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What is the 'Liquidity Preference Theory'

The liquidity preference theory suggests that an investor demands a higher interest rate, or premium, on securities with long-term maturities, which carry greater risk, because all other factors being equal, investors prefer cash or other highly liquid holdings. Investments that are more liquid are easier to sell fast for full value. According to the liquidity preference theory, interest rates on short-term securities are lower because investors are sacrificing less liquidity than they do by investing in medium-term or long-term securities.

!--break--Investors demand progressively higher premiums on medium-term and long-term securities as opposed to short-term securities. Consider this example: A three-year Treasury note might pay 2% interest, a 10-year treasury note might pay 4% interest and a 30-year treasury bond might pay 6% interest. In order for the investor to be willing to sacrifice more liquidity, he must be offered a higher rate of return in exchange for agreeing to have his cash tied up for a longer period of time.

The Theory

World-renowned economist John Maynard Keynes was the first to introduce the liquidity preference theory in Chapter 13 of his book The General Theory of Employment, Interest and Money. According to Keynes, individuals value money for, “the transaction of current business and its use as a store of wealth.” For this reason, Keynes purports that they tend to relinquish interest earnings on their money in order to spend their money in the present. He also suggests that these individuals prefer to keep their money on hand as a precautionary measure. Keynes also theorizes that when higher interest rates are offered, individuals are more willing to hold on to less money in order to obtain a profit.

The Three Motives

As Keynes describes the liquidity preference theory, he explains three motives that determine the demand for liquidity.

The transactions motive refers to the fact that individuals have a preference for liquidity in order to guarantee having sufficient cash on hand for basic transactions because income is not always readily available. With this motive, the level of an individual’s income determines that amount of liquidity that is demanded; higher income levels equal a demand for more money to accommodate increased spending.

The precautionary motive is related to individuals' preference for liquidity as additional security in the event that an unexpected occasion or problem arises that requires a substantial outlay of cash.

Individuals may also have a speculative motive, based on the belief that bond prices may begin to significantly decrease, thus offering the investor the opportunity to use liquid funds to make an investment offering a more attractive rate of return. Basically, the speculative motive refers to investors' general reluctance to commit to tying up investment capital in the present for fear of missing out on a better opportunity in the future.

BREAKING DOWN 'Liquidity Preference Theory'

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