Introductory Economics

Introduction to Capital and Keynes's Liquidity Preference theory of Interest

Term Capital:

• It is used to denote machines, raw material, buildings, factory premises, hard cash or money. Payment made for all these diverse services of capital is not called interest. Term interest is used for the payment made only for the use of monetary capital for a specific period. The person who lends it is called lender and the one who borrows it is called a borrower.
• According to Mc Conell, Interest is the payment for the use of money or the use of loan able funds.

Two terms of interest are used:

1. Gross interest includes payments for the loan of capital, payment to cover risks of loss which may be personal or business risk, payment for inconvenience of the investment and payment for the work and worry included in watching investment, calling them and investing them. Gross interest includes reward for net interest, reward for risk, personal risk, reward for management and inconvenience.
2. Net Interest refers to that amount which is paid for the use of money alone. There are different theories to determine the rate of interest such as classical theory, neo-classical and liquidity preference theory. The Keynes's liquidity preference theory of interest is discussed here under.

KEYNES'S LIQUIDITY PREFERENCE THEORY OF INTEREST

• Lord Keynes gave a new view of interest. According to him, "interest is the reward for parting with liquidity for a specified period.
• A man with a given income has to decide first how much he is to consume and how much to save. The former will depend on, what Keynes calls, the propensity to consume. Given this propensity to consume, the individual will save a certain proportion of his given income. He now has to make another decision
• Should he hold his savings? How much of his resources will he hold in the form of ready money (cash or non-interest-paying bank deposits) and how much will he part with or lend depend upon what Keynes calls his "liquidity preference".
• Liquidity preference means the demand for money to hold or the desire of the public to hold cash
• Demand for Money or Motives for Liquidity Preference: Liquidity preference of a particular individual depends upon several considerations. The question why should people hold their resources liquid or in the form of ready money, when they can, get interest by lending such resources? The desire for liquidity arises because of three motives: (i) the transactions motive, (ii) the precautionary motive, and (iii) the speculative motive

Transactions Motive:

• The transactions motive relates to the demand for money or need for cash for the current transactions of individual and business exchanges.
• Individuals hold cash in order "to bridge the interval between the receipt of income and its expenditure". This is called the' Income Motive.
• Most of the people receive their incomes by the week or the month, while the expenditure goes on day by day. A certain amount of ready money, therefore, is kept in hand to make current payments. This amount will depend upon the size of the individual's income, the interval at which the income is received and the methods of payments currently in use in the society.
• The businessmen and the entrepreneurs also have to keep a proportion of their resources in ready cash in order to meet current needs of various kinds. They need money all the time in order to pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses incurred by any business of exchange. Keynes calls this ' Business Motive for keeping money. It is clear that the amount of money held under this business motive will depend to a very large extent on the turnover (i.e., the volume of trade of the firm in question). The larger the turnover, the larger, in general, will be the amount of money needed to cover current expenses.

Precautionary Motive:

• Precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents, and the other uncertain perils. The amount of money held under this motive will depend on the nature of the individual and on the conditions in which he lives.

Speculative Motive:

• The speculative motive relates to the desire to hold one's resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices).
• The notion of holding money for speculative motive is a new typically Keynesian idea. Money held under the speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of money meant for a different purpose.
• The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate. If bond prices are expected to rise, which, in other words, means that the rate of interest is expected to fall, businessmen will buy bonds to sell when their prices actually rise. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, businessmen will sell bonds to avoid capital losses. Nothing being certain in this dynamic world, where guesses about the future course of events are made on precarious basis. Business men keep cash to speculate on the probable future changes in bond prices (or the rate of interest) with a view to making profits.
• Given the expectations about the changes in the rate of interest in future" less money will be held under the speculative motive at a higher 'Current or prevailing r
• Rate of interest and more money will be held under this motive at a lower current rate of interest. The reason for this inverse correlation between money held for speculative motive and the prevailing rate of interest is that at a lower rate of interest less is lost by not lending money or investing it, that is, by holding on to money, while at a higher rate of interest holders of cash balances would lose more by not lending or investing.
• Thus, the demand for money under speculative motive is a function of the current rate of interest, increasing as the interest rate falls and decreasing as the interest rate rises. Thus, demand for money under this motive is a decreasing function of the rate of interest as shown in the figure.

• Along X-axis is represented the speculative demand for money and along Y-axis the rate of interest. The liquidity preference curve LP is a downward sloping towards the right signifying that the higher the rate of interest, the lower the demand for speculative motive, and vice versa. Thus at the high current rate of interest Or, a very small amount OM is held for speculative motive. This is because at a high current rate of interest much money would have been lent out or used for buying bonds and therefore less money will be kept as inactive balances.
• If the rate of interest falls' to Or1', then a greater amount OM1is held under speculative motive. With the further fall in the rate of interest to Or2money held under speculative motive increases to OM2. It will be seen in Fig. that the liquidity preference curve LP becomes quite flat i.e., perfectly elastic at a very low rate of interest; it is horizontal line beyond point E2 towards the right.
• This perfectly elastic portion of liquidity preference curve indicates the position of absolute liquidity preference of the people. That is, at a very low rate of interest people will hold with them as inactive balances any amount of money they come to have. This portion of liquidity preference curve with absolute liquidity preference is called liquidity trap by some economists.
• But the demand for money to satisfy the speculative motive does not depend so much upon what the current rate of interest is, as on expectations of changes in the rate of interest. If there is a change in the expectations regarding the future rate of interest, the whole curve or schedule of liquidity preference for speculative motive will change accordingly.
• Thus, if the public on balance expect the rate of interest to be higher (i.e., bond prices to be lower) in the future than had been previously supposed, the speculative demand for money will increase and the whole liquidity preference curve for speculative motive will shift upward.
• If the total supply of money is represented by M, we may refer to that part of M held for transactions and precautionary motive as M1 and to that part held for the speculative motive as M2. Thus M =MI+M2.
• The money held under the transactions and precautionary motives, i.e. M1 is completely interest-inelastic unless the interest rate is very high. The amount of money held as M I, that is, for transactions and precautionary motive, is mainly a function of the size of income and business transactions together with the contingencies growing out of the conduct of personal and business affairs. We can write this in a functional form as follows:
  M1=L1 (Y). ------------------ (i)

Where Y stands for income, L1 for liquidity preference function, and M 1 for money held under the transactions and precautionary motive.

• The above function implies that money held under the transaction and precautionary motive is a function of income. On the other hand, money demanded 'for speculative motive, i.e., M2, as explained above, is primarily a function of the rate of interest.

• This can be written as:

M2=L2 (r) .. . (ii)

Where r stands for the rate of interest, L2 for liquidity preference function for speculative motive. Since total supply of money M=Ml+M2, we get from (i) and (ii) above
M =L1(Y)+L2 (r) .. .(iii)
It follows from (iii) above that given the supply of money M (and also income) the rate of interest will be determined by the liquidity preference.