linguistic:voice_change, structural:summarization
Interest and liquidity preference

Keynes proposes two theories of liquidity preference (i.e. the demand for money): the first as a theory of interest in Chapter 13 and the second as a correction in Chapter 15. His arguments offer ample scope for criticism, but his final conclusion is that liquidity preference is a function mainly of income and the interest rate. The influence of income (which really represents a composite of income and wealth) is common ground with the classical tradition and is embodied in the Quantity Theory; the influence of interest had also been noted earlier, in particular by Frederick Lavington (see Hicks's Mr Keynes and the "Classics"). Thus Keynes's final conclusion may be acceptable to readers who question the arguments along the way. However he shows a persistent tendency to think in terms of the Chapter 13 theory while nominally accepting the Chapter 15 correction.

Chapter 13 presents the first theory in rather metaphysical terms. Keynes argues that:

It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.

To which Jacob Viner retorted that:

By analogous reasoning he could deny that wages are the reward for labor, or that profit is the reward for risk-taking, because labor is sometimes done without anticipation or realization of a return, and men who assume financial risks have been known to incur losses as a result instead of profits.

Keynes goes on to claim that the demand for money is a function of the interest rate alone on the grounds that:

The rate of interest is... the "price" which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.

Frank Knight commented that this seems to assume that demand is simply an inverse function of price. The upshot from these reasonings is that:

Liquidity-preference is a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L(r). This is where, and how, the quantity of money enters into the economic scheme.

And specifically it determines the rate of interest, which therefore cannot be determined by the traditional factors of 'productivity and thrift'.

Chapter 15 looks in more detail at the three motives Keynes ascribes for the holding of money: the 'transactions motive', the 'precautionary motive', and the 'speculative motive'. He considers that demand arising from the first two motives 'mainly depends on the level of income' (p199), while the interest rate is 'likely to be a minor factor' (p196).

Keynes treats the speculative demand for money as a function of r alone without justifying its independence of income. He says that...

what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level...

but gives reasons to suppose that demand will nonetheless tend to decrease as r increases. He thus writes liquidity preference in the form L (Y)+L (r) where L is the sum of transaction and precautionary demands and L measures speculative demand. The structure of Keynes's expression plays no part in his subsequent theory, so it does no harm to follow Hicks by writing liquidity preference simply as L(Y,r).

'The quantity of money as determined by the action of the central bank' is taken as given (i.e. exogenous - p. 247) and constant (because hoarding is ruled out on page 174 by the fact that the necessary expansion of the money supply cannot be 'determined by the public').

Keynes does not put a subscript 'w' on L or M, implying that we should think of them in money terms. This suggestion is reinforced by his wording on page 172 where he says "Unless we measure liquidity-preference in terms of wage-units (which is convenient in some contexts)... ". But seventy pages later there is a fairly clear statement that liquidity preference and the quantity of money are indeed "measured in terms of wage-units" (p246).