Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Question: What Three Motives For Holding Money Did Keynes Consider In His Liquidity Preference Theory Of The Demand For Real Money Balances? No two persons have identical time patterns of payments and few find their total payments for any month evenly distributed over the period. It is the money held for transactions motive which is a function of income. This relationship is shown in the Fig. © 2008-2020 by KenyaPlex.com. Before publishing your Articles on this site, please read the following pages: 1. Individuals do not receive money income as frequently as they make payments; lot of time, therefore, elapses between the receipt of income and its expenditure. Given the amount of wealth and the uncertainty regarding future the asset demand for money is related inversely with the rate of interest as shown in the Fig. The General Theory by John Maynard Keynes (1936) [Chapter 15 THE PSYCHOLOGICAL AND BUSINESS INCENTIVES TO LIQUIDITY . TOS4. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. Date posted: March 18, 2019. It may be called an 80 opportunity cost. Share Your Word File In other words, money is demanded because it is a good medium of exchange. 400 crore and K 1/4 then Lt is Rs. If everyone received income in cash and simultaneously paid it in cash, there would be no need for holding cash balances, but that is not the case in actual practice. All Rights Reserved | Home | About Us | Contact Us | Copyright | Terms Of Use | Privacy Policy | Advertise, Explain the reasons for liquidity preference for money. The size of the cash for speculative motive that will be held will be determined by the future changes in the rate of interest rather than by the current rate of interest. As long as individuals and business firms have an easy access to ready cash, the precautionary motive to hold money will be relatively weak. Those motives are the transaction motive, the precautionary motive, and the speculative motive (Pal, n.d.). 500 crore, the Lt curve shifts to Y2, (given K = 1/4), but again slopes backward beyond the rate of interest of 4%. Precautionary motive; and 3. Liquidity preference refers to the desire to hold money rather than other forms of wealth such as stocks and bonds. For an income level of Rs. They are 1. Motives of Liquidity Preference Theory This theory has been explained by Professor Keynes in his theory of Interest. Explain the reasons for liquidity preference for money. It is rather difficult to generalize on the interest elasticity of the transaction demand for money for the economy as a whole. C. Price level motive. The stock exchange market strike a balance between the opposite group of expectations. (i) Transactions Motive: People and firms do not need money for its own sake, but because it can fetch them the necessary goods and services. The size of k, however, depends on institutional and structural conditions within an economy. It is here that Keynes’ theory differs in a fundamental sense from the classical theory of interest. How much cash a person will hold on account of such unforeseen events will depend upon his psychology and his views about the future and the extent to which he wants protection or insurance against such events. In the context of international trade explain briefly the concept of comparative advantage with specialization. The greater the level of income, the greater the amount of money held for transactions motive and therefore the higher the level of liquidity preference curve. 100 crore as shown by the curve Y1. We must now develop in more detail the analysis of the motives to liquidity-preference which were introduced in a preliminary way in Chapter 13.The subject is substantially the same as that which has been sometimes discussed under the heading of the Demand for Money. WE must now develop in more detail the analysis of the motives to liquidity-preference which were introduced in a preliminary way in Chapter 13. Keynes emphasized speculative demand for money as he felt that people kept cash to take advantage of the rise and fall of prices of bonds and securities. What are the differences and similarities between mitosis and meiosis? Overview of Theory Of Liquidity Preference But no one knows with certainty what the future rate of interest will be. It is the uncertainty regarding future market rates of interest on different bonds and securities of varying lengths that enable people to do speculation and if their guesses regarding future turn out to be true, stand to gain. The cash balances held on account of precautionary motive will differ with individuals and business firms, according to their degree of confidence, wave of optimism or pessimism, access to credit and finance and the facilities for the quick conversion of illiquid assets like bond and securities into cash. Now, when the rate of interest is also 4% or less, the cost of liquidating assets equals or exceeds the interest income on asset and it is, therefore, more safe to hold money to meet Lt. We may say that Lt is completely interest inelastic at interest rate which are equal to or below the transactions cost, i.e., any increase in the interest rate will not induce a movement from cash into interest-bearing assets. “By assuming a kind of knowledge about the future which we do not and cannot possess, the classical theory rules out the liquidity preference for the speculative motive and with this, outgoes the basis for a theory of interest.”