Speculative motive. Here we detail about the three motives for liquidity of money by Keynes. 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. Again, over time the amount of money held will tend to increase to the extent the volume of transactions increase. What does​ Keynes's liquidity preference theory predict about the relationship between interest rates and the velocity of​ money? Major differences between quantity and the Keynesian Liquidity preference theories of money demand. Thus, we find that the speculative demand for money—an integral part of the demand for money in Keynesian theory—represents a distinct break with Classical theory. According to him, the desire for liquidity exists because of three motives. All Rights Reserved | Home | About Us | Contact Us | Copyright | Terms Of Use | Privacy Policy | Advertise, Explain the reasons for liquidity preference for money. Keynes has taken the transaction and precautionary demands for money together, as they both are income determined. Make a distinction between fixed and variable costs of production. Liquidity Preference Theory: Motives and Criticism The Liquidity Preference Theory was propounded by the Late Lord J. M. Keynes. Therefore, we can say that L, becomes highly interest-elastic as the interest rate rises beyond transactions cost. This is because investors prefer cash and, barring that, prefer investments to be as close to cash as possible. Therefore, as long as the rate of interest paid on assets or securities is greater than zero, no individual or business firm will hold cash balances to meet transactions requirements (provided the cost of liquidating the assets into cash called transfer cost does not exceed the interest payment). The Fig. Lp = ƒ(Y. r). The Liquidity Preference Theory was first described in his book, "The General Theory of Employment, Interest, and Money," published in 1936. Not only individuals and households need money to meet daily transactions, but business firms also need it to meet daily requirements like payment of wages, purchase of raw materials and to pay for transport etc. 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”. 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. 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. This figure of Rs. 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. Next: What are the differences and similarities between mitosis and meiosis?Previous: Using example, differentiate between a firm and an industry 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 B. Precautionary motive. Question: What Three Motives For Holding Money Did Keynes Consider In His Liquidity Preference Theory Of The Demand For Real Money Balances? 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. 20.4. Liquidity preference refers to the desire to hold money rather than other forms of wealth such as stocks and bonds. 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. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term … On The Basis Of These Motives, What Variables Did He Think Determined The Demand For Money? In the context of international trade explain briefly the concept of comparative advantage with specialization. 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. 1. Precaution Motive 3. 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. The three divisions of liquidity-preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? Before publishing your Articles on this site, please read the following pages: 1. 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. As long as individuals and business firms have an easy access to ready cash, the precautionary motive to hold money will be relatively weak. 400 crore. Therefore, it is the existence of such costs along with the gap between income and expenditures which also give rise to the transactions demand for money. According to Keynes people demand liquidity or prefer liquidity because they have three different motives for holding cash rather than bonds etc. According to this theory, the rate of interest is the payment for parting with liquidity. View More CPA Economics Questions and Answers | Return to Questions Index. Answers (1), State the factors that a business firm should consider while developing an advertising policy, Date posted: February 7, 2019. According to John Keynes, there are three motives of liquidity theory: 1. Give examples of each. Liquidity preference or demand for money to hold depends upon transactions motive and specula­tive motive. Individuals, households and business firms find it a good practice to hold money than what is needed for transactions purposes. It may be called an 80 opportunity cost. At the other end of the curve speculative demand becomes perfectly elastic. Distinguish between a trade-off and an opportunity cost in macroeconomic theory. Liquidity refers to the convenience of holding cash. 1. At a rate of 10% or higher the speculative demand coincides with vertical axis—the speculative demand for money is zero. Like the transaction demand for money, the precautionary demand for money balances also slopes upwards from left to right as shown fig 20.3. No two persons have identical time patterns of payments and few find their total payments for any month evenly distributed over the period. Transaction Motive 2. If the units— individual or firms expect their future income to go up and there is easy availability of credit, financial institutions providing facilities of liquidity covertion of securities etc.—then there may not be much need to hold precautionary balances. If the total quantity of money remains unchanged, speculative transactions affect output and employment by changing the rates of interest. Overview of Theory Of Liquidity Preference This occurs at the rate of 2 per cent, a rate so low that wealth-holders believe that it can go no lower. 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. 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. 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. Keynes states in his Liquidity Preference theory that there are three motives that drive people’s desire for liquidity. Date posted: March 18, 2019. 