Question

Considering the idea of the liquidity preference theory of chapter 5, we are considering the relationship between changes in a measure of the US money supply and changes in interest rates.   Admittedly the theory and state of analysis is a bit vague in some ways because it isn’t really clear which interest rate and which money supply aggregate to use.   You will find in the data sheet DISC02Data.xlsx useful. In the first tab “RawDataFromFred” is data on M2 and a 3 month interest rate. I have added two additional items, calculations shown. The first is YRLY%M2, the second is MTHLY%M2.   YRLY%M2 is the yearly percentage change in M2 over a year period, MTHLY%M2 is the monthly change in M2 over a month to month period. Use the data in the tab “Q1Analysis” as that has all you need and the dates of the variables are matched.

1. According to the Liquidity Preference Theory, what type of relationship should I expect between changes in the money supply and interest rates? Explain.

Answer 1