Keynes’s Liquidity Preference Theory: 6 Criticisms | Interest Rate

The following points highlight the six criticisms against the Keynes’s liquidity preference theory. The criticisms are: 1. Indeterminate Theory 2. Ignores ‘Real’ Factors Altogether 3. No Liquidity without Saving is Available 4. Goes Contrary to Observed Facts 5. ‘All or Nothing’ Theory 6. Begs the Question.

Keynes’s Liquidity Preference Theory Criticism # 1. Indeterminate Theory:

Keynes criticised the classical theory for not taking income changes into account and thus rejected it for being indeterminate.

The same criticism, however, applies to his own theory. His theory also assumes a particular level of income and then proceeds to draw a liquidity preference schedule at that level of income.

The fact is that when income changes, a new liquidity preference schedule needs to be drawn: there are as many liquidity preference schedules as the levels of income. If income changes are taken into account, then Keynes’ theory is also indeterminate.

Keynes’s Liquidity Preference Theory Criticism # 2. Ignores ‘Real’ Factors Altogether:

Keynes’s liquidity preference theory is only a monetary theory. It does not consider any of the real factors like thrift, marginal productivity of capital and abstinence needed for saving. There is no denying the fact that money supply and demand exercise a lot of influence on determination of the rate of interest but loans are demanded only because capital is productive.

A full and determinate theory of interest rate must take note of real factors like the supply of real saving and the marginal efficiency of investment as much as of the demand and supply of money. Keynes’s theory is thus inadequate inasmuch as it ignores the real factors influencing rate of interest.

Keynes’s Liquidity Preference Theory Criticism # 3. No Liquidity without Saving is Available:

Keynes considers rate of interest to be a reward for surrendering one’s liquidity preference. He would not admit the influence of abstinence and time preference in the supply of saving and the role of saving in determination of the rate of interest.

He conveniently forgot that saving is necessary for the holding of cash which means liquidity preference. As Jacob Viner has said, “Without saving, there can be no liquidity to surrender. Rate of interest is the result of saving.” It is the denial to oneself of consumption of the whole of one’s income which makes liquidity possible.

Keynes’s Liquidity Preference Theory Criticism # 4. Goes Contrary to observed Facts:

The theory holds that interest is the reward for parting with liquidity. Higher is the liquidity preference, higher is the rate of interest and lower is the liquidity preference, lower is the rate of interest. During depression, people have a high liquidity preference but the rate of interest is extremely low.

In times of inflation people have low liquidity preference but the rate of interest is very high. Thus facts go against Keynes’s theory. This is because Keynes did not take the income level into account. The modern determinate theory can explain this fact satisfactorily.

Keynes’s Liquidity Preference Theory Criticism #  5. ‘All or Nothing’ Theory:

In his theory, Keynes assumes that the choice is always between liquid cash and illiquid bonds. His theory is, therefore, an ‘all or nothing’ theory. In fact, there are various types of investable assets varying in degrees of liquidity.

A person who has some saving does not always want it to be cither wholly cash or illiquid bonds. He wants some cash, some liquid assets and some illiquid assets. Keynes’s theory thus unnecessarily separates liquid from illiquid assets for determination of the rate of interest.

Keynes’s Liquidity Preference Theory Criticism # 6. Begs the Question:

A basic objection to Keynes’s liquidity preference theory was stated by Sir Dennis Robertson humorously. He observed that in Keynes’s theory, “the rate of interest is what it is because it is expected to be other than it is.” He then asked, “But if it is not expected to be other than it is, there is nothing to tell us why it is what it is ; the organ that secretes it has been amputated, but somehow it still survives ; a grin without a cat.”

The cogency of Robertson’s criticism may be lost in its humour. The liquidity preference curve and hence the whole of Keynes’s theory depends upon people expecting a change in the rate of interest and hence in the price of bonds.

If people do not, in fact, expect the rate of interest to change, there is nothing left of liquidity preference theory. If people expect the rate of interest to rise further when it is high, and to fall when it is low, the whole theory would be reversed. The relationship between the rate of interest and the demand for bonds is implicit in the theory itself. The theory, therefore, begs the question.