Keynesian Theory of Interest.

Keynesian Theory of Interest.
The term interest is used to express a rate of return on capital as a factor of production. It also refers to the price paid by the
borrowers to the lenders for the use of their saving funds. The real interest rate is the nominal interest rate corrected for
inflation. So,
Real interest rate = Nominal interest rate – rate of inflation
The Classical theory explained interest with the real factors like saving & investment. The monetary theory gained more
recognition with the publication of Keynes’ General Theory. According to Keynes, interest is a purely monetary phenomenon
& determined by demand [ liquidity preference ] for money & supply of money. According to him, interest is a price not for
sacrifice or waiting or time preference but for parting with liquidity.
A man with his given income has to decide how much he consume & how much to save. Consumption depends on
propensity to consume. The individual will save the rest of his income. But how much he will save as liquid cash & how much
he will part with or lend depends upon what Keynes called Liquidity preference. Liquidity preference means demand for
money to hold or the desire of the people to hold cash.
According to Keynes, demand for liquidity arises for three basic purposes.
1. Transaction motive 2. Precautionary motive 3. Speculative motive.
1. Transaction motive: This motive relates to the demand for cash for current transaction. A certain amount of ready
cash is kept in hand to make current payments for goods & services to be purchased. The amount depends on
individual’s income, the interval at which income is received & the methods of payments prevailing in the society etc.
2. Precautionary motive: This motive refers to the desire of the people to hold cash balance for unforeseen
contingencies. People hold a certain amount of cash to provide for the danger of unemployment, sickness, accidents
& other uncertain emergencies. The amount of money held under this motive will depend on the nature of the
individual & the condition in which he lives.
3. Speculative motive: This motive relates to the desire to hold one’s resources in liquid form in order to take advantage
of market movements regarding the future changes in the rate of interest [or bond prices]. The cash hold under this
motive is used to make speculative gains by dealing in bonds whose prices fluctuate.
If bond prices are expected to rise which means r is expected to fall, businessman will buy bonds to sell when their
prices actually rise. If however, bond prices are expected to fall, i.e, r is expected to rise businessmen will sell bonds to
avoid capital losses. Nothing being certain in this dynamic world, businessmen keep cash balances to speculate on the
probable future changes in the bond prices and r with a view to make profits. Less money will be held under speculative
motive at a higher r & more money will be held under this motive at a lower r. the reason for this inverse relation between
money held for speculative motive & the prevailing r is that at a lower r, less is lost by not lending money or not investing
it, i.e., by holding on to money, while at a higher r, holders of cash balances would lose more by not lending or investing.
Thus demand for money under speculative motive is a function of the current r, increasing as the r falls & decreasing as
the r rises. So demand for money is a decreasing function of r.
M = M1 + M2 where M1 = L1 ( Y ) and M2 = L2 ( r )
Where M1 = Money held for transaction & precautionary purposes
M2 = money held for speculative purposes
L1 = Liquidity preference for transaction & precautionary purposes
L2 = Liquidity preference for speculative purposes
So, M = L1 [Y] + L2 [ r ] .
Here, along the X axis, speculative demand for money and along the Y axis r is measured. The liquidity preference curve LP
is a downward sloping curve which shows that at a higher r, speculative demand for money will be less and at a lower r,
speculative demand will increase. At a higher rate of interest Or, a small amount of money OM will be held for speculative
purpose because more money will be lent out. If the rate of interest falls to Or՛, a greater amount OM՛ will be held for
speculative purpose. With further fall in r to OR՛՛, money held for speculative purpose will increase to OM՛՛. But the LP curve
is horizontal or perfectly elastic after M՛՛. This indicates the position of absolute liquidity preference of the people. At a very
low r, people will hold with them as inactive balance, any amount of money they come to have. This is called Liquidity Trap.
If the majority of the people expect the rate of interest to be higher, i.e., the bond prices to be lower in the future, the
speculative demand for money will increase & whole liquidity preference curve for speculative motive will shift upwards.
Thus, Keynes explained interest in terms of purely monetary forces & not in terms of real forces like productivity of capital.
According to him, demand for money for speculative purpose along with the supply of money determines rate of interest.
CRITICISM.: Keynes’ Liquidity Preference theory has been subjected to some criticisms.
1. Keynes ignored the real forces like productivity of capital, savings, demand for investment etc which can also
influence the rate of interest.
2. Keynes’ theory is also indeterminate. To him, r is determined by speculative demand for money & supply of money.
Given the money supply, we can’t know how much will be available for speculative purpose unless we know the
transaction demand which again depends on income. But we can’t know income unless we know r which will
determine investment which again helps to determine income.
3. To Keynes, r is a reward for parting with liquidity & in no way a compensation & inducement for saving or waiting.
But without saving it will be impossible to know how much fund will be kept as liquid cash. So r is indirectly related to
saving which was ignored by Keynes.
Keynesian theory of interest is also not without flaws. But the importance Keynes gave to liquidity preference as a
determinant of interest is correct. In fact the exponents of loanable funds theory incorporated the liquidity preference in their
theory by giving greater importance to hoarding & dishoarding. So, Keynesian theory of interest can be considered as an
important theory in the determination of rate of interest.

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Real interest rate = Nominal interest rate – rate of inflation

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