Interest rates in the economy rise unexpectedly. According to Keynes's theory, what happens to speculative money demand?
AIt increases — higher rates signal economic growth and people want more liquidity
BIt decreases — bonds now offer higher yields and potential capital gains, making money costly to hold
CIt stays the same — speculative demand depends on income, not interest rates
DIt increases — people want to hold cash to deploy it when rates eventually fall
When rates rise, bonds become more attractive relative to money: they offer high current yield and, if rates are expected to stabilize or fall, prospective capital gains as bond prices recover. Money earns nothing, so the opportunity cost of holding money rises with the interest rate. Speculative demand for money therefore falls as rates rise — this is the downward-sloping liquidity preference curve. Option 3 sounds plausible but is incorrect: if rates have risen and are expected to fall, you want to hold bonds (to capture both yield and capital gain) not money.
Question 2 Multiple Choice
A business keeps a buffer of cash on hand specifically to cover unexpected equipment repairs and emergency expenses. This best illustrates which Keynesian motive?
ATransactions motive
BSpeculative motive
CPrecautionary motive
DLiquidity preference
The precautionary motive covers money held as a buffer against unexpected expenses — emergencies, unplanned costs, contingencies. The transactions motive covers routine, predictable purchases. The speculative motive covers money held as an alternative to bonds to avoid capital losses. 'Liquidity preference' names the overall money demand function, not a specific motive. The scenario describes contingency-based holding, not routine spending or a bet on interest rates.
Question 3 True / False
If an individual expects interest rates to rise in the future, Keynes's theory says they should hold more bonds now to capture the higher future yields.
TTrue
FFalse
Answer: False
This is the key misconception about the speculative motive. When rates are expected to rise, existing bond prices will fall — bonds and interest rates move inversely. Holding bonds in anticipation of rising rates means suffering capital losses that could exceed the interest earned. The rational response is to hold money instead — preserving nominal value — until rates stabilize or peak. Higher future yields apply to newly issued bonds; what you currently hold will fall in price. This is why expected rate increases drive up speculative money demand.
Question 4 True / False
Keynes's speculative motive implies that money demand and the interest rate are inversely related.
TTrue
FFalse
Answer: True
When interest rates are low (or expected to rise), bonds are risky and unattractive — speculative demand for money is high. When rates are high (or expected to fall), bonds offer both yield and capital gains — money is relatively unattractive, so speculative demand falls. This inverse relationship is what gives the liquidity preference curve its downward slope, connecting the money market to interest rate determination and forming the basis of the LM curve.
Question 5 Short Answer
Why is the speculative motive considered Keynes's most original contribution to understanding money demand? What problem does it solve that the transactions and precautionary motives don't address?
Think about your answer, then reveal below.
Model answer: The transactions and precautionary motives explain why people need money to function — routine purchases and contingencies. But these motives would make money demand largely determined by income, with no clear link to interest rates. The speculative motive introduces the bond-vs-money trade-off: money demand also falls as rates rise because higher rates make bonds more attractive relative to holding idle cash. This is what gives monetary policy traction — changing the money supply shifts the interest rate until people willingly hold the new quantity. Without the speculative motive, there is no clear mechanism connecting money supply to interest rates.
The speculative motive is the hinge of Keynesian monetary theory. It explains why the liquidity preference curve slopes downward (not vertical), why interest rates are determined in the money market, and why central bank policy can influence rates by changing the money supply. The other two motives are about necessity; the speculative motive is about portfolio choice — and that's what makes it theoretically powerful.