Question

What is the liquidity effect and how is it related to the interest elasticity of Md?

Answer 1

In terms of economics,When there is a time of recession in a country the central bank injects money in the economy by adding money.It also provides easy credit to people.As now the more money is available economic activity in an country increases rapidly.More of purchase and sale is taking place hence economy is in more liquid state.therfore this whole situation is termed as liquidity effect.There are effects of this too--

1.Expansion on monetary policies like open market operations,Buying of treasury bills,bonds.

2.Interest rates goes down automatically when money supply increases.

3.Many a times dur to increase in income,infaltion rate rises as people have more purchasing power.

Coming to second part.

general money demand function - Md = P * L(Y, i). where,Md= nominal demand for money,P= price level, L= money demand,i=Nominal interest rate,Y= income.

The demand of moneey is inversely related to nominal interest rates.

It is more explained through LM curve.Lm curve shifts right when interest rate if money deceases.

Money demand declines as the rate of interest increases.

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