Question

Based on the liquidity preference theory, will the following factors would

affect one of the motives for holding money? Explain your answer.

– Lower nominal interest rates of bonds.

– Rumors that a computer virus had invaded the ATM network.

– A fall in real income.

– The use of Apple Pay makes your daily transactions cheaper and

easier.

Answer 1

The liquidity preference theory says that investors expect higher return for holding securities for longer period as holding securities with longer period possess the liquidity problem which results in higher risk. Therefore, investors prefer to hold the securities for shorter period to lessen the liquidity risk.

We will see whether the following factors affect the motives of holding money.

• Lower nominal interest rates of bonds: Lower nominal interest rate would increase the demand for money as it will reduce the opportunity cost of holding money. Lower nominal interest rate lead to increase in prices of bond, thus investor will prefer holding cash over the purchase of bonds.  If the invester expects the interest rate to be lower in future than he will decrease the holding of cash and invest in the purchase of bond as bond price will increase in future and he will capital gain for holding a bond.
• Rumors that a computer virus had invaded the ATM network: This will increase the transaction demand for money as this rumours will lead to worries about the system closing down.
• A fall in real income: A fall in real income means when inflation rises, the real income falls. This will decrease the spending power and lowers the demand for money. Thus, it will decrease the motives of holding money.

• The use of Apple Pay makes your daily transactions cheaper and easier : This will increase the transaction and precautionary motives as it makes everyday transaction and purchasing easier and safe. Thus, it fulfills the motives of holding money.