A2 Revision – Liquidity Preference

With the A2 multiple choice tomorrow here is a mind map on liquidity preference. The liquidity preference or the demand for money is the sum of the transactionary, precautionary and speculative demand for money. Only the speculative demand is inversely related to interest rates. It is the speculative demand that students find difficult to understand. This is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.  Demand is interest elastic – i.e. is affected by changes in interest rates. Below is a mind map and some notes.

Adapted from CIE AS A Level Revision Guide by Susan Grant

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑. If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

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