Question

Question 4. (12 marks) The implication of theory of liquidity preference on the interest rate explains the downward sloping money demand curve. Analyse this using an appropriate diagram.

Answer 1

John Maynard Keynes introduced liquidity preference theory in his book The General Theory of Employment, Interest and Money. Keynes describes the liquidity preference theory in terms of three motives that determine the demand for liquidity.

First, the transactions motive states that individuals have a preference for liquidity in order to guarantee having sufficient cash on hand for basic day-to-day needs.

Second, the precautionary motive relates to an individual's preference for additional liquidity in the event that an unexpected problem or cost arises that requires a substantial outlay of cash. These events include unforeseen costs like house or car repairs.

Third, 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.

Keynes illustrated the concept by considering the demand for money as an alternative to holding government bonds, which have fixed rates of interest. Bond prices and general interest rates are inversely related, so that a rise in the interest rate on new bonds issued will lead to a fall in the price of existing bonds. A speculator will only buy existing bonds at a fixed (lower) rate if the price of existing bonds falls to make it worthwhile and a realistic alternative to buying new bonds at a higher fixed rate. So, if we now look at the speculative demand for money, at very low interest rates, speculators tend to predict that the next movement in interest rates is upwards, and therefore the next movement in bond prices is downwards. Because of this speculators will prefer to hold their assets in a monetary (liquid) form rather than in bonds, which would result in a speculative loss. Therefore, at low interest rates the speculative demand for money is very high and approaching infinite elasticity. Clearly, government bonds are not the only alternative to money, but the concept is still important.

Interest rates Transactions demand Precautionary demand Speculative demand Quantity of money

The different components of the demand for money can be plotted against interest rates. Neither the transactions demand nor the precautionary demand are related to interest rates, and are shown as vertical curves. However, according to Keynes’ liquidity preference theory, the speculative demand for money – that is, the desire to hold money to gain a speculative return as an alternative to other forms of speculation – is inversely related to interest rates.

The overall ‘liquidity preference’ in an economy, that is the combined demand for money for tor transactions, as a precaution, and for speculative purposes, is downward sloping against interest rates.