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Liquidity preference theory explains interest rate determination as equilibrium between money supply (controlled by central bank) and money demand. The interest rate adjusts so desired money holdings equal the money supply.
Use supply-demand diagram for money: money supply is vertical, money demand slopes downward. Shift money demand with income or expectations changes; show equilibrium interest rate adjusts.
Your prerequisites gave you two building blocks: Keynes's theory of money demand (why people want to hold cash rather than bonds) and how the central bank controls the money supply. Liquidity preference theory assembles these into a model of how the interest rate itself is determined — a fundamentally different answer from the classical loanable-funds framework you may have studied, and the foundation for much of Keynesian macroeconomics.
Keynes's central reframing is to treat the interest rate not as the price of saving versus consumption but as the price of liquidity — the return required to induce people to part with cash and hold less-liquid assets like bonds. People hold money for three reasons: transactions demand (cash needed for everyday spending, which rises with income), precautionary demand (a buffer against unexpected expenses), and speculative demand (holding cash when you expect bond prices to fall — that is, when you expect interest rates to rise). The speculative motive makes money demand interest-sensitive in a way classical theory ignored: when interest rates are high, bonds look attractive (prices more likely to rise as rates fall), so people want to hold more bonds and less cash. When rates are low, cash looks relatively safe compared to bonds that could lose value if rates rise. This produces a downward-sloping money demand curve: as the interest rate rises, desired money holdings fall.
The money supply in this framework is set exogenously by the central bank — it is a vertical line in the money market diagram (with money quantity on the horizontal axis and the interest rate on the vertical). The equilibrium interest rate is where money supply equals money demand. If the central bank increases the money supply (shifts the vertical line rightward), at the old equilibrium rate there is now an excess supply of money: people hold more cash than they want. They respond by buying bonds, which drives bond prices up — and since bond prices and yields move inversely, the interest rate falls until a new equilibrium is reached. This is the monetary transmission mechanism: the central bank injects money → interest rate falls → borrowing costs fall → investment rises → output expands.
The famous failure of this mechanism is the liquidity trap. If interest rates are already very low, the speculative demand for money becomes nearly unlimited — people widely expect rates to rise (bond prices to fall) and prefer to hold cash rather than bonds. The money demand curve becomes nearly horizontal near zero rates. In this regime, any additional money injected by the central bank is simply absorbed into idle cash balances without pushing rates down further. Monetary policy loses traction. This was Keynes's argument that fiscal policy — not monetary policy — was the appropriate tool during the Great Depression. The liquidity trap re-emerged as a live policy debate after the 2008 financial crisis, when many central banks cut rates to the zero lower bound and found their usual transmission mechanism weakened. The concept of quantitative easing (purchasing long-term assets rather than just short-term bonds) was developed in part as a response to this limitation.