ECON 2 Lecture Notes - Lecture 15: Liquidity Trap, Aggregate Demand, Inverse Function

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amaranthgrasshopper262

27 Aug 2020

School

Irvine Valley College

Department

Economics

Course

ECON 2

Professor

colins

For unlimited access to Class Notes, a Class+ subscription is required.

Hao Tran

htran170@ivc.edu

Macroeconomics

Notes: Econ 2

Speculation Demand for Money

● It refers to the amount of money held to take advantage of profitable opportunities that may

arise in financial markets. Whereas the transactions and precautionary motives of demand

for money look at money as a medium of exchange, the speculative motive looks at it as

store of value. People hold money for speculation purposes due to uncertainty about the

future rate of interest. A fall in the interest rate leads to an increase in the speculation

demand for money. Speculation motive is an inverse function of interest rate as shown by

the following diagram.

● According to Keynes therefore, the aggregate demand for money (Md) is the sum of

speculative demand, transactions demand and precautionary demand for money, i.e.

● Due to the effects of the speculation demand for money, the aggregate demand for money

is downward sloping and convex to the origin. At a certain level of interest (r*), the

aggregate demand for money curve becomes horizontal, which means that demand for

money is perfectly interest-elastic. This implies that further fall in interest has no effect on

the speculative demand for money. This situation is referred to as liquidity trap.

● r* is the liquidity trap interest rate. At this rate people prefer to hold their wealth in cash

rather than bonds, since the interest foregone is very low. At this level of interest, the net

return to bonds is zero. At low interest rate, bond prices are high and therefore likely to

fall. This poses a risk of capital loss for investors, hence their decision to hold wealth in

cash.

1. The Modern Quantity Theory of Money

It was put forward by Friedman. According to this theory, money is just one of the many ways in

which wealth can be held. The other ways include consumer durables, all kinds of financial assets,

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Document Summary

It refers to the amount of money held to take advantage of profitable opportunities that may arise in financial markets. Whereas the transactions and precautionary motives of demand for money look at money as a medium of exchange, the speculative motive looks at it as store of value. People hold money for speculation purposes due to uncertainty about the future rate of interest. A fall in the interest rate leads to an increase in the speculation demand for money. Speculation motive is an inverse function of interest rate as shown by the following diagram. At a certain level of interest (r*), the aggregate demand for money curve becomes horizontal, which means that demand for money is perfectly interest-elastic. This implies that further fall in interest has no effect on the speculative demand for money. This situation is referred to as liquidity trap. R* is the liquidity trap interest rate.

Related Questions

QUESTION 46

When the Fed buys a U.S. bond in the open market

		its action has no effect on the total reserves or the money supply because the check it writes increases reserves at one bank but they fall at another.
		its action expands total reserves and the money supply.
		its action contracts total reserves and the money supply.
		total reserves increase by the amount of the purchase but the money supply stays the same.

1.11 points

QUESTION 47

When the Fed sells government securities,

		reserves increase, leading to a decrease in the money supply by an amount more than the sale of the government securities.
		reserves decrease, leading to a decrease in the money supply by an amount more than the sale of the government securities.
		reserves increase, leading to a increase in the money supply by an amount more than the sale of the government securities.
		reserves decrease, leading to a increase in the money supply by an amount more than the sale of the government securities.

1.11 points

QUESTION 48

The maximum potential money multiplier is equal to

		the reserve ratio.
		one minus the reserve ratio
		the inverse of the required reserve ratio.
		the number of dollars on reserve.

1.11 points

QUESTION 49

The potential money multiplier gives us

		the growth in the money supply when income increases.
		the growth in real national income when the money supply increases.
		the maximum potential change in the money supply due to a change in income.
		the maximum potential change in the money supply due to a change in reserves.

1.11 points

QUESTION 50

An increase in the reserve ratio

		increases the money multiplier.
		will cause banks to make more loans.
		has an expansionary effect on the money supply.
		has a contractionary effect on the money supply.

1.11 points

QUESTION 51

The Federal Deposit Insurance Corporation insures

		banks against lawsuits.
		the deposits held in member banks.
		the deposits held in the Fed.
		the federal funds market.

1.11 points

QUESTION 52

Bank runs are a possibility because

		in difficult times people want currency instead of demand deposits.
		the FDIC is inefficient.
		banks do not keep enough reserves to cover all their depository liabilities.
		bankers are often poor businesspeople.

1.11 points

QUESTION 53

The manner in which FDIC deposit insurance is set up in the United States encourages banks to

		make riskier loans than they otherwise would.
		reject some loans that probably would be profitable.
		maintain excess reserves that are too great.
		be too conservative in their lending practices.

1.11 points

QUESTION 54

The Federal Deposit Insurance Corporation

		discourages banks from engaging in excessive risk taking.
		was established after the Panic of 1907.
		only insures deposits in money-center banks.
		increases the stability of the banking system by reducing the likelihood of bank runs.

1.11 points

QUESTION 55

What are the two features of money that distinguish it from all other goods in the economy?

		Money is government issued and it is redeemable for gold or silver.
		Money is part of every barter transaction and it is divisible.
		Money is accepted as a medium of exchange and it is the common unit of account used to express prices.
		Money is a common unit of account and it is also can be traded for other currencies at a guaranteed exchange rate.

1.11 points

QUESTION 56

Holding money to meet unplanned expenditures and emergencies is known as

		asset demand.
		precautionary demand.
		aggregate demand.
		transactions demand.

1.11 points

QUESTION 57

When people want to hold money to make regular planned expenditures, this is

		the transaction demand for money.
		the spending demand for money.
		the asset demand for money.
		the precautionary demand for money.

1.11 points

QUESTION 58

When interest rates rise, the transactions demand for money usually

		decreases.
		increases.
		decreases initially and then increases to the original position.
		does not change.

1.11 points

QUESTION 59

As nominal Gross Domestic Product (GDP) rises, the transactions demand for money

		increases, and the money demand curve shifts to the right.
		remains constant, and the money demand curve remains the same.
		decreases, and the money demand curve shifts to the left.
		increases, and the money demand curve shifts to the left.

1.11 points

QUESTION 60

One of the economic costs of holding currency is that

		it fulfills no precautionary role.
		it fulfills no transactions role.
		it earns no interest income.
		its real value always increases.

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ECON 2 Lecture Notes - Lecture 15: Liquidity Trap, Aggregate Demand, Inverse Function

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