Discuss the limitations of Keynes’ Liquidity Preference Theory.

Discuss the limitations of Keynes’ Liquidity Preference Theory. 

Ans. After World War II, Keynes economic theories became very influential and other economists further refined his motives for holding money. One of these economists, James Tobin, later won a Nobel Prize for his contributions.Tobin (and another economist Baumol) both developed theories and how the transactions demand for money is also related to the interest rate. As interest rates rise, the opportunity cost of holding cash for transactions will also rise, so the transactions part of money demand is also negatively related to the interest rate. Similarly, people will hold fewer precautionary balances when interest rates are high. One problem with Keynes’ speculative demand is that his theory predicted that people would hold wealth as either money or bonds, but not both at once. That is not realistic. Tobin avoided this problem by observing that the return to money is much less risky than the return to bonds, so that people will still hold some money as a store of wealth even when interest rates are high. This diversification is attractive because is reduces risk. Still one problem with money demand remains. There are other low risk interest bearing assets: money market mutual funds, U.S. Treasury Bills, and others. So why would anyone hold money (M1) as a store of wealth? Economist today still tries to develop models of investor behaviour to solve this “rate of return dominance” puzzle.