Keynes Interest Theory

Keynes Interest Theory

Economics Assignment, Microeconomics Assignment

In his epoch making book, “the general theory of employment, interest and money”. A man with a given income has to be decide first how much he is to consume and how much he is to consume for this property to consume, the individual will save a certain proportion of this resource will he has to make another decision. Should he hold his savings? How much of his resources will he part with or lend depends upon the form of money he spent. Liquidity preferences mean the demand for money to hold or 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 is: why should the 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 transaction motive, (ii) the precautionary motive, (iii) the speculative motive.

The transaction motive: the transaction motive relates to the demand for money need for cash for the current transactions of individuals and businessmen. Individuals want to hold cash in order “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 make current payments for goods and services to be purchased. This amount will depend upon the size of the individual’s income, the interval at which the income at which the income is received and the methods of payment prevailing in the society.

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 a danger of unemployment, sickness, accidents and the other uncertain emergencies. 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. 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 money value as money held under this motive does. But it is a store of money meant for a different purpose. The cash held under this motive fluctuation. If bond prices are expected to rise, which, in other words, means that the rate of interest is expected to fall, businessman 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, businessmen keep cash between balances to speculate on the probable future changes in bond prices with a view to making profits.

Given the explanation about 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 rate of interest. The reason for this inverse relation 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 not 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 speculative motive is a decreasing function of the rate of interest.

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