You earn gross income (Y). It goes to one of 3 places: It is spent (C = consumpt

Question

You earn gross income (Y). It goes to one of 3 places: It is spent (C = consumption expenditures); it is taxed (T = income taxes); or it is saved (S = saving) How do you save your money? It can be invested in bonds or other interest-bearing assets (B) or it can be held in money form as currency or demand deposits (M). Differentiate between the bond market approach to predicting current interest rates and the liquidity preference framework. Based on the scheme above and/or the statement Bs + Ms = Bd + Md, should the liquidity preference framework predict the same market interest rates that the bond market approach does?

Explanation / Answer

a. In bond market approach The intersection of the demand and supply curves determines the equilibrium rate of interest, the rate at which the bond market is in equilibrium while in Liquidity preference approach the interest rate is determined in the money market (but not in the bond market), by the demand for and supply of money

b. The money and bond markets are related in such a way that, when the money market is in equilibrium, so is the bond market. When there is an excess demand (supply) in the money market, there is an excess supply (demand) in the bond market. Therefore, we can say that both bond and liquidity preference theory predict same market interest rate

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