Liquidity Preference Theory

What Is Liquidity Preference Theory?

Liquidity Preference Theory is a model that proposes that an investor ought to demand a higher interest rate or premium on securities with long-term maturities that carry greater risk since, any remaining factors being equivalent, investors favor cash or other highly liquid holdings.

How Does Liquidity Preference Theory Work?

Liquidity Preference Theory proposes that investors demand dynamically higher premiums on medium and long-term securities rather than short-term securities. As per the theory, which was developed by John Maynard Keynes in support of his thought that the demand for liquidity holds speculative power, liquid investments are more straightforward to cash in for full value.

Cash is usually accepted as the most liquid asset. As indicated by the liquidity preference theory, interest rates on short-term securities are lower since investors are not forfeiting liquidity for greater time periods than medium or longer-term securities.

Special Considerations

Keynes presented Liquidity Preference Theory in his book The General Theory of Employment, Interest and Money. Keynes depicts the theory in terms of three motives that determine the demand for liquidity:

1. The transactions motive states that people have a preference for liquidity to guarantee having adequate cash close by for fundamental everyday necessities. At the end of the day, stakeholders have a high demand for liquidity to cover their short-term obligations, like buying food and paying the rent or mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those everyday necessities.
2. The precautionary motive connects with a singular's preference for extra liquidity in the event that an unforeseen problem or cost arises that requires a substantial outlay of cash. These events incorporate unanticipated costs like house or vehicle repairs.
3. Stakeholders may likewise have a speculative motive. When interest rates are low, demand for cash is high and they might like to hold assets until interest rates rise. The speculative motive alludes to an investor's hesitance to tying up investment capital for fear of missing out on a better opportunity later on.

At the point when higher interest rates are offered, investors surrender liquidity in exchange for higher rates. For instance, on the off chance that interest rates are rising and bond prices are falling, an investor might sell their low paying bonds and buy higher-paying bonds or hold onto the cash and hang tight for an even better rate of return.

Illustration of Liquidity Preference Theory

A three-year Treasury note could pay a 2% interest rate, a 10-year treasury note could pay a 4% interest rate and a 30-year treasury bond could pay a 6% interest rate. For the investor to sacrifice liquidity, they must receive a higher rate of return in exchange for consenting to have the cash tied up for a longer period of time.

Highlights

• Liquidity Preference Theory alludes to money demand as estimated through liquidity.
• John Maynard Keynes referenced the concept in his book The General Theory of Employment, Interest, and Money (1936), examining the association between interest rates and supply-demand.
• In true terms, the more rapidly an asset can be changed over into currency, the more liquid it becomes.