A Reinterpretation and Remedy of Keynes's Liquidity Preference Theory

Abstract

The dissension on the mechanism of determination of interest rate is always in the center of much confusion and many controversies of monetary economics. Keynes's liquidity preference theory remains at the core of the center. This paper starts off with analyzing the inherent logic of liquidity preference theory and presents a new interpretation of the theory in a more logical and clear manner. The reinterpretation clearly indicates the necessity of introducing liquidity preference analysis into determination of interest rate, arguing that it is the liquidity preference analysis based on finance motive, rather than on transactions motive, that plays a more fundamental role in determining interest rate. The paper then points out a crucial and unsolved mistake in Keynes's liquidity preference theory, i.e. interest rate is indeterminate, which is revealed by introducing finance motive into the theory. Further, the paper develops a logically consistent and integrated model of determination of interest rate on the basis of the liquidity preference analysis centered on finance motive. In this model, interest rate is not determined by the demand for and supply of money, but determined by the demand for and supply of idle money.

Keywords: Liquidity preference theory, Finance motive, IS-LM model, Determination of interest rate

JEL Classification: E12, E41, E43