10 Criticisms of Keynes’ Theory of Liquidity Preference

Here we detail about the ten criticisms of Keynes’ theory of liquidity preference.

1. Indeterminate:

Keynes’ liquidity preference theory is also indeterminate like the classical theory of the rate of interest. This is because the liquidity preference curve itself shifts up and down with changes in the level , of income.

Keynes’ liquidity preference curve includes these motives [L₁ (Y) + L₂ (r)]. The first part of the liquidity preference curve (L₁) comprising transaction and precautionary motives cannot be known unless we know the level of income; therefore, we cannot know the relevant liquidity preference curve and hence the rate of interest.

The theory is indeterminate because liquidity curve is difficult to locate without knowing the level of income. What the Keynesian formulation regarding the rate of interest tells us is the various schedules of liquidity preference at various levels of income and not what the rate of interest is. Hence, Keynes’ own theory becomes indeterminate.

2. Narrow Version:

Keynes’ theory of liquidity preference has been criticized on the ground that it is too narrow as an explanation of the rate of interest, because it unduly treats interest rate as the price necessary to overcome the desire for liquidity. In actual practice liquidity (desire for money) arises on account of many factors and not only on account of motives mentioned by Keynes. As such it becomes too narrow an explanation of the rate of interest. Further, the rate of interest influences and in turn is influenced by other important factors like the rate of saving, propensity to consume and marginal efficiency of capital, which the liquidity preference theory completely ignores.

3. Hoarding:

It has been argued that the idea of hoarding has not been properly explained in Keynes’ theory of interest. The factors that go to increase the propensity to hoard and the volume of hoarding are not sufficiently analyzed and given their due place.

4. Liquidity:

The distinction between liquidity and illiquidity is not so simple as has been assumed by Keynes. In actual practice, there are different degrees of liquidity. Keynes unnecessarily restricted his theory by simplifying the distinction between liquidity and illiquidity, ignoring the complex system of rates of interest depending on the difference in the degree of liquidity. In other words, he completely ignored the time element involved. In actual practice, we find that the rates of interest on daily, weekly or monthly loans differ from the long term rates of interest. Thus, his theory based on unified (uniform) system of liquidity is not acceptable.

5. Inconsistent:

It is said that Keynes’ theory is inconsistent in-as-much as it goes against the very fact that it attempts to explain. According to his theory, in depression period the rate of interest should be the highest because people like to hold maximum cash in depression and a high rate of interest must be offered to induce people to part with liquidity. But in depression period price of everything including the rate of interest is the lowest. Thus, liquidity preference theory becomes inconsistent with facts.

6. Waiting Leads to Saving:

According to Keynes, rate of interest is not a reward for waiting or saving. He forgets that saving or waiting is a necessary means to obtain funds for liquidity as Jacob Viner has pointed out, “there can be no liquidity without saving”. Prof. D.H. Robertson has expressed similar views. A man first earns an income, then saves a part of it, and thereafter decides whether to keep it in liquid (cash) form or in it liquid (bonds and securities) form. It is obvious that there can be no liquidity without saving.

7. Productivity:

According to critics, interest is not the only reward for parting with liquidity (as claimed by Keynes). The rate of interest also arises because capital is productive. The demand for funds rises not only for speculative motive but also for investment. Hence, the rate of interest is paid because capital is productive.

8. Limited Validity:

Even from the side of supply, Keynes’ theory of interest has been found to be of limited validity, because it is not always possible to bring down the rate of interest by increasing the supply of money. It is just possible that as soon as the supply of money is increased, liquidity preference may also rise and the rate of interest may remain unaffected. Thus, from the practical point of view, his theory suffers from this limitation.

9. For Advanced Economies:

His theory of liquidity preference is applicable primarily in advanced economies, where the money market is wide and well organised and people make choices in speculative markets amongst different types of securities. As such, it does not apply in backward developing economies, where the choice of assets is limited.

10. One-Sided:

This theory is essentially one-sided and therefore cannot be general. It lays more emphasis on liquidity preference i.e., demand side and completely ignores the analysis of factors on supply side.