The demand for money and the issue of excessive liquidity preference.
Keynes developed his notion of liquidity preference as outlined in the GT (1936) building on ideas he may have developed in part through his earlier supervision of Fredrick Lavington who had been a student of Keynes and later he was the Girdler Lecturer in Economics at Cambridge. His work The English Capital Market was first published in 1921. Lavington lectured at Cambridge from 1918 to 1927 and spent seven prior years at the Board of Trade. He died in 1927. ( See Donald Moggridge, Maynard Keynes An Economist‘s Biography, Routledge, London&NYC, 1992; F. Lavington, The English Capital Market, Methuen, London 1921.) In addition Keynes made use of his considerable insights from his work The treatise on Money published in 1930.
Keynes developed his money demand and Money supply theory in the following way starting from classical assumptions but then building in risk, uncertainty, complexity in financial markets and liquidity preference in order to show that there was a non zero demand for cash balances. This is what permits what I once called quasi hoarding of money . If that is so then it is understandable how such idle balances do not produce full employment and financial markets can be unstable. Disequilibrium is a real possibility and Say‘s law does not hold.
Keynes writes that M = M1+M2=L1(Y)+L2(r) where M is the total demand for money M1 is transactions and precautionary demand, M2 is the speculative motive demand; L1 is the liquidity function corresponding to an income Y which determines M1 and L2 is the liquidity function of the rate of interest r which determines M2 .
Keynes then states It follows that there are three matters to explore. i) the relation of changes in M to Y and r, ii) what determines the shape of L1; and iii) what determines the shape of L2 (GT p.200).All the changes in M occur as a change in money income. The new level of additional income can be the result of the Government through the Fed creating additional money buying treasuries, for example, and expanding its balances sheet. But Keynes points out that the new higher level of income will not necessarily be high enough for the requirements of M1 to absorb the whole of the increase in M; some of the money will seek an outlet in buying securities or other financial assets until r has fallen so as to bring about an increase in the size of M2 sufficient to stimulate a rise in Y to the extent that the new money is absorbed either in M2 or in M1 which corresponds to the rise in Y caused by the fall in r.Remember that bond prices always move in the opposite direction to the rate of interest.Buying bonds bids up their price and lowers the rate of interest.Selling them lowers their price and hence bids up the rate of interest.
Keynes goes on to specify that V is the velocity of money and there is no reason to assume it is a constant. Hence he writes L1 (Y) = Y V = M1 where YV is Y divided by V. The value of V will depend on the character of banking and industrial organization, on social habits, on the distribution of income and on the effective cost of holding idle cash balances. In the short period (and in my view Keynes errs here which helps the classical find their way back to the quantity of money argument) We can safely assume no material change in these factors and we can treat V as nearly enough constant ,(GT pp200-201) In the Marshallian instant period which is no more than a snapshot in time this might be true but not always so.The current Covid crisis shows how quickly things can change.