Question

1A) Using the liquidity framework, explain supply and demand in the money market include a graph.

1B) Using the loanable funds model, describe the relationship between bond prices and the interest rate.

Answer 1

1A)The supply and demand for money can be explained with the help of liquidity preference theory by Keynes.According to these theory there are three different motives for holding money namely transactionary motive and speculative motive.Transactionary motive of demand of money is a function of rate of imcome and the speculative motive of money is a function of rate of interest.The above diagram shows that the interest rate is determined by the intersection of demand and supply of money.In the figure liquidity preference or demand for money is represented by L .Supply of money is shown by M and rate of interest by r.When rate of interest increases from r¹ to r² the demand for money or liquidity preference increases from L¹ to L² and supply of money reduces from M¹ to M²
1)B)Loanable fund theory is also known as theory of market interest .According to these theory interest rate is determined by demand and supply of the loanable funds.According to this theory there is an inverse relation between the bond price and the interest rate.When the interest rate increases the opportunity cost of holding money increases and thus bond prices decreases.The term loanable fund includes bonds ,loans ect..The lower the interest rate the greater is the demand for loanable funds or bonds.where as supply of loanable funds is positively related to the interest rate increases hence the supply curve of loanable funds is upward slopping and demand curve of loanable funds is downward sloping.