According to J M KEYNES
“Interest is a reward for parting with liquidity for a specified period of time”
According to Keynes, the rate of interest is determined by the factors of
1. Demand for money.
2. Supply of money.
1. Demand for money:
People demand money in order to meet their needs and requirements. For demand for money, Keynes, used a new term called liquidity preference, which mean a desire to hold money in cash. According to Keynes, people claim money in cash form, to satisfy their three main motives.
i. Transactive motive.
ii. Precautionary motive.
iii. Speculative motive.
i. Transactive motive:
It is the desire by household and business firms to keep money in cash form, to meet their day to day expenditure. A household need money in cash form to meet its day to day requirement like expenses on food, clothing etc. similarly a business firm also need money in cash form for meeting the day to day expenditure like to pay wages to the labour etc. the demand for money for Transactive motive depends upon (1) size of income (2) time gap between the receipt of income (3) spending habits of the people.
In symbols we can write
L1 = F(y)
Here l1 shows transaction demand for money and f(y) shows function of income.
ii. Precautionary motive:
The precautionary motive relate to the demand for money by the business firms and household to meet unforeseen emergencies and contingencies like fire, accident etc. the demand for money depends upon (1) size of income (2) nature of the people. It represent symbolically
L2 = f (y)
iii. Speculative motive:
It relates to the desire of the household and firms to keep a portion of their income in ready cash in order to take advantage of changes in the interest rate. At a higher rate of interest people will hold less money in cash form, as they prefer to lent it in order to eam more interest. Similarly at a lower rate of interest, people prefer to hold money in cash form rather than lending it to someone.
2. Supply of money:
By supply of money, Keynes means all coins, currencies and bank notes available in the economy for the purchase of goods and services. The supply of money is kept constant by the central monetary authority in the short period. So Keynes took money supply as constant (fixed) in the short run.
Determination of the interest rate:
In the diagram y-axis, the rate of interest is shown. X-axis the demand and supply of money is shown. According to Keynes, the rate of interest will be determined in the market as or because at this rate of interest, the demand and supply of money are equal.
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