PROJECT REPORT

ON
KEYNESIAN THEORY OF DEMAND FOR MONEY

MA ECONOMICS (PART 1)
SEMESTER 1
2019-20

SUBMITTED
BY
MADHURI NAIDU
ROLL NO 5

K.G. JOSHI COLLEGE OF ARTS AND N.G. BEDEKAR

COLLEGE OF COMMERCE
THANE – WEST
 DECLARATION

I, MADHURI NAIDU student of M.A. ECONOMICS PART 1

semester 1 hereby declare that I have completed the project on Keynesian
Theory of Demand for Money. I further declare that the information
imparted is true and fair to my knowledge.

SIGNATURE

NAME: MADHURI NAIDU

ROLL NO 5.
 ACKNOWLEDGEMENT

I hereby express my heartiest thanks to all sources who have contributed

to the making of this project. I oblige thanks to all who supported,
provided their valuable guidance and helped for the accomplishment of
this project.
I am thankful to Mumbai University for giving me such a task which
includes not only thinking and analyzing various facts and updates about
real work.
I am thankful to Prof. Mahendra Mishra sir who have given me the
opportunity to complete this project.
I also extent my hearty thanks to all my family, friends and all the well-
wisher.
 TABLE OF CONTENT

1. OVERVIEW
2. OBJECTIVES OF THE STUDY
3. LITERATURE REVIEW ON DEMAND FOR MONEY
4. RESEARCH METHODOLOGY AND DATA COLLECTION
5. KEYNESIAN THEORY OF DEMAND FOR MONEY
6. LIQUIDITY PREFERENCE THEORY IN INTEREST RATE
7. LIQUIDITY PREFERENCE THEORY: MOTIVES AND
CRITICISMS
8. CONCLUSIONS
9. BIBLIOGRAPHY
 OVERVIEW

The theory of liquidity preference of theory of demand of money states

that agents in financial markets demonstrate a preference for liquidity.
under the theory of liquidity preference, an investor faced with two assets
offering the same rate of return will always choose more liquid asset. The
term liquidity preference was introduced by English economist John
Maynard Keynes in his 1936 book, “The General Theory of
Employment, Interest, and Money. Keynes called the aggregate demand
for money in the economy liquidity preference.

The Keynesian Monetary Theory and the LM Curve

According to Keynes General theory, the short-term interest rate is
determined by the supply and demand for money. Holding money is the
opportunity cost of not investing that money in short-term bonds. The
demand for money is a function of short-term interest rate and is known
as the liquidity preference function.
Money supply is usually a fixed quantity set by a central banking
authority. L(r,Y) is a liquidity preference function if, where r is the short-
term interest rate and Y is the level of output in the economy.
Formally, the liquidity money (LM) curve is the locus of points in
Output-Interest rate space such that the money market is in equilibrium.
Alternatively, we can say that the LM curve maps changes in money
demand or supply to changes in the short-term interest rate.

The Theory of Liquidity Preference and an Upward Sloping Yield Curve

According to the Theory of Liquidity Preference, the short-term interest
rate in an economy is determined by the supply and demand for the most
liquid asset in the economy – money. The concept, when extended to the
bond market, gives a clear explanation for the upward sloping yield
curve. Since investors strictly prefer liquidity, in order to persuade
investors to buy long-term bonds over short-term bonds, the return
offered by long-term bonds must be greater than the return offered by
short-term bonds.

The Preferred Habitat Theory

The Theory of Liquidity preference is a special case of the Preferred
Habitat Theory in which the preferred habitat is the short-end of the term
structure. The preferred Habitat Theory states that the market for bonds is
segmented on the basis of the bonds term structure, and these segmented
markets are linked on the basis of the preferences of bond market
investors.
Under the preferred Habitat Theory, bond market investors prefer to
invest in a specific part or habitat of the term structure.
 INTRODUCTION

Keynes provides a more rigorous analysis than his predecessors and

looked at the money demand issue in a completely different analytical
angle. When the classical and neoclassical economists analyzed the
money demand mainly in terms of “money in motion” that is, there is no
hoarding possibility as all income is spent, keynes analyzed money in
terms of held(as in the Cambridge approach of quantity theory) and
focused on the motives that lead people to hold money and the money
demand arising from these motives. In this respect, keynes associated
himself with the Mercantalist views.
Keynes postulated that the individuals held with three motives:
transactions, precautionary, and speculative. The transactions motive is
similar to the emphasis the quantity theories placed on money as a
medium of exchange. He theorized that the level of transactions
conducted by an individual, and also by the aggregate of individuals,
bears a stable relationship to the level of income thereby suggesting that
the transactions demand for money depends on the level of income. The
transactions demand for money arises because of the nonsynchronization
of payments and receipts. Individuals are also uncertain about the
payments they might want, or have, to make. He hypothesized that this
precautionary motive also creates a demand for money. Therefore, the
precautionary demand for money provides a contingency plan for
unscheduled expenditures during unforseen circumstances. Money serves
as medium of exchange in this motive, and by large, it depends on the
level of income as well. His significant contribution to the money
demand theory, however, came from the role the speculative motive
plays. The speculative demand for money is what Keynes called as
“liquidity preference”. Keynes tried to formalize one aspect of the
suggestions earlier made by Marshall and Pigou that uncertainty about
the future was a factor influencing the demand for money. Instead, of
talking uncertainty in general, keynes focused on one economic variable,
the future level of the interest rate, in specific, the future yield on bonds.
Keynes approach to the money demand theory was well
developed by keynes (1930 and 1936). The store of value function is
emphasized in the speculative motive of the demand for money.
Individuals can hold their wealth either in money or in bonds. The price
the individuals are willing to pay for bonds depends on the rate of interest
as the prospective buyers would wish to earn at least the going rate of
interest on their bond portion of their portfolio. Keynes argued that, at
any time, there was a value, or perhaps a range of values, of the rate of
interest that could be regarded as normal. When the rate is above this
normal range there is a tendency for people to expect it to fall, and rise
when the rate is below this range.
For an individual agent with given and precise expectations about
the future value of the interest rate, the speculative demand for money is
a discontinuous function of its current level. However, for the economy
as a whole, people may have divergent expectations about the rate of
change of the interest rate toward their own precise estimates of its future
value. Provided that there is some diversity of opinion from the expected
rate of interest at any moment, and the money and bond holdings of each
agent are insignificant relative to the total amount in the economy, the
aggregate speculative demand for money function becomes a smooth and
negative function of the current level of the interest rate.
Thus the interest rate was formally introduced in the money
demand function and the function now can be represented as md = f(y,i),
where the demand for real money balances md is a function of real
income y and interest rate I. Thus the Keynesian theory of money
demand, like his predecessors is a theory of demand for real money. The
major implication of the Keynesian analysis is that when the interest rate
is very low, everyone in the economy will expect it to increase in the
future, and hence, prefers to hold money whatever is supplied. At this
stage, the aggregate demand for money becomes perfectly elastic with
respect to the interest rate. The economy goes into a situation called
“liquidity trap” in which the interest elasticity of money demand can be
infinite at low levels of interest rate.
Upon Keynes contribution to the theory of money demand,
researchers put forward a number of other theories by including both
income and interest rates as arguments to examine the nature and the
determinants of the money demand functions. These theories implicitly
address a broad range of hypotheses by emphasizing the transactions,
speculative, precautionary, or utility considerations of holding money.

