Liquidity Preference Theory of Interest  Part 2   –  Derivation of Demand curve for Money

Liquidity Preference Theory of Interest Part 2 – Derivation of Demand curve for Money


Liquidity Preference Theory of Interest Part 2 In this lesson we shall see how the liquidity preference curve or the demand curve of money is derived. Keynes has identified three motives behind the demand for money. They are – Transaction motive Precautionary motive, and Speculative motive These three motives are the main forces behind the demand for money. In plain and simple language, ‘demand for, money’ I mean, quantity of money people would like to keep with themselves, in the form of cash, ready to use on these three types of expenditures. We shall use a hypothetical table to derive the liquidity preference schedule. Rs.3 crores cash, people of a country would like to hold to meet everyday expenses is called as the Transaction demand for money. Rs.2 crores cash, people would like to hold to meet any unforeseen expenditures is called Precautionary demand for money. Again Rs.6 crores cash, people would like to hold to take advantage of the changes in the interest rate or changes in the bond prices is called speculative demand for money. In our discussion the term people refer to all the households, business houses and corporates, ,in short, all the economic units in the nation which developed the habit of holding money against these three motives. With this information, let us proceed to construct a liquidity preference schedule. Money demanded for Transaction and Precautionary motives are insensitive to changes in the interest rate. Look at the table, the interest level falls from 9% to 3%, the Transaction demand for money remains at Rs.3crores. It doesn’t change. It depends on the Income. Similarly the Precautionary demand for money, Rs.2 crores, also doesn’t vary when the interest rate changes. It also depends on the income.
Speculative demand for money is highly sensitive to the rate of interest. At 9% interest the community demands Rs.2 crores of money under speculative motive. At 6%, it wants to hold Rs.6 crores. At 3%, the community’s demand for money is 10 crores. There is inverse relation between rate of interest and the demand for money. Here the demand for money refers to the amount of money, the community wants keep readily with itself to buy bonds. OK, why does the community want to hold more money with itself at low rate of interest. We know, higher the bond prices, lesser the rate of interest. Here lies the answer for our question. The current interest rate is low in the market. It means the bond prices are high. The community expects, there is a high possibility for the bond prices to fall in the near future. The community feels, if the prices of bond fall to a satisfactory level, and if it keeps ready cash, it can buy and enjoy a high interest income. It is, this intention, that makes the community to demand more money at a low rate of interest. Then, why does the demand for money is low at high level of interest? The current rate of interest is high because the bond prices are low. The possibility for any further fall in the prices of bond is less. Even if the prices fall, the community strongly believes, the fall in price will be minimum and cannot be very large. So, the community feels, it is enough if it keeps less money to buy bonds.
For different interest rates, the quantity of money, the community decides to hold, under speculative motive, differs. But one thing is very clear. The community’s demand for money to perform speculation, is less at high rate of interest and more at low rate of interest. Well. It is time for us to derive the demand curve for money. Open a new column ‘ Total demand for money’ to hold the total of the three kinds of demand. Total demand for money at 9% rate of interest is 3 plus 2 plus 2, 7 crores. Similarly the total demand for money at 6% is 11 crores and 3% is 15 crores. To derive the demand curve for money, we are going to use Rate of interest and the corresponding total demand for money. These pairs of values are going to be plotted on a graph sheet. The rate of interest is measured along the Y-axis. The demand for money is measured along the x-axis. After plotting these pairs of values, join the points with the help of a smooth curve. The resultant curve is the demand curve for money. In the diagram LP is the demand curve of money or liquidity preference curve.
Now, it is time for us to test our understanding –
Say, true or false. Speculative demand for money varies directly with the rate of interest. False
Money is demanded only by the business community to carry out business activities. False
Money is demanded for carrying out investments. False.
Be ready for the next lesson. It is going to be about interest rate determination.

5 Comments

  • Venkatachalapathi Baskar

    May 19, 2018

    பணமா? பத்திரமா?, that's the problem.

    When the rate of interest is higher, it signifies a lower bond price. People think that the rate of interest is higher and it won't increase any further. So, people think that the next step in interest rate would be a fall which means higher bond prices. Analysing the present with the expectation of the future, people thought to buy bonds, (because they are cheap now and fetch capital gains in the future) and indeed they do so, which means less money would be held as liquid and more money is alloted for bonds. So, when the rate of interest is higher, the demand for liquidity preference is lower and the speculative demand for money is more!

    We must separate the concepts of speculative demand for money and liquidity preference.

    I think most of the textbooks confuse this.

    Reply
  • Venkatachalapathi Baskar

    May 20, 2018

    Spending the money to purchase bonds is the speculative demand for money. Not buying bonds but to keep money in liquid form is the 'liquidity preference'.

    Reply
  • Venkatachalapathi Baskar

    May 20, 2018

    If the rate of interest is higher, what people would do? Purchase bonds; since more money is used for purchase of bonds, less money is held in liquid form. And that is why, higher interest rate leads to lower liquidity preference and vice versa.

    Reply
  • jaya sankar

    August 27, 2018

    I want all video in tamil . please help me

    Reply
  • SURESH KUMAR M R

    February 23, 2019

    Sir I am requesting you to explain true or false questions by taking at least 3 – 5 seconds time… It will improve our understanding even more… Thank you…

    Hope you will do the needful sir…

    Reply

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