Introduction

 J.M. Keynes a famous British economist

presented this theory in which he answers
the question WHY INTEREST SHOULD BE
PAID? Also shows THE DTERMINATION OF
INTEREST RATE.
 Keynes developed the theory of liquidity
preference in order to explain what factors
determine the economy’s interest rate
 TOPIC

KEYNESIAN LIQUIDITY

PREFERENCE
THEORY OF INTEREST
 ALL STARS

GROUP MEMBERS
o AADIL PARVEZ
o AHMED RAZA
o ALI RAZA ARSHAD
o KHALIL AHMED
o SABA AKBAR
o USMAN RAFIQUE
Introduction
 The concept was first developed by
John Maynard Keynes in his book
The General Theory of Employment, Interest and M
(1936)
 Liquidity preference theory answers the
question that why interest should be paid?
 Explains determination of the interest rate by
the supply and demand for money.
 Attempts to explain both nominal and real
rates by holding constant the rate of inflation.
Definition
 Keynes defined interest as:
“INTEREST IS THE REWARD TO
SACRIFICE LIQUIDITY”
 According to the theory, the interest rate
adjusts to balance the supply and
demand for money.
 When people lend their money their
liquid assets decline, they must be paid
for the liquidity the have forgone
Keynes’s Liquidity Preference
Theory
Liquidity Preference Theory: why do
people hold money?

Recall functions of Money:

 Medium of Exchange

 Unit of Account

 Store of Value
Demand for Real Money
Balances
 Three motives for people holding money:

 Transactions motive (arising from

medium of exchange function):
positively related to Y
 Precautionary motive:

positively related to Y, Negatively related to

i
 Speculative motive (arising from store of

wealth function):
Negatively related to i
Total Demand For Money

 Total demand for money and liquid

assets is the sum of transaction,
precautionary and speculative
demands.
 It is a function of both; income and

interest rate.
 Liquidity Preference
Md Function:

= fi,Y  
P − +
Total Demand For Money

 If we assume that the income to be constant

( short period indication ) then
Md= f (i)
 Shows that there is a negative relationship
between money demand and interest rate.
 This relationship is given by liquidity

Preference Curve as shown.

Liquidity Preference Schedule
Interest Rate Money Demanded

1% 500

2% 400

3% 300

4% 200

5% 100
Liquidity Preference Curve

Interest
Rate

Money
demand

0 Quantity of
Money
Money Supply
 Money Supply includes currency notes in
circulation, demand deposits, credit
money etc is set by the government or
monetary authority.
 Keynes assumed that the supply of

money has nothing to do with the

interest rate i.e. it remains constant.
 This gives us a vertical money supply

curve as shown.
Vertical Money Supply Curve

Interest
Rate
Money
supply

0 Quantity fixed Quantity of

Money
 Equilibrium in the Money
Market
Interest
Rate
Money
supply

r1
Equilibrium
interest
rate
r2
Money
demand

0 M d1 Quantity fixed M d2 Quantity of

Money
Shifts in the demand for
money
 Income effect: a higher level of income
causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right.
 Price-level effect: a rise in the price level

causes the demand for money at each

interest rate to increase and the demand
curve to shift to the right.
Shifts in the demand for
money
The Downward Slope of the
Aggregate Demand Curve
 The price level is one determinant of
the quantity of money demanded.
 A higher price level increases the
quantity of money demanded for
any given interest rate.
 Higher money demand leads to a
higher interest rate.
 The quantity of goods and services
demanded falls.
The Downward Slope of the
Aggregate Demand Curve

The end result of this analysis is

a negative relationship between
the price level and the quantity
of goods and services demanded.
 The Money Market and the Slope of
the Aggregate Demand Curve...
(a) The Money Market (b) The Aggregate Demand Curve
Interest Money Price
Rate supply Level

2. …increases 1. An increase in
the demand the price level…
for money… P2
r2
Money demand at
price level P2, MD2
r1 P1 Aggregate
demand
Money demand at
price level P1, MD1

0 Quantity fixed Quantity 0 Y2 Y1 Quantity

of Money of Output
4. …which in turn reduces
3. …which increases the
the quantity of goods and
equilibrium interest rate…
services demanded.
Changes in the Money Supply
 There can be shift in the aggregate demand curve
when it changes monetary policy.
 An increase in the money supply shifts the money
supply curve to the right.
 Without a change in the money demand curve,
the interest rate falls.
 Falling interest rates increase the quantity of
goods and services demanded.
 A Monetary Injection...
(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money MS2 Price 3. …which

Rate supply, Level increases the
MS1 quantity of
1. When goods and
there is services
increase
the demanded at a
money P given price
supply… level.
r1

r2 AD2

Aggregate
demand, AD1

0 Quantity 0 Y1 Y2 Quantity
2. …the of Money of Output
equilibrium
Application in Real market in
Pakistan
This theory isn’t applicable in real
market in
Pakistan.
REASONS:
 Assumes particular level of income

Where as in Pakistan:
i. Un-equal distribution of Wealth
ii. Difference in Income level

iii. Disparity in Standard of Living

Application in Real market in
Pakistan
 Ignores savings as there can be
no liquidity to surrender without
savings
Where as in Pakistan:
i. Low Capital Formation
ii. Less Investment

iii. Low per Capita Income

Application in Real market in
Pakistan
 In real market as supply of money
changes the interest rate changes.
i. Deficit Financing in Pakistan
ii. Increase in money Circulation
iii. Inflation
iv. Increase in Interest Rate
 International Monetary Fund
Application in Real market in
Pakistan
 Fails to explain interest in long-run
 Presents commodity market, not the
money market
i. Investments and Savings
ii. Major determinants of Interest rate
 Explains rates by holding constant the
rate of inflation.
 Inflation rate > interest rate
 Equilibrium in the Real Money
Market...

Interest

LM
Rate

Real
Interest
Rate
(Nominal-
Inflation)

IS

0 income
Nominal Interest Rates Vs Real
Interest Rates
 Nominal interest rates are interest
rates as they are observed and quoted,
with no adjustment for inflation.
Return = 1+ i
 Real interest rates are adjusted for
inflation effects.
Return = 1+ i/ 1 + inflation rate
Real interest rate = nominal interest rate – inflation rate
Why Interest Rate Is So Much
Important?
Economic
 The higherSurvey Of Pakistan
interest rate has 08-
09unfavorable effect on private
investment by increasing the cost
of borrowing. Thus, the higher
interest rate results in “Crowding
Out” the private investment. It
also contributes to the rise in
fiscal deficit.
Economic Survey Of Pakistan
08-09
The higher rates of interest has disturbed the
economy. The economy, with slow expansion
rate, is unable to create job opportunities at
required level, resulting in increase in the
unemployment rate and rise in the level of
poverty in the country
 In the light of these facts it can be stated

without hesitation that the higher interest rate

is the major cause of fiscal crises in Pakistan
Comparison of Interest rate &
Inflation rate
 Conclusion
Government should focus on:
 Supply side (production), in particular the

production of food items.

 An increase in public investment on

infrastructure
 Improve the quality of education and

healthcare facilities
 Reduce the cost of production

 Use the higher level of technology

 Enhancement in living standard