OBJECTIVES OF THE STUDY

• To understand the Keynesian theory of demand for money

• To become aware of the keynesian theory of demand for money and
its attributes.
• To know the liquidity preference and demand for money of various
kinds.
• To offer conclusions to the study of keynesian theory of demand for
money
 LITERATURE REVIEW ON DEMAND FOR MONEY

Many scholars, researchers have contributed a lot of research

publications on demand for money. Hence, a review of few studies
deserve due attention for the analysis of the present study. The study of
literature review is an important aspect in any study, through which one
can understand the past trends in research output in any particular
discipline.
Ghysels, Eric in their study, "The spectrum of the non-seasonal part has a
dip right before the seasonal frequency and a peak right after. It is also
noticed that the spectrum of the non-seasonal may lied above the
spectrum of the observed series.
Kulkarni and Stephen Miller explores that, "the long-run analysis of
Indian monetary data suggest that base money growth is the major source
of money-stock growth -either Mi or M3. Adjustments in the money
multipliers do contribute to explaining money-stock growth but on a
much smaller scale.
John Maynard Keynes (1971) concentrated on the medium of exchange
function of money. Keynes extended the Marshallian analysis to include
the banking system. He considered both supply and demand for money in
his equation.
Milton Friedmen (1956) propounded the wealth theory of demand for
money. For him the demand for money function is relatively stable and
predictable.

RESEARCH METHODLOGY

Research methodology is a way to systematically solve the research

problem. It may be understood as a science of studying how research is
done systematically. We study the various steps that are generally taken
by the researcher in studying the research problem along with the logic
behind it. The research methodology include over all research design, the
sampling procedure, the data collection and analysis procedure.

Steps of Methodology

Collection of Data
Organization of data
Presentation of data
Analysis of data
Interpretation of data
Research design: Research design helps in proper collection and analysis
of data. It makes research relevant to the objective of research and sees
the proper process carried out. The present study was mainly the
exploratory study.

Data Collection
The analysis is purely based on the secondary data
Secondary research is based on:
1. Business Magazines
2. Internet Sources
3. Finance books.

KEYNESIAN THEORY OF DEMAND FOR MONEY

Keynesian theory of the demand for money was first formulated by

Keynes in his well-known book, The Genera’ Theory of Employment,
Interest and Money (1936). It has developed further by other economists
of Keynesian persuasion.

Why is Money Demanded?

The question to be asked in full is why is money demanded when money

does not earn its holders any income whereas there are competing non-

money financial assets in the economy which yield some income to their

holders?
One general answer can be that money yields its holders conveniences

yield of non-pecuniary nature. This yield is rooted in the peculiar

characteristic of money as the only generally acceptable means of

payment, and so it’s perfect liquidity.

More concretely, Keynes said that money was demanded due to three

main motives:

(1) The transactions motive,

(2) The precautionary motive and

(3) The speculative motive.

Ever since this threefold classification of motives has become standard

stock-in-trade of monetary economists. Later efforts to add other motives

such as the finance motive by Keynes (1937) and Robertson (1938) and

the diversification motive by Gurley and Shaw (1960) have not been

successful.

The three motives and corresponding demands for money are explained

briefly first, to be followed by somewhat extended discus-sion of the

individual components of the demand for money. The transactions

motive gives rise to the transactions demand for money which refers to

the demand for cash of the public for making current transactions of all

kinds. This is inextricably bound with the use of money as the medium of

exchange in a money-exchange economy.

The precautionary motive induces the public to hold money to provide

for contingencies requiring sudden expenditure and for unforeseen

opportunities of advantageous purchase. This motive (demand) is a

product of uncertainties of all kinds. The speculative motive giving rise

to the speculative demand for money is the most important contribution

Keynes made to the theory of the demand for money.

It explains why the public may hold surplus cash (over and above that

demanded due to the other two motives) in the face of interest- earning

bonds (and other financial assets). The reason is that the holders of such

speculative balances may anticipate such fall in future prices as will

make the loss of foregone interest earnings look relatively smaller.

So they wait with cash for bond prices to fall, avoid expected capital

losses, and switch into bonds when the anticipated bond prices have been

realized. The speculative demand for money is sometimes also called the

asset demand for money—not a happy term, because, money being an

asset, the entire demand for it is an asset demand.

Related to the above is the distinction between active and idle balances

made in the Keynesian literature. The active balances are defined as

balances used as means of payments in national income- generating

transactions. The rest are called idle balances. The distinction is useful to

explain how changes in’ the income velocity of money come about and
how the same quantity of money can support higher or lower levels of

money expenditure when idle balances are converted into active balances

or vice versa.

