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Limitations of Liquidity Preference theory of Interest

Here We Understand the Limitations of Liquidity Preference Theory of Interest in Detail.

Limitations of Liquidity Preference theory of Interest
This Liquidity Preference theory of interest has been explained by Professor Keynes. Keynes's liquidity preference theory of interest has been Criticised on the following grounds:
  1. Vague Concept of Money Supply: Here, Keynes is not very clear as to the meaning which he attaches to the term 'Supply of money'. At times he includes only legal tender money that is [Government money] in the total supply of money, while at other times he includes both the legal tender money and the bank money.
  2. Influence of Real Forces: According to the theory, the rate of interest of interest is purely a monetary phenomenon and therefore, it considers only the monetary forces in the determination of rates of interest. But it has been pointed out by the critics of the theory that interest is not purely a monetary phenomenon. Real forces like productivity of capital, saving etc. plays an important role in the determination of the rate of interest. Here, Keynesian theory ignores the influence of real forces on the interest rate determination.
  3. Influence of Investment: Here, the rate of interest is not independent of the demand for investment funds as is assumed by Keynes. The cash balances of the businessman are largely influenced by their demand for capital investment. This demand for capital investment being dependent upon the marginal productivity of capital, the rate of interest is not determined independently of marginal efficiency of capital and investment demand. For example, when the marginal efficiency of capital increases [that is when the expected rate of return on capital increases], the demand for capital investment will also increase and this will cause the rate of interest to rise, converse will happen when the marginal productivity of capital declines. Keynesian theory, however, does not take into account the fact that changes in the investment demand also influence the rate of interest.
  4. Reward for saving: According to Keynes, interest is not a reward for saving or waiting but a reward of parting with liquidity for a specified time. But the critics point out that without saving there can be no liquidity to part with. Professor, Jacob Viner aptly puts it, without saving there can be no liquidity to surrender, the rate of interest is the return for saving without liquidity. The rate of interest is connected with savings, it cannot be ignored by any theory of interest.
  5. Variable Income: According to the theory, the liquidity preference for speculative motive which alongwith the quantity of money determines the rate of interest. As pointed out by Keynes, the liquidity preference for transactions and precautionary motive is mainly a function of the size of the income while the liquidity preference for speculative motive is primarily a function of the rate of interest. According to Professor Keynes, the demand for money for transactions and precautionary motive remains constant during the short period. This means that we have to assume that the level of income remains constant. Even, in Keynesian theory, there lies the assumption of the constant level of income in the disguised form. But the level of income changes and is affected by variations in the rate of interest.
  6. Indeterminate Theory: Here, the rate of interest is determined by the liquidity preference for speculative motive and for the supply of money. Now, given the supply of money, we cannot know how much money will be available to satisfy speculative demand for money unless we know the demand for money for transaction and precautionary motives. And we cannot know this demand for money unless we know the level of income. Thus, the Keynesian theory like the classical theory is indeterminate and confusing.
  7. Contrary to the Facts: According to the Keynesian theory, given the supply of money, an increase in the liquidity preference leads to a rise of the rate of interest and a decline in the liquidity preference leads to a fall in the rate of interest. Actually, this is quite contrary to the facts. For eg- if the Keynesian theory was correct, then the rate of interest should be quite high during periods of depression because at such a time due to an increase in the value of money, the liquidity preference of the people is quite high. But actually we find that during the period of depression the rate of interest is quite low.
  8. Short Term Interest: The Keynesian theory of interest provides only a short-term explanation of the determination of the rate of interest and the changes therein, but it does not explain the level of interest and the changes therein during the long period.

Limitations of Liquidity Preference theory of Interest
Vague Concept of Money Supply
Influence of Investment
Influence of Real Forces
Indeterminate theory
Contrary to the Facts
Variable Income
Short Term Interest
Reward for saving
Liquidity Preference theory of Interest by Keynes- Limitations of Liquidity Preference theory of Interest.
Kinnari
Tech writer at NewsandStory
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