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Explain the Liquidity Preference Theory?

by Puja

The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. The ‘real’ factors of the supply of saving and the demand for investment are the determinants of the equilibrium interest rate in the classical model. Whereas in the Keynesian analysis, determinants of the interest rate are the ‘monetary’ factors alone.

As the determinants of interest rate, Keynes’ analysis concentrates on the demand for and supply of money. According to Keynes, the rate of interest is purely “a monetary phenomenon.” Hence, the price paid for borrowed funds is the interest. Therefore, the rate of interest in the Keynesian theory is determine by the demand for money and supply of money.

Liquidity preference theory – Demand for money

The desire for demand for money arises because of three motives:

1. Transaction Demand for Money:

Firstly, for day to day transaction money is needed. Money is demanded as there is gap between the receipt of income and spending. Income is earned at the end of week or month but individuals income are spent to meet day to day transaction. Throughout the period spending are made but income are received after a period of time. To finance the transaction individual needs active balance in the form of cash. This is known as transaction demand for money. To meet day to day transaction people with higher income keep more liquid money. Transaction demand for money is an increasing function of money income.

Tdm= f (Y)


·         Tdm stands for transaction demand for money and

·         Y stands for money income.

2.     Precautionary Demand for Money:

People keep cash to meet uncertain contingencies, like sickness, death, accidents, danger of unemployment, etc. Under this motive the amount of money held, called ‘Idle balance’, also depends on the level of money income of an individual. In addition to meet such unforeseen emergencies people with higher incomes can afford to keep more liquid money.  In other words the precautionary Demand for Money is an increasing function of money income.

Pdm = f (Y)

3.     Speculative Demand for Money:

The speculative motive refers to the desire to hold one’s assets in liquid form to take advantages of market movements regarding the uncertainty and expectation of future changes in the rate of interest.

Sdm = f (r) Where, Y is the rate of interest.

4.     Total demand for money –

The total demand for money (DM) is the sum of all three types of demand for money.

That is, Dm = Tdm + Pdm + Sdm.

Therefore the demand for money has a negative slope because of the inverse relationship between the speculative demand for money and the rate of interest.

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