Model Answer
0 min readIntroduction
John Maynard Keynes’s Liquidity Preference Theory, developed in his seminal work *The General Theory of Employment, Interest and Money* (1936), provides a framework for understanding the determination of interest rates in the short run. Unlike classical economists who believed interest rates were determined by the supply and demand for capital, Keynes argued that interest rates are determined by the supply and demand for money. This theory posits that individuals prefer to hold their wealth in the most liquid form – money – and the rate of interest is the ‘reward’ for parting with this liquidity. Understanding this theory is crucial for analyzing the impact of monetary policy on the economy.
The Theory of Liquidity Preference
The Liquidity Preference Theory centers around the idea that the interest rate adjusts to balance the supply and demand for money. The demand for money, according to Keynes, arises from three primary motives:
- Transactions Motive: Individuals and firms need money to carry out everyday transactions. This demand is positively related to the level of income.
- Precautionary Motive: People hold money as a buffer against unforeseen expenses or opportunities. This demand is also positively related to income and uncertainty.
- Speculative Motive: This is the most crucial motive for Keynes. Individuals hold money if they expect interest rates to rise (and bond prices to fall). If they anticipate a fall in interest rates (and a rise in bond prices), they will prefer to hold bonds.
Supply of Money
The supply of money is assumed to be exogenously determined by the central bank (e.g., the Reserve Bank of India). It is represented as a vertical line on a graph, indicating that the quantity of money available is independent of the interest rate.
How an Increase in Money Supply Lowers Interest Rates
When the central bank increases the money supply, the money supply curve shifts to the right. With the demand for money remaining constant (at least initially), this increase in the supply of money creates an excess supply of money in the market. To get rid of this excess money, individuals and firms will attempt to invest it in financial assets, primarily bonds.
This increased demand for bonds drives up their prices. Since the interest rate is inversely related to bond prices, the increase in bond prices leads to a fall in the interest rate. This process continues until the money market reaches a new equilibrium where the quantity of money demanded equals the quantity of money supplied at the new, lower interest rate.
Graphical Representation
Imagine a graph with the interest rate on the y-axis and the quantity of money on the x-axis. The demand for money is a downward-sloping curve, and the supply of money is a vertical line. An increase in the money supply shifts the supply curve to the right, leading to a lower equilibrium interest rate.
The Assumption about the Price Level
The explanation above crucially assumes that the price level remains constant. This is because the theory operates under the assumption of a short-run analysis where prices are ‘sticky’ and do not adjust immediately to changes in the money supply. If the price level were to rise as a result of the increased money supply (inflation), the real value of money would decrease, potentially offsetting the impact on interest rates. In other words, if prices rise proportionally to the increase in the money supply, the real interest rate (nominal interest rate adjusted for inflation) may not fall, or may fall by a smaller amount. The theory assumes a stable price level to isolate the impact of monetary policy on nominal interest rates.
Real-World Example: Quantitative Easing
The implementation of Quantitative Easing (QE) by central banks like the US Federal Reserve and the Bank of England following the 2008 financial crisis provides a real-world example. These policies involved injecting liquidity into the financial system by purchasing government bonds and other assets. The aim was to lower long-term interest rates and stimulate economic activity. While the effectiveness of QE is debated, the underlying principle aligns with the Liquidity Preference Theory – increasing the money supply to lower interest rates.
Conclusion
In conclusion, the Liquidity Preference Theory provides a compelling explanation for how an increase in the money supply can lead to a decrease in interest rates. This mechanism relies on the interplay between the supply and demand for money, driven by the transactions, precautionary, and speculative motives. However, it’s vital to remember that this explanation hinges on the crucial assumption of a constant price level, representing a short-run analysis. Understanding this theory is fundamental to comprehending the impact of monetary policy and its role in managing economic fluctuations.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.