Changes in Equilibrium Interest Rates in the Liquidity Preference Framework

Analyzing how the equilibrium interest rate changes using the liquidity preference framework requires that we understand what causes the demand and supply curves for money to shift.

Study Guide Learning the liquidity preference framework also requires practicing applications.

When there is an application in the text to examine how the interest rate changes because some economic variable increases, see if you can draw the appropriate shifts in the supply and demand curves when this same economic variable decreases. And remember to use the ceteris paribus assumption: When examining the effect of a change in one variable, hold all other variables constant.

Shifts in the In Keynes's liquidity preference analysis, two factors cause the demand curve for

Demand for money to shift: income and the price level.


Income Effect. In Keynes's view, there were two reasons why income would affect the demand for money. First, as an economy expands and income rises, wealth increases and people will want to hold more money as a store of value. Second, as the economy expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more money. The conclusion is that a higher level of income causes the demand for money to increase and the demand curve to shift to the right.

Price-Level Effect. Keynes took the view that people care about the amount of money they hold in real terms; that is, in terms of the goods and services that it can buy. When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot be used to purchase as many real goods or services. To restore their holdings of money in real terms to its former level, people will want to hold a greater nominal quantity of money, so a rise in the price level causes the demand for money to increase and the demand curve to shift to the right.

Shifts in the We will assume that the supply of money is completely controlled by the central bank,

Supply of Money which in the United States is the Federal Reserve. (Actually, the process that deter mines the money supply is substantially more complicated, involving banks, depositors, and borrowers from banks. We will study it in more detail later in the book.) For now, all we need to know is that an increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right.

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