INTEREST IS THE REWARD FOR PARTING WITH LIQUIDITY

Definition:

J.M. Keynes in his epoch-making book the General Theory of employment, Interest and Money, has put forward a new theory of interest. According to him:

"Interest is not the price for waiting. It is not the remuneration necessary to call forth saving because a man may save money, bury it in his backyard and get nothing from it in the way of interest. Interest is the reward for parting with liquidity, i.e., a reward for dispensing with the convenience of holding money immediately available".

Example:

Just to make it more clear, we take an example. Suppose, you lend a sum of $1000 to a person for six months in return for a promise to get something extra in addition to the sum borrowed. If the borrower returns you the same amount of money after six months, will you be interested to part with or lend your ready money? Well, if you are a philanthropist, then you may. But in case you are not, then some incentive must be given to you for dispensing with the convenience of holding money immediately available.

Interest is, thus, the reward for parting with liquid control over cash for a specific period, or we say:

"Interest is the payment for parting with the advantages of liquid control of money balance".

Here, a question can be asked as to why the need for liquidity arises when people can earn interest by lending their ready money. Keynes has given three distinct motives of demand for money or holding money in liquid form.

(i) Demand for Money:

The main components of demand for money are as under:

(a) Transaction motive.

(b) Precautionary motive.

(c) Speculative motive.

(a)           Transaction motive:

Transaction demand for money refers to the demand for money to hold cash balances for day to day transactions. The transaction motive relates to the desire of households and firms to keep a certain amount of cash in hand in order to bridge the interval between the receipt of income and expenditure. The

transaction demand for money depends upon

(i)                          size of income

(ii)                        time gap between the receipt of income and

(iii)                     Spending habit of the people.

Formula:

In symbols we can write:

L¹ = F(y)

Here:

L¹ is the transaction demand for money and F(y) shows it to be a function of income.

(b)          Precautionary motive:

 The precautionary motive relates to the desire of households and business concerns to hold a certain portion of the total ready money in cash in order to meet certain unforeseen or unexpected expenses like fire, theft etc. This demand for money depends upon

(i)                          size of income,

(ii)                        nature of the people and

(iii)                     Foresightedness of the people.

As transaction and the precautionary motives for holding cash depend upon income, as they are income elastic, Keynes has put them together. It is expressed in symbols us:

L² = F(y)

Which means that the liquidity preference on account of the two motives called L² is a function of income.

(c)           Speculative motive:

 The speculative motive relates to the desire of the households and firms to keep a portion of their resources in ready cash in order to take advantage of changes in the interest rates. If people expect a rise in the rate of interest in the future, they will try to hold money in cash in order to lend it in the future. Conversely, if they expect a fall in the rate of interest, they will at once like to invest money now in order to avail themselves of the advantages of high rate of interest. Thus, we find that an expected rise in rate of interest stimulates liquidity preference and an' expected fall has the opposite effect. It is written in symbols as:

L³ = F(r)

The liquidity preference for speculative demand for money is a function of expected changes in the rate of interest.

We have discussed in all the three factors which exercise powerful influence on the people's desire to hold money. The first two factors, i.e. the transaction motive and the precautionary motive are not very much influenced by; the changes in the rate of interest, but the third factor, viz, speculative motive is very sensitive to the changes in the interest rate. The major portion of money which people want to hold in the form of cash infact is meant for speculative purposes. When the rate of interest in a community is high, people hold less money in the form of cash because by lending it to other, they earn a sufficient amount of money. Conversely if the rate of interest is low, people will not be very anxious to lend money. So the total money held by individuals and business firms will be high. In short, the demand for money to hold in cash under speculative purposes is a function of the current rate of interest. It increases as the interest rate falls and decrease as the interest rate rises. We can say that demand for money for speculative motive is a decreasing function of the rate of interest as is shown in the fig. 21.2.

Diagram/Curve:

In fig, 21.2, along OX is measured the demand for money which people want to hold in the form of cash and along OY is shown the rate of interest. FG is the liquidity preference curve which slopes downward from left to right. When rate of interest is high, i.e. OL, the demand for money to hold in the form of ready money or cash is OS only. When the interest rate falls to OH, then the demand for money to hold in cash increases to ON.

(ii) Supply of Money:

The supply of money depends upon the currency issued by the central bank or the policy followed by the government of the country. The supply of money consists of currency and demand deposits. In the short run, the supply of money is assumed to be constant.

Determination of the rate of interest:

According to J.M. Keynes:

The rate of interest is determined at a where demand for money is equal to the supply of money.

M = Sm

M = Total demand for money.

Sm = supply of money.

 the rate of interest as determined by the interaction of the forces of demand and supply of money is OR, if there is any deviation from this interest rate, it will not be stable. For example, if the interest rate is OR₁ it will lead to more supply of money (by PQ) than its demand. This will lead to fall in the interest rate. The interest rate OR₂ is also not stable. Here demand for money is more than its supply by P^/Q₁. This will lead to rise in interest rate.

Criticism:

Keynes theory of interest is criticized on the following grounds:

(i) Indeterminate: J M. Keynes has criticized the classical theory of interest as being indeterminate. According to him, these theories do not take income changes into account. The fact is that Keynes theory of interest itself assumes a particular level of income and does not take income changes into account. As such it is also indeterminate.

(ii) Ignores real factors: The theory put forward by Keynes offers only a monetary explanation of the determination of rate of interest. It altogether ignores the real factors such as marginal productivity of capital, thrift etc., which work behind the demand for money and supply of it.

(iii) No liquidity without saving: According to Keynes, interest is the reward for parting with liquidity. It is in no way as inducement for saving. According to Jocob Viner, it is saving which makes funds available to be kept as liquid. Without saving, there can be no liquidity to surrender. Keynes has ignored this aspect in the determination of rate of interest.

(iv) Interest in the short run: Keynes theory explains the determination of the rate of interest in the short run. It fails to explain the rate of interest in the long run.

(v) Not an integrated theory: According to Hicks, Learner, the rate of interest along with the level of income is determined by

(a)marginal efficiency of capital,

(b) consumption function,

(c) the liquidity preference function and

(d) the quantity of money function.

 Keynes has discussed the last two elements in his interest theory and has ignored the first two elements. The theory of interest is, thus, not properly integrated by Keynes.