In this article we will discuss about the Keynesâ€™s liquidity theory of interest with its criticisms.
Keynes defines the rate of interest as the reward of not hoarding but the reward for parting with liquidity for the specified period. It “is not the ‘price’ which brings into equilibrium the demand for resources to invest with the readiness to abstain from consumption.
It is the ‘price’ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.” In other words, the rate of interest, in the Keynesian sense, is determined by the demand for and the supply of money. This theory is, therefore, characterized as the monetary theory of interest, as distinct from the real theory of the classicals.
Supply of Money:
Of the two determinants of the rate of interest, the supply of money refers to the total quantity of money in the country for all purposes at any time. Though the supply of money is a function of the rate of interest to a degree, yet it is considered to be fixed by the monetary authorities, that is, the supply curve of money is taken as perfectly inelastic.
Demand for Money:
For the second determinant, the demand for money, Keynes coined a new term “liquidity preference” by which his theory of interest is commonly known. Liquidity preference is the desire to hold cash. The money in cash “lulls our disquietude” and the rate of interest which is demanded in exchange for it is a “measure of the degree of our disquietude.”
The rate of interest, in Keynes words, is the “premium which has to be offered to induce people to hold the wealth in some form other than hoarded money.” The higher the liquidity preference, the higher will be the rate of interest that will have to be paid to the holders of cash to induce them to part with their liquid assets. The lower the liquidity preference, the lower will be the rate of interest that will be paid to the cash-holders.
According to Keynes, there are three motives behind the desire of the people to hold liquid cash:
(1) The transaction motive,
(2) The precautionary motive, and
(3) The speculative motive.
(1) Transactions Motive:
The transactions motive relates to “the need of cash for the current transactions of personal and business exchanges.” It is further divided into the income and business motives. The income motive is meant to bridge the interval between the receipt of income and its disbursement,” and similarly, the business motive as “the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa.
There will however be changes in the transactions demand for money depending upon the expectations of the income, of recipients and businessmen. They depend upon the level of income, employment and prices, the business turnover, the normal period between the receipt and disbursement of income, the amount of salary or income, and on the possibility of getting a loan.
(2) Precautionary Motive:
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, unemployment and other unforeseen contingencies. Similarly businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals.
Money held under the precautionary motive is rather like water kept in reserve in a water tank. 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 holds that the transactions and precautionary motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M1) is a function (L 1 of the level of income (Y) and is expressed as M1=L1(Y).
(3) Speculative Motive:
Money held under the speculative motive is for “securing profit from knowing better than the market what the future will bring forth.” Individuals and businessmen have funds, after keeping enough for transactions and precautionary purposes and like to 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.
Bond prices and the rate of interest are inversely related to each other. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. A bond carries a fixed rate of interest. For instance, if a bond of the value of Rs100 carries 4% interest and the market rate of interest rises to 8%, the value of this bond falls to Rs50 in the market.
If the market rate of interest falls to 2%, the value of the bond will rise to Rs200 in the market. Thus individuals and businessmen can gain by buying bonds worth Rs100 each at the market rate of Rs50 each when the rate of interest is high (8%), and sell them again when they are dearer (Rs200 each) when the rate of interest falls (to 2%).,
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. 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 lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as M2=L2(r) where L2 is the speculative demand for money and r is the rate of interest. Geometrically, it is a smooth curve which slopes downward from left to right, as shown in Figure 3.
But at a very low rate if interest, such as 2% the speculative demand for money becomes perfectly elastic. This portion of the curve is known as the liquidity trap. At a very low rate of interest, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will mean a definite loss.
Total Demand of Money:
If the total liquid money is denoted by M, the transactions plus precautionary motive by M. and the speculative motive for holding by M2, then M=M1+M2. Since M1 = L1 (Y) and M2=L2(r), the total liquidity preference function is expressed as M=L (Y,r).
M1 is circulating or active money and M2 is idle, or passive money. Though M1 is a function of income and M, of the rate of interest, yet they cannot be held in water-tight compartments. Even M1 is interest elastic at high interest rates.
If there is increased demand for M, it can be met by transferring funds from idle balances, M2. Prof. Haberler distinguishes between liquidity preference in the narrower sense and liquidity preference in the wider sense.
