Liquidity preference theory, developed by John Maynard Keynes, is also known as demand for money. It states that individuals hold their monetary assets in cash or bonds to earn potential profit due to fluctuations in the market interest rate and bond prices. Moreover, it shows how people keep or demand money to buy goods and services, as well as set aside a portion of it to speculate between the changes in market interest rates and bond prices for profit.
- What is liquidity preference theory?
- Transaction demand for money
- Precautionary demand for money
- Speculative demand for money
- Relationship between interest rate and bond prices
- Speculative money demand
- Keynesian liquidity trap
- Conclusion
What Is Liquidity Preference Theory?
John Maynard Keynes, a renowned economist, pioneered the liquidity preference theory in macroeconomics. The theory explains the relationship between interest rates and the demand for money. It states that individuals allocate their monetary assets between cash and bonds to maximize returns due to the fluctuations in the market rate of interest and bond prices. According to J. M. Keynes’s liquidity preference theory, people hold money for three purposes, i.e., transaction motive, precautionary motive, and speculative motive.
1. Transaction Demand For Money
Both households and businesses keep money in liquid form to facilitate everyday transactions. The money held for this purpose is called transaction demand for money. Households set aside a portion of their income in liquid form to cover everyday expenses, and businesses keep it to cover operational expenses. It is directly proportional to income level, meaning that as income rises, transaction demand for money also rises, and vice versa.
2. Precautionary Demand For Money
Households and businesses also demand money for precautionary purposes as a buffer against unexpected expenses. Households keep money in liquid form to meet unavoidable circumstances such as medical emergencies, unemployment, and education-related costs. Similarly, businesses also demand money to mitigate the impacts of economic downturns such as recessions and similar unforeseen circumstances. Precautionary demand for money is also influenced by the income level; as income rises, precautionary demand for money rises, and vice versa.
The transactional and precautionary motives of demand for money are insensitive to changes in interest rates. Individuals and businesses demand such money to navigate life’s daily circumstances and uncertainties and ensure a sense of financial security.
3. Speculative Demand For Money
Individuals keep their money in two major categories, such as cash and bonds, to avail themselves of the benefits of changing market conditions.
According to Keynes, people diversify their portfolios with two types of monetary assets to earn profit from speculative practices. These monetary assets include the following:
- Cash
- Bonds & Securities
If individuals keep their money in cash form, they may earn interest on it, and if they purchase bonds and securities, they may earn capital gain from it.
Inverse Relationship Between Interest Rate and Bond Prices
Suppose, an individual decides to keep his money in the form of bonds and securities. In this scenario, he has to face fluctuations in the prices of bonds, which may earn him capital gain or capital loss.
An individual will only prefer bonds and securities over cash when he is certain that their future value will increase, leading to capital gains in the future. On the other hand, if he realises that, the bond prices will fall in the future, he will sell them and keep cash with him to earn higher interest rates. The reason why a person switches between bonds and cash is due to the inverse relationship between the interest rate and bond prices.
According to Keynes, the rate of interest is inversely related to the price of bonds. If the rate of interest rises, bond prices will fall, and vice versa. Therefore, people speculate between bond prices and interest on cash to earn a profit from their money.
Speculative Money Demand
Speculative demand for money is inversely related to market interest rate. If the rate of interest rises, speculative demand for money decreases, and if the market rate of interest decreases, speculative demand for money increases.
At a higher rate of interest, speculative demand for money will be lower because people will expect a fall in the rate of interest and a rise in the prices of bonds in the future. Therefore, to make maximum profit from the increasing bond prices in the future, people will convert their cash balance into bonds, which will lower the speculative demand for money.
At a lower rate of interest, speculative demand for money will be higher because people will expect a rise in the rate of interest and a fall in the prices of bonds in the future. Therefore, to minimize losses from decreasing bond prices in the future, people will convert their bonds into cash balances, which will increase the speculative demand for money.
Keynesian Liquidity Trap
According to Keynes, a liquidity trap is a situation where an individual becomes indifferent between bonds and speculative demand for money. The reason is that, at this point, the rate of interest falls to a minimum or critical level, and the speculative money demand curve becomes horizontal with a zero slope.
In this situation, the expansionary monetary policy of the central bank becomes ineffective due to the hoarding of money by speculators, anticipating future interest rate increases. Suppose the central bank increases the money supply following an expansionary monetary policy to boost aggregate demand and national income in the country. However, the increased money supply will be hoarded by speculators in anticipation of future interest rate hikes. As a result, monetary policy will fail to bring about the desired changes in the economy.
Conclusion
In conclusion, demand for money is that portion of money that individuals and businesses choose to hold in order to meet their everyday transactional needs and speculative motives. According to Keynes, people demand money for three purposes, i.e., transaction, precautionary, and speculative motives. The transaction and precautionary demand for money depend on the income level, while the speculative demand for money depends on the rate of interest. The most important part of Keynesian demand is speculative motive, which says that individuals keep money in the form of cash or bonds to earn profit and capital gain from changing market conditions.
- According to Keynes, individuals demand money for three motives, i.e., transaction motive, precautionary motive, and speculative motive.
- Transaction money demand states that individuals and businesses keep liquid money to fulfil their daily and near-future needs.
- Precautionary demand for money states that individuals and businesses keep liquid money to counter unavoidable circumstances in the future.
- Speculative demand for money states that individuals keep a portion of their monetary assets in the form of cash and bonds to gain profit from changing market conditions.
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