The demand for money is one of the most important concepts in the Liquidity Preference Theory...

The demand for money is one of the most important concepts in the Liquidity Preference Theory of Interest. What are the three main components of the demand for money in this idea about how interest rates are determined?

Expert Solution

Liquidity Preference theory of interest says that interest acts as the 'price' of money. It says that the demand for money varies with interest rates. There are three components of demand for money according to this theory, they are:

1. Transactionary demnd for money: It is the demand for money to carry out day to day expenses. It depends on the level of income. Higher income means higher demand for money as more money is available to carry out expenses.

2. Precautioanry demand for money: It is the demand for money for unforeseen events or uncertain future. Here money is demanded for the unfortunate events like accidents or any medical emergencies. It also depends on income level, the higher income, the higher precautionary demand for moeny.

3. Speculative demand for moeny: This type of moeny is demanded to take the advantage of change future interest rates and bond prices. This type of demand for money arises when people find it less risky to hold money than to lend it. Thus, it varies inversely with the interest rates. The higher the interest rates, the lower speculative demand for moeny and vice versa.

Rahul Sunny answered 9 months ago

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