Keynes liquidity preference theory of interest rate determination.

2. CERTIFICATE
This is to certify, that the Assignment submitted by me is an
outcome of my independent and original work. I have duly
acknowledged all the sources from which the ideas and extracts have
been taken. I have made this Assignment under the guidelines of my
Professor. The project is free from any plagiarism.
Kratika Soni

3. ACKNOWLEDGEMENT
I would like to acknowledge that the Assignment created by me is
completed Under there supervision of my teacher with complete
determination and Authenticity.
I would also wish to express my gratitude to Professor Dr. Harinarayan
Vishwakarma for extended discussions and valuable suggestions which
have contributed greatly to the improvement of this project work.
Now I would like to extend my gratitude for the pretentious institution
Dr. Hari Singh Gour University who has given me an opportunity to learn
Interactively through this program of Bachelor of Arts.
Specially I would pay regards to all my dear friends who helped me
to understand the concept in depth, without them this workpiece
could not complete. Their suggestions and comments helped me to
finish my work under deadline.
I take this opportunity to thank all of those who supported me to
complete it.
April 6, 2020
Kratika Soni

4. Contents
• Introduction
• About Keynes
• What is interest?
• Determination of Rate of interest on money 💰
• Demand of money
o Transaction motive
o Precautionary motive
o Speculation motive
• Total demand of money
• Total supply of money
• Demand and supply equilibrium for determination of rate of interest
• Criticism of Keynes Theory of interest
• Conclusion
• Bibliographie

5. INTRODUCTION
Eminent economist of 20th century Lord Keynes has propounded a
Monetary Theory of interest in his famous book THE GRNERAL THEORY
OF EMPLOYMENT, INTEREST AND MONEY.
There were two more theories of determining rate of interest were
Propounded which were Classical Theory by J. S. Mill, Prof. Marshall,
Walres and Pigou. And Neo-liberal Theory by Robertson and B. Ohlin.
But among all such theories Keynes theory is most reliable and
trustworthy.
Keynes Theory of interest, also known as Liquidity Preference Theory of
Interest.
The determinants of the equilibrium interest rate in the classical model are
the ‘REAL’ factors of the supply of saving and the demand for investment.
On the other hand, in the Keynesian analysis, determinants of the interest
rate are the ‘MONETARY’ factors alone.
Keynes’ analysis concentrates on the demand for and supply of money
as the determinants of interest rate. According to Keynes, the rate of
interest is purely “A MONETARY PHENOMENON.” Interest is the price
paid for borrowed funds. People like to keep cash with them rather than
investing cash in assets. Thus, there is a preference for liquid cash.

6. JOHN MAYNARD KEYNES
About the economist
John Maynard Keynes was born on 5 June 1883, was a British economist,
whose ideas or school of thought known as Keynesian economics.
During the Great Depression of the 1930s, Keynes advocated the use
of fiscal and monetary policies to mitigate the adverse effects of
economic recessions and depressions. He detailed these ideas in his
magnum opus, The General Theory of Employment, Interest and Money,
published in 1936.
The Liquidity Preference theory is also one of his great set of ideas.

7. WHAT IS INETREST?
Meaning- The money that you pay for borrowing money from a bank,
etc. or the money that you earn when you keep money in a bank, etc.
According to keynes “ Interest is the reward for parting with liquidity for
specific period.”
Interest is of two types- Gross Interest and Net interest. It can be easily
understand by the
Equation below-
Gross Interest = Net Interest + Reward of risk + Reward of management+
Reward of inconvenience
Rate of interest
Meaning- the proportion of a loan that is charged as interest to the
borrower, typically expressed as an annual percentage of the loan
outstanding.
According to Keynes “ The rate of interest is the premium which is to be
offered to induce the people to hold wealth in same form then the
hoorded money.”
As far we can understand the meaning of liquidity by his defination
It means cash or preference of cash.

8. DETERMINATION OF INTEREST ON MONEY
The two factors on with the rate of interest depends are the
demand of money and the supply of money.
The rate of interest in the Keynesian theory is determined by the
demand for money and supply of money and create a equilibrium
condition.
DEMAND FOR MONEY
DEMAND FOR MONEY IS NOT TO BE CONFUSED WITH THE DEMAND FOR A
COMMODITY THAT PEOPLE ‘CONSUME’. BUT SINCE MONEY IS NOT
CONSUMED, THE DEMAND FOR MONEY IS A DEMAND TO HOLD AN ASSET.
THE DESIRE FOR LIQUIDITY OR DEMAND FOR MONEY ARISES BECAUSE OF
THREE MOTIVES:
(A) TRANSACTION MOTIVE
(B) PRECAUTIONARY MOTIVE
(C) SPECULATIVE MOTIVE

9. TRANSACTION DEMAND FOR MONEY:
Money which is needed for day to day transaction.
Transaction demand for money or need- based money—which directly
depends on the level of income of an individual and businesses.
People with higher incomes keep more liquid money at hand to meet their
need-based transactions. In other words, transaction demand for money is an
increasing function of money income.
Tdm = f (Y)
Where,
Tdm stands for transaction demand for money and
Y stands for money income.
Relationship between transaction demand and rate of interest can be
represented as –
By the graph shown above it can be seen that the rate of interest is
independent to demand for transportation because income comes just once
in a month but money needed for transaction required whole month and for
transportation the person won’t get any interest on it.