The Determinants of the Demand for Money:

Keynes made the demand for money a function of two variables, namely

income (Y) 4 and the rate of interest (r). Being a Cambridge economist,

Keynes retained the influence of the Cambridge approach to the demand

for money under which Md is hypothesised to be a function of Y. But he

argued that this explained only the transactions and the precautionary

demand for money, and not the entire demand for money.

The truly novel and revolutionary element of Keynes’ theory of the

demand for money is the component of the speculative demand for

money. Through it Keynes made (a part of) the demand for money a

declining function of the rate of interest, the latter a purely monetary

phenomenon and the sole carrier of monetary influences in the economy.

Thus the speculative demand for money constitutes the main pillar of

Keynes’ revolution in monetary theory and Keynes’ attack on the

quantity theory of money. This is explained below.

The speculative demand for money arises from the speculative motive for

holding money. The latter arises from the variability of interest rates in

the market and uncertainty about them. For simplicity Keynes -assumed

that perpetual bonds are the only non-money financial asset in the

economy, which compete with money in the asset portfolio of the public.

Money does not earn its holders any interest income, but its capital value

in terms of itself is always fixed. Bonds, on the other hand, yield interest

income to their holders. But this income can be more than wiped out if
bond prices fall in future. It can be shown algebraically that the price of a

(perpetual) bond is given by the reciprocal of the market rate of interest

times the coupon rate of interest.

Suppose the coupon rate (i.e. interest payable on a bond) is Re 1 per year

and the market rate f interest is 4 per cent per year. Then the market

(price of the bond will) be Rs. 1/.04 X 1 = Rs. 25. If the market rate of

interest rises to 5 per cent per year, the market price of the bond will fall
to Rs. 1/.05 X I Rs. 20. Thus, bond price is seen as an inverse function of

the rate interest.

Economic units hold a part of their wealth in the form of financial assets.

In the two-asset model of Keynes, these assets are money and (perpetual)

bonds. Bond prices keep on changing from time to time. Therefore, they

are subject to capital gains or losses. Thus, to a bond-holder the return

from bond-holding per unit period (say a year) per Rs 1, is the rate of

interest ± capital gain or loss per year, the time of making investment in

bonds, the market rate of interest will be a given datum to an individual,

but the future rate of interest or bond price, and so the expected rate of

capital gain or loss will have to be anticipated. Hence the element of

speculation in the bond market and as shown below, also in the money

market.

The speculators are of two kinds: bulls and bears. Bulls are those who

expect the bond prices to rise in the future. Bears expect these prices to

fall. In Keynes’ model, these expectations are assumed to be held with

certainty. Bulls, then, are assumed to invest all their idle cash into bonds.

Bears instead will move out of bonds into cash if their expected capital
losses on bonds exceed interest income from bond-holding. Thereby they

minimise their losses. Thus, the specula-tive demand for money arises

only from bears. It is the demand for bearish hoards. These bears build up

their cash balances to move into bonds when either bond prices have

fallen as expected or when they come to expect that bond prices will rise

in future.
The above model implies an all-or-nothing behaviour on the part of

individual asset holders. Either they are entirely into bonds (bulls) or

entirely into cash (bears). That is, their portfolios are pure and not

diversified.

To move to the aggregate speculative demand for money, Keynes

assumed that different asset holders have different interest-rate

expectations. Thus, at a certain very high rate of interest (and very low

price of bonds), all may be bulls. Then, the speculative demand for

money will be equal to hero. But at a lower rate of interest (higher bond

price) some bulls will become bears and positive demand for speculative

balances will emerge.

At a still lower rate of interest (and still higher bond price), Tie more

bulls will become bears and the speculative demand for higher still. Thus,

Keynes derived a downward-sloping aggregate speculative demand curve

for money with respect to the “a rate of interest, as shown

Keynes also suggested the possibility of the existence of what is called

the liquidity trap. This refers to a situation when at a certain rate of

interest the (speculative) demand for money becomes perfectly elastic.

