The theory of liquidity preference suggests that the interest rate is determined by the supply and demand of real money balances.
Theory suggests that if interest rates rise, people with excess money supply try to convert their money into interest-bearing money by depositing or investing it and that reduces the interest rate. Similarly if the interest rate is low, people tend to convert interest-bearing money into non-interest-bearning money and when less funds are available to the money market, interest rate rises again.
In other words, if Real Money Balances (M/P) increases, interest rate should rise and if it decreases, interest rate should fall.
The demonstration of theory on the basis of actual data show that increase and decrease in money supply (Real Money Balances, M/P) does increase and decrease interest rate.




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