1. The equilibrium between liquidity preference and demand for money determines the rate of interest.
2. In the short – run, the supply of money is assumed to be constant.
3. LP is the liquidity preference curve [demand curve.]
4. M2 M2 shows the supply curve of money to satisfy speculative motive. Both curves intersect at the point E, which is the equilibrium point. Hence, the rate of Interest is 2.5. If liquidity preference increases from LP to L P the supply of money remains constant, the rate of interest would increase from OI to OI1.
5. Suppose LP remains constant. If the supply of money is OM2 , the interest is OI2 and if the supply of money is reduced from OM to OM2 , the interest would increase from OI2 to OI3 . If the supply of money is increased from OM2 to OM4 , the interest could decrease from OI2 to OI4 .
