Introduction:

J.M Keynes created the theory of liquidity preference theory of interest to explain the role of the interest rate by supply and demand for money in 1936. According to Keynes the rate of interest is a purely monetary aspect. It is the reward for parting with liquidity for a specific period of time , the art of interest is determined by the demand for and the supply of money.

Theory:

The supply of money means to the stock of money in circulation and is fixed amount of money at a specific period of time. It is the sum of currency and commercial bank deposits. It remains fixed in the short run because it is determined and controlled by the central bank of a country. So it plays a important role in interest rate determination.

The demand for money, JM Keynes gave three reasons for holding money. The transactions reason, the precautionary reason and the speculative reason.

Transaction motive:

Individuals and business firms hold money in order to carry out day to day transactions each individual or firm has a time gap between receipts (income) and expenditure will need to hold money to cover this. the amount of cash held for transaction and precautionary purposes also depends on income and prices if income increases the more money will be hold some money  similarly price rises more money will be regard to purchase the same amount of goods and services.

Precautionary motive:

 People and business firms hold some money as a reserve to meet an unforeseen and contingency such as sickness or accidents. Or the need to take advantage of an opportunity to buy something which is being offered at a specially reduce price for only limited periods example during a sale.

Speculative motive:

 The people hold wealth in the form of money rather than the held for transaction and precautionary purposes. it is because any money left over could be invested in interest earning assets like bonds. Keynes pointed out that at time it may be preferable to hold idle money and to buy government securities if a person holds money loses interest but he does not suffer capital loss, in fact it cost money to hold money. Therefore the rate of interest is called opportunity cost of money holding by holding money an individual loss the opportunity to earn interest.

also read: explain the Keynesian psychological law of consumption.