Cheat Sheet: Keynes’ Liquidity Preference Theory
Origin
Propounded by John Maynard Keynes in 1936. Explains how interest rates are determined
by demand & supply of money.
Liquidity Preference
Desire to hold wealth as money (cash). Cash = most liquid asset; bank deposits = highly
liquid.
Assumptions
1. Wealth held in cash/bonds.
2. Banking system developed.
3. Money supply fixed.
4. One interest rate.
5. Demand not perfectly elastic.
6. Everyone speculates.
Motives for Holding Money
1. Transaction → daily expenses.
2. Precautionary → emergencies.
3. Speculative → future interest rate/bond price changes.
Interest Rate Determination
Interest = reward for parting with liquidity. Determined by demand for money (downward
sloping) & fixed supply of money (vertical). Equilibrium = intersection.
Criticisms
1. Ignores other liquid assets.
2. Assumes fixed money supply.
3. Neglects savings/investment.
4. Ignores real factors.
Key Point
Interest is not a reward for saving, but for giving up liquidity.
Origin
Propounded by John Maynard Keynes in 1936. Explains how interest rates are determined
by demand & supply of money.
Liquidity Preference
Desire to hold wealth as money (cash). Cash = most liquid asset; bank deposits = highly
liquid.
Assumptions
1. Wealth held in cash/bonds.
2. Banking system developed.
3. Money supply fixed.
4. One interest rate.
5. Demand not perfectly elastic.
6. Everyone speculates.
Motives for Holding Money
1. Transaction → daily expenses.
2. Precautionary → emergencies.
3. Speculative → future interest rate/bond price changes.
Interest Rate Determination
Interest = reward for parting with liquidity. Determined by demand for money (downward
sloping) & fixed supply of money (vertical). Equilibrium = intersection.
Criticisms
1. Ignores other liquid assets.
2. Assumes fixed money supply.
3. Neglects savings/investment.
4. Ignores real factors.
Key Point
Interest is not a reward for saving, but for giving up liquidity.
