Question

Explain Interest Rate Liquidity Theory and give an example of it?

Answer 1

The Liquidity Preference theory states that the demand for money is not to borrow money but the desire to remain liquid. In other words, the interest rate is the price for money.

John Maynard Keynes created the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative.

He also said that money is the most liquid asset and the more quickly an asset can be converted into cash, the more liquid it is.

1. Transactionary Demand : People prefer to be liquid for day-to-day expenses. The amount of liquidity desired depends on the level of income, the higher the income, the more money is required for increased spending. This is called transactionary demand.

2. Precautionary demand : Precautionary demand is the demand for liquidity to cover unforeseen expenditure such as an accident or health emergency. The demand for this type of money increases as the income level increases.

3. Speculative demand : Speculative demand is the demand to take advantage of future changes in the interest rate or bond prices. According to Keynes, the higher the rate of interest, the lower the speculative demand for money. And lower the rate of interest, the higher the speculative demand for money.

Example is given by way of a diagram attached.

Please revert in case of difficulty.