Answer to Question #320962 in Macroeconomics for Calvin

Question

Using the theory of liquidity preference, explain why an increase in the money supply

lowers the interest rate. What does this explanation assume about the price level? (5

marks)

Answer 1

money is the most liquid asset and the more quickly an asset can be converted into cash is the more liquid it is that according to Keynes. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. In other words, the interest rate is the ‘price’ for money. An increase in money supply leads to decrease in interest rate which triggers high investment in return, it leads to higher income.