10. PRECAUTIONARY DEMAND FOR MONEY:
Money needed for emergency purposes.
Future is uncertain. That is why people hold cash balances to meet
unforeseen contingencies, like sickness, death, accidents, danger of
unemployment, etc. It also depends on the level of money income of an
individual but irrespective to rate of interest.
This kind of demand for money is also an increasing function of money
income. The relationship between precautionary demand for money
(Pdm) and the volume of income is normally a direct one.
Pdm = f (Y)
Relationship between the precautionary motive and rate of
interest is also independent to each other because the money
saved for precautionary purposes do not give any interest to
man.
Therefore the graph will be similar as transaction demand.
The combined demand for money for both will be equal to
Mdm = Tdm + Pdm. …(1)

11. SPECULATIVE DEMAND FOR MONEY:
Money left after completion of demand for transaction and
precautionary motive and used for investment on risk.
This sort of demand for money is really Keynes’ contribution. The speculative motive
refers to the desire to hold one’s assets in liquid form to take advantages of market
movements regarding the uncertainty and expectation of future changes in the rate of
interest.
The cash held under this motive is used to make speculative gains by dealing in bonds
and securities whose prices and rate of interest fluctuate inversely.
Speculative demand for money (Sdm) varies inversely with the rate of interest. Thus,
Sdm = f (r)
Where, Y is the rate of interest.
And f(r) = a∝1/b
Relationship between Speculative demand and rate of interest can be
represented as-

12. 2
The the curve shown above on x-axis it shows speculative demand of
money and on y axis it shows rate of Interest. that means it interest rate
are higher as are on liquidity of cash in hand is the least but when rate of
interest is very low as are not people don’t prefer to invest instead they
prefer to hold money as cash this is known as liquidity trap
When rate of interest is 15 the Liquidity is 0, it means the preference on
hold money will be least and when rate of interest is 3, Liquidity remains
constant.
Total demand for money
The total demand for money (DM) is the sum of all three types of demand for money.
That is, Dm = Tdm + Pdm + Sdm. The demand for money has a negative slope because of the
inverse relationship between the speculative demand for money and the rate of
interest.
However, the negative sloping liquidity preference curve becomes perfectly elastic at a
low rate of interest. According to Keynes, there is a floor interest rate below which the
rate of interest cannot fall. This minimum rate of interest indicates absolute liquidity
preference of the people.

13. 3
The graphical representation of Total demand for money will be -
The total liquidity preference is equal total demand for money M1 + M2.
The curve LP which shows the total demand for money is a horizontal
summation of quantity of money demanded M1, and M2, with the same
rate of interest measured on the Y-axis. Thus, in the amount of money
balance held OQ is the same OA and has no relation to interest rate. But
the amount OR shows OA, +OB, Similarly, OS = OA+OC and OT = OA+OD.
Thus, the liquidity preference high interest rate and increase with a fall in

14. 4
the rate of interest. In other words, demand for money and rate of
interest are negatively related.
Total Supply of money
The quantity of Money supply can be determined by monetary authority
who has taken this conduct.
These authorities are usually the government agencies like in India , RBI
take control of supply of money and determine the flow of cash or
liquidity in economy.
The Supply of money is neither the function of income not rate of interest
as the authority do not get any interest in minting currency
Therefore,
Relation between supply of money and rate of interest are independent to
each other.
the supply of money is represented by a vertical line at the quantity of
money that the Fed decides to put out into the public realm. When the Fed

15. 5
increases the money supply this line shifts to the right. Similarly, when the
Fed decreases the money supply, this line shifts to the left.
DEMAND AND SUPPLY EQUILIBRIUM
For determination of rate of interest as per the theory suggested by
Keynes
The graphical representation of equilibrium shown below-
OM is the total amount of money supplied by the central bank. At point E, demand for
money becomes equal to the supply of money. Thus, the equilibrium interest rate is
determined.

16. 6
In such a situation, supply of money will exceed the demand for money. People will
purchase more securities. Consequently, its price will rise and interest rate will fall until
demand for money becomes equal to the supply of money.
On the other hand, if the rate of interest becomes less than or, demand for money will
exceed supply of money, people will sell their securities.
CRITICISM
EVEN KEYNES’ LIQUIDITY PREFERENCE THEORY IS NOT FREE FROM CRITICISMS:
• Firstly, like the classical and neo-classical theories, Keynes’ theory is an
indeterminate one. Keynes charged the classical theory on the ground that it
assumed the level of employment fixed.
• Secondly, Keynes committed an error in rejecting real factors as the determinants
of interest rate determination.
• Thirdly, Keynes’ theory gives a choice between holding risky bonds and riskless
cash. An individual holds either bond or cash and never both. In the real world, it
is the uncertainty or risk that induces an individual to hold both. This gap in

17. 7
Keynes’ theory has been filled up by James Tobin. In fact, today people make a
choice between a variety of assets.
CONCLUSION
Despite these criticisms, Keynes’ liquidity preference theory tells a lot on income, output
and employment of a country. His basic purpose was to demonstrate that a capitalist
economy can never reach full employment due to the existence of liquidity trap.
Though the liquidity trap has been overemphasized by Keynes yet he demolished the
classical conclusion the goal of full employment. Further, his theory has an important
policy implication. The RBI is incapable of reviving a capitalistic economy during
depression because of liquidity trap.
Although Keynes theory is one of the best theory ever discovered and this give scope to
Economists to know more about interest.

18. BIBLIOGRAPHIE
Here is the list of reference that were used to complete this assignment.
1. Principles of microeconomics by H. L. Aahuja
2. www.google.com
3. www.investopedia.in
4. Heena Chadha YouTube