A contribution to the liquidity preference theory of interest

Abstract

In the long controversy which succeeded Keynes’s presentation of the Liquidity Preference Theory, predominant attention was given to the interrelationship between national income and the rate of interest. The nature and significance of the demand for and supply of money have, by contrast, received considerably less attention. The present paper elucidates two unsolved problems in this regard: the determination of the supply of money in a model which admits of a simple banking system, and the nature and main determinants of the demand for idle money. An attempt is made at introducing to the theory the hypothesis that a rise in the amount of hoarded money in the economy is likely to be accompanied by a reduction in the public’s desire for notes and coins. For this purpose, the author distinguishes between the proportion of active money and that of passive money which the public desires to hold in the form of cash. Some statistical evidence is then presented which seems to support the presumption that the proportion of active money which people demand in the form of cash exceeds that of passive money. A second modification to the theory is based on the contention that the demand for idle money depends not only on the rate of interest but also on the amount of wealth in the economy and as the amount of idle money is part of that wealth any change in this amount may cause a change in the demand for idle money. Thus, the version of the Liquidity Preference Theory here presented makes explicit allowance for a causal relationship between, on the one hand, the supply of idle money and, on the other, the total supply of money and the demand for idle money. JEL: E41, E43, E51

Keywords

• Liquidity preference theory
• national income
• interest rate
• supply of money
• demand
• active money