KEYNESIAN LIQUIDITY

PREFERENCE THEORY
This notion of thought was introduced to
us by J.M. Keynes.
 Keynes pointed out that every individual through her
observations and experience in the financial markets
develop a notion of critical rate of interest denoted by
rc.
 If the market rate of interest (rm) is not equal to the
individual’s critical rate of interest, then she expects the
market rate of interest to converge to the critical rate of
interest and accordingly expects the price of bonds to rise
or fall.
 If rm > rc we get,
 When market rate of interest is higher than the
critical rate of interest, she expects the market rate
of interest to fall.
 This implies she expects the bond prices to rise in near
future.
 The individual therefore expects positive capital gains
from bond holding.
 So,she will want to hold all her wealth in form of
bonds.
 This will make her speculative demand for money
equal to zero.
Keynesian
Step
Demand
Function
for
Individuals
 If rm < rc we get,
 When market rate of interest is lower than the
critical rate of interest, she expects the market rate
of interest to rise.
 This implies she expects the bond prices to fall in
near future.
 The individual therefore expects capital losses from
bond holding.
 So,she will want to hold all her wealth in form of
money.
 This will make her speculative demand for money
equal to whole of her wealth.
For Market as a Whole
 Keynes further assumes that different individuals
have different notions about the critical rate of
interest.
 Ifwe record all these perceptions of all
individuals, we get the aggregate speculative
demand for money curve .
 Here it is assumed that the market rate of
interest can only rise upto a certain level and
similarly it can fall upto a pre-determined level.
This is controlled by the concerned authorities
i.e., government.
If rm falls from rmax we get ,
 More and more peoples’ critical rate of
interest is passed.
 From Step demand function we get if, for any
person, the market rate of interest is less
than the critical rate of interest, then the
individual holds money.
 So,
more and more peoples’ demand for
money rises.
Aggregate
Speculative

Demand for
Money
Curve
Similarly if rm rises from rmin we get ,
 More and more peoples’ critical rate of
interest is passed.
 From Step demand function we get if, for any
person, the market rate of interest is more
than the critical rate of interest, then the
individual prefers to hold money in bonds.
 So,
more and more peoples’ demand for
money falls.
LIQUIDITY TRAP
 Definition: It is a situation at a very low interest rate
where the speculative demand for money schedule
becomes nearly horizontal.
 In the aggregate money demand function, we observed
that, the curve obtained is smooth, reflecting the gradual
increase in speculative demand for money at successively
lower interest rates.
 But it flattens out at a very low rate of interest i.e., rmin
showing that at this level , the general expectation of
capital losses on bond outweigh the interest earnings.
 So, increments to wealth would be held in form of money
with no further drop on rate of interest. Keynes termed
this situation as liquidity trap .
Critique of the theory
 According to Hansen, the theory is indeterminate
because the aggregate demand schedule and the
perfectly inelastic supply schedule of money do
not give a picture of rate of interest as the
income level is not known to us.
 According to Tobin, individuals do not hold either
just money or only bonds. They usually have a
diversified portfolio with a blend of bonds, money
and other financial assets.
 And many more but beyond our scope of syllabus.
THANK YOU