The Fed increases money supply through open market purchase assuming a positive money multiplier. Analyze how...

The Fed increases money supply through open market purchase assuming a positive money multiplier. Analyze how the interest rate changes based on the liquidity preference framework in the short-run when the price level and output do not change. Also, analyze how money velocity changes in the short-run by the quantity theory of money.

Expert Solution

Liquidity preference is a macroeconomic theory under which when all other factors remain equal investors prefer cash, or they demand cash, considered as liquidity. According to this theory money is considered as the most liquid asset. That means if more quickly we can convert an asset into the form of money the economic situation can say more liquid.

According to Keyenesian Theory Demand for liquidity is determined by three factors. They are:

1.the transaction motive : - People need money for transactions. When their income level is high they need more money for spending.

2.the precuationery motive :- People need money for social requirements and for certain unexpected events. Even in this case people like to spend more amount of money if their income is much higher.

3. speculative motive :- Under this situation people demand more money when the interest rate is

very low.

The major rival of the Liquidity Preference theory is the Time Preference Theory. This theory focuses on the interest rates according to the interest of the people to spend right now. According to this theory interest is the price of time.

Quantity Theory of Money :- According to this theory the general price of goods and services is always directly proportioanl to the amount of money in circulation. It also states that in an economy where price level and money supply are in direct propotion to one another. This theory also assumes that the velocity of money remains constant if velocity is constant.

The velocity of money concept focuses on the rate at which one unit of money supply currency is being transacted for goods and services in an economy The velocity of money is hgher in xpanding econmies and lower in contrasting economies. That means when more transactions are made through out the economy velocity will increase and the economy is likely to expand. Eeventhough the factors affecting the supply and demand are complex, the role of money is quiet significant.

Rahul Sunny answered 2 years ago

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