Determination of tile Rate of Interest

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Determination of tile Rate of Interest
According to Keynes, the demand for money, i.e the liquidity preference and supply of money, determine the rate of interest. It is, in fact, the liquidity preference Cor speculative motive which, along with . the quantity of money, determines the rate of interest. We have explained above the speculative demand for money in detail. As for tile supply of money, it is detennined by the policies of the Government and of the . Central Bank of the country.1lte total supply of money of coins plus notes plus bank deposits. How the rate of interest is determined by the equilibrium between the liquidity preference for speculative motive and the curve liquidity preference for speculative motive. In other words, I.lOS curve shows the demand for money for speculative motive. To begin with, OM2 is the quantity of m~ney available for satisfying liquidity preference for speculative motive. Rate of interest will be determined where the speculative demand for money is in balance or equal to the (fixed) supply of money OM1. It is clear from the figure that speculative demand for money is equal • OM2 quantity of money at Or rate of interest. Hence, Or is the equilibrium rate of interest. Assuming no change in expectations, an increase in the quantity of money (via open market operations) for the speculative motive, (a) when the quantity of money increases from OM2 to OM’2 ‘ the rate of .interest falls from Or to Or ‘ because the new quantity of money OM’2 is in balance with the speculative demand for money at OR’ rate of interest. In this case we move down the curve. Thus, given the schedule or curve of liquidity preference for speculative motive, an increase in the quantity of money brings down the rate of interest But the increase in the quantity of money may cause a change in the expectations of the public and thereby cause an upward shift in liquidity schedule or curve for speculative motive pushing the rate of interest up. But this is not certain. “New developments may only cause wide differences of opinion leading to increased activity in the bond market without necessarily causing any shift in the aggressive speculative demand for money schedule. If the balance of market expectations is changed, there. will be a shift in the schedule. Central Bank policy designed to increase the money supply may, therefore, be met by an upward shift of speculative demand function leaving the rate of interest virtually unaffected.’·R Thus. a large increase in the quantity of money may exert only a small influence on the rate of interest in certain circumstances. ·It is worth mentioning that shifts in liquidity preference schedule or curve can be caused by many other factors which affect expectations and might take place independently of change in the quantity of money by the Central Bank. Shifts in the liquidity function may be either downward or upward depending on the way in which the public interprets a change in events. If some change in events leads the people on balance to expect a higher rate of interest in the future than they had previously supposed, the liquidity preference for speculative motive will increase, which will bring about an upward shift in the curve of liquidity preference for speculative motive,, assuming that the quantity of money remains unchanged at OM2 ‘ with the rise in the liquidity preference curve from LPS to L’ P’ S’ , the rate of interest rises from Or to Or” because at Or” , the new speculative demand fOf money is in equilibrium with the supply of money 0 r It is worth noting that when the liquidity preference for speculative motives rises from LPS to L’ P’ S’ , the amount of money held does not rise: it Remains as OM2 as before. Only the rate of interest rises from Or to Or” to equilibrate the new liquidity preference for speculative motive with the available quantity of money OM  Thus. we see that Keynes explained interest in terms of purely monetary forces and not in terms of real forces like productivity of capital and thrift which formed the foundation-stones of both classical and loanable fund theories. According to him, demand for money for speculative motive together wilh the supply of money determines the rate of interest. He agreed that the marginal revenue product of capital tends to become equal to the rate of interest, but the rate of interest is not determined by marginal. revenue productivity of capital. Moreover, according to him, interest is not a reward for saving or thriftiness or waiting but for parting with liquidity. Keynes asserted that it is not the rate of interest which equalises saving and investment. But this equality is brought about through changes in the level of incomes.

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Determination of tile Rate of Interest