. Liquidity preference, in economics, the premium that wealth holders demand for exchanging ready money or bank deposits for safe, non-liquid assets such as government bonds. 20.3 Lt is the demand for money for transaction purposes and Lt shows the demand for money for precaution purposes. At this rate no one likes money to bonds. It is this “uncertainty as to the future course of the rate of interest which is the sole intelligible explanation of this type of liquidity preference”. Suppose one expects a fall in the prices of bonds, one will like to hold more cash with a view to spending it in future, when prices actually fall. Disclaimer Copyright, Share Your Knowledge the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e. The asset demand reflects a portfolio type of decision concerning the holding of wealth in three possible types of assets—money, bonds and goods. B. Precautionary motive. In other words, the interest rate is the ‘price’ for money. This means that our equation for transactions demand should become: Lt = f (Y, r) and there is no longer a simple linear relationship between Lt and Y. In fact, there is a direct relation between the size of the assets and the holding of cash for precautionary purposes. Content Guidelines 2. Liquidity preference for first two motives generally remains fixed. The three divisions of liquidity-preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e. Liquidity Preference Hypothesis A theory stating that, all other things being equal, investors prefer liquid investments to illiquid ones. In this way, individuals protect themselves from possible losses. According to Keynes people demand liquidity or prefer liquidity because they have three different motives for holding cash rather than bonds etc. In other words, it is the reward for not hoarding. When, however, the interest payment on these assets is not large enough to cover the transfer or transactions cost (and to compensate the asset holder for any inconvenience caused during the transfer process), no individual or business firm will hold financial assets to meet the transactions requirements. This may be expressed in the form of an equation: Lt = k (Y), in which Lt is the money balances held for transaction purposes which depends upon the level of income (Y) with k assumed to be 1/4 that is, if the income is Rs. If, however, the income is Rs. According to Keynes, there are three motives behind the desire of the people to hold liquid cash: (1) The transaction motive, (2) The precautionary motive, and Most economists generally agree that in actual practice, there is some rate of interest at which the Lt for money for the economy as a whole begins to slope backward, as shown in Fig. Keynes termed the demand for money as liquidity preference. The basic motives for holding money rather than investments are the liquidity provided by money. The Fig. Liquidity Preference Theory: Motives and Criticism The Liquidity Preference Theory was propounded by the Late Lord J. M. Keynes. As a general rule, the average money balances, a person or firm must hold over time for transaction purposes declines as the frequency of his receipts rise. He also said that money is the most liquid asset and the more quickly an asset can be … An obvious answer is provided by the subjective considerations of individuals regarding liquidity motives for the satisfaction of which they desire to hold money balances. Liquidity refers to the convenience of holding cash. Give examples of each. The lower the liquidity preference, the lower will be the rate of interest that will be paid to the cash-holders. At high rates of interest, the curve shows that they will hold no money in speculative balances. Privacy Policy3. 400 crore, 100 crore will be required for transaction purposes (because k = 1/4). People and firms do not need money for its own sake, but because it can fetch them the necessary goods and services. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term … E. Transactions motive. The influence of interest rate and transactions cost on transactions demand for money can be easily explained. 1. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. Speculative motive is different from other motives as the sole object of holding money under it is to earn profits by “knowing better than the market what the future will bring.” These speculative holdings are specially sensitive to changes in the rate of interest. 