IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy
In Keynes's liquidity preference theory, the interest rate is determined by the interaction of the money supply with money demand. Suppose the central bank holds the nominal money supply fixed and the public's demand for money for transactions rises because national income increases. What is the predicted effect?
The interest rate rises. Higher income increases transactions demand for money, shifting the demand curve right, and with money supply fixed the rate must rise to bring money demand back into line with supply, discouraging holding of idle cash balances.
- AThe interest rate falls because money is more plentiful
- BThe interest rate rises as the money demand curve shifts rightCorrect
- CThe interest rate is unchanged because supply is fixed
- DThe money supply curve shifts left, lowering the rate
- The interest rate falls because the speculative demand falls
Explanation
Higher income raises transactions demand, shifting the money demand curve right. With a fixed (vertical) money supply, the market-clearing interest rate must rise to restore equilibrium by reducing the speculative demand for money. Option 'unchanged' ignores the demand shift.
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