Theory of Liquidity Preference Definition: History, Example, and How It Works

Liquidity preference theory argues that people prefer to keep assets in a liquid form such as cash rather than in less liquid assets like bonds, stocks, or real estate. The upshot is that investors expect a greater premium for taking on a longer-term loss of liquidity.

This inclination is primarily due to the uncertainty of the future. Individuals, businesses, and investors can better navigate unforeseen financial and economic changes, especially during crises, by holding liquid assets.

There's a tradeoff, however, between holding cash that offers liquidity but no returns versus bonds that provide interest or returns but are less liquid. The interest rate is effectively the reward that investors demand to part with liquidity and hold less liquid assets like bonds.

Liquidity preference theory says that interest rates adjust to balance the desire to hold cash against less liquid assets. The more people prefer liquidity, the higher interest rates must rise to make them willing to hold bonds. The theory views interest rates as a payment for parting with liquidity.

How Does Liquidity Preference Theory Work?

Liquidity preference theory was developed by John Maynard Keynes. It aims to explain how interest rates are determined. The key premise is that people naturally prefer holding assets in liquid form so they can be quickly converted into cash at little cost. The most liquid asset is money.

Interest rates provide an incentive for people to overcome their liquidity preference and hold less liquid assets like bonds, according to the theory. Bonds provide interest income but are less liquid than cash because they can't immediately be converted to money. The more illiquid a bond, the more incentive people will need in terms of its interest rate.

The theory holds that interest rates are determined by the supply and demand for money for this reason. People want to hold more cash, decreasing the money supply and reducing bond prices. when liquidity preference is high. Interest rates have to rise as an incentive for giving up this liquidity to match this preference. A lower liquidity preference conversely means that people are willing to hold more bonds, increasing the money supply and lowering interest rates.

Who Was John Maynard Keynes?

John Maynard Keynes was an influential 20th-century British economist. His groundbreaking 1936 work, The General Theory of Employment, Interest, and Money, challenged conventional economic wisdom and laid the foundation for modern macroeconomic theory.

His economic theories are collectively termed Keynesian economics. They fundamentally changed how governments and financial institutions perceive and respond to economic crises and helped shape postwar economic thinking. He championed the idea that government intervention is crucial to stabilizing economies during financial downturns.

His work became the cornerstone of modern macroeconomic theory although it's been challenged often by neoclassical economists, monetarist theorists, and others over the years. Liquidity preference theory is one of his notable contributions.

Three Motives of Liquidity Preference

Keynes argued that the desire for liquidity springs from three motives: transactions, precautionary motives, and speculative motives.

• Transactions motive: This represents the need to hold cash for day-to-day transactions like buying goods and services. This demand for liquidity is fairly predictable and correlates with the income and expenses of individuals and firms: the demand for liquidity increases with income. The transaction motive is fundamental and exists regardless of the level of interest rates, emphasizing the essential role of money as a medium of exchange in daily economic activities.
• Precautionary motive: This is the urge to hold onto cash as a buffer against unexpected expenses or emergencies. Individuals might hold onto money or easily accessible funds to cover unexpected medical costs, car repairs, or other financial demands. Businesses may similarly maintain a liquidity cushion to weather unexpected operational or market challenges. The precautionary motive underlines how money is a store of value that provides a sense of security in the face of uncertainty.
• Speculative motive: This involves holding onto cash to take advantage of future investment opportunities that aren't yet available. The speculative motive tends to be more pronounced among investors and financial institutions and its intensity can vary with expectations regarding the future trajectory of interest rates, economic growth, and market conditions. People hold onto money when the nominal interest rate is low even if it provides no interest income. This changes as the interest rate ticks upward, however.

 Liquidity Preference and the Yield Curve

Liquidity preference theory has important implications for the shape and movement of the yield curve that plots interest rates across various maturities for bonds of the same credit quality.