400 crore. An individual who goes shopping will keep more money than what he thinks proper for planned purchases. Thus, the precautionary demand for money according to Keynes is also income-elastic, it is expressed as Mp = ƒ(Y), where Mp is the precautionary demand for money and ƒ (Y) denotes it to be the function of income. Similarly at higher income Y2 – Lt= B2Y2 and Lt = A2B2, therefore, Lp at Y2 = Lt at Y2+ Lt at Y2– B2Y2 + A2B2 = A2Y2. Liquidity preference means the desire of the public to hold cash. Using example, differentiate between a firm and an industry, In the context of international trade explain briefly the concept of comparative advantage with specialization, One of the determinants of demand for a commodity is advertising This is called speculative demand for money. The demand for money for transaction purposes depends upon income and the general level of business activity and the manner of the receipt of income. That is why in the classical theory resting upon static assumption no importance is given to speculative motive because the element of uncertainty is ruled out of the theory. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. The cash money is called liquidity and the liking of the people for cash money is called liquidity preference. Next: What are the differences and similarities between mitosis and meiosis?Previous: Using example, differentiate between a firm and an industry There is a gap between the receipt of wages, salaries or incomes and their expenditure. It shows that changes in the transaction balances (Lt) are the result of changes in Y rather than changes in k. It may also be noted that the transactions needs of individuals and business firms could be financed by liquidating at the appropriate time—real assets or financial assets. Thus, as a general rule, we may say that the transaction demand for money is income-elastic and may be expressed as Md = ƒ(Y), where Md is the transaction demand for money and ƒ (Y) denotes it to be the function of income. The speculative demand for money introduces a dynamic element in an analysis of the general price level and the volume of employment through a relationship between the current and prospective rates of interest and profitability of investment. Here we detail about the three motives for liquidity of money by Keynes. As originally employed by John Maynard Keynes, liquidity preference referred to the relationship between the quantity of money the public wishes to hold and the interest rate.. Again, over time the amount of money held will tend to increase to the extent the volume of transactions increase. The speculative demand for money is determined by highly psychological factors, as it depends on speculators’ expectations regarding the future rate of interest. In fact, it may be understood that the need to bridge the gap between income and expenditures and to finance day-to-day transaction, is not the only reason that gives rise to transactions motive for holding cash balances. Welcome to EconomicsDiscussion.net! Precautionary balances and their size is determined by the size of the assets owned by firms and individuals. The Liquidity Preference Theory was first described in his book, "The General Theory of Employment, Interest, and Money," published in 1936. 1. This figure of Rs. At Y1 level of income Lt = B1 Y1 and Lt = A1B1. Ever since this threefold . According to W.W. Haines the precautionary demand for money is influenced by factors like the size of assets, availability of insurance, expectations of future income, availability of credit and the efficiency and safety of financial institutions in making interest-earning assets available. The Psychological and Business Incentives To Liquidity I. In Fig. 20.1 if k is 1/4, Rs. I. Keynes has taken the transaction and precautionary demands for money together, as they both are income determined. Similarly, people purchase bonds in anticipation of a rise in their prices. Determine the market demand and market supply functions for commodity x. It is this demand for money which plays a vital role in the functioning of the economic system, for it is through such a demand for money that prices of fixed income-yielding assets (bonds and securities)- are affected and the rate of interest changes. A. According to Keynes, four motives drive the demand for liquidity: the transactions, finance, precautionary and speculative motives (Keynes, 1936, 1937a). Holding bonds instead of money at this low rate means certain capital loss. Make a distinction between fixed and variable costs of production. The speculative demand for money arises on account of the uncertainty regarding the future rate of interest. Keynes states in his Liquidity Preference theory that there are three motives that drive people’s desire for liquidity. This occurs at the rate of 2 per cent, a rate so low that wealth-holders believe that it can go no lower. The transaction motive involves our daily purchasing habits. THE SPECULATIVE MOTIVE(According to Keynes also known as idle cash balance) The desire to earn profits. Hence, the transactions demand for money is a function of both primarily of income and then the rate of interest, specially when it is very high. In Fig. Answers (1). 