The liquidity-preference theory of interest

This paper is an expansion of some remarks delivered before a Round Table on General Interest Theory at the Fiftieth Annual Meeting of the American Economic Association in Atlantic City, December 29, 1937. Mr. Keynes's liquidity-preference theory of interest is that the interest rate is determined by liquidity preference and the quantity of money. A number of different interpretations of the term "liquidity preference" are possible. These alternative definitions are divided into two groups: (1) substantial definitions concerned with common-sense notions of liquidity; (2) formal definitions concerned with the total demand for money. No formal definition is equivalent to any substantial definition except under very artificial assumptions. Under more general conditions, the substantial definitions render the theory wrong and the formal definitions render it less useful than alternative correct theories, as tested by simple criteria of usefulness est up for the purpose. It is the ambiguity in the definition of liquidity preference which gives it the appearance to some of being at one and the same time useful, formally valid, and of very general application. It may with suitably chosen definitions be any two of these but never all three.