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According to the liquidity preference theory, investors prefer to keep their money liquid -- or as cash -- and they demand interest in return for sacrificing their liquidity.

Investors will pay more for short-term debt and the liquidity that comes with it. They’ll also look for higher interest rates before taking on longer-term debt.

For example, say an investor can choose between a 3-year Treasury note that pays 1 percent interest, a 10-year Treasury note that pays 3 percent, and a 30-year bond that pays 4 percent.

By choosing the 3-year note, he’ll have faster access to his money. But the other choices provide higher interest rates in exchange for less liquidity.

Famed 20th century economist John Maynard Keynes first wrote about the theory. Keynes believed people hold money for three reasons:

  1. To conduct everyday transactions, such as paying rent and bills.
  2. As a precaution for unforeseen expenses, such as unemployment or sickness.
  3. To use for speculation – to have in liquid form to take advantage of favorable changes in interest rates.

Keynes theorized the amount of money investors hold varies inversely with the rate of interest – if rates decrease, they’ll hold more money until rates increase.

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