Liquidity Preference Theory of Interest

People demand money to keep it as liquid (cash). Keynes calls this demand or preference for money or liquidity preference. Lending involves a decline in the stock of money held as liquid (cash). In other words, lending involves surrender of liquidity by the lender. Interest is the payment made to induce people to surrender their liquidity. In the words of Keynes, “rate of interest is the reward for parting with liquidity for a specific period”. Keynes has given three reasons for the liquidity preference of people. They are

(i) transaction motive

(ii) pre-cautionary motive and

(iii) speculative motive.

There is a gap between receipt of income and spending. In order to bridge this gap, people keep liquid money (cash) and this is known as transaction motive. People keep liquid money (cash) to spend during unforeseen or unexpected events. This is known as precautionary motive. People may keep cash on hand to make profit out of anticipated changes in the prices of bonds and shares. This is called speculative motive. When the rate of interest falls, the demand for money will increase and when the rate of interest rises, the demand for money will decrease. Thus, the demand for money is negatively related to the interest rate and the demand curve for money will slope downward from left to right. Supply of money is from two sources namely, (i) government and (ii) the banking system. Money put into circulation by the government is called legal tender money. The depositors can withdraw their money from the bank and the deposited money is called bank.