motives of liquidity preference

Share Your Word File 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. Disclaimer Copyright, Share Your Knowledge 20.1. Ever since this threefold . 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. It is rather difficult to generalize on the interest elasticity of the transaction demand for money for the economy as a whole. The asset demand reflects a portfolio type of decision concerning the holding of wealth in three possible types of assets—money, bonds and goods. Holding bonds instead of money at this low rate means certain capital loss. An individual who goes shopping will keep more money than what he thinks proper for planned purchases. Liquidity refers to the convenience of holding cash. 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. According to Keynes, people have liquidity preference for three motives. 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. 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. Welcome to EconomicsDiscussion.net! 20.4. 1. In Fig. Liquidity preference is his theory about the reasons people hold cash; economists call this a demand-for-money theory. Distinguish between a trade-off and an opportunity cost in macroeconomic theory. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. Date posted: March 20, 2019. 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”. According to John Keynes, there are three motives of liquidity theory: 1. 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. Similarly, people purchase bonds in anticipation of a rise in their prices. 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. Give examples of each. Similarly at higher income Y2 – Lt= B2Y2 and Lt = A2B2, therefore, Lp at Y2 = Lt at Y2+ Lt at Y2– B2Y2 + A2B2 = A2Y2. The Liquidity Preference theory proposes higher premiums on medium- and long-term securities. At the other end of the curve speculative demand becomes perfectly elastic. Income motive. If, however, the income is Rs. 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. 4 to liquidate a bond whose market value is Rs. 20.1 if k is 1/4, Rs. But no one knows with certainty what the future rate of interest will be. It may be called an 80 opportunity cost. According to this theory, the rate of interest is the payment for parting with liquidity. 500 crore and k is 1/4 then Lt will be Rs. Here we detail about the three motives for liquidity of money by Keynes. Those motives are the transaction motive, the precautionary motive, and the speculative motive (Pal, n.d.). 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 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. Privacy Policy3. The cash money is called liquidity and the liking of the people for cash money is called liquidity preference. 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. (Check all that apply.) If k is 1/5, then Rs. 400 crore and K 1/4 then Lt is Rs. 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). “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.”. According to Keynes, four motives drive the demand for liquidity: the transactions, finance, precautionary and speculative motives (Keynes, 1936, 1937a). 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. Before publishing your Articles on this site, please read the following pages: 1. Answers (1). 20.3 Lt is the demand for money for transaction purposes and Lt shows the demand for money for precaution purposes. The General Theory by John Maynard Keynes (1936) [Chapter 15 THE PSYCHOLOGICAL AND BUSINESS INCENTIVES TO LIQUIDITY . Liquidity preference refers to the desire to hold money rather than other forms of wealth such as stocks and bonds. Precautionary balances and their size is determined by the size of the assets owned by firms and individuals. 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. A. In this way, individuals protect themselves from possible losses. 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. D. Speculative motive. They are 1. 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… This part of the curve is called “liquidity trap”. 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). At high rates of interest, the curve shows that they will hold no money in speculative balances. Since both the transaction and precautionary motive are income-elastic, we merge them together (Mt + Mp) and show them as M1 = ƒ(Y). THE SPECULATIVE MOTIVE(According to Keynes also known as idle cash balance) The desire to earn profits. What does​ Keynes's liquidity preference theory predict about the relationship between interest rates and the velocity of​ money? 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. Like individuals, business firms also hold cash to safeguard against future uncertainties. This is because investors prefer cash and, barring that, prefer investments to be as close to cash as possible. E. Transactions motive. It is here that Keynes’ theory differs in a fundamental sense from the classical theory of interest. This is called speculative demand for money. Share Your PDF File Here we detail about the three motives for liquidity of money by Keynes. This need arises when income is received only occasionally (say once per month) in discrete amounts but expenditures occur continuously. 80 crore will denote Lt out of Rs. In Fig. Explain the extent to which advertising influences demand. The speculative demand for money arises on account of the uncertainty regarding the future rate of interest. It depends upon the level of income and is interest inelastic. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. This figure of Rs. Keynes denotes M 1, the combined demand for these two motives. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? On the other hand, demand for money or liquidity preference for speculative motive is interest elastic, i.e., the function of interest. Motives of Liquidity Preference Theory This theory has been explained by Professor Keynes in his theory of Interest. Date posted: March 18, 2019. The subject is substantially the same as that which has been sometimes discussed under the heading of the Demand for Money. The Fig. In the context of international trade explain briefly the concept of comparative advantage with specialization. For an income level of 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. 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. Keynes has taken the transaction and precautionary demands for money together, as they both are income determined. Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term … The Liquidity Preference Theory was first described in his book, "The General Theory of Employment, Interest, and Money," published in 1936. In other words, money is demanded because it is a good medium of exchange. Cash is a liquid asset. 100). 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. Interest inelastic theory predict about the future rate of 10 % or higher the speculative is! Kenya with Marking Schemes illiquid ones holding bonds instead of money at this low rate means capital. Which is a direct relation between the size of k, however, on! 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