Liquidity Preference Theory - Explained
What is the Liquity Preference Theory?
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Table of ContentsWhat is the Liquidity Preference Theory?How did the Liquidity Preference Theory Originate?Academic Research on the Liquidity Preference Theory
What is the Liquidity Preference Theory?
Liquidity preference according to macroeconomic theory is the demand for money taken into account as liquidity. It shows the relationship between the interest rate and the quantity of money the public wishes to hold. The Liquidity Preference Theory states that the interest rate is the price for money. In simple terms, this means that when money is demanded, it is not because one wants to borrow money but money is demanded due to one's desire to remain liquid. The theory suggests that cash is the most accepted liquid asset and more liquid investments are easily cashed in for their full value.
Back to: ECONOMIC ANALYSIS & MONETARY POLICY
How did the Liquidity Preference Theory Originate?
John Maynard Keynes' liquidity preference theory concentrates on the demand and supply for money as the interest rate determinants. According to his proposition that interest rate is the price paid for borrowed money, people will rather keep cash with themselves than invest cash in assets. Hence, people have a preference for liquid cash. People also intend to save a percentage of their income. The amount that will be held in the form of cash and the amount that will be spent depends on liquidity preference. People will prefer to hold cash since it is the most liquid asset and the reward for parting with liquidity is interest, whose rate according to Keynes' is determined by the economic demand and supply of money. Here are some important things to know about liquidity preference;
- The Liquidity preference theory which was developed by John Maynard Keynes states that the interest rate is the price for money.
- This shows the relationship between the interest rate and the quantity of money the public wishes to hold.
- According to Keynes, the demand for liquidity is determined by three motives which are, transactional motives, precautionary motives and speculative motives.
- The theory suggests that cash is the most accepted liquid asset and more liquid investments are easily cashed in for their full value.
- It proposes that people will rather keep cash with themselves than invest cash in assets.
- When higher interest rates are offered, investors give up liquidity in exchange for higher rates.
According to John Maynard Keynes, the demand for liquidity is determined by three motives: Transactional motive: people prefer to have the liquidity to ensure that they can take part in necessary basic transactions because their income is not always available. Precautionary motive: people prefer to have liquidity in order to be able to meet social unexpected problems that need unusual costs. The higher the income, the higher the quantity of money demanded for this purpose. Speculative motive: in order to speculate a fall in the prices of bonds, people retain liquidity. A decrease in the interest rate results in an increase in the quantity of money demanded by people until interest rates rise.
Academic Research on the Liquidity Preference Theory