Question

According to the liquidity preference model: a. an increase in the money supply lowers the equilibrium rate of interest. b. a decrease in the money supply lowers the equilibrium rate of interest. c. the money supply curve is a horizontal line. d. the demand for money curve is a vertical line.

Answer 1

Answer:

The correct answer is a. an increase in the money supply lowers the equilibrium rate of interest.

Explanation:

The preference for liquidity is a recurring expression in the study of economics, especially important in Keynesian theory and which assumes that people consider it better to have their savings in liquid form, that is, as money.

This concept, very recurrent in macroeconomics, assumes the existence of an outstanding trend in human and rational behavior whereby individuals prefer to have their assets in an accessible and liquid way compared to other possibilities. Originally, the definition of liquidity preference was coined by Keynes when explaining the concept of monetary demand and its mode of action.

This theory suggests that there is a direct relationship between interest rates or rates and people's preferences in terms of liquidity, since both keeping money effectively and not doing so carry certain costs for them. In other words, saving money can translate into financial gain.

For Keynes, there were three reasons why the individuals who make up the money demand opt for liquidity and money: transactions, caution and speculation.

Answer 2

Answer:

A) an increase in the money supply lowers the equilibrium rate of interest.

Explanation:

The liquidity preference theory states that investors, companies or even common individuals will require a higher return rate from long term investments or projects since they all prefer liquidity. In order to offset the preference for liquidity, higher returns must be obtained. This concept is based on the premise that investors are risk adverse, and liquid investments will always be much safer than illiquid investment which carry much higher risks. Therefore, illiquid investments must yield higher returns in order to a tract investors.

An increase in the money supply will always decrease the price of money (interest rate) simply because a higher supply lowers the equilibrium price. If investors hold too much cash, they will not face risks, but they will also not be earning significant profits. So they have to balance out the risks of investing and the safety of cash or near cash investments. The more cash available, the lower the interest rate, and the more long term riskier investments will be made.