There are two major theories that are used to explain the demand and supply of money in an economy. The classical theory developed by Irving Fisher used a simple equation to explain the demand and supply of money. Fisher’s theory was a modification of a theory advanced in 17th century (Mudida, 2003). The 17th century theory identified a connection between prices and supply of money. Fisher on the other hand identified four variables that affected demand and supply of money in his equation of exchange:


In the above equation, M represents the quantity of money present in an economy, V represents the velocity/speed of circulation, P represents the general price levels and Y represents the total number of transactions or the aggregate income. This theory was based on assumptions that the velocity was constant in the short run period and a full employment in the short run. He also assumed that each variable was independent of the other. However, this theory had its shortcomings and further research was required.

In the year 1936, Keynes advanced a general theory that explained the demand and supply of money, employment and interest rates in an economy. Keynes identified three motives for demanding money:

Speculative motive: money acted as store of wealth either in terms of bonds or in terms of money. People therefore held money or bonds with the aim of making future profits.
Precautionary motive: people demanded money for unforeseen events in the future. For example health emergencies, job loss and any other sort of emergencies
Transaction motive: individuals hold money for the day-to-day activities. Money in this case used as a medium of exchange.

The difference between the Keynesian theory and Fisher’s was that the Keynesian theory explained the concept of interest in the economy.

Analysis and discussion on Interest rates

Keynesian theory of interest has been used to explain the effects of changes in the Federal Reserve rate on the general interest rates and prices in the economy (Fukasawa, 2003). Keynes elaborated his arguments using government securities as an example of how interest rates changed in the economy.

He used the open market operations strategy to explain interest rates. This strategy has been used to regulate the excess reserves held by commercial institutions. These commercial institutions were observed to change their lending habits depending on the excess reserves.

The amount of loans being lent out would generally increase when the excess increases and reduce when the reserves are low. These institutions have the aim of maximizing their profits and would therefore lend any excess to increase their profits (Fukasawa, 2003).

Keynes came up with as simple equation to determine how market interest rates were affected by the open market operations. He stated that the market rate of interest was directly proportional to the federal discount rate and inversely proportional to the market prices of securities.

It follows that when the market prices of the securities are high the interest rates are low. It can there be said that when the interest rates are lower the speculative demand for money increases. With the high demand for money in the economy, the supply of money increases.

The following graphs show the relation between the interest rates and the liquidity preference for money (supply of money) also known as liquidity preference for money (LM) curve and relation between interest rates and demand for money also known as the Investment Saving (IS) curve.

The LM curve

The IS curve

When the interest rates increase Y decrease

In case of inflation or recession the Federal Reserve has various methods to combat it. Most of the times the federal reserves observe trends associated with the inflation or recession before they take action. Sometimes the inflation may be short term and can naturally correct itself by an increase in the number of transactions in the economy.

In such a case the federal reserves lets the market forces of demand and supply of money to control the inflation. If the inflation is severe and cannot be contained by the market forces of demand and supply, the federal reserves may use the monetary policy of open market operation. In this method, the Fed sells securities to the commercial institutions.

By selling the securities, the Fed is reducing the amount of excess money in supply (Fukasawa, 2003). With little amount in supply the commercial banks tend to reduce lending. If the demand of loans remains high and there is no excess to lend then the commercial institutions will raise their interest rates, eventually.

In case of depression or recessions the Federal Reserve purchases back the securities from the commercial institutions. This has the opposite effect to that of selling the securities. With lower interest rates, business investment will be stimulated since business ventures will be more profitable.

Decline in the interest rates may also induce the propensity of consumers to purchase durable goods such as houses, motor vehicles and furniture (Fukasawa, 2003). This is because credit is available at a cheaper rate and most consumers can afford it.

It is usually not a guarantee that use of open market operation will work. Other factors have to be considered before employing this strategy to reduce inflation or to combat recession. Economists have different opinions on how the method works.

There are arguments that have been advanced by economists to dispel use of this method. Economists argue that the Federal Reserve cannot control the amount of deposits made in financial institution. Therefore, after selling the securities to reduce the reserves customer deposits may still lead to excesses.

