The market price and the rate of interest, i.e., earnings yield, or fixed interest bonds is therefore inversely related. The choice regarding consumption is determined by time preference. A zero (or even a negative) rate of interest can be imagined under certain circumstances but in real life neither event is likely to occur. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. But they will so only when national income is in equilibrium, i.e., Y = C + I or S = I. The theory argues that forward rates also reflect a liquidity premium to compensate investors for exposure to interest rate risk. Liquidity preference: Keynes theory of interest is entirely depend on the assumption of Liquidity preference of the people. A shift of the money- supply curve from Ms0 to Ms1 by the central bank. When the interest rate is high (r1) bond prices will be low and a rise in bond prices, and therefore capital gains, will be anticipated and speculative balances will be very small (almost equal to zero). A shift of the liquidity preference curve from Md0 to Md1 as shown in Fig. If the rate of interest goes above the equilibrium level (to say, r1), there will be excess supply of money (AB), which implies excess demand for bonds (because in Keynes’ model money-holding is the only alternative to bond-holding). This is equivalent to a fall in the rate of interest (in this case from n to r0). Interest is a reward for parting with liquidity and is given to the wealth holder who surrenders control over money (liquidity) in exchange for a … (2) When the amount of capital in a community is so large that the marginal productivity of capital is zero. In this case, the opportunity cost of holding money is. Keynes places undue emphasis on monetary phenom­ena. Hence, the logical circularity in the model can be mentioned as one of principal sources of its weakness. Keynes ignored real factors like productivity of capital and thriftiness as determining the interest rate. Keeping in mind the (above) relationship between security prices and interest rates we can make the following assumptions. Owing to its vagueness it has been said that the Keynesian theory is indeterminate. Income does not determine interest but influences it indirectly because the amount of money required to be held for the transactions motive depends on income. Keynes alleges that the rate of interest is determined by liquidity preference. Since it is controlled by the central bank of a country it remains constant per period. Because of the uncertainty in the future, investors prefer to invest in short-term bonds. The choice regarding investment in production is determined by the marginal productivity of capital. If national income rises people will require more money for spending purposes. Liquidity Premium Theory on Bond Yield. In this paper, the possibility of using fundamental weighting as a tool to intentionally tilt a portfolio toward specific and unobservable risk factors in the illiquid and undeveloped Croatian stock market is explored. Similarly, if the price level rises people will require more money to buy that same amount of goods and services. TOS4. Hence, both the loan­able funds theory and the liquidity preference theory represents a partial equilibrium analysis of the determinants of the rate of interest. the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. This is due to complete elasticity of the liquidity preference curve at a very low rate of interest. It postulates that investors must be compensated with a higher return on long-term investments. This is found out by using the following formula: The price of a bond = Fixed annual return/The prevailing market rate of interest. In such a society, savings (if any) have to be kept in the custody of men having the power to protect the savings. Share Your PDF File There is no way of reducing the rate of interest further even though it may be desirable for ensuring recovery. Liquidity Preference Theory. View FREE Lessons! The liquidity premium is responsible for the upward yield curve typically seen across interest rates for bond investments of different maturities. The supply of money refers to the quantity of money in circulation at a fixed point of time. Before publishing your Articles on this site, please read the following pages: 1. The expected profit­ability of new investment (or the marginal efficiency of capital, as Keynes calls it) does not determine interest but is determined by it. New developments may only cause wide differences of opinion leading to increased activity in the bond market without necessarily causing any shift in the aggregate speculative demand for money schedule. The basic motive for holding speculative money balances was therefore to avoid losses in a declining securities market. Keynes agreed with this view on the ground that in course of time capital accumulation would grow large and the yield from new invest­ments would tend to diminish. Money is the most liquid assets. On accounts of above shortcomings it has been said that Keynes ignores the real factors of determination of interest. If the balance of market expectations is changed, there will be a shift in the schedule. [4], This article is about liquidity preference in macroeconomic theory. The liquidity preference theory of interest explained. The money supply. In fact, LPT is a synthesis of both ideas on bonds, maturities and their respective effects on yields. Hence, we must say that the demand and supply of securities, liquidity preference, marginal productivity and time preference all play their part in determining the rate of interest. 8. Share Your PPT File. 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… Liquidity Preference Model. This is equivalent to a rise in the rate of interest. Liquidity means shift ability without loss. If there is no liquidity preference, this theory will not hold good. The choice regarding the holding of cash is determined by liquid­ity preference. Welcome to EconomicsDiscussion.net! The demand for money. Liquidation Preference Examples . The progressive diminution of yield would lead to a progressive fall in the rate of interest and ultimately it might be zero. People will meet the demand for money by selling bonds. BIBLIOGRAPHY “Liquidity preference” is a term that was coined by John Maynard Keynes in The General Theory of Employment, Interest and Money to denote the functional relation between the quantity of money demanded and the variables determining it (1936, p. 166). The converse is also true. The supply of money at any point of time is fixed by mone­tary authorities (the central bank) and is therefore inde­pendent of the rate of interest. So, at low rates of interest people hold as much money as possible and at high rates as less money as possible. Precisely the same is true of loanable funds theory. That is, ( M / P) s = M ˉ P ˉ. 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