Monetary policy operating through increases in the supply of money, then becomes totally ineffective in reducing r and thereby having any expansionary effect on I and Y. Determination of the Rate of Interest: The IS and LM curves relate to income levels and interest rates. The reverse will happen if a chance disturbance pushes the rate of interest above ro. The interest rate, Keynes says, is determined by people‘s money demand, or “liquidity preference.” It is a measure of the willingness of individuals to part with their liquid assets. According to Keynes, interest is a monetary phenomenon and is determined by the demand for and the supply of money. The money market will be in equilibrium when = i.e. We have already studied Keynes’ theory of the demand for money or, which is the same thing, his theory of the liquidity preference of the public. Thus, to conclude, given the level of income, the liquidity preference and the current rate of interest are inversely related. Consider Figure 13.1. Demand for money means the desire of the people to hold their wealth in liquid form. TOS 7. In economic theory, interest is the price paid for inducing those with money to save it rather than spend it, and to invest in long-term assets rather than hold cash. During times of recession (or “bust” cycles), the theory prompts governments to lower interest rates in a bid to encourage borrowing. Changes in the quantity of money do not affect the interest rate but only influence the price level (as per the quantity theory of money). It is the Essentially, Keynes’ theory of demand for money is an extension of the Cambridge cash-balances approach and stresses the asset role (i.e., the store of value function) of money. The Cambridge theory (or the QTM) suppresses the role of r and Keynes’ theory the role of Y. Hicks’ IS-LM model allows for both. HE THEORY OF INTEREST RATE The Keynesian theory of interest rate refers to the market interest rate, i.e. Interest, according to Keynes, is in reverse proportion to the amount of money in circulation. Keynes denied completely the influence of real factors, represented by real savings and investment (so much emphasised by both classical and neoclassical economists) in the determination of r. This is an extreme view which neo-Keynesians do not share. Content Filtrations 6. The rate of interest, according to Keynes, is a purely monetary phenomenon, a reward for parting with liquidity, which is determined in the money market by the demand and supply of money. Aggregate demand refers to the total Historical background: The Keynesian Theory was proposed to show what could be done to shorten the Great Depression. A strong contender of Keynes’ liquidity preference theory of the rate of interest is the neoclassical loanable funds theory of rate interest. The flexibility of the interest rate as well as other prices is the self‐adjusting mechanism of the classical theory that ensures that real GDP is always at its natural level. Although the term has been used (and abused) to describe many things over the years, six principal tenets seem central to Keynesianism. the Loadable- Funds Theory explains interest over a per iod of time when the supply of money is supposed 10 be fluctuating. Disclaimer 9. Thus, ro represents the stable equilibrium value of r under the circumstances. US-dollar per euro, GBP, yen and RMB 1999-2015 (index, ... for the short-run horizon, the interest rate parity theory (IRP). In it the total demand for money is repre­sented by the downward-sloping curve labelled Md = L1(Y) + L2(r). People have desire for liquidity and interest is a reward for parting with liquidity. 1. 1. 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