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The liquidity preference theory suggests that investors should demand higher premiums or higher interest rates on securities with long-term maturities due to the higher risk associated with them and the investors' preference for cash or highly liquid assets (Carvalho, 2015). The demand for the money curve is determined by interest rates and the money supply.
The graph below shows the money demand curve with S1 and S2 being different quantities (supply) of money and D is the demand curve. An increase in the money supply from S1 to S2 results in a lower interest rate R2 and a new equilibrium point for the demand for money (T). Changes in interest rates and money supply affect the quantity of money demanded.
The components of demand for money are the transactions demand, precautionary demand, and speculative demand/asset motive. They are determined by the real GDP, price levels, interest rates, expectations, transfer costs, and preferences (Keynes, 2019). Liquidity preference theory argues that assets that are more liquid are easier to exchange for cash for their full value. Interest rates on short-term investments should therefore be lower than medium or longer-term maturities sine investors are not sacrificing liquidity for long periods of time.
At an interest rate above the equilibrium rate, there is excess money supply and if the interest rates are below the equilibrium, there is excess money demand. The government can influence the interest rate by increasing or decreasing the money supply depending on the prevailing economic conditions as demonstrated by the graph.
The transactions demand for money refers to the money needed to purchase goods and services in everyday life. It is determined by the real GDP, price levels, and transfer costs. As real GDP increases, the income also increases (Pettinger, 2017). Individuals with a higher income level demand more money at each interest rate for consumption purposes. Higher price levels, on the other hand, would require an individual to hold more money to purchase the required goods and services. Lastly, transfer costs are the costs associated with transferring between non-money and money deposits. If these costs increase, individuals will choose to make fewer of them and thus would hold more money to be used for transactions.
Precautionary demand for money refers to the amount of money needed for unexpected emergencies and purchases. It is determined by the real GDP, price levels, and transfer costs just as the transactions demand for money (Johnson, 2017).
The speculative demand for money or the asset motive refers to the amount of money held as a store of wealth in response to concerns that prices of financial assets like bonds might fall. It is determined by interest rates, preferences, and expectations (Piros & Pintos, 2013). Due to low-interest rates, people will expect the interest rates to get higher causing the bond prices to fall. In this case, individuals will prefer to hold wealth in form of money. On the other hand, Individuals with high-risk preferences would hold bonds instead of holding a more liquid demand deposit as they speculate for a rise in interest rates. Lastly, if individuals expect bond prices to fall, they will hold more money thus raising the demand for money. The opposite is also true for a rise in bond prices.
Carvalho, F. J. C. (2015). Liquidity Preference and Monetary Economies. United Kingdom: Taylor & Francis.
Keynes, J. M. (2019). The General Theory of Employment, Interest, and Money. India: General Press.
Pettinger, T. (2017). Cracking Economics. United Kingdom: Octopus Books.
Johnson, H. G. (2017). Macroeconomics and Monetary Theory. (n.p.): Taylor & Francis.
Piros, C. D. & Pinto, J. E. (2013). Economics for Investment Decision Makers: Micro, Macro, and International Economics. Germany: Wiley.
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