This will come about when at that rate all the asset holders turn bears, so

that none is willing to hold bonds and everyone wants to move into cash.

In Figure above, such a situation occurs at the rate of interest ro. Then, no

amount of expansion of money-supply can lower the rate of interest

further. The public is willing to hold the entire extra amount of money at
ro. The extra liquidity created by the monetary authority gets trapped in

the asset portfolios of the public without lowering r. The ro serves as the

minimum r below which it cannot be lowered.

Another element in Keynes’ theory of the speculative demand for money

is the concept of the ‘normal’ rate of interest. Keynes postulated that at

any moment there was a certain r which the asset holders regard as

‘normal’, as the r which will tend to prevail in the market under ‘normal

conditions’. This ‘normal’ r acts as the benchmark with respect to which

any actual r is judged as high or low.

Differences of r expectations among asset holders then can be interpreted

as differences about the level of the ‘normal’ r. The amount of money

demanded for speculative purposes depends on the current level of r

relative to this ‘normal’ r as seen by various individuals. If the latter

changes, the quantity of money demanded at any particular r will also

change.

Since ‘normal’ r, or people’s expectation about it, cannot be taken as a

time constant, Keynes argument implies that the relation between the

demand for money and r will not be stable over time. This is an important
result which has not been fully appreciated even by Keynes’ followers. It

can be seen to damage Keynes’ own theory of the interest rate

determination but more so the quantity theory of money and the

effectiveness o monetary policy.

Keynes’ micro theory of the speculative demand tor money has been

called into question by Tobin (1958). It was noted above that for an

individual Keynes’ explanation leads to a pure asset portfolio of either

money or bonds. This is contrary to experience. In actual life mixed asset

portfolios are the rule. Tobin’s alternative formulation yields such

portfolios even at individual level. For this, unlike Keynes, he assumes

that an individual does not hold his interest-rate expectations with

certainty.

Then liquidity preference is analyzed as behaviour towards risk under

uncertainty. Acting on uncertain interest-rate expectations means

assuming some risk of capital loss. The degree of risk increases with

every increase in the proportion of bonds in the asset portfolio. Normally,

asset holders are risk averters, so that they will require a higher

compensation (rate of interest) for undertaking higher risk.

Thus, at a higher r more bonds and less money will be held in the

portfolio and at a lower r less bonds and more money will be preferred.

The result is a , diversified asset portfolio and a downward sloping asset

demand curve for money with respect to r even at the micro level. On

suitable assumptions, the aggregate asset demand for money is also

shown as a declining function of r.

Keynes’ theory of the speculative demand for money has also been
criticized on the ground that it treats all non-money financial assets

(NMFAs) as bonds. Such treatment is an unwarranted simplification,

because a large number of such assets are unlike bonds in that their

capital values are nominally fixed and do not vary (inversely) with r.

In India, the examples of such NMFAs are fixed deposits with

commercial banks, post offices, and public limited companies, nation-al

savings certificates, UTI units, etc. Substitution between them and money
does not entail Keynes’ speculative motive, because they are not subject

to variation in their nominal capital values. In their case, their rates of

return influence as simple opportunity-cost variables without any element

of speculation.

Gurley and Shaw (1960) also do not favour keeping the Md function

confined to a simple two-asset world. In their analysis of the effects of

financial growth, exhibited by security differentiation and the growth of

secondary securities, they have stressed the growing competition or asset

substitution which money has to face from the NMFAs in the asset

portfolios of wealth-holders.

According to them, things being the same, this ever-growing asset

substitution has to downward displacements of the demand for money,

has made demand less stable, and made monetary policy less effective

than before.Much systematic empirical work has not been done on these

hypotheses. Most empirical studies on the demand for money have

tended to ignore them. What little empirical work has been done for the

USA (Fiege, 1964) does not lend definite support to the Gurley and Shaw

hypotheses.After a fairly long detour, we come back to Keynes’ theory of

the demand for money.

