Explain Keynesian theory of demand for money.

Explain Keynesian theory of demand for money : The Keynesian theory of demand for money, often referred to as the liquidity preference theory, is an important aspect of John Maynard Keynes’ macroeconomic framework.

This theory seeks to explain why individuals hold money and how their preferences for holding money versus other assets impact the overall economy. The demand for money is a significant factor in determining the equilibrium interest rate and the overall level of economic activity.

Explain Keynesian theory of demand for money.

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Keynes proposed three motives for holding money:

  • Transaction Motive: People hold money to facilitate day-to-day transactions. This motive is driven by the need to have sufficient cash on hand for regular expenses such as groceries, bills, and other immediate needs.
  • Precautionary Motive: People hold money as a precautionary measure to meet unexpected expenses or emergencies. Holding money for this purpose provides a buffer against unforeseen financial needs.
  • Speculative Motive: People hold money as a form of “idle” cash that can be used to take advantage of investment opportunities or to make financial investments when asset prices are expected to change.

The demand for money is influenced by these motives. Keynes argued that the demand for money was a function of the interest rate and income:

M = L(i, Y)


  • M represents the quantity of money demanded.
  • L represents the liquidity preference function.
  • i represents the interest rate.
  • Y represents the level of income.

According to the Keynesian theory of demand for money:

  • As the interest rate (i) increases, the cost of holding money increases, leading to a decrease in the demand for money.
  • As the level of income (Y) increases, the demand for money increases since people require more money for transactions and precautionary purposes.

In the Keynesian framework, the equilibrium in the money market is established when the supply of money equals the demand for money. The equilibrium interest rate corresponds to the point where the total amount of money people want to hold matches the amount of money in circulation.

Keynes’ liquidity preference theory emphasizes that changes in the money supply can impact interest rates and, consequently, investment and overall economic activity. If the money supply increases, the interest rate decreases, which can lead to higher investment and economic growth. Conversely, a decrease in the money supply can lead to higher interest rates, potentially dampening investment and economic activity.

In summary, the Keynesian theory of demand for money highlights how individuals’ motives for holding money influence their preferences for liquidity. These preferences have implications for interest rates, investment decisions, and overall economic performance.

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