Keynes' Liquidity Preference Theory

by Jim Priebe, C.F.A. ; Updated July 27, 2017
Keynes described three reasons why people want to hold onto money.

John Maynard Keynes (1883-1946) was a British economist whose ideas still influence academics and government policy makers. Liquidity preference is his theory about the reasons people hold cash; economists call this a demand-for-money theory. The theory asserts that people prefer cash over other assets for three specific reasons. The Liquidity Preference Theory was first described in his book, "The General Theory of Employment, Interest, and Money," published in 1936.

The Transactions Motive

Keynes dubbed the first of his three reasons people want to hold cash the transactions motive. People want to have money available so they can conveniently buy things. The alternative, putting money into an asset such as bonds and selling the bonds to purchase something, is far too cumbersome. This motive is related to income. Keynes noted that the more money people make, the more they purchase. The more people purchase, the more cash they need to have on hand.

The Precautionary Motive

The precautionary motive is also related to income. People want to have cash readily available in case of an unforeseen incident, such as unemployment, accident or illness, and those with larger incomes need more money should such situations arise. Keynes precautionary motive predicts that people with larger incomes will hold more cash as a contingency measure.

The Speculative Motive

Keynes argued that when interest rates are low, the demand for money is greater. He called this the speculative motive because, when interest rates go up, people will hold less cash and instead hold more bonds. In other words, the higher the interest rate, the lower the speculative demand for money. People would rather earn the higher rate of interest than hold the cash and earn no interest.

Considerations

When it was first published, Keynes' theory changed the way many economists understood money and monetary policy. Then, as now, the Federal Reserve set monetary policy by controlling the amount of money and by influencing interest rates. In Keynes' day, the leading theory was the quantity theory of money, developed by American economists Irving Fisher and Simon Newcomb. This theory looked to monetary policy to stabilize and boost employment and national income. Keynes argued that monetary policy was neither the best way to stabilize the economy nor help the unemployed. Rather, governments need to spend when people are unemployed or national income is low.

The Debate Continues

Milton Friedman, an American economist, restated the argument for the quantity theory of money. This movement is now known as monetarism and goes against Keynesian economics. Monetarists believe that less spending by government and better monetary policy is the best way to stabilize employment and national income. Keynesian economics has changed significantly since the Liquidity Preference Theory was first published, but it still focuses on government spending, more generally called fiscal policy, as the best way to stabilize employment and national income.

About the Author

Jim Priebe has been writing and publishing since 1992, when he self-published the newsletter "Spiritually Speaking." His next assignment was with a small-town newspaper in which he authored the column "Environmentally Sound." Later he wrote Web content and maintained a blog for a community radio station. He holds a master's degree in economics from Queen's University and studied radio broadcasting at Humber College.

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