Keynesian Theory of Demand for Money

Demand for money:

Liquidity preference means the desire of the public to hold cash. According to
Keynes, there are three motives behind the desire of the public to hold liquid cash:
(1) the transaction motive,
(2) the precautionary motive, and
(3) the speculative motive.

Transactions Motive:
 The transaction motive relates to the demand for money or the need of cash
for the current transactions of individual and business exchanges.
 Individuals hold cash in order to bridge the gap between the receipt of
income and its expenditure.
 The businessmen also need to hold ready cash in order to meet their current
needs like payments for raw materials, transport, wages etc. This is called
the business motive.
 The transaction demand for money depends upon (i) size of income (ii) time
gap between the receipt of income and (iii) spending habit of the people.

Precautionary motive:
 Precautionary motive for holding money refers to the desire to hold cash
balances for unforeseen contingencies. Individuals hold some cash to
provide for illness, accidents, unemployment and other unforeseen
contingencies. Similarly, businessmen keep cash in reserve to tide over
unfavourable conditions.
 Keynes holds that the transaction and precautionary motives are
relatively interest inelastic, but are highly income elastic.
 This demand for money depends upon (i) size of income, (ii) nature of
the people and (iii) foresightedness of the people.
Speculative Motive:

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  The speculative motive relates to the desire to hold one’s resources in
liquid form to take advantage of future changes in the rate of interest or
bond prices.
 Bond prices and the rate of interest are inversely related to each other.
 If bond prices are expected to rise, i.e., the rate of interest is expected to
fall, people will buy bonds to sell when the price later actually rises.
 If, however, bond prices are expected to fall, i.e., the rate of interest is
expected to rise, people will sell bonds to avoid losses.
 At a high interest rate, individuals will expect interest rates to fall and
bond prices to rise. To benefit from the rise in bond prices individuals
will use their speculative balances to buy bonds. Thus, when interest
rates are high, speculative balances are low.
 At low interest rates, individuals will expect interest rates to rise and
bond prices to fall. To avoid the capital losses associated with a fall in
bond prices, individuals will sell their bonds and add to their speculative
cash balances. Thus, when interest rates are low, speculative balances
will be high.

 It will be seen from the figure that the liquidity preference curve becomes
quite flat at a very low interest rate; it is horizontal beyond point X
towards the right. This portion is known as liquidity trap.
 At such a low rate, people prefer to keep money in cash rather than invest
in bonds because purchasing bonds means a definite loss.
Implications of Liquidity Trap
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 A situation in which prevailing interest rates are low and savings rates are high,
making monetary policy ineffective. In a liquidity trap, consumers choose to avoid
bonds and keep their funds in savings because of the prevailing belief that interest
rates will soon rise. Because bonds have an inverse relationship to interest rates,
many consumers do not want to hold an asset with a price that is expected to
decline.
Should the regulatory committee try to stimulate the economy by increasing the
money supply, there would be no effect on interest rates as people do not need to
be encouraged to hold additional cash. There can be no further decline in the rate
of interest as the rate of interest cannot fall to zero.

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