Q.Explain the Keynesian liquidity preference theory of interest.
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Start your 14-day free trial to unlock the full solution →J.M. Keynes offered a fundamentally different explanation of interest from the classical and loanable funds theories. He argued that interest is not a reward for saving or for "waiting" as such, but rather the reward for parting with liquidity — for giving up the safety and convenience of holding readily-spendable cash in exchange for a less liquid asset such as a bond or a loan.
According to Keynes, people wish to hold money for three distinct motives, which together make up liquidity preference (the aggregate demand for money):
- The transactions motive — money held to meet everyday spending needs between receipt of income and its expenditure;
- The precautionary motive — money held as a buffer against unforeseen expenses or emergencies; and
- The speculative motive — money held in anticipation of a fall in bond prices (equivalently, a rise in interest rates), so as to be able to buy bonds cheaply later.
On the other side, the supply of money in the economy is treated as fixed in the short run, determined by the monetary policy of the central bank rather than by any real economic forces. …
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