Keynes identified three motives for holding cash: Transaction (for daily needs), Precautionary (for emergencies), and Speculative (to take advantage of future interest rate movements). "Inflationary Motive" is not a component of this theory.

The IS (Investment-Saving) curve shows combinations of interest rates and output where the goods market is in equilibrium (Investment = Saving). The LM curve represents the Money Market.

The Classical Theory posits that interest is the reward for saving (abstinence) and the price paid for the use of capital (investment). It is a real phenomenon determined by real factors: Saving (Supply) and Investment (Demand).

Real Interest Rate represents the true purchasing power gained from an investment. It subtracts the erosion of value caused by inflation from the nominal rate (Fisher Equation approximation).

In a Liquidity Trap, prevailing interest rates are low and savings rates are high, making monetary policy ineffective. Investors expect interest rates to rise in the future (bond prices to fall), so they hoard cash to avoid capital losses.

This theory (Neo-Classical) improved upon the Classical theory by including monetary factors like bank credit and hoarding alongside real factors like saving and investment.

In a liquidity trap, people are willing to hold any amount of money supplied by the central bank (demand curve is horizontal/flat) because opportunity costs are near zero. Injecting more money doesn't lower rates further or stimulate spending.

Expansionary fiscal policy shifts the IS curve to the right. This increases output (Income). However, higher income increases money demand, which pushes up interest rates (assuming money supply is fixed). Thus, both Y and r increase.

Fisher Equation: Real Interest Rate ˜ Nominal Interest Rate - Inflation Rate. 8% - 3% = 5%.

Sir John Hicks and Alvin Hansen developed the IS-LM model to summarize Keynesian economics, integrating the real (Goods) and monetary (Money) markets.

Expectations Theory explains the term structure of interest rates (Yield Curve), positing that long-term rates are an average of current and expected future short-term rates.

Speculative demand arises from the desire to hold cash to take advantage of future changes in bond prices. When interest rates are high, bond prices are low, so people buy bonds (low cash holding). When rates are low, bond prices are high, so people sell bonds and hold cash (high cash holding), anticipating rates to rise. Thus, it has an inverse relationship.

The Classical theory viewed interest purely as a real phenomenon (savings vs investment). The Neo-Classical Loanable Funds theory recognized that the supply of loanable funds also comes from monetary sources like new money created by banks (credit) and dis-hoarding of cash, not just real savings.

The Fisher Effect states that the Real Interest Rate is independent of monetary measures. Therefore, if expected inflation rises by 1%, the Nominal Interest Rate will also rise by 1% to keep the Real Rate constant.