What is a Liquidity Preference?

Liquidity preference concerns the extent to which individuals prefer to be liquid in their asset holdings.

What is the Liquidity Preference Theory?

The Liquidity Preference Theory concerns the relationship between the interest rate (the price of money) and the quantity of money the public will borrow at the rate. Per the theory, people borrow money based upon their desire to remain liquid. Consistent with principles of supply and demand, how much money people demand will affect the interest rate charged for the money. 

When higher interest rates are offered, investors are forced to give up liquidity.

How did the Liquidity Preference Theory Originate?

John Maynard Keynes proposed liquidity theory as part of his research of the economic demand and supply of money. 

What Affects the Demand for Liquidity? 

According to Keynes, the demand for liquidity is determined by three motives which are: 

• transactional motives, 
• precautionary motives 
• speculative motives.

What is a Transactional Motive?

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. 

What is a Precautionary Motive?

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. 

What is a Speculative Motive?

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.

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