KEYNES’ LIQUIDITY PREFERENCE THEORY OF INTEREST

KEYNES’ LIQUIDITY PREFERENCE THEORY OF INTEREST

Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. According to him, the rate of interest is determined by the demand for and supply of money.

Demand for money: Liquidity preference means the desire of the public to hold cash. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) The transaction motive, (2) The precautionary motive, and (3) The speculative motive.

Transactions Motive: The transactions motive relates to the demand for money or the need of cash for the current transactions of individual and business exchanges. Individuals hold cash in order to bridge the gap between the receipt of income and its expenditure. This is called the income motive.

The businessmen also need to hold ready cash in order to meet their current needs like payments for raw materials, transport, wages etc. This is called the business motive.

Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for unforeseen contingencies. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavorable conditions or to gain from unexpected deals.

Keynes holds that the transaction and precautionary motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M1) is a function (L1) of the level of income (Y) and is expressed as M1 = L1 (Y)

Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other. If bond prices are expected to rise, i.e., the rate of interest is expected to fall, people will buy bonds to sell when the price later actually rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses.

According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as

M2 = L2 (r)

Where, L2 is the speculative demand for money, and r is the rate of interest.

Geometrically, it is a smooth curve which slopes downward from left to right.

Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M1 and the speculative motive by M2, then

M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity preference function is expressed as M = L (Y, r).

Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line.

Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money.  In the following figure, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curve intersects at E2 where the equilibrium rate of interest OR is established.

If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E2 will be re-established.

At the point E1 the supply of money OM is greater than the demand for money OM1. Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest OR is reached. Similarly at OR2 level of interest rate, the demand for money OM2 is greater than the supply of money OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR.

It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise.

Criticisms: Keynes theory of interest has been criticized on the following grounds:

1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest.

2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds.

3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time.

4. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless.

5. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run.

6. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is.

LAW OF VARIABLE PROPORTIONS

LAW OF VARIABLE PROPORTIONS

The law of variable proportions states that as the quantity of one factor is increased, keeping the other factors fixed, the marginal product of that factor will eventually decline. This means that up to the use of a certain amount of variable factor, marginal product of the factor may increase and after a certain stage it starts diminishing. When the variable factor becomes relatively abundant, the marginal product may become negative.

Assumptions: The law of variable proportions holds good under the following conditions:

Constant State of Technology: First, the state of technology is assumed to be given and unchanged. If there is improvement in the technology, then the marginal product may rise instead of diminishing.

Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity is kept fixed. It is only in this way that we can alter the factor proportions and know its effects on output. The law does not apply if all factors are proportionately varied.

Possibility of Varying the Factor proportions: Thirdly, the law is based upon the possibility of varying the proportions in which the various factors can be combined to produce a product. The law does not apply if the factors must be used in fixed proportions to yield a product.

Illustration of the Law: The law of variable proportion is illustrated in the following table and figure. Suppose there is a given amount of land in which more and more labour (variable factor) is used to produce wheat.

                                  

Units of Labour	Total Product	Marginal Product	Average Product
1	2	2	2
2	6	4	3
3	12	6	4
4	16	4	4
5	18	2	3.6
6	18	0	3
7	14	-4	2
8	8	-6	1

It can be seen from the table that up to the use of 3 units of labour, total product increases at an increasing rate and beyond the third unit total product increases at a diminishing rate. This fact is shown by the marginal product which is the addition made to Total Product as a result of increasing the variable factor i.e. labour.

It can be seen from the table that the marginal product of labour initially rises and beyond the use of three units of labour, it starts diminishing. The use of six units of labour does not add anything to the total production of wheat. Hence, the marginal product of labour has fallen to zero. Beyond the use of six units of labour, total product diminishes and therefore marginal product of labour becomes negative. Regarding the average product of labour, it rises up to the use of third unit of labour and beyond that it is falling throughout.

Three Stages of the Law of Variable Proportions: These stages are illustrated in the following figure where labour is measured on the X-axis and output on the Y-axis.

Stage 1. Stage of Increasing Returns: In this stage, total product increases at an increasing rate up to a point. This is because the efficiency of the fixed factors increases as additional units of the variable factors are added to it. In the figure, from the origin to the point F, slope of the total product curve TP is increasing i.e. the curve TP is concave upwards up to the point F, which means that the marginal product MP of labour rises. The point F where the total product stops increasing at an increasing rate and starts increasing at a diminishing rate is called the point of inflection. Corresponding vertically to this point of inflection marginal product of labour is maximum, after which it diminishes. This stage is called the stage of increasing returns because the average product of the variable factor increases throughout this stage. This stage ends at the point where the average product curve reaches its highest point.

Stage 2. Stage of Diminishing Returns: In this stage, total product continues to increase but at a diminishing rate until it reaches its maximum point H where the second stage ends. In this stage both the marginal product and average product of labour are diminishing but are positive. This is because the fixed factor becomes inadequate relative to the quantity of the variable factor. At the end of the second stage, i.e., at point M marginal product of labour is zero which corresponds to the maximum point H of the total product curve TP. This stage is important because the firm will seek to produce in this range.

Stage 3. Stage of Negative Returns: In stage 3, total product declines and therefore the TP curve slopes downward. As a result, marginal product of labour is negative and the MP curve falls below the X-axis. In this stage the variable factor (labour) is too much relative to the fixed factor.

Importance and Applicability of the Law of Variable Proportion:

The Law of Variable Proportion has universal applicability in any branch of production. It forms the basis of a number of doctrines in economics. The Malthusian theory of population stems from the fact that food supply does not increase faster than the growth in population because of the operation of the law of diminishing returns in agriculture.

Ricardo also based his theory of rent on this principle. According to him rent arises because the operation of the law of diminishing return forces the application of additional doses of labour and capital on a piece of land. Similarly the law of diminishing marginal utility and that of diminishing marginal physical productivity in the theory of distribution are also based on this theory.

               

The law is of fundamental importance for understanding the problems of underdeveloped countries. In such agricultural economies the pressure of population on land increases with the increase in population. This leads to declining or even zero or negative marginal productivity of workers. This explains the operation of the law of diminishing returns in LDCs in its intensive form. Ragnar Nurkse have suggested ways to make use of these disguisedly unemployed labour by withdrawing them and putting them in those occupations where the marginal productivity is positive.