 For the last few lectures we have been studying interest rate determination and we have discussed asset market approach to interest rate determination. Now we move on to second approach of interest rate determination which is called liquidity preference approach or liquidity preference framework. You must have heard the term liquidity preference before when we are discussing the topic of money demand. We have read a theory in which Keynesian theory of money demand is called liquidity preference theory of money demand. Liquidity preference means that your mind should be clear. Liquidity word is used for money. When we say liquidity preference means people prefer holding money or they prefer to hold money. This means that people prefer to hold money or to hold liquidity. We have also seen in the asset market that the liquidity of the asset is more, people hold it more. So the basis of this is money. This means that now we have come out of the bond market and we study the determination of interest rate from the money market. Interest rate determination is determined in the bond market and interest rate determination is determined in the money market as well. If there were some determining factors there then there will be some determining factors here as well. There we will find out some variable because of which the interest rate fluctuates. Here we will find out some variables because of which the interest rate fluctuates. Yes, some variables can be common whereas some variables can be different. But before that, the liquidity preference framework or the liquidity preference approach considers two types of markets. One is the money market and the other is the bonds market. Now this is a difference here. When we were studying the bonds market approach, there were many assets in comparison to bonds. Whether it is a real asset, whether it is an asset of the financial market, whether it is equity or money can be the alternative. We used to say that the return on bond has increased relative to other assets. This means that other assets are also available. But the liquidity preference approach considers that there are only two types of assets. One is the bond as an asset and the other is the money as an asset. This means that the total wealth of WS, supply of wealth, that is equal to demand for wealth WD. If we make an equilibrium for total wealth, WS is equal to WD, supply of wealth is equal to demand for wealth. According to the liquidity preference theory, wealth is in two types of assets. Either it is money or it is a bond. This means that supply of wealth is basically supply of money and supply of bonds. And the demand for wealth is demand for money and demand for bonds. That is why WS is equal to WD, which we have written as MS plus BS. Money supply plus bond supply is equal to money demand plus bond demand or demand for bonds. Now, if you take this term to the left and take it to the right, let BS remain on the left and let BD remain on the left. Since the sign changes, it will remain on the left side BS minus BD and on the right side MD minus MS. Now, BS is supply of bonds, BD is demand for bonds. If supply and demand of bonds are equal to the market, then the answer is 0. If the number of bonds remains on the left side, then MD minus MS will remain on the right side, which means MD minus MS will remain on the right side, which means the money market will remain on the right side. So, the first thing to understand is that this approach of the money market considers that there are two types of assets, a bond and a money. And if there is equilibrium in one market, then there will definitely be equilibrium in the other market. This means that if there is equilibrium in the bond market, then there will definitely be equilibrium in the money market. On the other hand, if you study the money market and only study the equilibrium of the money market, then you are sure that the bond market is also in equilibrium. This is the basic concept. So, when the bond market is in equilibrium, then the money market is also in equilibrium. This means that if we go a little deeper, think a little more, then the two approaches of the bond market and the money market will ultimately reach the same conclusion. They will almost reach the same level of interest rate. Both of them have to determine the interest rate. They will reach the same level. Why? Because this approach assumes that when the money market is in equilibrium, then the bond market is definitely in equilibrium. This means that the equilibrium of the bond market and the equilibrium of the money market basically have no difference. So, if both of them have to determine the interest rate, then the interest rate will be the same. But theoretically, there is no basic difference in the equilibrium of the bond market because there is one equilibrium and the other is also in equilibrium. But practically, when we look at the effect of the variable interest rate, that the expected return change, the money supply change, the variable change, the variable change, then the difference will be practically in both of them. And the difference is that the liquidity preference theory only takes bonds and ignores other assets. Whereas, the bond market approach considers many assets in other assets. So, there is a practical difference between these two. Now, before I go to this, the first thing that came here is that the bond market and the money market are practically the same. Practically, there is a difference in their approach. So, the question is that before we read the money market equilibrium, we need to know which approach should be read. If our answer is that when both of them are theoretically the same, then we need to read the bond market only. Because if the bond market is in equilibrium, then the money market is in the last equilibrium, then we do not need to discuss the money market. So, let us first answer this question that which approach should be used practically. So, the answer is both. That is why we want to read the money market. That is why we want to discuss the money market equilibrium despite the bond market equilibrium. So, the bond market, if you want to look at the effect of expected inflation on the bond prices and the interest rates, which we discussed in the last lecture in the diagram for Fisher hypothesis, that if the expected inflation rate changes, then the demand for the bond also changes, the supply of the bond also changes and that is why the nominal interest rate also changes. So, if your focus is on the effect of the expected inflation rate, then the bond market approach is better. But if your determining factor or the factors that change the interest rate, then you do not want to focus on the expected inflation rate. In fact, if you want to look at other factors like the income level, price level or money supply, then we do not consider the money supply in the bond market. So, this means that both the approaches are practically theoretical. That is why we need to discuss both the approaches. So, now let us look at the money market equilibrium. So, when we talk about market, then market also means the demand and supply and in the money market, the demand for the money and the supply of the money, and do you know that how many theories of demand of the money have been studied— the function of the money, the quantity theory of the money, the Keynesian theory of the money, the freedom theory of the freedom, and the theory of the total sum of the total sum of the total sum. We know that money demand interest rates are inversely related and there are 2 reasons for this. A portfolio theory says that when the interest rate increases on bonds, interest rate does not increase on money. It will increase on bonds because according to this theory, the alternate asset of the money is only a bond. When the interest rate increases on bonds, people will hold bonds and then why will money hold? The demand of money will decrease. If you do not go into the portfolio theory, it is simple that the interest rate of the money is the opportunity cost. When the opportunity cost increases, the demand of the money will decrease. We have already made the curve of the demand. I have made it to remind you again that this is a negative slope. You have already read the money supply. We have read the whole topic of the money supply. And you know that in the money supply, the velocity of money was the role of the money multiplier. And these parameters, whether it is the money multiplier or the velocity, the role of the interest rate is there. But most of the time when we study the money market, we assume that the money supply is exogenous, i.e. the interest rate does not have an effect. The money effect from the interest rate is basically when the money on the central bank is a multiplier process, i.e. when commercial banks create a deposit, the role is there. So, if we assume that the money is controlled by the central bank, then we can easily assume that supply is exogenous, money supply. That is why the money supply curve is vertical. Now, if we combine these two, what will become the money market equilibrium? i.e. point C equates demand and money supply. So, the interest rate here is equilibrium interest rate and this equilibrium interest rate did not come from the bonds market, it came from the money market. And if at any time it reaches the economy point A, then you can see that on point A, the demand for money is less and the supply is more, then the excess supply will be there. The excess supply of which is more, the cost of which is less, then the interest rate will be less, which is showing you the downward arrow. And if at any time it goes to the economy point E, then the demand for money supply is less on the point E given interest rate, then the demand for which the excess demand is increased, then the interest rate in the money market will increase. Ultimately, the stable equilibrium point C is where the demand and supply are equal and there is no tendency for further change. So, this is the determination of the interest rate from the money market and its equilibrium. Thank you.