The former is the demand for idle balances, M1 and is called “liquidity preference proper”, and the latter is the total liquidity demand (M or M1+M2). Given the level of income at high interest rates, liquidity preference refers to the total demand for money (M1+M2) and at low interest rates the demand for speculative motive (M2) alone.
Determination of the Rate of Interest:
We have analysed the factors behind the supply and demand for money. The rate of interest, like the price of any product or service, is determined at a level where the demand for money equals the available supply of money. In Figure 3, the vertical line Q1 M represents the supply of money and L is the total demand for money curve. Both intersect at E where the equilibrium rate of interest R is established.
If there is any deviation from this equilibrium position, an adjustment will take place via the rate of interest, and the equilibrium level E is re-established. E1 is the position of unstable equilibrium where the supply of money OM is greater than the demand for money OM1.
Consequently, the rate of interest will start declining from R1, till the equilibrium rate of interest R is reached. Similarly at R2 level of interest rate, the demand for money OM2 is greater than the supply of money OM. As a result, the rate of interest R2 will start rising till it reaches the equilibrium rate R.
If the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. This is illustrated in Figure 4. Given the L curve, the supply of money curve being QM, the rate of interest is R5.
With the increase in the supply of money from QM to O1M1and Q2M2, the rate of interest falls from R3 to R2. But any further increase in the supply of money has no effect on the rate of interest because the liquidity preference curve L is perfectly elastic at R2 rate of interest. So when the supply of money increases to Q3M3, the rate of interest remains stationary at R2 corresponding to the equilibrium point E3. This is Keynes “Liquidity Trap”.
If the demand for money increases and the liquidity preference carve shifts upward, given the supply of money, the rate of interest rises. This is shown in Figure 5. Given the supply of money curve QM when the L curve shifts upward, the new equilibrium point is E1 which determines R6 interest rate. This rate of interest is higher than R4 interest rate at the equilibrium point E.
If with the increase in the liquidity preference, the supply of money also increases in the same proportion to Q1M1 there will be no change in the rate of interest R4, except that the new equilibrium point is E2. Thus the theory explains that the rate of interest is determined at a point where the liquidity preference curve equals the supply of money curve.
Criticisms of Keynes’s Liquidity Theory of Interest:
The Keynesian theory of interest has been severely criticised by Hansen, Robertson, Knight, Hazlitt, Hutt and others. It has been variously characterized as “a college bursar’s theory”, “at best an inadequate and at worst a misleading account, and “pre-classical, mercantilist, and man-in-the-street economics.”
(1) College Bursar’s Theory:
One of the fallacies of the Keynesian analysis is that the demand for money is mainly associated with the liquidity preference for the speculative motive to which the rate of interest is brought directly into touch. The theory presumes the existence of a number of wealthy and shrewd persons who will hold more money by selling bonds when the rate of interest falls and hold less cash but more bonds in the case of rise in the interest rate.
But Robertson does not regard bonds as the only alternative to money, as a use for resources both by the individual and the entrepreneur. And a theory of money which insists on working everything through the bond market is a College Bursar’s theory and seems to be lacking in realism and comprehensiveness.
(2) Inadequate and Misleading Theory:
The theory tells us nothing as to what determines the normal rate and therefore, given the degree of divergence, the actual rate of interest. The actual rate of interest cannot be described consistently as measuring the cost of the uncertainty of risk involved in holding bonds rather than money.
If there were no uncertainty at all, the actual rate would simply stand at a certain definite level below the normal rate. It is for these reasons that Robertson regards the liquidity preference theory “is at best an inadequate and at worst a misleading account.”
(3) Falls into Methodological Fallacy:
Just as the rate of interest is explained as the price for parting with liquidity, similarly the price of eggs or any other commodity can be explained by the relative preference for them. But there is a vital difference. A change in the quantity of money would tend to change the price of the good in the same proportion, but not the price of bonds beyond a temporary disturbance.
In fact, there is no functional relationship between the price level and any rate of interest while discussing the influence of speculation on the interest rate on loans. As a result, no monetary change has any direct or permanent effect on the rate of interest. Thus the Keynesian theory falls into “methodological fallacy” by assuming a definite functional relationship between the quantity of money and the rate of interest.
(4) Money as a Store of Wealth is Barren:
Keynes holds that only money held for speculative purposes is fruitful for it brings interest as a reward, while money as a store of wealth is barren. This is a mistaken notion. As pointed out by W.H. Hutt, money “is as productive as all other assets, and productive in exactly the same sense. The demand for money assets is a demand for productive resources.
