Liquidity Preference Theory

At The Money (ATM)

What is liquidity preference theory?

The liquidity preference theory is a model that suggests that an investor should charge a higher interest rate or premium on higher-risk long-term securities because, all other things being equal moreover, investors prefer cash or other very liquid assets.

According to this theory, developed by John Maynard Keynes in support of his idea that the demand for liquidity holds a speculative power, more liquid investments are easier to collect at full value. Money is generally accepted as the most liquid asset. According to the liquidity preference theory, interest rates on short-term securities are lower because investors do not sacrifice liquidity for longer terms than medium- or long-term securities.

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Theory of liquidity preferences

How does the theory of liquidity preferences work?

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

Take this example: a three-year treasury bill can pay an interest rate of 2%, a 10-year treasury bill can pay an interest rate of 4% and a 30-year treasury bond can pay a 6% interest rate. In order for the investor to sacrifice his liquidity, he must receive a higher rate of return in exchange for his agreement for the money to be tied up for a longer period.

Key points to remember

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

Understanding the theory of liquidity preferences

World renowned economist John Maynard Keynes introduced liquidity preference theory in his book The general theory of employment, interest and money. Keynes describes the theory of liquidity preference in terms of three reasons that drive demand for liquidity.

First the reason for transactions indicates that individuals have a preference for liquidity to ensure that they have sufficient liquidity for basic daily needs. In other words, stakeholders have a high demand for cash to cover their short-term obligations, such as buying groceries, paying rent and / or mortgage. Higher costs of living mean higher demand for cash / liquidity to meet these daily needs.

Second, the precautionary reason refers to an individual’s preference for additional cash in the event of a problem or unforeseen cost requiring large cash expenditures. These events include unforeseen costs such as home or car repairs.

Third, stakeholders can also speculative pattern. 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 block investment capital for fear of missing a better opportunity in the future.

When higher interest rates are offered, investors forgo liquidity in exchange for higher rates. For example, if interest rates go up and bond prices go down, an investor can sell their bonds at low interest rates and buy higher yielding bonds or keep cash and wait for a further rate of return. better.

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