Theories Of Liquidity Preference Theory

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Liquidity preference is a theory that falls under interest rate theory. The liquidity preference theory refers to the demand for money that is considered as liquidity. Liquidity preference theory consists in the statement that “the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. The rate of interest is the ‘price’ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash...” (Keynes, 1964, p. 167)

In simple words, liquidity preference means how much cash people like to keep with them at a particular time. The concept of this liquidity preference was first developed John
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These three motives are the reasons why the money is demanded by the people. According to Keynes, the three motives are transaction motive, precautionary motive and the speculative motive. The details about the motives as stated as below:

1. Transaction motive

Transaction motive means people prefer to have liquidity in order to assure the basic transaction that is needed to be made every day. The reason of this motive is because individuals and firms demand for money for current transactions. For the individuals and households, they need income to cover all the expenses. They are paid weekly or monthly but the spending is made every day. Because of that, particular amounts of cash need to be kept in order to meet the daily expenditures. The cash required for the spending is depends on the size of income.

Similarly, firms also need cash to meet their current needs in the company such as the payment of wages, purchases of raw materials and transport charges. This demand of money for transaction by firms also depends on the level of income and the business activities by the firms. When the turnover of the company is greater, so, the amount of cash needed to meet the transaction also greater. The higher the expenditures that needs to be covered, the higher the amount of cash
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People prefer to have liquidity since it will be easier for them to have ready money to cover the unexpected costs. According to the theory, the amount of money demanded for this purpose increases as income increases.

3. Speculative motive

Speculative motive is the most important motive of the demand for money. According to Keynes theory, he assumes that people prefer to hold either cash or bonds to present their wealth. The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest or bond prices. For this purpose, the notion of holding money for speculative motive was a new and revolutionary Keynesian idea.

When they expect the interest rate for bonds will be increase, people will shift from holding cash to holding financial assets such as bonds and stocks. At first, people will keep cash with them until the price of securities changes. When this happens, people will take advantage on this and purchase the bonds and securities in the capital market. They purchase these financial assets since the interest rate is going to increase and it is a profitable investment for most

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