Blog Work 4. Question 2

Q 2.1
The liquidity preference theory concentrates on the supply and demand for money to explain how interest rates are determined. Keynes considered the desire for individuals to hold their wealth in liquid form as the demand for money. The desire on the part of the individual was called liquidity preference, which was specifically defined as an arrangement of a person’s resources, valued on money or wage units which the person will keep in monetary form in various sets of circumstances.

According to Keynes, liquidity preference determines the actual rate of interest in given circumstances. It fixes the quantity of money, which agents will hold when the rate of interest is given.

M = L(r)

M = quantity of money
L = function of liquidity preference
r = interest rate



If the interest rate is reduced, people will increase their demand for monetary assets.

Keynes identifies three motives for people to hold their wealth in monetary form.

• Transactions motive – the need for cash for current spending
• Precautionary motive – the desire for security for unknown contingencies.
• Speculative motive – to take advantage of a profit making opportunity.

Q. 2.2
Model PC is a good illustration of Keynes’ original vision of decision-making and includes Keynes’ three divisions of liquidity preference, however it may not ultimately be a faithful representation.

Model PC states that the quantity of money held depends on the interest rate of other assets, which represents Keynes’ precautionary demand for money. The rate of interest will influence people’s desires to hold money as security for future contingencies. Model PC also relies on two decisions by households; how much to save and how to allocate these savings. According to Keynes, the marginal propensity to consume will determine how much will be saved and then households must decide in what form their money will be held; in the form of immediate liquidity or savings for a specified or indefinite period.

In the PC Model, the rate of interest equalizes the supply of and demand for bills at the end of the current period, which is the rate of interest for portfolio decisions. Similarly, Keynes maintains that the interest rate is the equalising function in the desire to hold wealth in cash form and the availability of cash.

However, in Model PC agents have perfect knowledge regarding the incomes they will receive, in fact this is how the model is built, the interest rate is also fixed such that r = ˉr with the purchase of government bills. Conversely, uncertainty is a key influence in Keynes’ model. A critical explanation for holding wealth as money is the uncertainty surrounding the future cash value of a holding of bonds and the complex rates of interest for varying maturities that will prevail at future dates. The risk in Keynes’ theory is the risk of capital losses on bond portfolios caused by an increase in interest rates, however Model PC is not concerned about possible capital gains or losses that could arise from changes in the prices of financial assets. Hence, Model PC can be seen to be a slight deviation from Keynes’ original interest rate theory.

Websites:

Reference 1.pdf
Reference 2.
Reference 3.