Question

1. Decompose the liquidity preference demand for money function: M^d = D_t(PY) + D_a(R).

That is, what are the different reasons we wish to hold money and what are these reasons/demands determined by (or a "function of")?

And, in our model of the economy, “where” & how is the equilibrium interest rate determined?

2. Briefly explain with—or without—a bit of maths, why bond prices & interest rates are inversely related.

Answer 1

Answer 1:

According to Keynes, money is demanded for three motives which are as follows:

a. Transaction Motive: Most of the transactions in the economy involve an exchange of money. Thus, people keep money with themselves to satisy their transaction demand for money.It is positively related to income level in the economy. As income in the economy increases, the transactions demand for money increases.

b. Speculative Motive: The demand for money also depends on rate of return and opportunity cost.The opportunity cost of holding money is the interest rate that one can earn by lending or investing money.Specualtive demand for money arises when holding money is less risky than keeping it in assets or lending it.As rate of interest increases., speculative demand for money decreases and vice versa.

c. Precautionary Motive: When people demand money as a precuation against uncertain future, then it is known as Precautionary motive of holding money.

In the keynesian model of money market,equilibrium rate of interest is detetmined at the point of intersection of money demand and money supply functions.