LESSON 14:

KEYNES LIQUIDITY PREFERENCE APPRAOCH:Objectives:

After studying this lesson, you will be able to understood,

The defination of demand for money given by Keynes The different motives for demand for money The Transactions, Precautionary and Speculative motives for money The difference between Transactions demand for money, Precautionary

demand for money and speculative demand for money The total demand for money

14.1 Introduction

14.2.1 Transactions demand for money

14.2.2. Precautionary demand for money

14.2.3 Speculative Demand for money

14.2.4 Total demand for money

14.2.5 Derivation of LM Curve

14.3 Summary

14.4 Check your progress

14.5 Key concepts

14.6 Self Assessment questions

14.7 Answers to check your progress

14.8 Suggested Readings14.1 Introduction

Keynes propounded a theory of demand for money in his general theory which occupies an important place in his monetary theory. In other words his demand for money is called as liquidity preference. How much of his income or resources will a person hold in the form of ready money and how much will he part with or lend depends upon what calls his ‘liquidity preference’. Liquidity preference means the demand for money to hold or the desire of the public to hold cash.

Keynes suggested three motives which led to the demand for money in an economy they are: the transactions motive, Precautionary motive and Speculative motive.

14.2.1 The Transactions demand for money:

The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to ‘the need of cash for the current transactions of personal and business exchange’. Further, he stated that the changes in transactions demand for money depending upon the changes in income. Therefore, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as :Lt = f(ky) where Lt is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and y is the income. This equation is illustrated in the following diagram;

Regarding the rate of interest and transactions demand for money, Keynes made the Lt function interest inelastic. But he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizers ignored it altogether. In recent years, two post Keynesian economists WJ Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money. they have also pointed out that the relationship between transactions demand for money and income is not linear and proportional . Rather changes in income lead to proportionately smaller changes in transactions demand. The modern view is that the transactions demand for money is a function of both income and interest rates which can be expressed as:Lt = f(Y,r) because, as the rate of interest starts rising over and above certain level the transactions demand for money becomes interest elastic. It is because the higher rates of interest will attract some amount of transactions balances into securities. So the backward slope of Y curve shows that at still higher rates, the transaction demand for money declines. When there is a rise in income level, the level of decline in trasactions balances at the same rate of interest is comparatively low. Thus, the transactions demand for money varies directly with the level of income and indirectly varies with the rate of interest.

14.2.2 The Precautionary demand for money:

The precautionary motive relates to “ the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases”.Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. The precautionary demand for money depends upon the level of income, and business activity, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves etc. Keynes held that the precautionary demand for money, like transactions demand, was function of the level of income. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates.

14.2.3. The speculative demand for money:

The speculative demand for money is for ‘securing profit from knowing better than the market what the future will bring froth’ Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value, which can be invested at an opportune moment in interest – bearing bonds or securities.

According to Keynes, it is expectations about changes in bond prices or in the current market rate of interest that determine the speculative demand for money. In

explaining the speculative demand for money, Keynes had a normal or critical rate of interest in mind. If the current rate of interest is above the critical rate of interest, businessmen expect it to fall and bond price to rise. They will, therefore, by bonds to sell them in future when their prices rise in order to gain thereby. A t such times, the speculative demand foe money would fall, conversely, if the current rate of interest happens to be below the critical rate businessmen expect it to rise and bond prices to fall.

Thus, the speculative demand for money is a decreasing function of the rate of interest. The higher the rate of interest, the lower the speculative demand for money, and the lower the rate if interest, the higher the speculative demand for money. It can be expressed algebraically as Ls = f ®, where Ls is the speculative demand for money and r is the rate of interest. Thus, the Keynesian speculative demand for money function is highl6y volatile, depending upon the behaviour of interest rates.

14.2.4 The total Demand for Money:

According to Keynes, money held for transactions and precautionary purposes its primarily a function of the level of income, Lt = f(Y), and the speculative demand for money is a function of rate of interest, Ls = f®. Thus the total demand for money is a function of both income and interest rate. L = f (Y,r)

Where L represents the total demand for money. Thus the total demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand function for spec8ulative purposes, as illustrated in figures

Panel A of the figure shows OT, the transactions and precautionary demand for money at Y level of income and different rates of interest. Panel B shows the speculative demand for money at various rate of interest. It is an inverse function of the rate of interest. For instance, at r6 rate of interest it is OS and as the rate of interest falls to r2, the Ls curve becomes perfectly elastic. Panel C shows the total demand curve for money L which is a lateral summation of LT and Ls curves: L = LT + Ls. Total demand for money also becomes perfectly elastic showing the position of liquidity trap.

14.2.5 Derivation of LM Curve

The LM curve can be derived from Keynesian theory from his analysis of money market equilibrium. According to Keynes, demand for money to hold depends on Transaction and speculative motive. It is the money held for transactions motive which is the function of income. The demand for money also depends on the rate of interest which is the cost of holding the money. This is because by holding money rather then lending it and buying other financial assets, one has to forego interest. The intersection of the various money demand curves corresponding to different income levels with the supply curve of money fixed by the monetary authority would give us the LM curve. LM curve related the level of income with the rate of interest which is determined by money market equilibrium corresponding to different level of demand for money. The LM curve tells what the various rates of interest will be ( given the quantity of money and family of demand curves of money) at different levels of income. But the money demand curve or what Keynes called liquidity preference curve alone cannot tell us what exactly the rate of interest will be.

14.9 Summary

Keynes in his theory stated that the demand for money arises for three motive; transactions motive, precautionary and speculative motive. According to Keynes the total demand for money means total cash balances which may be of two types: active and Idle balances. The former comprises transactions and precautionary demand and the later comprise speculative demand. Both the transaction and precautionary demand are positively associated with the changes in the money income but change in rate of interest no role to play in determining transaction and precautionary demand. Speculative demand for money is negatively associated with the changes in the rate of interest. Finally Keynes held that the total demand for money is determined by both interest and income.

14.10 Check your progress

State whether the following statements are true or flase

a) According to Keynes demand for money arises because of liquidityb) Transactions motive is the function of rate of interestc) Speculative motive is the function of incomed) Total demand for money is the function of income and interest

14.11 Key concepts

LiquidityTransactions demandPrecautionary demandLiquidity trapActive balancesIdle balances

14.12 Self Assessment questions

Short answer type questions1. Define the term liquidity preference?2. Explain the Keynes theory of Speculative demand for money?3. what is meant by total demand for money?4. what is liquidity trap?5. Derive the LM Curve?

Essay type Questions

1) Critically evaluate the Keynes liquidity preference theory?2) Discuss liquidity preference theory of money, explain how is

it superior than classical theory of demand for money?

14.13 Answers to check your progress

a) True b) False c) False d) True

14.14 Suggested Readings

Ackley Gardner : Macro economic theory Ward R A: Monetary theory and policy Rana & Verma : Macro economic analysis Hajela TN: Monetary economics Ghatak : Monetary economics in developing economies