The Keynesian theory of interest rates

The Keynesian approach explains how interest rates are established through the interaction between the availability of money and the desire to hold it.

Factors determining interest rates in Keynesian theory

• Supply of money - This is controlled by central banks and remains constant in the short term.
• Demand for money (liquidity preference) - People hold money for three main reasons:
  • Transactions motive - To cover everyday expenses.
  • Precautionary motive - To have funds available for unexpected needs.
  • Speculative motive - To take advantage of potential investment opportunities.
• Equilibrium interest rate - This occurs where the liquidity preference curve meets the vertical money supply curve.

The effect of money supply changes on interest rates

Changes in the money supply can influence interest rates by altering the balance between available funds and economic agents' preferences.

How an increase in money supply affects interest rates

• When central banks expand the money supply, individuals and firms end up with more cash than they need.
• This surplus leads them to invest in financial assets, such as government bonds.
• The heightened demand for these assets drives up their prices.
• As bond prices rise, the interest rates associated with them decrease.

The liquidity trap

The liquidity trap describes a scenario where efforts to stimulate the economy through increased money supply fail to reduce interest rates further.

Conditions leading to a liquidity trap

• This typically happens when interest rates are already extremely low, making bond prices very high.
• Investors anticipate that bond prices will decline in the future.
• Returns on bonds are minimal due to the low rates, offering little incentive to invest.

Effects of increasing money supply in a liquidity trap

• Additional money is simply held by investors rather than used to purchase bonds.
• The demand for money becomes infinitely elastic, meaning people are willing to hold unlimited amounts at the prevailing low rate.
• As a result, expanding the money supply does not lower interest rates.

The loanable funds theory of interest rates

The loanable funds theory views interest rates as the outcome of borrowing and lending activities in the financial market.

Demand for loanable funds

The demand for loanable funds represents the desire to borrow money for various purposes. The demand curve slopes downwards, showing that lower interest rates make borrowing more attractive, increasing the quantity demanded.

Sources of demand for loanable funds:

• Individuals - Borrow for large expenditures, such as homes or cars.
• Businesses - Seek funds for capital investments or to manage cash flow issues.
• Governments - Borrow to finance spending when tax revenues fall short.

The supply of loanable funds

The supply side of the loanable funds market focuses on the funds available for lending, primarily derived from savings.

Sources and characteristics of supply

• Savings as the main source - Households and firms save portions of their income, making these funds available for lending.
• Upward-sloping supply curve - Higher interest rates motivate greater saving.
• Impact of changes in savings - An increase in overall savings shifts the supply curve rightwards, leading to lower interest rates.