Liquidity Preference Theory

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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.

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