Determining Rate of Interest

Liquidity Preference

The correct answer to the question is option 'C', liquidity preference. Liquidity preference refers to the demand for money or cash. People prefer to have money with them to meet their day-to-day expenses, emergencies, and other financial requirements. This demand for money or cash determines the rate of interest in the market.

When the demand for money is high, the rate of interest also increases. Similarly, when the demand for money is low, the rate of interest falls. The liquidity preference theory of interest was propounded by John Maynard Keynes, which explains how the demand for money affects the rate of interest.

Factors affecting liquidity preference

The following are the factors that affect liquidity preference:

1. Income: Higher the income, higher will be the demand for money to meet the expenses. Hence, the rate of interest will be high.

2. Wealth: People with higher wealth tend to hold more money to meet their future expenses. Hence, the rate of interest will be high.

3. Price level: When the price level increases, the demand for money also increases, leading to a rise in the rate of interest.

4. Uncertainty: The higher the uncertainty, the higher the demand for money or cash as people tend to hold more money to meet any unforeseen emergencies. Hence, the rate of interest will be high.

Conclusion

Thus, the rate of interest is determined by the demand for money or cash, which is influenced by various factors like income, wealth, price level, and uncertainty. Hence, liquidity preference plays a crucial role in determining the rate of interest in the market.