According to liquidity preference theory, the money supply curve would shift rightward
The Correct Answer and Explanation is:
According to liquidity preference theory, the money supply curve would shift rightward if the central bank increases the amount of money in circulation. Liquidity preference theory, initially developed by economist John Maynard Keynes, explains the relationship between the demand for money and interest rates. It is based on the idea that individuals and businesses prefer to hold a certain amount of money for transactions, precautionary, and speculative reasons.
The money supply curve is typically vertical in the liquidity preference framework, as it is determined by the central bank and is not influenced by interest rates in the short term. However, when the central bank expands the money supply, the overall amount of money available in the economy increases. This shift rightward occurs because the central bank injects more money into the system, either through open market operations, lowering the reserve requirement for banks, or reducing interest rates. These actions increase the quantity of money in circulation.
When the money supply curve shifts rightward, there is an immediate impact on the liquidity available in the economy. With more money in circulation, individuals and businesses have a higher amount of cash on hand to conduct transactions and invest. The increased liquidity leads to lower interest rates, as people now have more money to lend and invest in various assets. As a result, the cost of borrowing decreases, which stimulates investment and consumption.
However, it is important to note that the effects of an increase in the money supply depend on the liquidity preference of the population. If individuals and businesses are unwilling to spend or invest the extra money, the shift in the money supply curve may not lead to significant economic growth or lower interest rates. In extreme cases, such as in a liquidity trap, increasing the money supply may have little to no effect on interest rates or economic activity.
