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What is 'Liquidity Preference Theory'

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. Cash or money is the most liquid asset. According to the liquidity preference theory, interest rates on short-term securities are lower because investors are not sacrificing liquidity for as long as they would be with medium- to longer-term securities. 

Breaking Down 'Liquidity Preference Theory'

Liquidity preference theory suggests that 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, they 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 introduced liquidity preference theory in his book The General Theory of Employment, Interest and Money.

Keynes describes the liquidity preference theory in terms of three motives that determine the demand for liquidity.

The transactions motive states that individuals have a preference for liquidity in order to guarantee having sufficient cash on hand for basic day-to-day needs. In other words, people have a high demand for liquidity to cover their short-term obligations, such as buying groceries, and paying rent or the mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those day-to-day needs. 

The precautionary motive relates to individuals' preference for additional liquidity in the event that an unexpected problem or cost arises that requires a substantial outlay of cash. These include unforeseen costs like house or car repairs.

Individuals may also have a speculative motive. When interest rates are low, demand for cash is high as individuals prefer to use the cash or hold onto it until interest rates rise. 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. When higher interest rates are offered, investors will give up liquidity in exchange for the higher interest rates. As an example, if interest rates are rising and bond prices are falling, an investor may sell their low paying bonds and buy higher paying bonds, or hold onto the cash and wait for an even better rate of return.

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