4.14. Demand for Money, Interest Rate Determination and Paradox of Thrift

Question 1

Liquidity preference theory definition

Answer 1

a Keynesian concept that explains why people demand money

Question 2

Liquidity preference theory shows what?

Answer 2

It shows the relationship between liquidity (i.e. the demand for money) and the interest rate.

According to Keynes, there are three motives (reasons) that determine the demand for liquidity:

1) Transactions motive
2) Precautionary motive
3) Speculative motive

Question 3

Transactions motive

Answer 3

the preference for liquidity (i.e. money) so that an individual has sufficient cash to make everyday payments e.g. food, rent, bills

Question 4

Demand for liquidity for transactions motive will be higher when;

Answer 4

• Higher income is earned (most important factor).
• Higher costs of living.
• Income is received less frequently.

Question 5

Precautionary motive

Answer 5

the preference for liquidity (i.e. money) so that an individual has sufficient cash to cover unexpected events e.g. medical emergency, car repair

Question 6

Demand for liquidity for precautionary motive will be higher when:

Answer 6

• More risk averse (most important factor).
• Higher income is earned.
• Higher social status.
• More dependents.
• Older age

Question 7

Speculative Motive

Answer 7

the preference for money as a store of value as investors speculate that holding money is less risky than investing it in bonds and shares

Question 8

Demand for money due to the speculative motive will be higher when:

Answer 8

• Interest rates are low (this is because less money will be kept in banks as it earns lower returns. Therefore speculators will demand more money so they can invest when better opportunities arise).
• Investors become more pessimistic / less confident (they are likely to sell investments if they believe prices will fall, meaning they will have more speculative money)

Question 9

Liquidity preference theory elasticities

Answer 9

• The demand for money for the transactions motive and the precautionary motive is perfectly interest inelastic i.e. does not vary with the interest rate.
• The demand for money for the speculative motive is interest elastic i.e. it varies with the rate of interest

Question 10

Liquidity preference theory equation

Answer 10

Precautionary  motive
\+
Transactionary motive
\+
Speculative motive
=
Liquidity preference curve (total demand for money)

Question 11

Active balances

Answer 11

Demand for money (liquidity) for the transactions motive and the precautionary motive is known as active balances - its main purpose is to act as a medium of exchange.

Question 12

Idle balances

Answer 12

Demand for money (liquidity) for the speculative motive is known as idle balances - its main purpose is to act as a store of value

Question 13

Interest rates and bond prices relationship

Answer 13

Inverse relationship

• Higher interest rates increase the returns from saving, resulting in less demand for government bonds and therefore a fall in bond prices
• Lower interest rates decrease the returns from saving, resulting in more demand for government bonds and therefore a rise in bond prices

Question 14

Equilibrium Interest Rate

Answer 14

The rate of interest that occurs when the supply of money is equal to the demand for money (liquidity preference)

Question 15

Keynesian money supply

Answer 15

According to Keynesians, the money supply is fixed in the short run (hence vertical line).

Question 16

Increase in the demand for money effect on interest rates

Answer 16

Transactionary motive:
- higher income, higher cost of living.
Precautionary motive:
- more cautious outlook, higher income, higher social status, more dependents, old age.
Speculative motive:
- high bond prices, low interest rates, higher income.

Equilibrium interest rate rises

Question 17

Decrease in the demand for money effect on interest rates

Answer 17

Transactionary motive:
- lower income, lower cost of living.
Precautionary motive:
- Less cautious outlook, lower income, lower social status, fewer dependents, young age.
Speculative motive:
- low bond prices, high interest rates, lower income.

Equilibrium interest rate falls

Question 18

Changes in the money supply effect on interest rates

Answer 18

• Expansionary monetary policy means there is an increase in the money supply (S1 to S2), which causes a fall in interest rates (r1 to r2).
• Contractionary monetary policy means there is a decrease in the money supply (S1 to S3), which causes a rise in interest rates (r1 to r3).

Question 19

Liquidity Trap Definition

Answer 19

a situation where monetary policy becomes ineffective because, despite zero/very low interest rates, people choose to hold cash instead of spending or buying illiquid assets

Question 20

Liquidity Trap Characteristics

Answer 20

• Very low-interest rates
• Low inflation
• Slow/negative economic growth
• Preference for saving rather than spending or investment
• Monetary policy becomes ineffective in boosting demand

Question 21

Liquidity Trap Solutions

Answer 21

• Keynesians: use expansionary fiscal policy.
• Monetarists: Central Banks should use QE to increase the money supply, and if necessary purchase bonds and assets to reduce yields on corporate and government bonds.
• Modern Monetarists: higher inflation rate target, increase inflation expectations and increase the money supply by giving cash to households directly

Question 22

The Paradox of Thrift (Keynes) Process

Answer 22

• During a recession, individuals worry about their situation.
• Individuals will reduce spending and increase saving.
• Fall in consumption.
• Fall in aggregate demand.
• Fall in national output.
• Rise in unemployment.
• Decrease in incomes.
• Decrease in saving.

Question 23

The Paradox of Thrift (Keynes) Summary

Answer 23

A rise in saving (by the individual) causes a fall in saving (in the economy as a whole).

Question 24

The Paradox of Thrift - criticisms (Monetarists)

Answer 24

1) Market mechanism - a drop in demand will cause a lower equilibrium price, which stimulates demand.
2) Loanable funds - more saving means banks have more funds for lending, which lowers interest rates and encourages more investment.
3) Open economy - the paradox assumes a closed economy, however in an open economy the drop in consumption will reduce demand for imports, which reduces the impact on AD.