The Multiplier, Growth and Money and Banking: Question 5

Worked solution

Part (a): The three motives for holding money

Liquidity preference theory identifies three reasons why households and firms choose to hold money rather than other assets:

• Transactions motive: money is held to cover everyday, planned spending on goods and services between receiving income and spending it (e.g. the gap between being paid a monthly salary and making purchases through the month).
• Precautionary motive: money is held as a buffer against unforeseen or unplanned expenses (e.g. an unexpected repair bill), so that cash is available even though the need for it was not anticipated.
• Speculative motive: money is held, instead of being used to buy bonds, when bond prices are expected to fall (equivalently, interest rates are expected to rise). Holding money now means that money is available to buy bonds later at the lower expected price, rather than holding bonds now and suffering a capital loss.

Part (b): How the equilibrium rate of interest is determined

Under liquidity preference theory, the demand for money slopes downward against the rate of interest: as the interest rate rises, the opportunity cost of holding non-interest-earning money (the interest given up by not holding bonds) rises, so less money is demanded at higher interest rates. In the short run, the supply of money is set by the central bank and banking system and does not depend on the interest rate, so it is drawn as a vertical (fixed) line.

The equilibrium rate of interest is found where this downward-sloping demand for money curve meets the fixed money supply, the interest rate at which the quantity of money people wish to hold exactly matches the quantity of money actually in circulation.

If the actual interest rate were currently below this equilibrium level, the quantity of money demanded at that low rate would exceed the fixed money supply. There is an excess demand for money. Equivalently, to get hold of extra money, some asset-holders sell bonds, creating an excess supply of bonds that pushes bond prices down and the interest rate (which moves inversely with bond prices) back up towards its equilibrium level.

Part (c): Effect of an increase in the money supply

If the central bank increases the money supply while the demand for money is unchanged, the fixed money-supply line shifts outward (to a larger quantity of money at every interest rate). At the original interest rate, there is now an excess supply of money relative to the (unchanged) quantity demanded: holders of this extra money use it to buy bonds, bidding bond prices up, which pushes the interest rate down. The interest rate keeps falling until the (now lower) rate raises the quantity of money demanded enough to absorb the larger money supply, so the equilibrium rate of interest falls.

However, the actual fall in the interest rate might be smaller than this simple model predicts. One reason is that, if the economy is already close to a liquidity trap (where the demand for money becomes very interest-elastic (almost flat) at low interest rates, because asset-holders widely expect interest rates to rise (bond prices to fall) from their current low level) then much of the extra money supplied may simply be absorbed into idle money balances rather than used to buy bonds. In that case, bond prices, and so the interest rate, change very little, and the fall in the interest rate is smaller than the basic liquidity preference model would suggest.

Part (d): Contrast with loanable funds theory

Loanable funds theory explains the rate of interest very differently: it is determined in the market for loanable funds. The supply of funds available for lending, which comes mainly from households’, firms’ and government’s savings, meeting the demand for those funds from borrowers wanting to finance investment. This is a market for real flows of saving and borrowing over time, rather than liquidity preference theory’s focus on the choice between holding money and holding bonds at a point in time. (For example, loanable funds theory predicts the interest rate rises if desired saving falls or desired investment rises, without reference to the stock of money in the economy at all.)

Final answers

• (a) Transactions motive (planned spending), precautionary motive (unplanned spending), speculative motive (holding money instead of bonds when bond prices are expected to fall)
• (b) Equilibrium interest rate is where money demand meets the fixed money supply; a rate below equilibrium creates excess demand for money, which pushes the interest rate back up
• (c) A rise in the money supply lowers the equilibrium interest rate; the fall may be smaller than predicted if money demand is highly interest-elastic (near a liquidity trap)
• (d) Loanable funds theory prices the interest rate in the market for savings and investment (real flows), unlike liquidity preference theory’s focus on the choice between holding money and bonds