Q.Briefly explain Keynes' Liquidity Preference theory of interest. How does it differ from the classical demand-and-supply-of-capital view of interest?

Keynes located the reward for interest in a different place than the classical economists did — not in saving itself, but specifically in giving up ready cash.

The classical theory treats interest as simply the PRICE of capital: it is determined at the point where the demand for capital (chiefly for investment by firms) equals the supply of capital (chiefly from the savings of households) — exactly the same demand-and-supply logic used to price an ordinary commodity or any other factor.

John Maynard Keynes argued that this misses WHY people demand money-holdings in the first place. In his Liquidity Preference theory, interest is not the reward for saving as such, but specifically the reward for PARTING WITH LIQUIDITY — for giving up the convenience of holding perfectly liquid cash in exchange for a less liquid asset, such as a bond. The public's desire to hold wealth as ready cash rather than as interest-earning assets is called liquidity preference, and Keynes held that the rate of interest is determined at the point where this liquidity preference (the demand for money) equals the total supply of money in the economy. The key difference from the classical view, then, is WHAT determines interest: the classical theory looks at the market for capital/loanable funds (investment vs. savings), while Keynes looks inst …