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Keynes' concept of 'Liquidity Preference' is based on three reasons why people desire to hold wealth in money form - Leaving Cert Economics - Question (b) - 2009
Question (b)
Keynes' concept of 'Liquidity Preference' is based on three reasons why people desire to hold wealth in money form. (i) State and explain each of these reasons. (i... show full transcript
Worked Solution & Example Answer:Keynes' concept of 'Liquidity Preference' is based on three reasons why people desire to hold wealth in money form - Leaving Cert Economics - Question (b) - 2009
Step 1
State and explain each of these reasons.
Answer
Keynes identified three main motives for holding wealth in the form of money:
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Transactionary Motive: This refers to the desire to hold money for day-to-day expenses, such as buying goods and services. People need to have liquid funds available to meet their everyday spending needs, which are related to their income rather than the rates of interest.
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Precautionary Motive: Individuals hold money for unexpected emergencies or future uncertainties (e.g., sudden illness, home repairs). This motive recognizes the importance of having a financial buffer, which may be affected slightly by interest rates since lower rates might encourage individuals to hold slightly more cash to take advantage of lower opportunity costs.
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Speculative Motive: This is the desire to hold money in anticipation of taking advantage of future investment opportunities. Individuals prefer to keep cash on hand to invest when the conditions are favorable, and lower interest rates may reduce the incentive to hold cash as potential returns on investments become more attractive.
Step 2
Discuss the effect a fall in interest rates is generally expected to have on each of these reasons.
Answer
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Transactionary Motive: The demand for money for transactionary reasons is not affected by changes in interest rates. People will still require cash for their everyday expenses regardless of any fluctuations in interest rates.
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Precautionary Motive: A fall in interest rates might lead to a slight increase in the demand for money held for precautionary purposes. As interest rates decline, people might choose to hold a little more liquidity to manage unforeseen situations, given that lower rates provide less incentive to invest in riskier assets.
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Speculative Motive: A decrease in interest rates is generally expected to increase the demand for money for speculative reasons. As the opportunity cost of holding cash decreases (due to lower returns from interest), individuals might prefer to hold more liquid wealth, as they anticipate better investment opportunities that may arise in the future.