The liquidity preference theory, proposed by John Maynard Keynes, explains why people hold money instead of investing it.
Key idea: Money is held for three motives – transactions, precautionary, and speculative. The theory shows that the speculative motive creates a negative relationship between the demand for money and the interest rate.
Think of money as a backpack you carry around. If you need to buy a new phone (transactions), you keep some cash in your backpack. If you’re worried about a surprise trip (precautionary), you keep extra cash. But if you think you can earn more by investing in stocks (speculative), you’ll leave some cash in your backpack and put the rest in a savings account that pays interest. The higher the interest rate, the more you want to leave your money in the bank and the less you keep in your backpack.
Equation of Liquidity Preference:
\$L = kY - hR\$
Where:
| Determinant | Effect on Money Demand |
|---|---|
| Real Income (\$Y\$) | ↑ → ↑ (more transactions) |
| Nominal Interest Rate (\$R\$) | ↑ → ↓ (more opportunity cost of holding cash) |
| Price Level (\$P\$) | ↑ → ↑ (need more money to buy the same goods) |
Suppose the interest rate rises from 2 % to 4 %.
Using \$L = kY - hR\$ with \$k=0.5\$, \$h=2\$, and \$Y=100\$ (in millions):
\$L_{2\%} = 0.5 \times 100 - 2 \times 2 = 50 - 4 = 46\$
\$L_{4\%} = 0.5 \times 100 - 2 \times 4 = 50 - 8 = 42\$
The demand for money falls by 4 million units (≈ 8.7 %).
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