In this video we will look at the transaction, precautionary and speculative motives influencing
the demand for money.
We’ll analyse the diagram for the Liquidity Preference Model and use that to develop an
understanding of the liquidity trap.
Liquidity preference is the preference for cash over less liquid assets such as government
bonds.
Individuals will choose to hold cash as opposed to other financial assets for three key reasons.
We’ll now explore each of these in turn.
First up is the transaction motive, which is tied to the use of money for purchasing
goods and services.
Individuals need a certain amount of money on hand to manage daily transactions.
If they are big spenders they will require a higher balance and if they are not, then
they will tend to require less.
Individual’s balances will tend to be higher if they are paid infrequently.
Being paid once a month as opposed to every week means you’ll probably keep a higher
amount of money in your account.
Transaction demand is interest inelastic but income elastic, because those with higher
incomes will demand more money as you can imagine they tend to spend more than those
with lower incomes.
Next up is the precautionary motive which is tied to emergency spending.
Individuals tend to keep a certain amount of money aside to prepare for unexpected emergencies.
This is also income elastic as people with higher incomes typically face higher emergency
expenses.
A simple way to think about this is to consider the cars typically driven by those with higher
incomes vs those on lower incomes.
A higher income individual is more likely to drive an expensive car and thus face more
expensive repairs when they arise.
With respect to this motive, money demand is income elastic and interest inelastic.
Finally we have the speculative, or asset motive.
The The speculative demand for money is sensitive to changes in the interest rate.
It applies to speculative balances kept as the interest rate varies.
When interest rates are high, the demand for money is low.
Whereas when interest rates are low, the demand for money is high.
To understand why, we need to look at the relationship between the interest rate, bond
prices and money.
Let’s look at how bond prices vary with changes in the interest rate.
Suppose current $100 bonds has a coupon rate of 5%.
That means the bond holder receives $5 a year (the coupon) until the bond matures at which
point they receive back the original $100.
Now the government decides to issue new bonds with a coupon rate of 2.5%.
To earn a $5 coupon payment, an investor would have to purchase a $200 worth of bonds.
Each $100 bond would pay out $2.50 annually.
The holder of the original $100 bond can now sell their bond at a higher price than which
they purchased it.
Therefore when the interest rate is high, investors would prefer to hold bonds because
they believe the value of the bond will rise when interest rate falls.
When the interest rate is very low, investors have a stronger preference for cash because
they believe the value of bonds will fall when interest rates eventually rise.
You may also encounter these two terms, active and idle balances.
Active balances includes all money held for the transaction and precautionary motives.
Idle balances refers to money held for the speculative motive.
Now let’s move on to the diagram.
In the next slide we’re going to put the money supply and the demand for money, or
liquidity preference, into one diagram.
You will notice how the demand for money at higher interest rates is low and as the interest
rate drops, the demand for money increases.
The supply of money, Sm, is inelastic at Q*.
We’ll insert the downward sloping demand for money and label it Dm.
The interest is determined by the intersection of the demand for money (or liquidity preference)
and the money supply.
In this instance, the equilibrium interest rate is r* and the equilibrium quantity of
money is q*.
If the rate of interest is higher than R*, then the quantity demanded of money will be
less than the quantity supplied of money and the interest rate will fall to reach R*.
If the rate of interest is below R*, then the quantity demanded of money will be greater
than the quantity supplied of money and the interest rate will rise to reach R*.
The equilibrium rate of interest will not change unless there is a change in the demand
for money or a shift in the money supply.
Let’s look at what happens when the central bank increases the money supply to reduce
interest rates.
Suppose now that the central bank aims to reduce the interest rate.
They can achieve this by increasing the money supply from Sm to Sm2.
In doing so, the equilibrium interest rate falls from R* to R2 and the equilibrium quantity
of money in the economy increases from Q* to Q2.
As you can probably tell, as we approach the horizontal portion of the demand curve for
money, there is little room for interest rates to drop any further.
In times of recession and depression, central banks will aim to lower interest rates to
spur growth and boost aggregate demand within the economy.
However, once the money supply has increased to a point that the rate of interest approaches
zero, it is difficult to lower the rate any further with additional increases in the money
supply.
This is known as the liquidity trap.
Monetary policy becomes very limited in its ability to influence the economy at this point.
This is partly because interest rates are difficult to lower once they’ve reached
very low levels.
Banks are likely to be hoarding cash at this point, playing it safe, and individuals are
more focused on repaying debt as opposed to taking out new loans.
Also, consumer and business confidence are quite low so even at low interest rates, borrowing
is likely to be low as well.
In such cases, the government will turn to fiscal policy as it is likely to be more effective
at boosting aggregate demand and getting the economy moving.
Central banks might also turn to another unconventional monetary policy tool, quantitative easing,
to help revive the economy.
That wraps up this video on the liquidity preference model.
If you have any questions, leave them below and let’s try and answer them together.
That’s us done for now and I will see you in the next one!