In his classic work The General Theory, Keynes offered his view of how the interest rate is determined in the short run. His explanation is called the theory of liquidity preference because it posits that the interest rate adjusts to balance the supply and demand for the economy’s most liquid asset—money. Just as the Keynesian cross is a building block for the IS curve, the theory of liquidity pref- erence is a building block for the LM curve.

To develop this theory, we begin with the supply of real money balances. If $M$ stands for the supply of money and $P$ stands for the price level, then $\frac{M}{P}$ is the supply of real money balances. The theory of liquidity preference assumes there is a fixed supply of real money balances. That is,

$(M/P)^s = \frac{\bar{M}}{\bar{P}}$

The money supply $M$ is an exogenous policy variable chosen by a central bank, such as the Federal Reserve. The price level $P$ is also an exogenous variable in this model. (We take the price level as given because the IS–LM model—our ultimate goal in this chapter—explains the short run when the price level is fixed.) These assumptions imply that the supply of real money balances is fixed and, in particular, does not depend on the interest rate. Thus, when we plot the supply of real money balances against the interest rate, we obtain a vertical supply curve.

Next, consider the demand for real money balances. The theory of liquidity preference posits that the interest rate is one determinant of how much money people choose to hold. The underlying reason is that the interest rate is the opportunity cost of holding money: it is what you forgo by holding some of your assets as money, which does not bear interest, instead of as interest-bearing bank deposits or bonds. When the interest rate rises, people want to hold less of their wealth in the form of money. We can write the demand for real money balances as:

$(M/P)^d = L(r)$

where the function $L(r)$ shows that the quantity of money demanded depends on the interest rate. The demand curve slopes downward because higher interest rates reduce the quantity of real money balances demanded.

According to the theory of liquidity preference, the supply and demand for real money balances determine what interest rate prevails in the economy. That is, the interest rate adjusts to equilibrate the money market. At the equilibrium interest rate, the quantity of real money balances demanded equals the quantity supplied.

How does the interest rate get to this equilibrium of money supply and money demand? The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their portfolios of assets and, in the process, alter the interest rate. For instance, if the interest rate is above the equilibrium level, the quantity of real money balances supplied exceeds the quantity demanded. Individuals holding the excess supply of money try to convert some of their non-interest-bearing money into interest-bearing bank deposits or bonds. Banks and bond issuers, which prefer to pay lower interest rates, respond to this excess supply of money by lowering the interest rates they offer. Conversely, if the interest rate is below the equilibrium level, so that the quantity of money demanded exceeds the quantity supplied, individuals try to obtain money by selling bonds or making bank withdrawals. To attract now-scarcer funds, banks and bond issuers respond by increasing the interest rates they offer. Eventually, the interest rate reaches the equilibrium level, at which people are content with their portfolios of monetary and nonmonetary assets.