This is summed up in the following equa-tion:

Md = L1(Y) + L(r). It is an additive demand function with two separate

components. L1(Y) represents the’ transactions and precautionary

demand for money. Keynes made both an increasing function of the level

of money income. In the Cambridge tradition, he tended to assume that

L1(Y) had proportional form of the kind represented in Figure 11.1. The
second component L 2 (r) represents the speculative demand for money,

which, as shown above, Keynes argued to be a declining function of r. As

shown in Figure, this relation was not assumed to be linear. Keynes’

additive form of the demand function for money of equation Md = L1(Y)

+ L(r). (11.3) has been discarded by Keynesians and other econo-mists. It

has been argued that money is one asset, not two, three, or many. The

motives to hold it may be of any number. The same unit of money can

serve all these motives. So the demand for it cannot be compartmenalised

into separate components independent of each other.Also, as in Baumol-

Tobin theory, the transactions demand for money also is interest elastic.

The same can be argued for the precautionary demand for money too.

The explanation of the speculative demand for money shows that this

kind of demand will be an increasing function of total assets or wealth. If

income is taken as a proxy for wealth, the speculative demand also

becomes a function of both income and the rate of interest.These

arguments have led to the following revised form of the Keynesian

demand function for money:

Md=L(Y,r),

where’ it is hypothesised that Md is an increasing function of Y and a

declining function of r.The replacement of the simple Md function of

equation Md = K Y, (11.1) by that of equation Md = L(Y,r), (11.4) has

been the single most important revolution- any development in the field

of monetary theory. It has also been the use of many battles between the

neoclassical economists and the Keynesians. It has necessitated

integration of value theory with monetary theory or of the real sector with

the monetary sector, of which Hicks’ IS-LM model is a well-known

example.This makes the simple quantity theory of money model suspect

by making the income-velocity of money responsive to changes in the

rate of interest. The latter changes can come about by any number of

factors originating in the money market or the commodity market. Our

main purpose in adding this paragraph to the text is to emphasize once

again the importance of the demand function for money in monetary

theory.
 LIQUIDITY PREFERENCE THEORY IN INTEREST RATE

1. Liquidity Trap:
By liquidity trap, we mean a situation where the rate of interest cannot
fall below a particular minimum level. It means rate of interest is always
positive.
It cannot be zero or negative. It can be shown with the help of below
figure

Along the X-axis is represented the speculative demand for money and
along the Y-axis the rate of interest. The liquidity preference curve LP is
downward sloping towards the right. It signifies that the higher the rate of
interest, the lower the demand for speculative motive, and vice-versa.
Thus, at the high current rate of interest OR, a very small amount OM is
held for speculative motive. This is because at a high current rate of
interest much money would have been lent out or used for Buying bonds
and therefore less money will be kept as inactive balances.
If the rate of interest rises to OR1 then less amount OM1 will be held
under speculative motive. With the further fall in the rate of interest to
OR2, money held under speculative motive increases to OM2. It will be
seen in Fig. 12 that the liquidity preference curve LP becomes quite flat
i.e., perfectly’ elastic at a very low rate of interest. It is horizontal line
beyond point EE1 towards the right. This perfectly elastic portion of
liquidity preference curve indicates the position of absolute liquidity
preference of the people.
That is, at a very low rate of interest people will hold with them as
inactive balances any amount of money they come to have. This portion
of liquidity preference curve with absolute liquidity preference is called
liquidity trap by some economists.
M1, = L1, (Y)
2. Interest is Monetary Phenomenon:
According to Keynes, interest is a purely monetary phenomenon. His
theory has focused on the role of money in determining the rate of
interest.
3. More Generalized:
The classical theory was a special theory applicable only to a full-
employment situation. Keynes theory is more general in that it is
applicable both to full as well as under employment situations.
4. Integrated Theory:
A great merit of Keynes theory is that it has integrated the theory of
interest with the general theory of output and employment. Employment
depends on the level of investment and inducement to invest is
influenced apart from marginal efficiency of capital, by the rate of
interest.
5. Integration with Price:
Keynes has integrated the theory of interest with the theory of price. The
classical writers had unduly emphasized such real factors as abstinence
and time preference. According to Keynes, interest is the price of money,
and like the price of any commodity, it is determined by the demand for
and supply of money.
6. More Practical:
The theory is of great practical significance also. The rate of interest
depends on the demand for and supply of money. The supply of money is
regulated by the government or the monetary authority of the country.
Therefore, the government can greatly influence the rate of interest by
regulating money-supply. Also through its liquidity trap hypothesis, the
theory stresses the limitation of monetary authority in lowering the rate
of interest beyond a certain level.
7. Inverse Relation between Interest and Price:
Another importance of Keynes liquidity preference is that bond prices are
inversely related to interest rate. It means, interest rate and bond prices
move in opposite direction.
8. Long Term Vs. Short Term Interest Rates:
According to Keynes, interest is a reward for parting with liquidity. The
interest rate differs on debts of different lengths and maturities. The
interest rate on daily loans will be different from the rates of interest on
weekly, monthly and yearly loans. Debts of longer maturity’ like three,
five or ten years will have different interest rates.
 Liquidity Preference Theory: Motives and Criticism