The yield curve normally slopes upward. Long-term interest rates are higher than short-term rates. Imagine a line graph where the vertical axis is for interest rates and the horizontal axis extends time for the duration of investments. The yield curve indicates what interest rates you can earn for different lengths of time.

The graph slopes upward under normal circumstances. You'll see higher interest rates as you invest your money for longer periods. This upward slope reveals that people expect higher returns for locking their money away in long-term investments like bonds. This fits with what liquidity preference theory would suggest: individuals prefer liquidity, leading them to favor short-term securities over long-term ones.

Short-term securities provide more liquidity because they mature faster. This enables reinvestment or cashing out sooner. This higher demand for short-term bonds leads to lower short-term interest rates. Their interest rates decline as bond prices are bid higher. But these bonds must offer higher interest rates to compensate for the decrease in liquidity to entice investors toward long-term securities. This dynamic naturally steepens the yield curve.

Changes in liquidity preference can also shift the position and shape of the yield curve. The demand for short-term bonds will increase as investors flock to quality, liquid assets when liquidity preferences rise due to uncertainty or a recession. This raises short-term rates relative to long-term rates, flattening or inverting the yield curve.

The yield curve steepens as investors become more willing to invest in higher-yielding long-term bonds when liquidity preferences decline during periods of economic stability.

Liquidity Preference Theory and Investing

Liquidity preference theory provides a useful framework for investors to consider when they're making asset allocation and risk-management decisions. Investors can apply their understanding of liquidity preference to choose assets and strategies that align with their liquidity needs and risk tolerance.

Investors might increase allocations to safe and liquid assets like cash and short-term government bonds during periods of high liquidity preference such as recessions. Holding highly liquid assets provides protection and the flexibility to shift into other investments when the market changes. You might take on more risk and illiquidity through investments like stocks, real estate, or high-yield bonds when that occurs.

The theory also highlights the value of laddering strategies and planning investments to provide a steady cash flow to balance liquidity. Bond ladders with staggered maturities can provide stable cash inflows to cover liquidity needs. Cash reserve buffers also help manage liquidity risk. Investors can hold higher cash reserves when liquidity preferences rise to avoid being forced to sell illiquid assets at unfavorable prices.

Liquidity preference theory doesn't give you an ideal set of assets to buy but it provides a framework for adapting to economic conditions and your liquidity needs. Investors can apply the theory to build portfolios that are resilient across the liquidity preference cycle, combining liquid low-risk assets with higher-return illiquid assets in appropriate proportions.

Criticisms of Liquidity Preference Theory

Liquidity preference theory is influential but it's been critiqued by some economists.

One common objection is that many complex factors determine interest rates, not just liquidity preference. The approach is also said to simplify changes in interest rates to just the demand and supply of money but factors like inflation, default risk, credit risk, and the range of investment opportunities also do so.

The theory has been criticized as being too passive. It sees interest rates adapting to changing liquidity preferences rather than vice versa. Monetary policy can actively affect interest rates, however, affecting investment and consumption behavior beyond just passively responding to liquidity demand.

The empirical evidence for the impact of liquidity preference on interest rates is mixed. Some economists argue that other factors like inflation expectations play a bigger role in shaping rate changes.

Measuring liquidity preference quantitatively is also difficult. The theory may not work well in the globalized economy of the 2020s. Capital mobility allows liquidity to flow internationally to where rates are highest so national interest rates would reflect global liquidity preferences, not just domestic factors.

The Bottom Line

Liquidity preference theory attempts to explain the relationship between liquidity, interest rates, and economic stability. It highlights how individual and institutional behaviors regarding liquidity can occur within financial markets.

Liquidity preference theory originated in the work of Keynes and continues to serve as a pivotal lens through which to consider monetary economics phenomena. A grasp of liquidity preference by investors can be productive in making better asset allocation and risk-management decisions. It sheds light on how monetary policies might sway interest rates and market stability for policymakers.