Cambridge International as and a level Economics Ebook

Liquidity trap: 
a situation where interest rates cannot 
be reduced any more in order to stimulate an upturn in 
economy activity.
KEY TERM
Figure 9.27 
The liquidity preference theory of interest 
rate determination
0
Rate of Interest
Quantity of money
Q
L
MS
L
R
Figure 9.28 
An increase in the money supply causing a fall in 
the rate of interest
0
Rate of Interest
Quantity of money
Q
Q
1
L
MS MS
1
L
R
R
1
called 
idle balances
when they believe that the returns 
from holding fi nancial assets are low. One fi nancial 
asset that fi rms and households may decide to hold is 
government bonds. Th
ese are govern ment securities 
that represent loans to the government. Th
e price of 
government bonds and the rate of interest (in percentage 
terms) move in opposite directions. For example, a 
government bond with a face value of $500 may carry 
a fi xed interest rate of 5% of its issue price. If the price 
of the bond rises to $1,000, the interest paid will now 
represent 2.5% of the price of the bond. Households and 
fi rms are likely to hold money when the price of bonds 
is high and expected to fall. Th
is is because they will not 
be forgoing much interest and because they will be afraid 
of making a capital loss. Th
e speculative demand for 
money will be low when the price of bonds is low and the 
rate of interest is high. 
Figure 9.27
 shows the combined 
transactions, precautionary and speculative motives for 
holding money in the form of liquidity preference (or 
demand) for money. Th
e rate of interest is at R, since 
this is where the liquidity preference curve intersects the 
supply of money curve.
An increase in the money supply will cause a fall in 
the rate of interest, as illustrated in 
Figure 9.28.
 Th
e rate 
of interest falls because the rise in the money supply will 
result in some households and fi rms having higher money 
balances than they want to hold. As a result they use some 
to buy fi nan cial assets. A rise in demand for government