What Is the Liquidity Preference Theory?
Liquidity preference theory is a short-term interest rate determination theory proposed by economist Keynes. This theory believes that interest rates are determined by the supply and demand of money. Money supply and interest rates change in the opposite direction, and money demand and interest rates move in the same direction.
Liquidity preference theory
Liquidity preference theory demand curve
- In Keynes's liquidity preference theory, there are two main factors that cause the movement of the money demand curve. That is, income growth causes more value storage and purchase more goods. .
Liquidity preference theory supply curve
- Keynes assumed that the money supply was completely controlled by the monetary authority. The money supply curve represented a vertical line. As the money supply increased, the money supply curve shifted to the right, and conversely, the money supply curve shifted to the left.
Factors Influencing Liquidity Preference Theory
- All the changes in these factors will cause the movement of the money supply and demand curve, and then cause fluctuations in the equilibrium interest rate.
Liquidity preference theory interest rate effect
- Keynes pointed out that the speculative demand for money is a decreasing function of interest rates, and further explained that when the interest rate fell to a certain level, the speculative demand for money will tend to infinity. Because the bond price at this time has almost reached its highest point, as long as the interest rate rises slightly, the bond price will fall, and the bond purchase will have a great risk of loss. Therefore, no matter how large the central bank's money supply is, people will hold money instead of buying bonds, bond prices will not rise, and interest rates will not fall. This is Keynes's "liquidity trap." In this case, expansionary monetary policy has no impact on investment, employment and output.
- The Keynesian theory of interest rate determination corrects the classics' neglect of monetary factors, but it goes to the other extreme, ignoring practical factors such as savings and investment at all. The more persuasive nowadays is the "IS-LM" model.