Liquidity preference (macroeconomic theory)
Liquidity preference is a macroeconomic theory developed by economist John Maynard Keynes, which posits that the demand for money is prioritized over other assets. This theory suggests that the interest rate in an economy is influenced by the supply of and demand for money. Money, being the most liquid asset, is preferred by individuals and businesses for various reasons, including transactions, precautionary needs, and speculative motives. The transactions motive pertains to the everyday expenses individuals and organizations encounter, necessitating cash on hand. The precautionary motive involves holding money for unforeseen circumstances, such as emergencies, while the speculative motive relates to expectations about interest rates and bond prices.
According to Keynes, if the quantity of money individuals wish to hold diverges from the supply, adjustments occur in the interest rates to restore equilibrium. If interest rates exceed the equilibrium level, individuals will likely invest in bonds or interest-bearing accounts, prompting banks to lower rates. Conversely, if rates fall below equilibrium, demand for cash increases, leading to bond sales and rising interest rates. Although influential in shaping monetary policy, liquidity preference theory has faced criticism for not considering other crucial factors that influence interest rates, such as capital productivity and saving behavior. Critics argue that the theory's reliance on liquidity preference as a singular explanation for interest rate fluctuations may not fully capture the complexities of real-world economics.
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Liquidity preference (macroeconomic theory)
In economics, liquidity preference is the demand for money over other assets. The concept was devised by pioneering economist John Maynard Keynes and forms the basis of his liquidity preference theory. The theory states that an economy's interest rate is determined by the supply of and demand for money. Liquidity is the ease of converting an asset into money, and money is the most liquid of all assets. Keynes devised the theory in his 1936 book The General Theory of Employment, Interest and Money.
According to the liquidity preference theory, the rate of interest is the reward that investors receive for parting with liquidity. Keynes theorized that people like to hold onto money instead of less liquid assets that offer higher rates of return, such as bonds and securities, because they can use cash to buy goods and services. Keynes proposed three motives that determine the demand for money: transactions, precautionary, and speculative.
The liquidity preference theory has come under criticism as the forces that determine the interest rate are not purely monetary. The theory does not take real-world factors into account.
Background
The liquidity preference theory falls under macroeconomics, the branch of economics that studies the overall behavior of a country's economy. Keynes's ideas fundamentally changed the field.
Under the liquidity preference theory, Keynes proposed for simplification purposes that people keep their wealth in two kinds of assets: money or bonds (or other securities). He suggested that if an individual's wealth remains fixed, holding more cash means holding fewer bonds. When people decide to change the amount of money they hold, this affects whether they hold more or fewer bonds.
Keynes theorized that people had three reasons for holding onto their money. The transactions motive refers to the everyday spending conducted by individuals and businesses. Most individuals are on a fixed income and receive their income through paychecks issued at specific intervals. Between paychecks, people must hold onto some cash to pay for their transactions. This may include paying rent, buying groceries, and filling their vehicles with gas. Businesses must have cash on hand to pay for expenses that arise. Their expenditures include covering the costs of raw materials, transportation, and employee wages.
The precautionary motive is setting money aside for unexpected contingencies. Individuals may keep money on hand in case of emergencies, such as a layoff, a vehicle accident, or the onset of sickness. People may also need to attend to house repairs, unexpected guests, or a plane trip to visit an ailing relative. Businesses may save money in case of equipment repairs or unexpected propositions.
The speculative motive involves holding money with the expectation of gaining from a change in the interest rate or bond prices. Interest rates and bond prices are inversely related. If the interest rate is expected to decrease, then bond prices will likely go up. People will buy bonds now to sell them and profit when the price increases. If the interest rate is expected to increase, then bond prices will likely go down. Individuals will sell their bonds now to avoid future losses. Keynes suggested people would rather hold onto cash than bonds or securities if the prices are expected to drop relatively soon.
Overview
Keynes developed the liquidity preference theory as a reaction to the classical theory of interest, which proposed that two real factors, saving and investment, determined the interest rate. According to Keynes's theory, the interest rate was determined by the supply of money and the demand for money. He believed the rate of interest is the payment that investors receive not for saving or waiting but for sacrificing the liquidity of bonds and securities.
The supply of money is the quantity of money in a nation's economy controlled by the central monetary authority. In the liquidity preference theory, the supply of money is fixed in the short term. The demand for money is people's desire to hold cash. The theory assumes the liquidity of money explains its demand.
The liquidity preference theory proposes that the interest rate will adjust accordingly to keep the supply and demand of money in balance. This can be shown graphically as a liquidity preference schedule. The demand curve for money, or the liquidity preference curve, shows the amount of money demanded at various interest rates. The liquidity preference curve intersects the money supply curve at the interest rate where the quantity of money demanded is equal to the quantity of money supplied. This interest rate is called the equilibrium interest rate.
If the interest rate is not at equilibrium, the liquidity preference theory suggests that people will adjust their assets to propel the interest rate toward the equilibrium level. If the interest rate goes above the equilibrium interest rate, then the quantity of money that people want to hold is less than the amount of money in supply. People will react to the surplus of money by buying bonds or saving the extra cash in an interest-paying bank account. Banks or bond issuers will lower interest rates so they do not have to pay investors as much. As the interest rate falls, people will prefer to hold onto their money until demand meets supply at the equilibrium interest rate.
When the interest rate falls below equilibrium level, the amount of money that people want to hold is more than the amount in supply. To deal with the shortage, people will try to raise their cash holdings by selling bonds and other securities. As people reduce their bonds, bond issuers will raise interest rates to draw buyers. This will push up the interest rate until it reaches equilibrium.
Keynes's theories, including the liquidity preference theory, have been influential in paving the way for governments to take a primary role in economic activity through monetary policy. However, the liquidity preference theory has garnered much criticism. Critics assert that the interest rate is not affected by monetary forces alone. Keynes's theory ignores real factors that impact the interest rate, such as the productivity of capital, saving, and thriftiness. Keynes's theory prioritizes liquidity preference, which is not the only factor that can affect the demand and supply of money.
The liquidity preference theory also employs circular reasoning. Keynes states that the speculative demand for money and supply of money determine the interest rate. He supposes, however, that the speculative demand for money is dependent upon the interest rate, which is somehow already known. In addition, Keynes's theory states that interest is not the reward for saving or waiting, but if people do not save in the first place, they have no liquidity to give up.
Bibliography
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