Bonds, the speculative motive and the liquidity trap

People can keep their wealth as money or as bonds. A bond is a paper that promises fixed payments in the future. Its price today is its present value: future payments, discounted at the market interest rate.

Example: a bond pays ₹20 after one year and ₹220 after two years. At an interest rate of 10%, it is worth 20 ÷ 1.1 + 220 ÷ 1.1² = 18.18 + 181.82 = ₹200. If the rate rises to 12%, the same payments are worth only about ₹193.

So bond prices move opposite to interest rates: when rates rise, bond prices fall.

The speculative motive. If people expect interest rates to rise, they expect bond prices to fall, which would mean a capital loss on bonds they hold. So they sell bonds and hold money instead.

• When the interest rate is low, people expect it to rise, so they want to hold a lot of money: speculative demand is high.
• When the rate is very high (r max), everyone expects it to fall, so they all hold bonds: speculative demand is zero.

So speculative demand for money is inversely related to the interest rate.

At a very low floor rate (r min), everyone expects rates to rise and wants to hold only money. Any extra money is simply held, and the interest rate does not fall further. This is the liquidity trap: the demand for money becomes infinitely elastic.

Total demand for money = transaction demand + speculative demand.