Question

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

Ans. The Liquidity Preference theory of interest rate states that the desire to hold money arises due to three motives:

Rate of Interest R Ml M → Quantity of money

1. The transactions motive: This is the desire to hold cash balances in order to fulfill the day to day transactionary expenses. This demand for money is mainly dependent on the income of the individual and it is interest inelastic.

2. The precautionary motive: It refers to the desire to hold cash balances in order to meet any unforeseen contingencies like any emergency, accidents, sickness, etc. This demand for money is also interest inelastic as it mainly depends on the psychology of the individual and the conditions in which he lives.

3. The speculative motive: It refers to the desire to hold cash balances in order to take the advantage of market movements as changes in the rate of interest or bond prices. If the bond prices are expected to rise, i.e., the rate of interest is expected to fall in the future, businessmen will buy bonds in order to sell them when the prices actually rise. Similarly if the bond prices are expected to fall, i.e., the rate of interest is expected to rise, businessmen will sell the bonds currently to avoid capital losses in future.

Thus, under the speculative motive for demand for money, more cash balances will be held when the current interest rate is low and less cash balances will be held when the current interest rate is high. It can also be explained in terms of opportunity cost. Higher interest rate means greater opportunity cost of holding money in the form of foregone interest that could have been earned by investing that money in other assets. Similarly, lower interest rate means lesser opportunity cost of holding money.

So it is clear that there is an inverse relationship between the demand for money and rate of interest.

We can draw a downward sloping aggregate demand for money curve as shown in the figure by measuring rate of interest on the vertical axis and quantity of money on the horizontal axis.

It can be noted that the aggregate demand for money is increases with the fall in rate of interest or with increase in the nominal income. At a given level of nominal income, we can draw a downward sloping money demand curve at various rates of interest.

At a high "OR" level of rate of interest, less quantity of money is demanded, i.e., "OM". And as the rate of interest falls to "OR1" level, the demand for quantity of money increases to "OM1" level. So this is how an inverse relationship between rate of interest and money demand is stated by Keynes in his Liquidity Preference theory.