Liquidity Preference Theory

Keynes view of Aggregate Demand for Money

Md = M1 + M2 , where Md = Aggregate Demand of money M1 = Money held under the transactions & precautionary motive M2 = Money held for speculative motive
M1 depends on Y (income) and is completely interest inelastic ie. M1 does not change with change in r So M1 = L1 (Y) where Y1 & M1 are positively related

 M2 depends on r and is a decreasing function of r , ie. When r increase M2 falls & vice-versa. So, M2 = L2 ( r ) Therefore , Md = L1 (Y) + L2 (r) Or we can write Md = L( Y, r) where Md increases with increase in Y & decreases with increase in r.

 Keynes have considered two asset economy. They are : 1) Money in the form of currency & demand deposits in the banks which earn no interest. 2) Long term bonds The demand for money by the people depends upon how they decide to balance their portfolios between money & bonds. This decision about their portfolio balance again depends on two factors : 1) Higher the level of nominal income, more cash money is hold for transaction motive (M1) 2) Higher is r, lower is M2 because 1stly,higher r implies higher opportunity cost for holding money, so they prefer holding more bonds than money .

2ndly, if the current rate of interest is higher than what is expected in the future, the people would like to hold more bonds and less money in their portfolio. Money demand Curve
Rate of interest,r

LP 2 LP 1 Quantity of Money

 LP I is the curve showing the demand for money. As demand for money is inversely related to r, the curve is downward sloping. When the level of money income increases from Y1 to Y2, the curve shifts upward to LP2. Supply of Money Supply of money at a given time, is fixed by the monetary authority of the country and is shown by a vertical straight line.

 Equilibrium in the Money Market Money market is at equilibrium when at a particular r ,demand for money = supply of money
r
MS

r*

MD

Money quantity

 Effect of increase in money supply r

MS

r r1

MD

 Effect of Increase in Liquidity Preference on r

r MS

r1

Q of Money

Critical Appraisal of Keyness Liquidity Preference Theory of Interest Keynes ignored the role of real factors in the determination of interest. Keynes theory is indeterminate , ie, we are not able to arrive at a single determinate r, we have various r at different level of incomes. Rate of interest is virtually connected with saving which is neglected by Keynes.He have just considered r to be a reward for parting with liquidity.