Money and Banking

 Q1. What do you mean by liquidity preference theory? How do we determine the demand and the supply of money in the market?

Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid properties.

According to this theory, which was advanced by John Maynard Keynes in provision of his idea that the demand for liquidity holds speculative power, investments that are more liquid are easier to cash in for full value. Cash is commonly accepted as the most liquid asset. According to the liquidity preference theory, interest rates on short-term securities are lower because investors are not sacrificing liquidity for greater time frames than standard or longer-term securities.

While the mandate of money involves the desired holding of financial assets, the money supply is the total amount of monetary assets available in an economy at a specific time.

Changes in the money supply lead to changes in the interest rate. when real GDP increases, there are more goods and services to be bought. More money will be needed to purchase them. On the other hand, a decline in real GDP will cause the money demand curve to decrease.

The Fed can impact the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.