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SSC Micro Macro Economics P-I QUESTION #1686
Question 1
According to Keynes's liquidity preference theory, the relationship between the money supply and the rate of interest is best characterised as:
  • Negative — a higher money supply leads to a lower interest rate✔️
  • Positive — a higher money supply leads to a higher interest rate
  • Indirect — the relationship is mediated through the price level
  • No systematic relationship exists between the two
Correct Answer Explanation
In Keynes's Liquidity Preference Theory, the interest rate is determined by the supply of and demand for money. Given a fixed money demand curve, an increase in money supply shifts the supply curve rightward, lowering the equilibrium interest rate. The relationship is therefore negative (inverse): \(\uparrow M_s \Rightarrow \downarrow r\). This is the mechanism through which monetary policy affects investment and aggregate demand in the Keynesian framework.