Theories of Interest

This is a extreme Keynesian concept. It happens when the interest rate is at its lowest possible level. At this point, everyone believes interest rates will only go up in the future. Therefore, no one wants to hold bonds; they only want to hold cash. Even if the central bank increases the money supply, the interest rate does not fall further. This makes monetary policy ineffective. Example: Japan faced a liquidity trap for many years where even zero interest rates could not jumpstart the economy.

This is the 'Great Synthesis' in economics. The IS curve shows all points where the goods market is balanced. It slopes downward because lower interest rates lead to more investment. The LM curve shows where the money market is balanced. It slopes upward because higher income leads to more demand for money, which raises interest rates. Where they meet, both markets are stable. For example, if the government builds more highways (Fiscal Policy), the IS curve shifts, leading to higher income and higher interest rates.

This concept explains why people want to hold liquid cash instead of investing it. Keynes identified three motives. The Transaction motive is for daily expenses like groceries. The Precautionary motive is for 'rainy days' or medical emergencies. The Speculative motive is for making money by betting on bond prices. If you think bond prices will fall, you hold cash to buy them later. Therefore, demand for cash is high when interest rates are low. Example: During a pandemic, people hold more cash for health emergencies, showing a high precautionary motive.