Top Menu

Liquidity Preference Theory of Interest (12 Criticism)

ADVERTISEMENTS:

The liquidity preference theory of interest has been widely criticized on the following bases:

1. No Liquidity without Saving:

Keynes, argued that interest is the reward for parting with liquidity.

However critics point out that without saving there can be no funds. The question of parting with liquidity arises only after we have saved money. If there are no saving, there is no parting with liquidity either.

2. Real Factors Ignored:

ADVERTISEMENTS:

It is observed the rate of interest is not purely a monetary phenomenon. Real factors comprising of productivity and savings play an important role in the determination of the interest-rate. According to Keynes, interest is independent of the demand for investment funds whereas in reality cash balances of businessmen are greatly influenced by their demand for investment funds.

The demand for investment funds depends on the marginal revenue productivity of capital. When marginal efficiency of capital is high, businessmen expect higher profits, there is greater demand for investment funds and so the rate of interest goes up. Similarly, if the propensity to consume of the people declines, savings would increase. Therefore, supply of funds in the market will increase which tend to lower the market rate of interest.

3. Indeterminate:

Most economists have pointed out that like the classical and the neo­classical theories of interest, the liquidity preference theory is also indeterminate. According to Keynes, rate of interest is determined by the speculative demand for money and the supply of money available for speculative purposes.

Given the total supply of money we cannot know how much is available for the speculative motive, unless we know what the transactions demand for money is and we cannot know the transactions demand for money unless we first know the level of income.

ADVERTISEMENTS:

According to Hansen, “in the Keynesian case, the supply and demand for money schedules cannot give the rate of interest unless we already know the income level ; in the classical case, the demand and supply schedules for savings offer no solution until income is known. Precisely the same is true of the loan able funds theory. Keynes criticism of the classical and loan able fund theories applies equally to his own theory.”

4. Applicable to Advanced Countries:

Keynes theory of interest is applicable only to advanced countries where money is widely in circulation and the money market is well organized. It is only in such countries that people can choose among different types of securities. It does not apply to backward countries where the choice of assets is limited. It cannot be applied to a barter economy.

5. Contradictory:

According to the theory, the rate of interest depends on liquidity preference. Greater the liquidity preference, higher is the rate of interest; smaller the liquidity preference, the lower is the rate of interest. However, it is noticed that during depression, people have high liquidity preference and yet the market rate of interest is low. Similarly in times of inflation, peoples’ liquidity preference is low but the rate of interest is high. These facts contradict with Keynes theory.

6. All or Nothing Theory:

Keynes assumes that the choice always lies between liquid cash and liquid bonds. The theory is, therefore, all or nothing theory. In reality, however, various investable assets, differing in liquidity, are available in the market. A person who has some savings does not want to cither hold in cash or invest it in illiquid bonds. Instead, he keeps some cash, some liquid assets, and some illiquid assets. Keynes has thus unnecessarily separated the liquid from the illiquid asset for the determination of the interest-rate.

7. Hoarding:

ADVERTISEMENTS:

Keynes in his theory has not explained the term hoarding properly. All those factors which raise propensity to hoard have not been explained by Keynes. On this account, we cannot call Keynes theory as complete.

8. Productivity of Capital:

Keynes theory ignores productivity of capital. According to critics, interest is not only the reward for parting with liquidity but it arises due to productivity of capital. Had the capital not been productive, no one had demanded it and, hence, paid no interest on capital.

9. Supply Side Ignored:

Keynes theory has limited validity from supply side also. It is not possible to reduce the rate of interest by increasing money supply and vice-versa. It is possible that when supply is increased, increase in liquidity preference in the same ratio may keep the interest rate unaffected.

10. Several Motives for Liquidity Preference:

According to Keynes, “interest is a reward for parting with liquidity. In reality, liquidity is kept not only for three motives. Practically, liquidity preference depends on money, rate of savings, propensity to consume, marginal efficiency of capital etc. All these factors are completely ignored by Keynes.

11. Time Element Ignored:

Keynes could not draw distinction between different degrees of liquidity. Keynes restricted his theory by simplifying the distinction between different degrees of liquidity. He ignored the complex system of rates of interest depending on the different degrees of liquidity.

In other words, he ignored the time element. As the time changes, we find changes in the liquidity preference which lead to changes m the interest rate. Thus Keynes’ liquidity preference theory suffers from the drawback that it ignores time element.

12. Without Saving-No Meaning of Liquidity:

Keynes in his theory has given no place to savings. According to him interest is a reward for parting with liquidity’. Only that individual can part with liquidity that has liquidity with him. That person will have liquidity with him who has saved and accumulated money.

The person who has no savings, how can he part with liquidity? According to Prof. Jacob Viner “There can be no liquidity without saving.” Prof. D.H. Robertson has also expressed similar views.

Hazlitt has observed Keynes liquidity preference theory as incomplete. According to him, “This type of demand and supply theory is not incorrect but it is superficial and incomplete.” But this theory in modern economics occupies an important place because it takes into account monetary factors in determining interest rate. There is always less than full employment in an economy. It is with the help of liquidity preference theory that full employment can be restored.

, ,

hit counter