liquidity preference theory
TRANSCRIPT
Introduction
J.M. Keynes a famous British economist presented this theory in which he answers the question WHY INTEREST SHOULD BE PAID? Also shows THE DTERMINATION OF INTEREST RATE.
Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate
TOPIC
KEYNESIAN LIQUIDITY
PREFERENCE THEORY OF INTEREST
ALL STARS
GROUP MEMBERSo AADIL PARVEZo AHMED RAZAo ALI RAZA ARSHADo KHALIL AHMEDo SABA AKBARo USMAN RAFIQUE
Introduction The concept was first developed by
John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936)
Liquidity preference theory answers the question that why interest should be paid?
Explains determination of the interest rate by the supply and demand for money.
Attempts to explain both nominal and real rates by holding constant the rate of inflation.
Definition Keynes defined interest as: “INTEREST IS THE REWARD TO
SACRIFICE LIQUIDITY” According to the theory, the interest
rate adjusts to balance the supply and demand for money.
When people lend their money their liquid assets decline, they must be paid for the liquidity the have forgone
Keynes’s Liquidity Preference TheoryLiquidity Preference Theory: why
do people hold money?
Recall functions of Money: Medium of Exchange Unit of Account Store of Value
Demand for Real Money Balances Three motives for people holding money:
Transactions motive (arising from medium of exchange function):
positively related to Y Precautionary motive:positively related to Y, Negatively
related to i Speculative motive (arising from store
of wealth function): Negatively related to i
Total Demand For Money
Total demand for money and liquid assets is the sum of transaction, precautionary and speculative demands.
It is a function of both; income and interest rate.
Liquidity Preference Function:
Yif
P
M d
,
Total Demand For Money
If we assume that the income to be constant
( short period indication ) then
Md = f (i) Shows that there is a negative
relationship between money demand and interest rate.
This relationship is given by liquidity Preference Curve as shown.
Liquidity Preference Schedule Interest Rate Money Demanded
1% 500
2% 400
3% 300
4% 200
5% 100
Liquidity Preference Curve
Quantity ofMoney
InterestRate
0
Moneydemand
Money Supply Money Supply includes currency
notes in circulation, demand deposits, credit money etc is set by the government or monetary authority.
Keynes assumed that the supply of money has nothing to do with the interest rate i.e. it remains constant.
This gives us a vertical money supply curve as shown.
Vertical Money Supply Curve
Quantity ofMoney
InterestRate
0 Quantity fixed
Moneysupply
Equilibrium in the Money Market
Quantity ofMoney
InterestRate
0
Moneydemand
Quantity fixed
Moneysupply
r2
M d2
r1
M d1
Equilibrium interest
rate
Shifts in the demand for money Income effect: a higher level of
income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
Price-level effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
Shifts in the demand for money
The Downward Slope of the Aggregate Demand Curve The price level is one determinant
of the quantity of money demanded.
A higher price level increases the quantity of money demanded for any given interest rate.
Higher money demand leads to a higher interest rate.
The quantity of goods and services demanded falls.
The Downward Slope of the Aggregate Demand Curve
The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.
Aggregate demand
(b) The Aggregate Demand Curve
Quantity of Output
0
Price Level
(a) The Money Market
Quantity of Money
Quantity fixed0
r1
Money supply
Interest Rate
Money demand at price level P1, MD1
Y1
P1
The Money Market and the Slope of the Aggregate Demand Curve...
Money demand atprice level P2, MD2
2. …increases the demand for money…
1. An increase in the price level…
P2
3. …which increases the equilibrium interest rate…
r2
4. …which in turn reduces the quantity of goods and services demanded.
Y2
Changes in the Money Supply
There can be shift in the aggregate demand curve when it changes monetary policy.
An increase in the money supply shifts the money supply curve to the right.
Without a change in the money demand curve, the interest rate falls.
Falling interest rates increase the quantity of goods and services demanded.
Y2
AD2
3. …which increases the quantity of goods and services demanded at a given price level.
1. When there is increase the money supply…
MS2
A Monetary Injection...
Y1
P
Quantity of Output
0
Price Level
Aggregate demand, AD1
(a) The Money Market
Quantity of Money
0
Money supply, MS1
r1
Interest Rate
(b) The Aggregate-Demand Curve
r2
2. …the equilibrium interest rate
falls…
Application in Real market in PakistanThis theory isn’t applicable in real
market inPakistan.REASONS: Assumes particular level of incomeWhere as in Pakistan:i. Un-equal distribution of Wealthii. Difference in Income leveliii. Disparity in Standard of Living
Application in Real market in Pakistan Ignores savings as there can be
no liquidity to surrender without savings
Where as in Pakistan:i. Low Capital Formationii. Less Investmentiii. Low per Capita Income
Application in Real market in Pakistan In real market as supply of money
changes the interest rate changes.
i. Deficit Financing in Pakistanii. Increase in money Circulationiii. Inflationiv. Increase in Interest Rate International Monetary Fund
Application in Real market in Pakistan Fails to explain interest in long-run Presents commodity market, not
the money marketi. Investments and Savingsii. Major determinants of Interest rate Explains rates by holding constant
the rate of inflation. Inflation rate > interest rate
Equilibrium in the Real Money Market...
income
InterestRate
0
IS
LM
Real Interest
Rate (Nominal-Inflation)
Nominal Interest Rates Vs Real Interest Rates Nominal interest rates are interest
rates as they are observed and quoted, with no adjustment for inflation.
Return = 1+ i Real interest rates are adjusted for
inflation effects.
Return = 1+ i/ 1 + inflation rateReal interest rate = nominal interest rate – inflation rate
Why Interest Rate Is So Much Important?Economic Survey Of Pakistan 08-09 The higher interest rate has
unfavorable effect on private investment by increasing the cost of borrowing. Thus, the higher interest rate results in “Crowding Out” the private investment. It also contributes to the rise in fiscal deficit.
Economic Survey Of Pakistan 08-09 The higher rates of interest has
disturbed the economy. The economy, with slow expansion rate, is unable to create job opportunities at required level, resulting in increase in the unemployment rate and rise in the level of poverty in the country
In the light of these facts it can be stated without hesitation that the higher interest rate is the major cause of fiscal crises in Pakistan
Comparison of Interest rate & Inflation rate
ConclusionGovernment should focus on: Supply side (production), in particular
the production of food items. An increase in public investment on
infrastructure Improve the quality of education and
healthcare facilities Reduce the cost of production Use the higher level of technology Enhancement in living standard
