Keynes’s liquidity preference theory of interest rate

Keynes’s liquidity preference theory of interest rate

Keynes’s theory of interest and money is one among several theories explaining interest rates changes, mainly basing its argument on liquidity. According to Keynes’s liquidity preference theory of interest rates, the rate of interest within the market is determined by the supply and demand for money. As such, an increase in the quantity of money within the economy would result in a fall in the interest rates. Uncertainty is one of the key factors that result in people preferring to hold their cash other than opting for interest-bearing assets.  The propensity to own or invest the cash is mainly driven by three main motives, which include; transaction, precautionary, and the speculative purpose.

Hoarding due to the transaction motive is mainly based on the ground that the citizens would instead hold money to service their daily exchange and business transactions. The precautionary motive also results in hoarding by the citizens, the reason being meeting unforeseen contingencies and opportunities that might arise. Lastly, the speculative motive of holding cash is mainly driven by the gaining profits that might arise due to price changes in the future. The transaction and the speculative motive are primarily a function of the income given the fact the amount withheld will depend on the size of income. On the other hand, the speculative motive is inversely varied with interest rates, given the fact that the interest rates are high, the securities tend to become attractive whereas when the interest rates are low, the liquidity preference becomes high

Ohlin’s loanable funds’ theory of interest

According to Ohlin’s loanable funds’ theory of interest rates, the supply and demand for loans govern the rates of interest. The interest rate is the price for credit. As such, Ohlin’s highlights the factors affecting the supply and demand of loanable funds are crucial. Some of the parameters that affect the quantity of the loanable funds include; the net dishoarding, which includes the smaller amounts being saved and the savings which were being previously saved and are now being used in the market. Besides that, the current savings that get affected at a particular period also play a role in influencing the loanable funds. There are also the additional net loans from the banks.

The demand for loanable funds, on the other hand, is affected by three main aspects, which include; Investment, disaving and hoarding. As such that, the net supply for the credit determines the public willingness to invest and hold on assets. According to the author, the two aspects; x-ante and ex-post analysis are essential, as it facilitates in the calculation of the net savings and investments which play a significant role in influencing demand and supply of loans and later the interest rates (Ohlin Pg.224). These three factors mainly affect the rates at which the public borrows the loans from the commercial banks. And the amount to which the participants in the market can supply relies upon the interest rates. Generally According to Ohlin’s article, at the point where the supply curve meets the demand curve, that is the equilibrium point, and it implies equality in the market.

Dis-similarities between the liquidity funds theory and the loanable funds theory of interest rates

To begin with, the antagonism between these two theories begins with the notions put in place by these two philosophers. Drawing from the two theories, the basis of the claims for the liquidity theory by kynes is the fact that the rates of interest areas are determined by the supply and demand for money. On the other hand, the loanable funds theory by Ohlin’s asserts on the fact that the rates of interests within an economy are determined by the demand and supply for the loans. As such, the theory put forward by Keynes’s bases its argument on liquidity preference where the Ohlin’s theory bases its argument on loanable funds

The other significant difference between these two authors is the fact that Ohlin’s proposition of loanable funds theory is concerned with fluctuations in demand for bank borrowing. In contrast, his counterpart, who came up with the liquidity preference theory, is focused on the alteration of the need for money. This brings us to the fact that the loanable funds theory mainly concentrates its line of the basis on the bank as the supplier of credit to the general public. In contrast, the liquidity preference theory takes into consideration other sources of credit besides just the banks.

The other major point of difference between these two theories is the fact the loanable funds theory takes into consideration not just the bank money but also dishoarded wealth and the voluntary savings. On the other hand the liquidity preference theory by Keynes is mainly concerned with the money supply as determined by the monetary institutions.

Fisher’s equation of exchange

According to the fishers’ equation of exchange, the purchasing power of money (P) is majorly determined by five major factors. These include (M), the money volume to which is in circulation, (V) the number of times to which the money is turned over, (M) bank deposits volumes that are subject to check, (V) bank accounts activity, (T) Money transactions influenced by deposits and money. This brings us to the equation MV +M‘V’=PT (Fisher P.g 296). With that equation, the price is therefore determined by the five price-determining magnitudes. As such, the purchasing power of money determines the number of services and goods a unit of a currency can purchase, and thus a higher price level implies a lower purchasing power for the given currency

Determinants of (M)

Given the fact that (M) in fisher’s discussion represents both the money volume in circulation and the bank deposit volumes that are subject to check, this implies that these two parameters that determine the purchasing power of money play a role in influencing the interest rates based on Keynes’s liquidity presence theory. For the case of the liquidity preference theory, the volume of money in circulation play a crucial role in determining the rates of interest given the fact that in the event that the citizens decide to withhold the money to increase the liquidity, it would result in higher interest rates and vice versa for the latter. For the case of the fishers’ discussion, the determinants of (M), which include the velocity of money circulation, are also a crucial aspect in determining the price (P).

The determinants of(V) and (V)

For the fishers’ discussion, the two (Vs) which imply the bank accounts activity and the times in which the money is turned over are very crucial in determining the purchasing power of money. In this case, the liquidity preference theory comes into play in the sense that the bank activities, which mainly include hoarding and saving, also play a great role in determining the viable interest rates in the market. Given the fact that these two crucial determinants play a great role in determining the purchasing power of money, these factors eventually come to affect the interest within the economy.

Reference

Fisher, Irving. “‘The Equation of Exchange,” 1896-1910.” The American Economic Review, vol. 1, no. 2, 1911, pp. 296–305. JSTOR, www.jstor.org/stable/1804304. Accessed 4 Mar. 2020.

Keynes, J. M. “The General Theory of Employment.” The Quarterly Journal of Economics, vol. 51, no. 2, 1937, pp. 209–223. JSTOR, www.jstor.org/stable/1882087. Accessed 4 Mar. 2020.

Ohlin, Bertil. “Some Notes on the Stockholm Theory of Savings and Investments II.” The Economic Journal, vol. 47, no. 186, 1937, pp. 221–240. JSTOR, www.jstor.org/stable/2225524. Accessed 4 Mar. 2020.