Question

Question 4. (12 marks) The implication of theory of liquidity preference on the interest rate explains the downward sloping money demand curve. Analyse this using an appropriate diagram.

Answer 1

So . liquidity trap refers to a situation where the rate low that people refer to hold money of interest is Cliquidity preference) rather than invest in it bonds. Cto eam interest) keynes pointed out that at low rates of interest the demand came form money cor liquaidity preference core) becomes completely cinfinitely) elastic, so the liquidity preberence Cemre is not downward sloping throughout. This wually happens cluring depression. During depression any attempt by the centercy bank to reduce the rate of interest by increasing the stock of money will be tutile. In such situation no change in money supply is sufficient to alter the rate of interest. The rate of interest Quich is the price of money is determined by demand and supply in a com peritive situation. The demand for idle money balances in inversely related to the rate of interest. keynes umed that the demand for money for the other two motives is not affichid by change CS Scanned with CamScanner

ot in the rate of interest lie. is perfectly meros inelastic with regard to interest. the rate Therefore if all 3 elements in demand for money are added together to derire the total demand money, the result would be came of the type shown in fig. CA A demand cure for money is lo liquidity preference care) came for known as حر Rate of interest mda kpy tl (~) Mi quantity of money. M interest falls, that it the rate of The cure Shows Onu the dem and for money increases Reg. toom Oo to from om to om, cat some to keynes, According the dem mand for mo ney because it the rate would be no One low rate of interest becomes porfectly elastic talls below thi's level, pepara to buy bonde.. CS Scanned with CamScanner