Keynes Theory of Demand for Money

In 1936, economist John M. Keynes wrote a very famous and influential book, The General Theory of Employment, Interest Rates, and Money. 
In this book he developed his theory of money demand, known at the liquidity preference theory.  According to him the demand for money arises because of its liquidity or ‘liquidity preference. Demand for money arises for three motives: 

(i) transactions motives, 
(ii) the precautionary motive, and 
(iii) the speculative motive. 

The total demand for money means total cash balances i.e. active or idle. The active cash balances comprise transactions demand and precautionary demand for money and the idle ash balances comprise of speculative demand for money.
  1. 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. Thus the transactions demand for money depends upon: 

1. The personal income, and
2. The business turnover.  

The demand for money for transactions motive thus varies proportionately to the changes in the money income. The higher the money income, the greater the demand for money is and vice versa. The rate of interest has no role to play in determining the transactions demand for money. It is assumed to be constant and stable function of income because the proportion of income to be held for transaction purposes is determined by institutional and technological factors influencing the payment and receipt of money, which do not change in the short period.
 

2. Precautionary Motive:  

The precautionary motive refers to the desire of individuals to have cash available for certain unexpected situations. 
These situations could include a sudden illness or accident, or even an unforeseen social situation. In the case of households the decisions are affected by these factors. 
Similarly, in the case of business firms the decision is influenced by the element of uncertainty of the future. 

•  Both the transactions and the precautionary motives are fairly stable and constant function of income and both are interest inelastic. 
• The money balances under these two motives are referred to as ‘active balances’. 
• The amount varies from one individual to the other and from one business firm to another. 
• It will depend upon the frequency of income, credit arrangements, converting of assets into money, degree of insecurity and uncertainty of future. 
• But, these factors do not normally change in the short period. 
• Relationship between the demand for active balances and money income is, therefore, proportionately positive.

3. Speculative motive: 

The speculative motive relates to the desire to hold one’s resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other. If bond prices are expected to rise, i.e., the rate of interest is expected to fall, people will buy bonds to sell when the price later actually rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses. According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as M₂ = L₂ (r). Where, L₂ is the speculative demand for money, and r is the rate of interest. Geometrically, it is a smooth curve which slopes downward from left to right. Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M₁ and the speculative motive by M₂, then M = M₁ + M₂. Since M₁ = L₁ (Y) and M₂ = L₂ (r), the total liquidity preference function is expressed as M = L (Y, r). Thus, according to Keynes, demand for money was a function of both income and interest rate