Ainnur Najihah binti Hanafi

2018209464
ECO 531 MONETARY THEORY AND POLICY
Determination of interest Rate in Liquidity Preference
Theory
 Interest rate is determine by the intersection of the money supply curve and the money
demand curve.
 The equilibrium where the quantity of money demanded equals the quantity of money
supplied occurs at point A.
 The condition of excess supply means that people are holding more money than they
desire, so they will try bid up the price of bonds.
Changes in Equilibrium Interest Rate

 Income Effect Cycle Fluctuations

An higher level of income causes the demand for money to increase and the demand
curve shift to the right

 Price-Level Effect/Inflation
A rise in the price level the demand for money to increase and the demand curve for
money to the right
 Changes in Equilibrium Interest Rate due to changes in
Income, the price Level or the money supply

 Changes in Income
When income rising, Interest rate will Fall, and vice versa
 Changes in the Price Level
When the price level increases, Interest rate will rise, and vice versa
 Changes in the money supply
An increase the money supply, Interest Rate will decline and vice versa
Increase in income or Price Level
Changes in money supply Revisited

 The liquidity preference framework seems to suggest that an increase in money supply will lower
interest rate.
 Income Effect
The income effect of an increase in the money supply is a rise in interest rates in response to the higher
level of income
 Price-Level Effect
The price-level effect from an increase in the money supply is a rise in interest rates in response to the
rise in the price level
 Expected-Inflation Effect
The expected-inflation effect of increase in the money supply is a rise in interest rates in response to the
rise in the expected inflation rate
 Further analysis of the determination of interest
rate in the liquidity preference theory
 Equilibrium in the market for REAL money balances could be reworked as follow:

 Our whole analysis on interest rates determination (Keynesian) thus would look different.
 A rise in the price level and an increase in the nominal money supply would have
additional effects on the level of interest rate.
 Refer to the diagram:

 Increase in Nominal Money Supply

 Increase in Price Level