Keynes's Liquidity Preference Theory

• Keynes's Liquidity Preference Theory explains how the interest rate is determined by the supply and demand for money

Money Demand

• Money demand reflects how much wealth people want to hold in liquid form
• Keynes identified three motives for holding money: the transactions motive, the precautionary motive, and the speculative motive
  • The transactions motive arises because money is needed for day-to-day transactions
  • The precautionary motive arises because people hold money as a buffer against unforeseen circumstances
  • The speculative motive arises because people hold money to take advantage of future changes in interest rates
• Money demand is negatively related to the interest rate
  • A higher interest rate increases the opportunity cost of holding money, thus reducing the quantity of money demanded
  • A lower interest rate reduces the opportunity cost of holding money, thus increasing the quantity of money demanded
• The money demand curve illustrates the relationship between the interest rate and the quantity of money demanded
  • The curve is downward sloping

Money Supply

• Money supply is determined by the central bank
• The central bank can alter the money supply through open market operations, reserve requirements, and the discount rate
• The money supply is independent of the interest rate
  • The money supply curve is vertical

Equilibrium

• The equilibrium interest rate is determined by the intersection of the money demand and money supply curves
• At the equilibrium interest rate, the quantity of money demanded equals the quantity of money supplied
• If the interest rate is above the equilibrium level, there is an excess supply of money, which puts downward pressure on the interest rate
• If the interest rate is below the equilibrium level, there is an excess demand for money, which puts upward pressure on the interest rate

Shifts in Money Demand and Supply

• Changes in factors other than the interest rate can shift the money demand or money supply curves, leading to changes in the equilibrium interest rate
• Factors that can shift the money demand curve include:
  • Changes in income: Higher income increases money demand, shifting the curve to the right
  • Changes in price level: A higher price level increases money demand, shifting the curve to the right
  • Changes in expectations: If people expect interest rates to rise, they may increase their current demand for money, shifting the curve to the right
• Factors that can shift the money supply curve include:
  • Open market operations: Purchasing government bonds increases the money supply, shifting the curve to the right
  • Changes in reserve requirements: Lowering reserve requirements increases the money supply, shifting the curve to the right
  • Changes in the discount rate: Lowering the discount rate increases the money supply, shifting the curve to the right
• An increase in money supply lowers the equilibrium interest rate
• A decrease in money supply raises the equilibrium interest rate
• An increase in money demand raises the equilibrium interest rate
• A decrease in money demand lowers the equilibrium interest rate

Liquidity Trap

• A liquidity trap is a situation in which monetary policy becomes ineffective because nominal interest rates are very low or near zero
• In a liquidity trap, individuals prefer to hold cash rather than investing in interest-bearing assets because they expect interest rates to rise or fear deflation
• When interest rates are near zero, the opportunity cost of holding cash is minimal, making people indifferent between holding cash and bonds
• In a liquidity trap, increases in the money supply do not lead to lower interest rates or increased investment spending
  • People simply hoard the additional money, leading to a horizontal money demand curve at the zero interest rate
• The ineffectiveness of monetary policy in a liquidity trap can hinder economic recovery during recessions or periods of low aggregate demand