Another method employed by the Federal Reserve In case of inflation is raising the discount rate of the Federal Reserve. Federal discount rate is the amount of interest that the Federal Reserve charges on loans advanced to financial institutions. An increase in the Federal Reserve rate of interest has a ripple effect in other rates of interest in the economy. When the federal interest rates rise, the market interest rates will also increase as per the Keynesian equation on interest.

The effect of high interest rate is usually a reduction in investment habits and a reduction in consumer spending. Since the cost of obtaining credit is high, most businessmen will shun the prospect of borrowing to increase the capital on investment (Fukasawa, 2003). On the other hand, consumers will be reluctant to spend on durable goods since the cost of services such as mortgages and loans has increased.

In the case of a depression or recession, the vice-versa is true. The Federal Reserve reduces the cost of lending in order to increase the probability of investments and consumer spending. Like the open market operation, this strategy has its weaknesses and needs careful consideration before implementation.

Economists believe that this monetary policy like any other is affected by the time lapse in that it takes some time before it comes to force. Matters on time and economic demands should therefore be considered before using this method.

Liquidity trap

According to Keynes, the total demand of money is given by the summation of the active motive for demanding money (Mudida, 2003). Therefore, the total demand equals to the sum of speculative demand and transaction demand. Liquidity trap is reached when the rate of interests reach a point where government securities offered by the Federal Reserve and the liquid currency can be substituted perfectly (Brevinge, 2009).

Using the IS-LM curves liquidity trap can be understood to be the region where the LM curve flattens (Brevinge, 2009). At this point the interest rate is near zero and any addition of money to the economy will neither lower the interest rate further nor increase the affect the output (Brevinge, 2009). The graph below shows the liquidity trap.

The liquidity trap in an IS-LM framework

Figure 1

The liquidity trap in an I-S equilibrium

Figure 2

From the figure 1, it can be seen that if the LM curve is moved to right the supply of money increases but the effect of the movement is that output does not change and equally the interest rates do not fall (Brevinge, 2009). In figure 2 the I-S curve the investment – saving equilibrium is reached at when the nominal rates of interest are below zero. But since the nominal interest rates cannot go beyond zero the resulting outcome of this situation is excessive saving and less investment (Brevinge, 2009).. The Income-Saving equilibrium therefore indicates that the main reason behind a liquidity trap is the lack of investment opportunity.

Currently the United States can be said to be in a liquidity trap where there is fewer chances of investment and there is a high supply of money in the economy. The inflation rate is higher and the propensity to save has increased among the America people.

The demand for government bonds are high and people are avoiding risks of investing in. according to Brevinge (2009), by means of more inflation the United States economy can be pulled out the liquidity trap by the means of more inflation.

Bevinge (2009) also was of the notion that the United States economy has been having negative interest rates for one third of the years between 1945 and 1996. Therefore, he concludes that an economy does not need extreme situation to require negative interest.


The Keynesian monetary theory has been used to explain a number of economic theories. The concept of interest rates and money supply are explained in the general theory advanced by Keynes. Keynes elaborated his arguments on interest rates using the open market operations policy used by the Federal Reserve. Inflation and depressions can be controlled by various methods. Among the methods is letting market forces of demand and supply correct the situation naturally.

Monetary policies are also used to correct these situations. The Federal Reserve can either increase the interest rates or reduce them depending on the situation. Open market operations can also be used to reduce the inflation rates or depression in an economy. However, the use of these methods is subject to various considerations. Economists argue that the each of these methods is applicable under certain conditions to correct inflation or recession.


Brevinge, J. (2009). Escaping a Liquidity Trap through Monetary Policy: An Overview of Policy Proposals. Copenhagen: Copenhagen Business School.

Fukasawa, Y. (2003). How Does the Federal Reserve’s Lowering Interest Rates Affect the Economy? Texas Labor Market Review Newsletter. Texas: Texas Workforce Commission.

Mudida, R. (2003). Modern Economics. Chicago: Focus