Demand of Money: Liquidity Preference Theory Flashcards
What is the Liquidity Preference Theory?
A theory developed by John Maynard Keynes explaining why people hold some assets in liquid form (cash) and how interest rates are determined by the supply and demand of money.
What are the three motives for holding money in cash form, according to Keynes?
Transaction Motive (for daily transactions)
Precautionary Motive (for unexpected expenses)
Speculative Motive (to take advantage of future investment opportunities)
How does the demand for cash relate to interest rates?
They have an inverse relationship. Higher interest rates reduce the demand for cash holdings as people prefer to deposit money for earning returns. Lower interest rates increase the demand for cash holdings.
Explain the Transaction Motive for holding cash.
People hold cash to facilitate everyday transactions, such as buying groceries and paying bills. The amount needed for this motive depends on income levels and spending patterns.
Give an example of the Precautionary Motive in action.
Someone keeps extra cash at home in case of a car breakdown, a sudden medical expense, or an unexpected job loss.
How does the Speculative Motive influence cash holdings?
Investors may hold cash if they believe that asset prices (stocks, real estate, etc.) will fall in the future, allowing them to buy these assets at a lower price.
If interest rates on savings accounts increase significantly, how might this affect people’s demand for cash?
Demand for cash is likely to decrease as people would be incentivized to deposit their money for higher returns.
In a time of economic uncertainty, how might the Precautionary Motive influence people’s cash holdings?
People might hold more cash as a safety net against potential financial difficulties.
Why might an investor with a strong belief that stock prices will soon decline choose to hold a larger portion of their assets in cash?
They would hold cash to be ready to buy stocks at a lower price when their prediction of a decline comes true.
What is the total demand for money?
The total amount of money households and businesses wish to hold at any given moment. It includes transaction demand (for everyday purchases) and speculative demand (for storing wealth).
Explain the relationship between GDP and transaction demand for money.
Positive relationship. When GDP increases, more economic transactions occur, requiring more money for purchases and payments. This increases the transaction demand for money.
How do interest rates affect the speculative demand for money?
Inverse relationship. High interest rates raise the opportunity cost of holding money (vs investing in bonds and such). This lowers speculative demand. Lower interest rates make holding money more attractive, increasing speculative demand.
What impact does inflation have on the demand for money?
Generally negative. High inflation erodes the value of money. People tend to hold less cash when they expect prices to continue rising rapidly.
Besides GDP, interest rates, and inflation, name two other factors that might influence the demand for money.
Financial innovations (less cash needed with credit cards and online payments)
Precautionary motive (desire to hold money for emergencies and uncertain times)
What is the formula for the total demand for money in an economy?
Total demand for money = transaction demand + speculative demand