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. In other words, the interest rate is the ‘price’ for money. Liquidity preference theory is a classical model that proposes that an investor should mandate a higher interest rate or premium on securities with long-term maturities that are prone to high risk. The transactions, finance and precautionary motives are assumed to be largely interest-inelastic; only the speculative motive is sensitive to the rate of interest (Keynes, 1936, p. 199). The theory asserts that people prefer cash over other assets for three specific reasons. 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. 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. Transaction motive, Precautionary motive, Speculative motive, liquidity trap. 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. In other words, money is demanded because it is a good medium of exchange. The cash money is called liquidity and the liking of the people for cash money is called liquidity preference. The influence of interest rate and transactions cost on transactions demand for money can be easily explained. ... 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. Under the circumstances where there is no uncertainty, no basis would exist for liquidity preference for the speculative motive. Liquidity preference means the desire of the public to hold cash. 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. This type of demand for money is also determined by income and the general level of business activity. Liquidity Preference Hypothesis A theory stating that, all other things being equal, investors prefer liquid investments to illiquid ones. An individual who goes shopping will keep more money than what he thinks proper for planned purchases. 125 crore. Content Guidelines 2. Therefore, Lt at Yt = Lt at Y1 + Lp at Y1 = B1Y1 + A1B1 = A1Y1. 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. Keynes distinguished three such motives which induce people to hold money. Since both the transaction and precautionary motive are income-elastic, we merge them together (Mt + Mp) and show them as M1 = ƒ(Y). 100). C. Price level motive. (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. Keynes termed the demand for money as liquidity preference. Holding bonds instead of money at this low rate means certain capital loss. 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. This is called speculative demand for money. 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. John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. They are 1. 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. 20.1 if k is 1/4, Rs. Precautionary balances and their size is determined by the size of the assets owned by firms and individuals. The subject is substantially the same as that which has been sometimes discussed under the heading of the Demand for Money. What are the differences and similarities between mitosis and meiosis? Share Your PDF File The stock exchange market strike a balance between the opposite group of expectations. Date posted: March 20, 2019. 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 100 crore denote L, out of Rs. Similarly, people purchase bonds in anticipation of a rise in their prices. 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.. It is rather difficult to generalize on the interest elasticity of the transaction demand for money for the economy as a whole. Chapter 15. If, however, the income is Rs. transactions, precautionary, and speculative. 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. On the other hand, demand for money or liquidity preference for speculative motive is interest elastic, i.e., the function of interest. Ever since this threefold . Everyone in this world likes to have money with him for a number of purposes. 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. In Fig. In fact, there is a direct relation between the size of the assets and the holding of cash for precautionary purposes. 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. It is here that Keynes’ theory differs in a fundamental sense from the classical theory of interest. 20.1. Share Your PPT File, Differences between Classical and Keynesian Theories of Interest. Here we detail about the three motives for liquidity of money by Keynes. There is a gap between the receipt of wages, salaries or incomes and their expenditure. 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. 20.4 shows that the higher the rate of interest, the smaller the amount of assets that wealth-holder choose to hold in money form. In this way, individuals protect themselves from possible losses. The main feature which distinguishes this demand from the two categories considered previously (Lt and Lp) is that it represents demand for money to hold as an asset. Keynes denotes M 1, the combined demand for these two motives. Let us suppose that the transaction cost for liquidating interest-bearing assets is fixed at 4% of the market value of the asset being liquidated (for example, it costs 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. Motives of Liquidity Preference Theory This theory has been explained by Professor Keynes in his theory of Interest. Introduction iquidity preference theory was developed by eynes during the early 193 ’s following the great depression with persistent unemployment for which the quantity theory of money has no answer to economic problems in the society Jhingan (2004). The influence of interest rate is much less or insignificant. If, however, the rate of interest is higher than 4%, interest income earned on financial assets exceeds the transactions costs and there is a clear incentive to move out of cash into interest- bearing assets and the higher the rate of interest rises, the greater the inducement to move into interest-bearing assets. The General Theory by John Maynard Keynes (1936) [Chapter 15 THE PSYCHOLOGICAL AND BUSINESS INCENTIVES TO LIQUIDITY . Such a portfolio decision of Individuals and firms concerning the holding of idle balances or other assets depends on the accumulated wealth (w), rate of interest (r), uncertain future (Ur) and the attitude of people towards risk and income, that is, the speculative or asset demand for money can be shown symbolically as : La – ƒ(r, Ur, w). According to