Q1. What do you mean by liquidity preference theory? How do we determine the demand and the supply of money in the market?
Liquidity preference theory is a model that suggests that an
investor should demand a higher interest rate or premium on securities with
long-term maturities that carry
greater risk because, all other factors being equal, investors prefer cash or
other highly liquid properties.
According to this theory, which was advanced by John Maynard
Keynes in provision of his idea that the demand for liquidity holds speculative
power, investments that are more liquid are easier to cash in for full value.
Cash is commonly accepted as the most liquid asset. According to the liquidity
preference theory, interest rates on short-term securities are lower because
investors are not sacrificing liquidity for greater time frames than standard
or longer-term securities.
While the mandate of money involves the
desired holding of financial assets, the money supply is the total
amount of monetary assets available in an economy at a specific time.
Changes in the money supply lead to changes in the
interest rate. when real GDP increases, there are more goods and services
to be bought. More money will be needed to purchase them. On the
other hand, a decline in real GDP will cause the money demand curve
to decrease.
The Fed can impact the money supply by modifying
reserve requirements, which generally refers to the amount of funds banks must
hold against deposits in bank accounts. By lowering the reserve requirements,
banks are able to loan more money, which increases the
overall supply of money in the economy.
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