Demand for Money & Interest Rate Determination (Cambridge (CIE) A Level Economics): Revision Note

The demand for money and interest rate determination

• The interest rate is the price of money, determined where demand meets supply.

  • Keynes's liquidity preference theory explains interest rates through the demand for and supply of money itself

  • Classical loanable funds theory explains them through the demand for and supply of funds available for lending

The demand for money: liquidity preference theory

• Liquidity preference is the desire to hold wealth in the form of money (the most liquid asset) rather than in less liquid financial assets such as bonds

• Keynes identified three motives for holding money

The three motives

Total demand for money

• Adding the three motives together gives the total demand for money curve (L), which slopes downwards against the interest rate

• Higher interest rates increase the opportunity cost of holding money, reducing money demand

• Lower interest rates reduce the opportunity cost of holding money, increasing money demand

Interest rate determination: liquidity preference theory

• The supply of money (Ms) is set by the central bank and is usually drawn as vertical

  • It does not respond to the interest rate

• The equilibrium interest rate is where money demand equals money supply

• Changes in money supply or money demand shift the curves and change the equilibrium interest rate

The liquidity trap

• The liquidity trap is a situation in which interest rates are so low that money demand becomes perfectly elastic

  • Any increase in money supply is absorbed into idle balances rather than reducing interest rates further

• At very low interest rates, everyone expects rates to rise and bond prices to fall - so no one wants to hold bonds

• Money supply increases have no effect on interest rates - the liquidity preference curve becomes horizontal

• Monetary policy loses its effectiveness in stimulating the economy - implications for central banks are significant, particularly during recessions

• The Bank of England faced this problem after the 2008 financial crisis, which is one reason quantitative easing was introduced

Interest rate determination: loanable funds theory

• Loanable funds theory is the classical view that the interest rate is determined by the demand for and supply of funds available for borrowing and lending in the financial market

How does it work?

• Supply of loanable funds comes from savings - households with surplus income lend to borrowers

  • The higher the interest rate, the greater the reward for saving, so supply of loanable funds rises with the interest rate

• Demand for loanable funds comes from borrowers - firms seeking to invest and households seeking to borrow

  • The higher the interest rate, the higher the cost of borrowing, so demand for loanable funds falls as the interest rate rises

• Equilibrium interest rate is set where supply of savings equals demand for borrowing

Key implication

• In the loanable funds view, the interest rate coordinates saving and investment decisions over time

• A rise in saving pushes down interest rates and encourages investment — the classical mechanism by which economies self-correct

Comparing the two theories

Why the disagreement matters

• Keynes argued that the classical view misses the speculative motive for holding money

  • Saving is not automatically channelled into investment because some of it is held as idle balances

  • This is why Keynes believed an increase in saving could reduce aggregate demand without reducing interest rates enough to stimulate offsetting investment

• Modern economic thinking often treats the two theories as complementary rather than mutually exclusive

  • Liquidity preference explains short-run interest rate movements driven by monetary policy

  • Loanable funds explains long-run rates driven by real saving and investment decisions