Introductory Economics

Determination of the Rate of Interest

Interaction of Liquidity Preference and the Supply of Money

• According to Keynes, the demand for money, i.e., the liquidity preference and supply of money determine the rate of interest.
• It is in fact the liquidity preference for speculative motive which along with the quantity of money determines the rate of interest. We have explained above the speculative demand for money in detail. As for the supply of money, it is determined by the policies of the Government and the Central Bank of the country. The total supply of money consists of coins plus notes plus bank deposits. How the rate of interest is determined by the equilibrium between the liquidity preference for speculative motive and the supply of money is shown in Fig. below.

• In Fig. LP is the curve of liquidity preference for speculative motive. In other words LP curve shows the demand for money for speculative motive.
• To begin with, ON is the quantity of money available for satisfying liquidity preference for speculative motive. Rate of interest will be determined where the speculative demand for money is in balance or equal to the fixed supply of money ON. It is clear from the figure that speculative demand for money is equal to ON quantity of money at O r rate of interest.
• Hence O r is the equilibrium rate of interest. Assuming no change in expectations, an increase in the quantity of money (via open market operations) for the speculative motive will lower the rate of interest.
• In Fig when the quantity of money increases from ON to ON1, the rate of interest falls from Or to Or1because the new quantity of money ON1 is in balance with the speculative demand for money at Or' rate of interest. In this case we move down the curve. Thus given the schedule or curve of liquidity preference for speculative motive, an increase in the quantity of money brings down the rate of interest
• But the act of increase in the quantity of money may cause a change in the expectations of the public and thereby cause an upward shift in liquidity preference curve for speculative motive bringing the rate of interest up.
• But this is not certain. "New developments may only cause wide differences of opinion leading to increased activity in the bond market without necessarily causing any shift in the aggregate speculative demand for money schedule. If the balance of market expectations is changed, there will be a. shift in the schedule. Central Bank policy designed to increase the money supply may therefore be met by an upward shift of speculative demand function leaving the rate of interest virtually unaffected. Thus a large increase in the quantity of money may exert only a small influence on the rate of interest in certain circumstances.
• It is worth mentioning that shift in liquidity preference schedule or curve can be caused by many other factors which affect expectations and might take place independently of changes in the quantity of money by the Central Bank. Shifts in the liquidity function may be either downward or upward depending on the way in which the public interprets a change in events.
• If some change in events leads the people on balance to expect a higher rate of interest in the future than they had previously supposed, the liquidity preference for speculative motive will increase, which will bring about an upward shift in the curve of liquidity preference for speculative motive and will raise the rate of interest.
• In Fig., assuming that the quantity of money remains unchanged at ON, the rise in the liquidity preference curve from LP to LP1, the rate of interest rises from Or1 to Or because at Or, the new speculative demand for money is in equilibrium with the supply of money ON. It is worth noting that when the liquidity preference for speculative motive rises from LP to LP1, the amount of money hoarded does not increase; it remains ON as before. Only the rate of interest rises from Or1 to Or to equilibrate the new liquidity preference for speculative motive with the available quantity of money ON.
• Thus we see that Keynes explained interest in terms of purely monetary forces and not in terms of real forces like productivity of capital and thrift which formed the foundation-stones of both classical and loan able fund theories. According to him, demand for money for speculative motive together with the supply of money determines the rate of interest. He agreed that the marginal revenue product of capital tends to become equal to the rate of interest but the rate of interest is not determined by marginal revenue productivity of capital.
• Moreover, according to him, interest is not a reward for saving or thriftiness or waiting but for parting with liquidity. Keynes asserted that it is not the rate of interest which equalizes saving and investment. But this equality is brought about through changes in the level of income.

Critical Appraisal of Keynes's Liquidity Preference Theory of Interest:

1. Keynes ignored real factors in the determination of interest. Firstly, it has been pointed out that rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving also play an important role in the determination of the rate of interest.
2. Keynes makes the rate of interest independent of the demand for investment funds. In fact, it is not so independent. The cash-balances of the businessmen are largely influenced by their demand for capital investment. This demand for capital-investment depends upon the marginal revenue- productivity of capital. Therefore, the rate of interest is not determined independently of the marginal revenue productivity of capital (marginal efficiency of capital) and investment demand. When investment demand increases due to greater profit prospects or, in other words, when marginal revenue productivity of capital rises, there will be greater demand for investment funds and the rate of interest will go up. But Keynesian theory does not account for this. Similarly, Keynes ignored the effect of the availability of savings on the rate of interest. For instance, if the propensity to consume of the people increases, savings would decline. As a result, supply of funds in the market will decline which will raise the rate of interest.
3. Keynesian theory is also indeterminate. Now exactly the same criticism applies to Keynesian theory itself on the basis of which Keynes rejected the classical and loanable funds theories. Keynes's theory of interest, like the classical and loanable funds theories, is indeterminate.
4. According to Keynes, rate of interest is determined by the speculative demand for money and the supply of money available for satisfying speculative demand. Given the total money supply, we cannot know how much money will be available to satisfy the speculative demand for money unless we know how much the transactions demand for money is. And we cannot know the transactions demand for money unless we first know the level of income. Thus the Keynesian theory, like the classical, is indeterminate. “In the Keynesian case the supply and demand for money schedules cannot give the rate of interest unless we already know the income level; in the classical case the demand and supply schedules for saving offer no solution until the income is known. Precisely the same is true of loanable -fund theory. Keynes's criticism of the classical and loanable fund theories applies equally to his own theory.
5. No liquidity without Savings. According to Keynes, interest is a reward for parting with liquidity and in no way a compensation and inducement for saving or waiting. But without saving how the funds can be available to be kept as liquid and how can there be the question of surrendering liquidity .if one has not already saved money. Jacob Viner rightly maintains, "Without saving there can be no liquidity to surrender". Therefore, the rate of interest is vitally connected with saving which is neglected by Keynes in the determination of interest.
6. It follows from above that Keynesian theory of interest is also not without flaws. But importance Keynes, gave to liquidity preference as a determinant of interest is correct. In fact, the exponents of loan able funds theory incorporated the liquidity preference in their theory by lying greater stress on hoarding and dishoarding. We are inclined to agree with Prof. D. Hamberg when he says, "Keynes did not forge nearly as new a theory as he and others at first thought. Rather, his great emphasis on the influence of hoarding on the rate of interest constituted an invaluable addition to the theory of interest as it had been developed by the loan able funds theorists who incorporated much of Keynes's ideas into their theory to make it more complete.