Liquidity Function in Low Income Countries

Read this article to learn about the liquidity function in low income countries by Keynes.

Keynes was of the opinion that the stagnation in an underdeveloped economy is due to the presence of high liquidity preference.

He says,

“The history of India at all times has provided an example of a country impoverished by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth”.

The stock and capital market being underdeveloped the speculative demand for money arises especially at the harvest time for storage of essential commodities, thus, causing a seasonal stringency in the credit market.

Thus, the nature of liquidity in underdeveloped countries is quite different from the nature of liquidity in advanced economies. In underdeveloped countries liquidity for liquid funds is just to gain the capacity to store goods for speculative purposes rather than to earn from the differences in the rates of interest as is done in the advanced economies.

In such low income countries where unorganized sector still accounts for about 70% of the national product, the pull of commodity speculation in the commodity market is very strong. In such an economy where goods market is more important than bonds market, the Keynesian remedy of increasing the supply of money does not lower the interest rates, in fact, it may cause it to rise. It follows, therefore, that any theory of speculative demand for money based on only two markets of bonds and money has limited usefulness, if not misleading in such economies.

The rate of interest does not fall with an increase in the supply of money because the liquidity compensation element is not present in most of lending’s in underdeveloped countries. The rates of interest may fall in the organized sector, because here rate of interest is very close to the reward for parting with liquidity. If increase in the money supply generation fears of inflation, lenders will demand a higher rate of interest than before, so that they may compensate themselves for a fall in the purchasing power of the means of repayment.

In the vast area of the unorganized money market, increases in money supply can be expected to reduce the pure rate of interest along traditional lines. But the problem is that the pure rate of interest, the reward for sacrificing liquidity, is often not the most important component of the gross rate of interest in developing economies. For the moneylenders— who make small loans against little or no security—administration, risk and monopoly profit (usury) components might be much more important than the pure rate.

Now coming to the motives for liquidity as mentioned by Keynes, there are mainly two criticisms which are relevant to our analysis in underdeveloped countries. In the first instance the transactions demand for money is variable and elastic and not a constant because even if income and the speculative demand for money do not change, there may be a change in the demand for money on account of non- speculative hoarding of money, monetization of the non-monetized sectors and seasonal demands for money.

Keynes himself said that in the money markets which are not properly organized and integrated with other markets the precautionary demand for money is going to be high. The uncertainty of earnings on capital invested, sudden and violent shifts in absolute and relative prices, the economy being a gamble in monsoons, etc. make the precautionary demand for money in such low income countries both high and changeable.

Again, Keynes laid down the motive of Mo function as “the object of securing profit from knowing better than market what the future will bring forth,” but he related it only to bonds to the exclusion of all other assets. In other words, he assumed a sort of neutrality of the liquidity preference function between bonds and commodities, by taking commodity prices as constant. The exclusion of commodities from M₂ function as we have seen above, became the subject matter of serious criticism by Patinkin and others. In other words, he left out the price-elasticity of the demand for money.

This leads us to a very important conclusion that if the pull of the commodity speculation is strong enough in an economy where the commodity market is far more important than the money, it may not only lower the interest rate but also may cause it to rise, particularly, if the relative attraction of commodity speculation is stronger than that of bond speculation”. A natural corollary of this is that there is no infinite elasticity of the demand for money in relation to the interest rate at any positive level, unless we ignore the commodity market, which in other words means that commodity market must be perfectly controlled i.e., there is no liquidity trap in such economies.

Thus, whereas it can be granted that there is a general relationship and interdependence of interest rates, speculative demand for money in the Keynesian system. What is, however, lacking is that in this interrelationship neither the price level nor the total demand for money, nor the quick realization of money supply into prices is integrated.

From the experience of low income countries, like India we get the impression that the price effect on the demand for money is strong and the rate of interest is more a dependent variable than an independent one. In other words, Keynes failed to distinguish between the basic proposition that the amount of money demanded is inversely dependent on the rate of interest and the completely different proposition that the rate of interest also depended upon the demand for money.

The second criticism of Keynesian interest theory has been that it has neglected the real balance effect. The demand for money is influenced by variations in prices, interest rates, level of income, and the value of all other assets which can be substituted for money, and not alone by bond prices, or their inverse, the interest rates, as Keynes assumed. Patinkin has shown that ignoring the real balance effect from either the commodity or the bond market makes the whole framework of a monetary theory internally inconsistent.

As far as poor economies like India are concerned, the real balance effect in the commodity market is great. Therefore, the more realistic conclusion is that the demand for money is simultaneously determined in all the three markets, and the assumption of neutrality of liquidity preference between bonds and commodities is false.

Thus, the test of invalidity of the Keynesian liquidity function in an underdeveloped country has important implications. First, it shows that idle balances cannot be very large on account of the stickiness of high interest rates. Second, changes in the interest rate do little to determine the speculative demand for money. Third, the cash balance effect with respect to the bond market is of no great consequence.

However, this does not mean that increase in the money supply will have no effect at all upon the rate of interest. If it leads to inflation, farmers in particular will probably be able to get more for their produce, in real terms because of the short-run inelasticity of supply. Their crisis-ridden demand for loans will decline, their collateral or surplus will increase, and they approach the money-lender.

This can lead to a reduction in the rural rate of interest: at the same time interest rates are rising in the towns due to expectations of further price rises. These reductions may be even greater if the inflationary pressures help spread the use of money throughout the rural economy, since there appears to be a definite inverse correlation between the degree of monetization in a particular area and the prevailing rate of interest which money-lenders can impose.

The main use of the Keynesian monetary theory in developing countries is that it provides a logical framework for the discussion of the place of money in economic development, “We can say that the Keynesian framework has helped us to identify the points at which quantitative as opposed to qualitative monetary expansion may fail to generate development. We are, then, in a position to outline whatever reforms or policy decisions may be necessary in order to approximate the rate of interest to the reward for sacrificing liquidity, to the marginal efficiency of capital to represent the demand for investible funds, and to orientate investments so that the multiplied demand is met by a multiplied supply. We shall probably find that these changes are at the heart of the development process.”

Although throughout our analysis in this section we have laid stress on the invalidity of the Keynesian liquidity preference theory, yet the foregoing analysis also provides no support of application of the neoclassical theory of Wicksell and post-Wicksell writers in such economies. Approaching from the supply side, we find no evidence for the assertion that an increase in the quantity of money would raise prices indirectly through reducing the rate of interest, first and that after prices have risen they would cause the reversal of the earlier changes in the rate of interest.

It is just possible that as the investment on account of planning and development increases on a large scale and bond markets of such economies are strengthened, both the Keynesian and neo-classical theories may start operating simultaneously, until then, perhaps, the old classical theory will operate fully because the pull of commodity market may even be so strong so as to discourage the growth of the bond market.