The Liquidity Preference Theory was propounded by the Late Lord J. M.

Keynes.
According to this theory, the rate of interest is the payment for parting
with liquidity.
Liquidity refers to the convenience of holding cash. Everyone in this
world likes to have money with him for a number of purposes. This
constitutes his demand for money to hold.
The sum-total of all individual demands forms the demand for money for
the economy. On the other hand, we have got a supply of money
consisting of coins plus bank notes plus demand deposits with banks. The
demand and supply of money, between themselves, determine the rate of
interest.
Motives for Liquidity:
Money may be demanded to satisfy a number of motives.
These are:
(i) Transactions Motive:
We get income only periodically. We must keep some money with us till
we receive income next, otherwise how can we carry on transactions?
Transactions motive also includes business motive. It takes some time
before the businessman can sell his product in the market. But he must
pay wages to the workers, cost of raw material, etc., now. He must keep
some cash for the purpose.
(ii) Precautionary Motive:
Everyone lays by something for a rainy day. Some money must be kept
to meet unforeseen situations and emergencies.
(iii) Speculative Motive:
Future is uncertain. Rate of interest in the market continues changing. No
one can guess what turn the change will take. But everybody hopes, and
with confidence, that his guess is likely to be correct. It may or may not
be so. Some money, therefore, is kept to speculate on these probable
changes to earn profit.
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 Central Bank of
the country. The total supply of money consists of coins plus notes plus
demand deposits with banks.
We see, thus, that according to liquidity preference theory, the rate of
interest is purely a monetary phenomenon. Productivity of capital has
very little, though indirect, say in determining the rate of interest. How
the rate of interest is determined by the equilibrium between the liquidity
preference for speculative motive and the supply of money is shown in
Fig
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, OM2 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.Assuming no change in expectations, an
increase in the quantity of money (via open-market operations) for the
speculative motive will lower the rate of interest. In part (a) of the figure,
when the quantity of money increases from OM1 to OM2, the rate of
interest falls from Or to Or’, because the new quantity of money OM’; is
in balance with the speculative demand for money at Or’ rate of interest.
In this case, we move down the LPS curve. Thus, given the schedule or
curve of liquidity preference for speculative motive, an increase in the
quantity of money brings down the rate of interest.It is worth mentioning
that shifts in liquidity preference schedule or curve can be caused by
many other factors which affect expectations and might take place
independently of changes in the quantity of money by the Central Bank.
Shifts in the liquidity preference curve may be either downward or
upward, depending on the way in which the public interprets a change in
events.If some change in events leads the people on balance to expect a
higher rate of interest in the future than they had previously anticipated,
the liquidity preference for speculative motive will increase, which will
bring about an upward shift in the curve of liquidity preference for
speculative motive and will raise the rate of interest.
In part (b) of fig, assuming that the quantity of money remains
unchanged at OM2, with the rise of the liquidity preference curve from
LPS to L’P’S’, the rate of interest rises from Or to Or”, because at Or”,
the new speculative demand for money is in equilibrium with the supply
of money OM2. It is worth noting that when the liquidity preference
speculative motive rises from LPS to L’P’S’, the amount of money
hoarded does not rise; it remains as OM; as before. Only the rate of
interest rises from Or to Or” to equilibrate the new liquidity preference
for speculative motive with the available quantity of money OM 2.Thus,
we see that Keynes explained interest in terms of purely monetary forces
and not in terms of real forces like productivity of capital and thrift,
which formed the foundation-stones of both classical and loanable fund
theories. According to him, demand for money for speculative motive
together with the supply of money determines the rate of
interest.Moreover, according to Keynes, interest is not a reward for
saving or thriftiness or waiting, but for parting with liquidity. Keynes
asserted that it is not the rate of interest which equalizes saving and
investment, but this equality is brought about through changes in the
level of incomes.

