AN EXERCISE IN KEYNESIAN

LIQUIDITY PREFERENCE

THEORY AND POLICY

ANSWERS

At rates of interest so high that virtually no one believes they are likely to go still higher, the speculative demand for money is perfectly inelastic and is co-incident with the vertical axis. This is the “classical region,” so named because in the classical theory, there is no speculative demand for money.

At rates of interest so low that virtually no one believes they are likely to go still lower, the speculative demand for money becomes perfectly elastic. In this “extreme Keynesian region,” all additions to the money supply are simply hoarded.

i

MSPEC

This special demand curve is non-linear and has three identifiable regions:

The speculative demand for money is unique to Keynesian macroeconomics and, according to some, is the sine qua non of Keynesianism. CLASSICAL

REGION

EXTREME KEYNESIAN

REGION

In the “intermediate region,” the quantity of money holdings demanded varies inversely with the rate of interest.

INTERM

EDIATE

REGION

In the Keynesian model, the accumulation of large speculative balances implies that people expect the rate of interest to rise. They do not want to hold bonds because the interest rate and bond prices are inversely related. If the supply of money remains constant, the high speculative demand implies a low level of transactions balances, which corresponds to a low level of income.

i

Y

i

MSPEC

LM

At full-employment income, the Fed's policy rule of "Print money to hold but not money to spend" may not be a viable policy because the speculative demand for money is too unstable. Besides, the Fed may not have an unambiguous indicator of the needed policy because its timely information includes the interest rate but not income.

AN EXERCISE IN KEYNESIAN

LIQUIDITY PREFERENCE

THEORY AND POLICY

ANSWERS