Question

What is the theory of liquidity preference? how does it help explain the downward slope of the aggregate demand curve?

Answer 1

The theory is, in essence, an application of supply and demand. According to Keynes, the interest rate adjusts to balance the supply of and demand for money.

How does the theory of liquidity preference help explain the downward slope of the aggregate-demand curve?

(1) A higher price level raises money demand. (2) Higher money demand leads to a higher interest rate. (3) A higher interest rate reduces the quantity of goods and services demanded. The result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded