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Keynes' Liquidity Preference Theory of Interest Rate - ppt1
Keynes' Liquidity Preference Theory of Interest Rate - ppt1
Chauhan
Topic: Keynes liquidity preference theory
of interest rate
Sub:macroeconomics-2
MA-2nd year economics
Introduction
The concept was first developed by John
Maynard Keynes in his epoch-making
book the general theory of employment,
interest and money(1936).
The rate of interest is purely monetary
phenomenon and is determined by
demand for money and supply of money.
The thoery explains determination of the
interest rate by the supply of money and
demand for money.
Definition
Explaination
In the diagram, LP is the liquidity preference curve. It
represents the demand for money. The demand for
money varies with the interest rate. It increases as the
rate of interest falls, and decreases as the rate of
interest rises. There is an inverse relationship between
the rate of interest and the liquidity preference.at a
lower rate of interest, people find it more profitable to
old their savings in the form of cash balances (liquidity
preferences) than at a higher rate of interest . This is the
reason why the LP curve slopes downwards to the right.
The QM represents the total mount of money which is
assumed to be constant and as such inelastic vis--vis
the interest rate . That is why the curve QM is vertically
straight.
At Os2 rate of interest, the supply o f money which
people wish to hold (liquidity preference) is OQ, and the
supply of money in existence is also OQ. Thus, the
liquidity preference and supply of money are both
Explaination
ON is the quantity of money available. The
Rate of interest will be determined where the
demand for money is in balance or equal to
the fixed supply of money ON. Demand of
money is equal to ON quantity of money at Or
rate of interest . Or is the equilibrium rate of
interest. Assuming no change in expectations
and nominal income, an increase in the
quantity of money will lower the rate of
interest. When the quantity of money
increases from ON to ON. The rate of interest
falls from Or to Or1 because the new quantity
of money ON1 is in balance with demand for
the money at Or1 rate of interest.
Criticism
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