Theories of interest rate determination are very important in economics. We have already discussed the classical theory of interest rate. Today we are discussing the Keynesian theory of interest rate. we can also call this theory as Liquidity Preference theory. According to Keynes, the interest rate is not given for the saving i.e. hoarding. The interest rate according to Keynes is given for parting with liquidity for a particular period of time. So, the interest rate solely depends on the demand and supply of money. The people decide whether to keep cash with themselves or part with liquidity and earn interest on interest-bearing instruments.
So, the key variable which determines interest rate is the idea of whether an individual keeps cash or part of the control of the cash over a specified period of time. Keynes explained this factor as liquidity preference. So, it is quite clear that people demand money for liquidity preferences. Hence, their preference level and the supply of money together decide the interest rate.
Demand for Money of Liquidity Preference:
There are actually three motives behind keeping the cash. These three motives together determine the liquidity preference of the people. The three motives are the transaction, precautionary and speculative motives. According to Keynes’s theory, these three motives constitute the demand for money. So, considering the money supply at any given time, it is the liquidity preference of the people which helps in the interest rate determination. Now, we will discuss those three motives/reasons for which people demand cash in more detail.
The Transaction Motive:
We need cash To fulfill our day-to-day transactions. So, you need to fulfill the current personal or business transactions which are the transaction motive behind keeping the cash. There is an obvious gap between spending and the receipt of income. From the business point of view, there is a gap between sale proceeds and the expenditure. If there is less gap between receipt and spending, the demand for liquid cash will be less. In case, there is a wide gap between the receipts and spending, the demand for liquid cash will be high. Because we need liquid cash to deal with our day-to-day expenses. We do transactions on daily basis and for that purpose, we need to keep a certain amount of our income or earnings in the form of cash.
So, when cash is kept for this reason i.e. to meet day-to-day transactions. This is the transaction motive for keeping the cash. The transaction motive is directly dependent on the income of an individual or business. As Keynes argued that demand for money to satisfy transaction motive changes with the change in the level of the income.
People having high income will keep more cash and has a higher demand for money. Whereas, those with less income will keep less cash and has lesser demand for the money for transaction motive.
As we know that future is always uncertain. That is the reason people keep cash to cope up with those uncertainties. The amount hold for this purpose is called the precautionary demand for cash. Anything can occur in the future such as accidents, illness, unemployment, or any other incident like that. one must have some cash to deal with such situations. So, people keep cash for this purpose. The amount of cash demanded also depends on the level of income.
People with higher income can keep more cash for such a situation. People with low income will demand a low level of cash for this purpose. The same is the case with businesses. They also keep cash for this purpose. That is why business does contingency planning and have some cash for this purpose.
The Speculative Motive:
After keeping enough cash for the transaction and precautionary motive, people invest some funds for speculative purposes. Individuals and business invest their money in interest-bearing bonds and securities based on their speculation. Moreover, the demand for speculative motives is sensitive to interest rates. So, the aggregate demand or money to fulfill the speculative motive is a direct response to the changes in the interest rate.
So, if there is speculation that bond prices will rise in the future. People will start buying bonds when the prices are low and sell them in the future. This how they will benefit from it. Hence, in this case, the bond is more attractive than actual cash.
Opposite to that, if the prices are predicted to fall, people will start selling bonds to avoid the loss. Cash will be more attractive to keep in such a situation.
Overall Demand for the Money:
The overall demand for the money is the collective demand for transaction, precautionary and speculative motives.
Thus, DM= D (transaction motive) + D (precautionary motive) + D (speculative Motive)
Supply of the Money:
The supply of money at a given time is dependent on the monetary policy and the credit creation by banks. So, the amount of currency which a government allows to issue is the money supply at a given time. one cant increase the supply of money on its own like they do in the case of a commodity, so the supply function of money is in the form of a straight line parallel to the y-axis. The money supply is fixed in the short run.
Determination of Interest Rate:
Now, let us discuss the determination of interest rate according to the Keynesian theory of interest rate. We will discuss it with the help of the diagram;
In this diagram, the Curve SS represents the supply of money which is perfectly inelastic. Whereas, LP is the Liquidity Preference Curve which is downward sloping. The Curves intersect each other at point E which is the equilibrium point. OM is the Quantity of money demanded and supplied. Finally, “or” is the equilibrium point for the rate of interest.
Let us suppose that the supply of money remains constant, however, the liquidity preference curve rises to L’P’. in this situation a new equilibrium point will be E’ and the interest rate rises to “or’”.