The Liquidity Preference Theory of Interest was developed by the British economist John Maynard Keynes. It is a significant departure from the classical and loanable funds theories as it considers interest to be a purely monetary phenomenon. According to Keynes, interest is the reward for parting with liquidity, i.e., for giving up the desire to hold money in liquid form.
Liquidity preference refers to the desire of individuals to hold wealth in the form of liquid cash rather than in other non-liquid assets like bonds. People prefer liquidity because money is the most convenient and safest asset.
Keynes explained that the demand for money arises due to three main motives:
The speculative motive is the most important factor influencing the rate of interest in this theory.
According to Keynes, the rate of interest is determined by the demand for money (liquidity preference) and the supply of money.
The demand for money depends on liquidity preference. The transaction and precautionary demands are relatively stable and depend on income. However, speculative demand depends on expectations about future interest rates and is inversely related to the current rate of interest.
When the rate of interest is high, people expect it to fall in future, leading to a fall in bond prices. Therefore, they prefer to invest in bonds rather than hold cash, reducing liquidity preference.
On the other hand, when the rate of interest is low, people expect it to rise in future, causing bond prices to fall. Hence, they prefer to hold money instead of bonds, increasing liquidity preference.
The supply of money is determined by the central bank and is assumed to be fixed in the short run. The equilibrium rate of interest is determined at the point where demand for money equals supply of money.
If the demand for money exceeds supply, the rate of interest will rise. If the supply of money exceeds demand, the rate of interest will fall. Thus, equilibrium is achieved through adjustments in the rate of interest.
Equilibrium where Liquidity Preference = Money Supply
The liquidity preference theory provides a realistic explanation of interest by emphasizing monetary factors and expectations. However, it is incomplete as it ignores real factors. Therefore, a comprehensive theory must combine both real and monetary aspects of interest determination.