What is Liquidity Preference Theory?

Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings.

According to this theory, which was developed by John Maynard Keynes in support of his idea that the demand for liquidity holds speculative power, investments that are more liquid are easier to cash in for full value. Cash is commonly accepted as 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 greater time frames than medium or longer-term securities. 

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Liquidity Preference Theory

How Does Liquidity Preference Theory Work?

Liquidity preference theory suggests that investors demand progressively higher premiums on medium and long-term securities as opposed to short-term securities.

Consider this example: a three-year Treasury note might pay a 2% interest rate, a 10-year treasury note might pay a 4% interest rate and a 30-year treasury bond might pay a 6% interest rate. For the investor to sacrifice liquidity, they must receive a higher rate of return in exchange for agreeing to have the cash tied up for a longer period of time.

Key Takeaways

  • Liquidity preference theory refers to money demand as measured through liquidity.
  • John Maynard Keynes mentioned the concept in his book The General Theory of Employment, Interest, and Money (1936), discussing the connection between interest rates and supply/demand.
  • In real-world terms, the more quickly an asset can be converted into currency, the more liquid it becomes.

Understanding Liquidity Preference 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.

First, 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, stakeholders have a high demand for liquidity to cover their short-term obligations, such as buying groceries, paying rent and/or the mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those day-to-day needs. 

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

Third, stakeholders may also have a speculative motive. When interest rates are low, demand for cash is high and they may prefer to hold assets until interest rates rise. The speculative motive refers to an investor's reluctance to tying up investment capital for fear of missing out on a better opportunity in the future.

When higher interest rates are offered, investors give up liquidity in exchange for higher 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.