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Theory:
Interest-rate Determination:
Money demanded for all these motives or purposes constitutes
demand for money, or liquidity preference. Liquidity preference
means how much cash people like to keep with them at a particular
time. The higher the liquidity preference, given the supply of money,
the higher will be the rate of interest; and vice versa. Further, given
the liquidity preference, the larger the supply of money, the lower will
be the rate of interest, and the smaller the supply of money, the higher
the rate of interest.
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. As for the supply
of money, it is determined by the policies of the Government and the
In part (a) of the figure, LPS is the cur of liquidity preference for
speculative motive. In other words, LPS curve shows the demand for
money for speculative motive. To begin with, OM 2 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 with, or equal to, the (fixed) supply of
money OM.2It is clear from the figure that speculative demand for
money is equal to OM2quantity of money at or rate of interest. Hence
or is the equilibrium rate of interest.
Criticism:
Keyness theory, too, has come in for considerable criticism:
(i) Firstly, it has been pointed out that the rate of interest is not a
purely monetary phenomenon. Real forces like productivity of capital
and thriftiness also play an imp i.ant role in the determination of the
rate of interest.
(ii) 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 savings
ADDITIONAL NOTES
(1) Reed factors ignored:
Keynes held that interest is purely a monetary phenomenon as it is determined by the monetary
forces of supply and demand. Hazlitt criticized the theory on the ground that Keynes did not take
into consideration the real factors on the determination of the rate of interest. Keynes believed that
real factors like productivity, time preference had no influence on the rate of interest. Thus liquidity
preference is one-sided.
(2) No liquidity without saving:
Keynes held that interest is the reward for parting with liquidity. He believed that interest is the
amount of compensation for surrendering liquidity. He did not say that interest is a price for saving
without saving no ingestible funds can be crated. Thus he ignored the abstinence waiting and time
preference as the sole cause of interest payment. According Jacob Viner without saving there can be
no liquidity to surrender. Thus rate of interest and saving are related.
(3) In determinate theory:
Keynes liquidity preference theory interested is indeterminate. According to him, the rate of interest
is determined by the supply of money and liquidity preference. The position of liquidity preference
depends on the level of income. Thus the rate of interest cannot be known without knowing the
income level, on the other hand, cannot be known without knowing the volume of investment and
volume of investment can not be determined without the knowledge of interest rates. Thus liquidity
preference is indeterminate.