(a) Explain the reasons why people demand money according to the liquidity preference theory. Consider which reason is the most important. [12]
(b) In 2015, after a period of low inflation and low interest rates a commentator wrote, ‘If inflation suddenly increases it could result in a faster than expected rise in interest rates. The consumer spending boom will end.’ (Source: London Evening Standard, 26 January 2015)
Discuss the possible reasons behind this suggested result. [13]
a.
intro: define liquidity preference theory and explain what does demand for money mean.
body
why people demand for money?
- Transactional motive
- Precautionary motive
- Speculative motive
Which is the most important? Transactional likely to be most important. Involves largest proportion of demand for money for daily and regular expenses.
b.
intro: define inflation
body:
Why inflation may suddenly increase after a long period of low inflation and low interest rate?
Possible reasons
- Low interest rate – encourages consumer to spend and borrow. This can cause demand-pull inflation. Diagram – AD/AS, shift in AD to the right.
- Low interest rate – cause demand for money for speculative purposes high. Greater amount of money in speculation, eg. Stock market and property/real estate sector, causing bubble in these sectors. This will cause overall inflation to rise rapidly. And consumption to suddenly fall.
- Economy has been growing from a sustained recovery, now nearing its level of potential output. Diagram – Keynesian LRAS. No more unemployed workers and increase in AD only result in higher price level.
- Low interest rate for a long time and yet low inflation during these times. May be due to animal spirit. Consumers are too pessimistic, and prefer to save despite low interest rate. When consumer confidence rises, spending would suddenly increase, leading to demand-pull inflation.
Kyo of Economics 