According to the liquidity preference theory, a flat yield curve would be interpreted as the market expecting ____ in interest rates. This Demonstration illustrates how the liquidity preference–money supply (or LM) curve is formed; the curve shows equilibrium points in the money market. How the rate of interest is determined by the equilibrium between the liquidity preference for speculative motive and the supply of money is shown in Fig. In other words, LPS curve shows the demand for money for speculative motive. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model). In the money market money supply is a fixed amount determined by the central bank whereas money demand is a downward-sloping function (interest rate) as a function of (income) and (quantity of money). Under his Chapter 15 doctrine, if L is an increasing function of Y and a decreasing function of r, then the LM curve will slope upwards. The demand curve slopes downward because when the interest rate is high, most people invest more and hold less cash. 1. That is, the interest rate adjusts to equilibrate the money market. The horizontal portion of the liquidity preference curve is referred to as the liquidity trap. A shift of the money- supply curve from Ms 0 to Ms 1 by the central bank. Re­ductions in the interest rate, in this portion only, increases people’s desire to hold cash balances. 6 as a result of anticipated changes in bond prices. Transaction Motive 2. The IS curve always slopes downwards. It will be seen from Fig. According to Keynes people demand liquidity or prefer liquidity because they have three different motives for holding cash rather than bonds etc. 2. Precaution Motive 3. According to the theory of liquidity preference, the supply and demand for real money balances determine what interest rate prevails in the economy. Speculative Motive For the LM curve, when we think about liquidity preference, holding real money constant, high levels of GDP, a lot of economic activity, people want to have currency, demand for currency is high so the price is currency is high which is real interest rates and so we would have real interest rates high due to liquidity preference. This perfectly elastic portion of liquidity preference curve indicates the position of absolute liquidity preference … 18.2 that the liquidity preference curve LP becomes quite flat i.e., perfectly elastic at a very low rate of interest; it is horizontal line beyond point E” towards the right. In this portion of the curve, the demand for money is infinitely elastic with re­spect to the interest rate. A liquidity preference curve is a demand curve for money because a household’s or business’s value of liquidity is the same as its demand for cash. Expert Answer view the full answer b. money demand curve right so the interest rate decreases. c. money demand curve left so the interest rate decreases. LIQUIDITY PREFERENCE THEORY The cash money is called liquidity and the liking of the people for cash money is called liquidity preference. In part (a) of the figure, LPS is the cur of liquidity preference for speculative motive. The demand curve slopes downward because higher interest rates reduce the quantity of real money balances demanded. The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. 34.4. 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liquidity preference curve

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