggregate investment. LIQUIDITY PREFERENCE AND THE THEORY OF INTEREST AND MONEY By FRANCO MODIGLIANI PART I 1. But, in reality, the yield curves tend to slope upward to the right on more occasions than they slope downward. Keynes alleges that the rate of interest is determined by liquidity preference. At the equilibrium rate of interest real sector and monetary sector are at equilibrium. Rate of interest is shown on OY-axis and the level of income on OX-axis. Demand for money: Liquidity preference means the desire of the public to hold cash. Liquidity preference theory, on the other hand, posits that people prefer liquidity and must be induced to give it up. Life insurance companies, on the other hand, have long-term liabilities and tend to purchase long-term credit instruments. It has ignored the money and credit factors which also play important role in interest determination. 115.56. So long as the expected rate of 10.01% for one-year loans in one year’s time persists, there will be no change in the current term structure of interest rates (i.e., 8% and 9% for one and two-year loans respectively). Keynes has propounded the theory of interest known as the liquidity preference theory. People will be prepared to part with liquidity when they are paid higher rate of interest. His arguments offer ample scope for criticism, but his final conclusion is that liquidity preference is a function mainly of income and the interest rate. The point of equilibrium is at E where the investment is equal to savings. The slope of IS curve is negative showing the inverse relationship between the level of income and the rate of interest. Income or wealth can be kept in the form of land, building, shares, debentures, government securities, etc., but it cannot be used in the form of money or cash. Uploader Agreement. If the expectations theory is correct, then there are equal chances of having yield curves sloping upward to the right or sloping downward to the right. Keynes has pointed out that the expansion or contraction of credit can bring the change in market rate of interest and thereby the natural rate of interest is also affected. It is also worth noting that for demand for money to hold Keynes used the term what he called liquidity preference. Everybody likes to hold assets in form of cash money. Keynes’ theory based on Liquidity preference is called monetary theory of the rate of interest as against the classical real theory of rate of interest. According to Professor Keynes, when the rate of interest affects investment it will also affect level of income and thereby savings are also affected. Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. 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