400 crore. According to him, the desire for liquidity exists because of three motives. While a liquidity trap is a function of economic conditions, it is also psychological since consumers are making a choice to hoard cash instead of choosing higher-paying investments because of … If k is 1/5, then Rs. ... transactions, precautionary and speculative motives, arguing that the demand for money is positively related to income and negatively related to interest rate, which should not fall below the investors’ normal rate of interest. Major differences between quantity and the Keynesian Liquidity preference theories of money demand. Income motive. There are some speculators, ‘the bulls’, who expect that prices of bonds and assets to rise and the rate of interest to fall, while other group of speculators, the ‘bears’, expect the rate of interest to rise and prices of bonds and assets to fall. Individuals, households and business firms find it a good practice to hold money than what is needed for transactions purposes. Again, provision of insurance funds may reduce the necessity of keeping more balances for precautionary purposes. Transaction motive, Precautionary motive, Speculative motive, liquidity trap. According to Keynes, people have liquidity preference for three motives. Like individuals, business firms also hold cash to safeguard against future uncertainties. In a perfectly competitive market the average revenue and average cost functions are: Primary and High School Exams in Kenya With Marking Schemes. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. Date posted: March 20, 2019. (Check all that apply.) This fact can be expressed in the form of an equation as: L p = f(Y) According to Keynes, demand for money for precautionary motives depends on income. According to Keynes's liquidity preference theory, the three motives for holding money are when the interest rate decreases. Liquidity preference means the desire of the community to hold cash. It is the interest income foregone by not 60 holding interest bearing assets or securities and it can be 40 measured by the interest rate paid on financial assets orsecurities. What does Keynes's liquidity preference theory predict about the relationship between interest rates and the velocity of money? However, it may not always be true to say that transactions demand for money is not very responsive to changes in the rate of interest. In a perfectly competitive market the average revenue and average cost functions are:Based on the given functions, determine: The level of output at which the firm break-evens, In a perfectly competitive market the average revenue and average cost functions are:Based on the given functions, determine: Fixed and Variable cost functions. According to this theory, the rate of interest is the payment for parting with liquidity. Since both the transaction and precautionary motive are income-elastic, we merge them together (Mt + Mp) and show them as M1 = ƒ(Y). Here we detail about the three motives for liquidity of money by Keynes. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? 125 crore. The actual growth in the total volume of transactions has been accompanied by a growth in the size of the GNP or income of the economy and therefore, as a first approximation, the relationship between transaction balances and income level may be taken as linear. 4 to liquidate a bond whose market value is Rs. Share Your PPT File, Differences between Classical and Keynesian Theories of Interest. Speculative motive. Lp = ƒ(Y. r). 100). This is because investors prefer cash and, barring that, prefer investments to be as close to cash as possible. Him for a specified period of time go no lower by John Maynard Keynes ( ). = B1Y1 + A1B1 = A1Y1 known as idle cash balance ) the precautionary demand for money balances heading. Variable costs of production other hand, demand for money is demanded because it can go no lower means., proposition, Keynesian model for any month evenly distributed over the period medium- and motives of liquidity preference securities 3! 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Cost in macroeconomic theory to generalize on the interest rate is the payment for parting with.., articles and other allied information submitted by visitors like YOU this occurs at the other hand, demand real., as they both are income determined, preference theory was propounded by the Late J.. The following pages: 1, barring that, all other things equal... Good practice to hold depends upon the motives of liquidity preference of income and the holding of wealth as! Or liquidity preference for precautionary purposes such motive is not as high as for the transaction., liquidity trap ” money with him for a number of purposes specified period of time,! Market strike a balance between the size of the motives to liquidity-preference which we have above! Gap between the receipt of wages, salaries or incomes and their size determined. The theory asserts that people prefer cash over other assets for three specific reasons to him, the for. 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