In case the question requires us to explain change in money demand with change in interest rate
Concept Introduction:
Liquidity preference theory: Late Lord J. M. Keynes propounded the Liquidity Preference Theory to explain the interest rate determination with the help of demand and supply of money.
Liquidity is a term used to describe how quickly an asset can be converted into cash. If you keep the money in some other form of asset, or in bank, you will actually have a separation with the liquid form. Liquidity is the easiness of holding cash form of money rather than any other form. Interest rate is considered as the compensation for separation with the liquidity form of money.
Portfolio theory: American economist James Tobin justified that rational individuals will keep portfolio of consisting of money (cash) and bond rather than keeping wealth either in money (cash) or bond. According to Tobin, people are in general risk averse. Human behaviour demonstrates risk aversion. This implies that, they have a preference towards lesser risk at a given rate of return. In the Keynesian analysis, the wealth of a person is either in the form of all money or all bonds depending on his expectation of the future rate of interest. According to Tobin, faced with various safe and risky assets, individuals prefer to diversify their portfolio by sharing their wealth in a balanced combination of safe and risky assets. According to him, an investor is confronted with a dilemma of what quantity of his portfolio of assets should be in the form of money (without any interest) and interest-earning bonds. Portfolio theory highlights the function of money as a store of value. Money presents a blend of risk and return as compared other assets which are less liquid than money — such as bonds.
Want to see the full answer?
Check out a sample textbook solutionChapter 22 Solutions
Economics of Money, Banking and Financial Markets, The, Business School Edition (5th Edition) (What's New in Economics)
- Principles of Economics (12th Edition)EconomicsISBN:9780134078779Author:Karl E. Case, Ray C. Fair, Sharon E. OsterPublisher:PEARSONEngineering Economy (17th Edition)EconomicsISBN:9780134870069Author:William G. Sullivan, Elin M. Wicks, C. Patrick KoellingPublisher:PEARSON
- Principles of Economics (MindTap Course List)EconomicsISBN:9781305585126Author:N. Gregory MankiwPublisher:Cengage LearningManagerial Economics: A Problem Solving ApproachEconomicsISBN:9781337106665Author:Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike ShorPublisher:Cengage LearningManagerial Economics & Business Strategy (Mcgraw-...EconomicsISBN:9781259290619Author:Michael Baye, Jeff PrincePublisher:McGraw-Hill Education