Keynes, four motives drive the demand for liquidity: the transactions, finance, precautionary and speculative motives (Keynes, 1936, 1937a). Explain the extent to which advertising influences demand. Thus, speculative demand for money is interest- elastic and is expressed as M2 = f(r), where M2 is the speculative demand for money and fir) denotes it to be the function of the rate of interest. These are: (1) the transactions motive; (2) the precautionary motive, and (3) the speculative motive. The basic motives for holding money rather than investments are the liquidity provided by money. The asset demand for money is related to the decision-making by persons and firms regarding the forms of assets in r which their savings are accumulated. But there is an inverse relationship between the rate of interest and the holding of precautionary balances, that is. Similarly at higher income Y2 – Lt= B2Y2 and Lt = A2B2, therefore, Lp at Y2 = Lt at Y2+ Lt at Y2– B2Y2 + A2B2 = A2Y2. Key words: refinement, liquidity, preference theory, proposition, Keynesian model. According to Keynes, people have liquidity preference for three motives. Transaction motive; 2. Liquidity preference means the desire of the community to hold cash. 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 … In Fig. 20.2 if Y is Rs. The reason why individuals or business firms hold assets againstcash when cash is more convenient to hold, is that there is a 100 cost of holding idle cash balances. 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. But no one knows with certainty what the future rate of interest will be. 20.3 Lt is the demand for money for transaction purposes and Lt shows the demand for money for precaution purposes. Precautionary motive; and 3. At high rates of interest, the curve shows that they will hold no money in speculative balances. At Y1 level of income Lt = B1 Y1 and Lt = A1B1. Explain the reasons for liquidity preference for money. 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. “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.”. It is the money held for transactions motive which is a function of income. TOS4. Liquidity preference can be thought of as stemming from the following sources: (i) The precautionary motive This relates to the factor that causes people or firms to hold a stock of money in order to finance unforeseen The size of k, however, depends on institutional and structural conditions within an economy. 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 MOTIVE(According to Keynes also known as idle cash balance) The desire to earn profits. This part of the curve is called “liquidity trap”. 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. The asset demand reflects a portfolio type of decision concerning the holding of wealth in three possible types of assets—money, bonds and goods. 20.2. Disclaimer Copyright, Share Your Knowledge 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. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. 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. © 2008-2020 by KenyaPlex.com. Like individuals, business firms also hold cash to safeguard against future uncertainties. It depends upon the level of income and is interest inelastic. In a perfectly competitive market the average revenue and average cost functions are: Primary and High School Exams in Kenya With Marking Schemes. On account of uncertainty everybody forms his own estimate about the future rate of interest based on expectations. I. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds (here, the term "bonds" can be understood to also represent stocks and other less liquid as… In other words, money is demanded because it is a good medium of exchange. Liquidity preference for such motive is not as high as for the transaction motive. The transactions motive for the demand for M1 (directly spendable money balances) results from the need for liquidity for day-to-day transactions in the near future. Income motive. Answers (1), One of the determinants of demand for a commodity is advertisingExplain the extent to which advertising influences demand, Compute the market equilibrium price (Px) and quantity (Qx). 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. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. Although the major influence on precautionary balances, according to Keynes’ position, is that of income yet the influence of the rate of interest cannot be underestimated, because at low interest it is more attractive to hold cash than assets. Liquidity preference is his theory about the reasons people hold cash; economists call this a demand-for-money theory. Determine the market demand and market supply functions for commodity x. 500 crore and k is 1/4 then Lt will be Rs. D. Speculative motive. Cash is a liquid asset. In other words, it is the reward for not hoarding. This relationship is shown in the Fig. 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. He also said that money is the most liquid asset and the more quickly an asset can be … 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. At this rate no one likes money to bonds. Welcome to EconomicsDiscussion.net! Here we Understand the Motives of Liquidity Preference Theory in detailed. E. Transactions motive. If k is 1/5, then Rs. the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e. It may be so at a relatively low rate of interest, but becomes increasingly responsive at relatively high rates of interest. For an income level of Rs. 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. 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. 400 crore. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The Psychological and Business Incentives To Liquidity I. 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. 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. 100 crore holds true as long as the rate of interest is not above 4%, for example, As the rate rises above 4%, the figure shows that Lt for money becomes interest-elastic, showing that given the cost of switching into and out of securities, an interest rate above 4% is sufficiently high to attract some amount of transactions balances into securities.
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