Community’s total demand for money depends on:
(i) The transactions and precautionary motives, and
(ii) The speculative motive. In reality, however, the demand for money held under a particular motive is difficult to identify. Hence, for all practical purposes, total cash balances should be regarded as depending on the combined factors relating to these motives. Thus:
L = L 1 + L 2
ADVERTISEMENTS:
Where L stands for an overall demand for money, which is the sum of the demand for active and idle balances.
Since L 1 = /(Y), and L 2 = / (i), it follows that L = / (Y, i). This means that the community’s overall demand for money depends upon the level of national income and the rate of interest.
Thus, the liquidity preference schedule of a community can be derived by the super imposition of the L 1 curves, at each level of income, on the L 2 curve, denoting the relationship between the rate of interest and the idle balances held. The point is made explicit.
Panel (A) shows the schedule of active balances held at different levels of income. The demand for active balances is perfectly interest-inelastic in the short period. It changes in proportion to the changes in income.
ADVERTISEMENTS:
Thus, the curve L 1 (Y 1 ) represents the demand for active balances at Y 1 level of income; the curve L 1 (Y 2 ) relates to the demand for active money balances at Y 2 level of income, and L 1 (Y 3 ) at Y 3 level of income.
These L 1 curves are vertical straight lines because, on the Y-axis, we have measured the rates of interest, while the demands for active balances are perfectly interest- inelastic.
Curve L2 in panel (B) of the diagram represents the demand for money under the speculative motive (or idle cash balances), which is the inverse function of the rate of interest. It becomes horizontal or parallel to the x-axis.
Panel (C) represents the super-imposition of L 1 curves on the L 2 curves. Thus L(Y 1 ), L(Y 2 ) and L(Y 3 ) curves represent the liquidity-preference schedule of the community implying that the demand for money varies inversely as the rate of interest, and it increases with the increase in national income.
ADVERTISEMENTS:
It is a much simplified case. Actually, there may be an infinite number of L curves for all possible levels of income in the map of the liquidity preference schedule.