Critical Assessments of The General Theory
Edited by L. Randall Wray and Matthew Forstater
Chapter 16: A Reinterpretation, Remedy and Development of Keynes’s Liquidity Preference Theory
Wenge Huang INTRODUCTION Liquidity preference theory is always the most confused and controversial part of Keynes’s General Theory. This results in the dissension on the mechanism of determination of interest rate in monetary economics. Liquidity preference theory was ﬁrst introduced by Keynes in his profoundly inﬂuential General Theory in 1936. Before that, the classical theory of interest argues that the level of interest rate is determined by two real factors: the demand for investment and supply of saving. In The General Theory, Keynes (1936) criticizes the classical theory of interest and presents a brand-new theory of interest, namely liquidity preference theory. In Keynes’s opinion, interest rate is not determined by saving and investment, but by the demand for and supply of money. Demand for money, or broadly deﬁned liquidity preference, is composed of transactions motive, precautionary motive and speculative motive. Among the three, transactions motive and precautionary motive mainly depend on the level of income; and speculative motive, or narrowly deﬁned liquidity preference, mainly depends on the level of interest rate. The supply of money is the quantity of money determined by the monetary authority. Interest rate is a price that makes the quantity of money the public would like to hold equal to the quantity of money in existence. Keynes’s liquidity preference theory gave rise to many controversies soon after he introduced it. Most curiously, The General Theory holds that the change in propensity to invest (namely, a shift of the investment demand curve or Keynes’s...
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