(5) Inconsistent Theory:
Knight criticised Keynes’s theory in view of the facts which are directly contrary to what the theory calls for. Hazlitt also discusses this point without giving credit to Knight. According to the Keynesian theory, the rate of interest should be the highest at the bottom of the depression because the liquidity preference is the strongest at that time due to falling prices. A large reward will have to be paid to induce wealth-holders to part with their cash.
But the facts are just the opposite. Short-term interest rates are the lowest in a depression because investment opportunities are temporarily closed and the lenders have no outlets to part with their cash. Contrariwise, the Keynesian short-term interest rates should be lowest during the peak of the boom because people would be investing their money rather than keep it in cash. The liquidity preference being the lowest, a very small reward would be required to partake with it. But in reality, the rate of interest is the highest at the peak of a boom. Thus the theory is inconsistent with facts.
(6) Saving Essential for Liquidity:
Keynes regards the rate of interest as the reward for parting with liquidity and not a return merely for saving or waiting as such. Saving is necessary for obtaining funds to be invested at interest. In Viner’s words “Without saving there can be no liquidity to surrender. The rate of interest is the return for saving without liquidity.”
(7) Liquidity not Essential for Interest Rate:
Even the term liquidity preference is neither helpful nor necessary in explaining the nature of interest. It is more confusing and less illuminating. It is not only vague but is also self-contradictory. For, as pointed out by Hazlitt, “If a man is holding his funds in the form of time deposits or short-term treasury bills, he is being paid interest on them, therefore he is getting interest and “liquidity” too. What becomes, then, of Keynes’s theory that interest is the “reward” for parting with liquidity ?”
(8) Wrong Notion of Liquidity Trap:
Keynes’s notion of the “Liquidity Trap” is also wrong. In reality, the liquidity preference schedule may be perfectly inelastic rather than elastic at a low rate of interest. We know that during a depression all expectations are extremely pessimistic. It is, therefore, not correct to argue that expectations with regard to the rate of interest will be that it will go up.
(9) Ignores Real Factors:
The greatest fallacy in Keynes’s analysis is that he ignores the influence of real factors in determining the interest rate. He regards the interest rate as a purely monetary phenomenon and thus merely returns “to the pre-classical assumption of the mercantilists and to what has always been the assumption of the man in the street.” According to Hazlitt, “Keynes made no new contribution. He merely muddled shallow waters and the kind of interest theory represented by him is pre-classical, mercantilists and man in the street economics.”
(10) Indeterminate Theory:
The Keynesian theory, like the classical theory of interest, is indeterminate. Keynes asserts that the liquidity preference and the quantity of money determine the rate of interest. But this is not correct because a new liquidity preference curve will have to be drawn at each level of income.
Therefore, unless the income level is already known, the demand and supply curves of money cannot tell us what the rate of interest will be. Thus, according to Prof. Hansen, “Keynes’s criticism of the classical theory applies equally to his own theory,”
(11) Incomplete Theory:
Hicks, Somers, Lerner, Hansen and others opine that the rate of interest along with the level of income is determined by four factors:
(i) The investment demand function (MEC),
(ii) The saving function (or the consumption function),
(iii) The liquidity preference function, and
(iv) The quantity of money function.
Though all these elements are found in the Keynesian analysis, yet Keynes does not bring them in his interest rate theory. He takes only the last two elements and ignores the first two, thus Keynes fails to provide an integrated and determinate theory of interest.
(12) Confusion regarding Relation between Interest Rate and Quantity of Money:
There is confusion in Keynes’s analysis about the relation between rate of interest and amount of money. On the one hand, he says that the demand for money is inversely dependent on the rate of interest, and on the other, that the equilibrium rate of interest is inversely dependent upon the amount of money.
Throughout his analysis, Keynes does not make any distinction between the two propositions and often uses them in an identical manner .This is a fundamental error in Keynes’s analysis for the former relation holds true for an individual and the latter for the market.
The Keynesian theory of interest is not only indeterminate, but is also an inadequate explanation of the determination of the rate of interest. It treats the interest rate as a purely monetary phenomenon and by neglecting the real factors makes the theory narrow and unrealistic.