Factors Governing Liquidity Preference
Liquidity preference of a particular individual depends upon several considerations: The question is: Why should the people hold their resources liquid or in the form of ready money. when they can get interest by lending such resources? The desire for liquidity arises because of three motives: (i) the transactions motive. (ii) the precautionary motive. and (iii) the speculative motive. Transactions Motive. The transactions motive relates to the demand for money or the need for cash for thc current transactions uf individual and business exchanges. Individuals hold cash in order “tu bridge he interval between the receipt of income and its expenditure.” This is called the ‘Incoll Motive.’ Most of thc people receive their income by thc week ur the month. while thc expenditure gocs 011 day by day. A certain amount of ready money. therefore. is kept in hand to make current payments. This amount will depend upon the size of the individual’s income, the interval at which the income is received and thc methods of payments current in the locality. TIle businessmen and the entrepreneur also have to keep a proportion uf their resources in ready cash in order to meet their current needs of various kinds. They need money all the time in order to pay for rqw materials and transport. to pay wages and salaries and to meet all other current expenses incurred by any business. This Keynes calls the ‘Business Motive’ for keeping money. It is clear that the amount of money held. under the business motive. will depend 10 a very large extent on the turn-over the volume of trade of the firm in question). Thc larger the turn-over the larger. in general. will be the amount of money needed to cover current expenses. Precautionary Motive. Precautionary motive fur holding money refers to the desire of the people to hold cash balances for unforeseen contingencies. People hold a certain amount of money 10 provide for the danger of unemployment. sickness. accidents and other more uncertain perils. The amount of money held under this motive will depend on the nature of the individual and on the conditions in which he lives.
The combined sum of balances held for transactions and precautionary motives, Keynes termed ‘active balances’ and labelled M. The demand for active balances can be referred to as LI and thus LI = f (Y). This relationship is shown diagrammatically in According to keynes, LI is directly proportionate to ihe level of national income. OLI is the demand (or active balances at OY I of national incOme.When the national income increases from Oy I to OY2 the demand for active balances goes up from OIL to O~. It should be noted here that the demand for active balances, according to Keynes, is independent of the rate of interest or the demand for active balances with respect to the rate of interest is absolutely inelastic. OM is the demand for active balances which does not change, whether the rate of interest Speculative Motive, The speculative motJ relates to the desire to hold one’s resources in . form in order to take advantage of market move regarding the future changes in the rate of interest (or bond prices). The notion of holding money Cor speculative motive is a new typically Keynesian idea. Money held under the speculative motive serves as a store of value 8.0; money held under the precautionary motive does. But it is a store of money meant Cor a different purpose. The cash held under this motive is used to make speculative gains by dealing in bonds 1 whose prices fluctuate. If bond prices are expected to rise, which in other words means that the rate of interest is expected to Call, businessmen will buy bonds to sell when the price later rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise. businessmen will sell bonds to avoid capital losses. Nothing being certain in this dynamic world. where guesses about the future course of events are made on precari- OIlS bases. businessmen keep cash to speculate on the probable future changes in bond prices (or the rate of interest) with a view to making profits. Given the expectations about the changes in the rate of interest in future, less money will be held under the speculative motive at a higher current or prevailing rate of interest and more money will be held under this motive at a lower current rate of interest. The reason for this inverse correlation between money held for speculative motive and the prevailing rate of crest is that at a lower rate of interest less is lost by DOt lending money or investing it. that is by holding 00 to money; while at a higher rate the holders of cash ances would lose more by not lending or investing. ing as the interest rate rises. In other words, demand for money under this motive is decreasing function of the rate of interest. This will be clear from the following diagnuu (Pig. 34.6). Along OX-axis is represented the speculative demand tor money (called inactive balances, by Keynes} and along OY the rate of interest. The liquidity preference schedule Ip is a downward sloping curve towards the right signifying that the higher the rate of interest, the lower the demand for speculative motive, and vice-versa. The schedule becomes ,more elastic towards the right end at very low rates of interest. But the demand for money to satisfy the speculative motive does not depend so much upon what the current rate of interest is as on expectation of changes in the rate of interest. If there is a change in the expectations regarding the future rate of interest, the whole . curve or schedule of liquidity preference for speculative motive will change accordingly. Thus, if the public on balance expect the rate of interest to be higher (i.e., bond prices to be lower) in the future than they had previously supposed. tllC speculative demand for money will increase and whole liquidity preference curve for speculative motive will shift upwards. If the total supply of money is represented by M, we may refer to that part of M held for transactions and precautionary motives as MI’ and to that part held for the speculative motive as M2. Thus, M = M, + M2. The money held under the transactions and precautionary motives, i.e., M” is completely interest-inelastic unless the interest ratt is very high. Also, the amount of money held as M” that is for transactions and precautionary motive. is mainly a function of the size of income and business transactions together with the contingencies growing out of the conduct of personal and business affairs. On the other hand, money demanded for speculative motive, i.e., M2 ‘ as explained above, is primarily a function of the rate of interest.