Discuss how far (i) an increase in wages and (ii) a loss of business confidence might affect the rate of interest.

Cambridge a level june 2019

(i) According to the liquidity preference theory an increase in wages is expected to increase interest rate for it increases people’s demand for money.
Demand for money refers to the amount of cash everyone in the economy wishes to hold against a given interest rate.


Keynes argued that there are three distinct motives for holding wealth in cash as opposed to holding either non-money financial assets or physical assets.


Individuals need to hold cash in order to meet daily transactions such as buying petrol, paying for groceries or purchasing a newspaper.
Money balances held for this purpose is called transaction demand for money.
Everyone holds a certain amount of money since they are normally paid weekly or monthly whereas their expenditure is spread over the whole period.
The average amount held for transactions purposes depends upon the level of money income, the price level, the time of the year and the frequency of pay days.
In terms of wages, the higher the money wages, the more likely that individuals purchase more goods and services, and therefore they require extra transactions balances.
Demand for money is also based on the desire to provide for the unexpected.
The precautionary demand for money allows the individual to cover unforeseen events, such as the car breaking down, a lengthy period off work through illness, or an unexpected redundancy.
Hence it is likely that as the wages rise the precautionary demand for money also increases for people always want to be more secure against the unexpected events.
Money balances held for these two purposes is called active balances i.e money to be used as a medium of exchange.
Speculative demand for money is based on the expectation of making a speculative gain or avoiding a loss.
This part of demand for money changes in response to a change in interest rate, hence it has no direct relationship with increase in wages.
The total demand for money ( LP) is plotted against the rate of interest (r) and it is found by the sum of demand for cash for all three motives.
In terms of wages, the higher the money wages, the more likely that individuals purchase more goods and services, and therefore they require extra transactions balances.


Demand for money is also based on the desire to provide for the unexpected.


The precautionary demand for money allows the individual to cover unforeseen events, such as the car breaking down, a lengthy period off work through illness, or an unexpected redundancy.
Hence it is likely that as the wages rise the precautionary demand for money also increases for people always want to be more secure against the unexpected events.
Money balances held for these two purposes is called active balances i.e.money to be used as a medium of exchange.
Speculative demand for money is based on the expectation of making a speculative gain or avoiding a loss.
This part of demand for money changes in response to a change in interest rate, hence it has no direct relationship with increase in wages.


(ii) Similar to households businesses also demand for money for transactionary and precautionary motives. Businesses need to hold cash in order to meet daily transactions such as buy ing raw material, paying for wages and utilities etc. So, they hold a certain amount of money for they earn revenues infrequently whereas their expenditure is spread over the whole period. They also demand for money to provide for the unexpected. The precautionary demand for money allows them to cover unforeseen events, such as a machine break down, or a delay in receipts etc.A loss of business confidence is expected to decrease businesses' demand for money because they feel the need to decrease their output and hence their expenditure on inputs is likely to decrease.