Liquidity Preference Theory

AAA

DEFINITION of 'Liquidity Preference Theory'

The idea that investors demand a premium for securities with longer maturities, which entail greater risk, because they would prefer to hold cash, which entails less risk. The more liquid an investment, the easier it is to sell quickly for its full value. Because interest rates are more volatile in the short term, the premium on short- versus medium-term securities will be greater than the premium on medium- versus long-term securities. For example, a three-year Treasury note might pay 1% interest, a 10-year treasury note might pay 3% interest and a 30-year treasury bond might pay 4% interest.

BREAKING DOWN 'Liquidity Preference Theory'

Economist John Maynard Keynes describes liquidity preference theory in Chapter 13, "The General Theory of the Rate of Interest," of his famous book, "The General Theory of Employment, Interest and Money." Keynes said that people value money for both "the transaction of current business and its use as a store of wealth." Thus, they will sacrifice the ability to earn interest on money that they want to spend in the present, and that they want to have it on hand as a precaution. On the other hand, when interest rates increase, they become willing to hold less money for these purposes in order to secure a profit.

RELATED TERMS
  1. Keynesian Economics

    An economic theory of total spending in the economy and its effects ...
  2. Forward Rate

    A rate applicable to a financial transaction that will take place ...
  3. Term Structure Of Interest Rates

    The relationship between interest rates or bond yields and different ...
  4. Liquidity

    1. The degree to which an asset or security can be bought or ...
  5. Liquidity Trap

    A situation in which prevailing interest rates are low and savings ...
  6. Preferred Habitat Theory

    A term structure theory suggesting that different bond investors ...
Related Articles
  1. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  2. Options & Futures

    Understanding Financial Liquidity

    Understanding how this measure works in the market can help keep your finances afloat.
  3. Options & Futures

    Common Bond-Buying Mistakes

    Avoid these errors made daily in bond portfolios everywhere.
  4. Active Trading

    Giants Of Finance: John Maynard Keynes

    This rock star of economics advocated government intervention at a time of free-market thinking.
  5. Mutual Funds & ETFs

    ETF Analysis: U.S 12 Month Natural Gas

    Learn about the United States 12 Month Natural Gas Fund, an exchange-traded fund that invests in 12-month futures contracts for natural gas.
  6. Fundamental Analysis

    What Causes Inflation in the United States

    Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out.
  7. Term

    Understanding Net Exports

    Net exports are the difference between a country’s exports and imports.
  8. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  9. Active Trading Fundamentals

    The Top 5 Impact Investing Firms

    Learn what impact investing is and obtain information on some of the top impact investing firms ranked by total assets under management.
  10. Economics

    Leading Economic Indicators: U.S. Bureau of Labor Monthly Stats

    The Bureau of Labor Statistics' monthly employment figures are a key economic indicator. Here's how they work.
RELATED FAQS
  1. What does the yield curve actually predict?

    Technically speaking, the yield curve does not make predictions. Rather, it is just a way of representing a set of interest ... Read Full Answer >>
  2. How were nominal interest rates in the economy set before the Federal Reserve?

    Interest rates – especially nominal interest rates – are ultimately decided by individual preferences for liquidity and current ... Read Full Answer >>
  3. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  4. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  5. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bubble Theory

    A school of thought that believes that the prices of assets can temporarily rise far above their true values and that these ...
  2. Stock Market Crash

    A rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, ...
  3. Financial Crisis

    A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated ...
  4. Election Period

    The period of time during which an investor who owns an extendable or retractable bond must indicate to the issuer whether ...
  5. Shanghai Stock Exchange

    The largest stock exchange in mainland China, the Shanghai Stock Exchange is a nonprofit organization run by the China Securities ...
  6. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend. A dead cat bounce ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!