# The Theory of Liquidity Preference

The theory of liquidity preference is Keynes’s theory which states that the interest rate adjusts to bring money supply and money demand into balance.

As mentioned in the previous post Opens in new window, this theory of interest rates helps explain the downward slope of the aggregate-demand curve Opens in new window, as well as how monetary and fiscal policy can shift this curve.

In his classic book The General Theory of Employment, Interest, and Money, John Maynard Keynes Opens in new window proposed the theory of liquidity preference to explain the factors that determine an economy’s interest rate. The theory is, in essence, an application of supply and demand.

According to Keynes, the interest rate adjusts to balance the supply of and demand for money.

You may recall that economists distinguish between two interest rates:
• The nominal interest rate is the interest rate as usually reported, and
• the real interest rate is the interest rate corrected for the effects of inflation.

When there is no inflation Opens in new window, the two rates are the same. But when borrowers and lenders expect prices to rise over the term of the loan, they agree to a nominal interest rate that exceeds the real interest rate by the expected rate of inflation.

The higher nominal interest rate compensates for the fact that they expect the loan to be repaid in less valuable dollars.

Which interest rate are we now trying to explain with the theory of liquidity preference?

The answer is both. In the analysis that follows, we hold constant the expected rate of inflation. This assumption is reasonable for studying the economy in the short run, because expected inflation is typically stable over short periods of time.

In this case, nominal and real interest rates differ by a constant:

When the nominal interest rate rises or falls, the real interest rate that people expect to earn rises or falls by the same amount.

For the rest of this entry, when we discuss changes in the interest rate, these changes refer to both the real interest rate and the nominal interest rate.

Let’s now develop the theory of liquidity preference by considering the supply and demand for money and how each depends on the interest rate.

### Money Supply

The first piece of theory of liquidity preference is the supply of money. The money supply in the U.S. economy is controlled by the Federal Reserve Opens in new window.

The Fed alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open-market operations.

When the Fed buys government bonds, the dollars it pays for the bonds are typically deposited in banks, and these dollars are added to bank reserves. When the Fed sells government bonds, the dollars it receives for the bonds are withdrawn from the banking system, and bank reserves fall.

These changes in bank reserves, in turn, lead to changes in banks’ ability to make loans and create money. Thus, by buying and selling bonds in open-market operations, the Fed alters the supply of money in the economy.

In addition to open-market operations, the Fed can influence the money supply using various other tools.

One option is for the Fed to change how much it lends to banks.

For example, a decrease in the discount rate (the interest rate at which banks can borrow reserves from the Fed) encourages banks to borrow, increasing bank reserves and in turn the money supply. Conversely, an increase in the discount rate discourages banks from borrowing, decreasing bank reserves and the money supply.

The Fed also alters the money supply by changing reserve requirements (the amount of reserves banks must hold against deposits) and by changing the interest rate it pays banks on the reserves they hold.

These details of monetary control are important for the implementation of Fed policy, but they are not crucial for the analysis in this entry. Our goal here is to examine how changes in the money supply affect the aggregate demand for goods and services.

For this purpose, we can ignore the details of how Fed policy is implemented and assume that the Fed controls the money supply directly. In other words, the quantity of money supplied in the economy is fixed at whatever level the Fed decides to set it.

Because the quantity of money supplied is fixed by Fed policy, it does not depend on other economic variables. In particular, it does not depend on the interest rate.

Once the Fed has made its policy decision, the quantity of money supplied is the same, regardless of the prevailing interest rate. We represent a fixed money supply with a vertical supply curve, as in Figure I. Figure I, Equilibrium in the Money Market | Source: Slideshare Opens in new window According to theory of liquidity preference, the interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium level (such as at r1), the quantity of money people want to hold (Md1) is less than the quantity the Fed has created, and this surplus of money puts downward pressure on the interest rate. Conversely, if the interest rate is below the equilibrium level (such as at r2), the quantity of money people want to hold (Md2) exceeds the quantity the Fed has created, and this storage of money puts upward pressure on the interest rate. Thus, the forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people are content holding the quantity of money the Fed has created.

### Money Demand

The second piece of the theory of liquidity preference is the demand for money. To understand money demand, recall that an asset’s liquidity refers to the ease with which that asset can be converted into the economy’s medium of exchange.

Because money Opens in new window is the economy’s medium of exchange, it is by definition the most liquid asset available.

The liquidity of money explains the demand for it:

People choose to hold money instead of other assets that offer higher rates of return so they can use the money to buy goods and services.

Although many factors determine the quantity of money demanded, the theory of liquidity preference emphasizes the interest rate Opens in new window because it is the opportunity cost Opens in new window of holding money.

That is, when you hold wealth as cash in your wallet, rather than as an interest-bearing bond or in an interest-bearing bank account, you lose the interest you could have earned.

• An increase in the interest rate raises the cost of holding money and, as a result, reduces the quantity of money demanded.
• A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded.

Thus, as shown in Figure I, the money demand curve slopes downward.

### Equilibrium in the Money Market

According to the theory of liquidity preference, the interest rate adjusts to balance the supply and demand for money.

There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly balances the quantity of money supplied.

If the interest rate is at any other level, people will try to adjust their portfolios of money and nonmonetary assets and, as a result, drive the interest rate toward the equilibrium. For example, suppose that the interest rate is above the equilibrium level, such as r1 in Figure I.

In this case, the quantity of money that people want to hold, Md1, is less than the quantity of money that the Fed has supplied.

Those people who are holding the surplus of money will try to get rid of it by buying interest-bearing bonds or by depositing it in interest-bearing bank accounts.

Because bond issuers and banks prefer to pay lower interest rates, they respond to this surplus of money by lowering the interest rates they offer.

As the interest rate falls, people become more willing to hold money until, at the equilibrium interest rate, people are happy to hold exactly the amount of money the Fed has supplied. Conversely, at interest rates below the equilibrium level, such as r2 in Figure I, the quantity of money that people want to hold, Md2, exceeds the quantity of money that the Fed has supplied.

As a result, people try to increase their holdings of money by reducing their holdings of bonds and other interest-bearing assets. As people cut back on their holdings of bonds, bond issuers find that they have to offer higher interest rates to attract buyers. Thus, the interest rate rises until it reaches the equilibrium level.