Question

Question B3

According to the book “The General Theory of Employment, Interest, and Money, John Maynard Keynes purposed the theory of liquidity preference to explain the factors that determine an economy’s interest rate.

(i) State the definition of the theory of liquidity preference.

(ii) How does the theory of liquidity preference explain downward-sloping aggregate-demand curve? Explain your answer in both words and diagrams.

Answer 1

(i)

Theory was proposed by Keynes. The basic idea is that people demand for money is not to borrow but the desire to keep the money liquid. The opportunity cost of holding money is the interest rate which is also considered as the price for money.

Keyes bifurcated the demand for money in three objectives:

- Transaction motive of money

- The precautionary motive of money

- the speculative motive of money

At a high-interest rate, the liquidity preference curve L becomes vertical. During this phase, the demand for money is transactional and precautionary

According to theory, there exists a negative relationship between interest rates and the demand for money. This is known as speculative demand for money and shown by the downward sloping region of L curve

At very low-interest rate, L curve becomes flat. This is called Liquidity Trap. Any change in the interest rate will not affect the demand for money.

(ii)

Liquidity Preference Theory explains the downward sloping AD curve on the following grounds:

- Higher the price, more is the money demand

- Higher the money demand higher will be the interest rate

- A high-interest rate leads to a reduction in the quantity demanded

Hence, at high price people demand fewer goods and services and therefore the AD curve is downward sloping as shown in the below graph: