In his classic book The General Theory of Employment, Interest, and Money, John Maynard Keynes
proposed the theory of liquidity preference to explain what factors determine an economy’s interest rate. The theory is, in essence, just an application of supply and demand. According to Keynes, the interest rate adjusts to balance the supply and demand for money. You may recall that economists distinguish between two interest rates: The nominal interest rate is the interest rate as usually reported, and the real interest rate is the interest rate corrected for the effects of inflation. When there is no inflation, the two rates are the same. But when borrowers and lenders expect prices to rise over the course of the loan, they agree to a nominal interest rate that exceeds the real interest rate by the expected rate of inflation. The higher nominal interest rate compensates for the fact that they expect the loan to be repaid in less valuable dollars. Which interest rate are we now trying to explain with the theory of liquidity preference? The answer is both. In the analysis that follows, we’ hold constant the expected rate of inflation. This assumption is reason able for studying the economy in the short run, as we are now doing. Thus, when the nominal interest rate rises or falls, the real interest rate that people expect to earn rises or falls as well. For the rest of this chapter, when we refer to changes in the interest rate, you should envision the real and nominal interest rates moving in the same direction. Let’s now develop the theory of liquidity preference by considering the supply and demand for money and how each depends on the interest rate.