Keynes' Liquidity Theory

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Keynes' Liquidity Theory

Liquidity Preference Theory is a monetary explanation of the rate of Interest forward by Keynes in the book "The General Theory of Employment, Interest and Money" Interest according to Keynes, is the reward to money owner for parting with his liquid control over cash. He says,
Interest is not the price of waiting. It is not the remuneration., necessary to call forth saving because a man may save money, bury it in his backyard, and get nothing from it in the way of interest. Interest is the reward for surrounding liquidity, i.e., a reward for dispensing with the convenience of holding money immediately available.

A man with a given income has to decide how much he should spend on consumption and how much should he save. The part of the income which he will consume depends on what Keynes calls propensity to consume. Then, he has to decide how much of his savings he should keep in the form of liquid cash and how much he should lend to others. This according to Keynes, depends on his liquidity preference. The greater the desire of man to hold liquid cash, the greater will be his liquidity preference. If, then he parts with liquidity, the greater will be his sacrifice of liquidity preference the greater therefore the interest that he would be demanding on his loan.

The rate of interest is thus influenced by liquidity preference and is “the reward for parting with liquidity for a special period.

The degree of liquidity preference, Keynes further point out, depends upon the motives for which men want to hold cash. There are three motives

  • the transaction motive
  • the precautionary motive
  • the speculative motive


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