CRITICISM

Keynes’s 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 important 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 for
capital investment. The demand for capital investment depends upon the
marginal revenue productivity of capital. Therefore, the rate of interest is
not determined independently of the marginal productivity of capital or
marginal efficiency of capital, as Keynes calls it.
(iii) Liquidity preference is not the only factor governing the rate of
interest. There are several other factors which influence the rate of
interest by affecting the demand for and supply of investable funds.
(iv) This theory does not explain the existence of different rate of interest
prevailing in the market at the same time.
(v) Keynes ignores saving or waiting as a source or means of investible
funds. To part with liquidity without there being any saving is
meaningless.
(vi) The Keynesian theory explains interest in the short run only. It gives
no clue to the rates of interest in the long run.
(vii) Finally, exactly the same criticism applies to Keynesian theory itself
on the basis of which Keynes rejected the classical and loanable funds
theories. Keynes’s theory of interest, like the classical and the loanable
funds theories, is indeterminate.
According to Keynes, the rate of interest is determined by the speculative
demand for money and the supply of money available for satisfying
speculative demand. Given the total money supply, we cannot know how
much money will be available to satisfy the speculative demand for
money unless we know how much the transactions demand for money is;
and we cannot know the transactions demand for money unless we first
know the level of income. Thus, the Keynesian theory, like the classical,
is indeterminate.
“In the Keynesian case the supply and demand for money schedules
cannot give the rate of interest unless we already know the income level;
in the classical case the demand and supply schedules for savings offer
no solution until the income is known. Precisely the same is true of
loanable-funds theory. Keynes’s criticism of the classical and loanable-
funds theories applies equally to his own theory.”—Hansen.
 CONCLUSION

Keynesian theory was innovative as it attempted to explain

macroeconomic fluctuations in the short run, where previously
economists generally thought in terms of the long run and where the
economy would tend to settle over time. Keynesian economics was never
meant to explain more than the short run. Modern macroeconomics
courses are taught the modern versions of Keynesian theory.
I,view Keynes as one of the great early economists. He created a base of
knowledge and insight still useful in economics today. Many of his
insights are still taught in economics today in undergraduate courses
(although the models were advanced, developed, and evolved by
Samuelson and others and popularized in texts such as Samuelson’s
famous text).
That being said, Keynes came from a different era when economics was
often posited using simply graphics, algebra, and intuition. Modern
economics has evolved dramatically to using much more complex
mathematic models, advanced statistical testing, general equilibrium
modeling and solutions, and dynamic models of economic behavior.
Some of the basic Keynesian models have been shown to be inconsistent
with general equilibrium principles and these more advanced
mathematical models. Statistical evidence for the stimulative effects of
tax cuts have shown that tax cuts do not have the stimulative effects
predicted by the simpler Keynesian models.
These more advanced modeling methodologies, particularly developed in
the 1970s and 1980s, have shown that the more simplistic Keynesian
models are incomplete, inconsistent with certain equilibrium conditions,
and require more insight into human behavior in order to effectively
predict and match observed economic behavior.
 BIBLIOGRAPHY
www.google.com
www.sharenet.com
www.hindustantimes.com
www.banknedindia.com
Prasanna Chandrahan, magazine by S.chand.