Liquidity Preference refers to the additional premium which holders of wealth or investors will require in order to trade off cash and cash equivalents in exchange for those assets that are not so liquid. Among these might be government bonds, stocks, or real estate.
It is the basis of a theory in economics known as the liquidity preference theory. The theory goes a step further in suggesting that the investors will want a greater interest rate level on any investments that have longer-dated maturities. This is because such securities will necessarily have a larger amount in time factor and interest rate level risks. The idea states the following: if all else is equal, sensible investors would rather hold cash or similarly liquid assets, given the choice.
There are several good reasons for why investors have such a preference, but one of them is most critical to understanding the motivation behind it. This is that any investments which are quickly liquidated will be far simpler to sell rapidly at full value. It explains why the theory states that shorter term securities’ interest rates will generally be less since the investors are giving up a smaller amount of prized liquidity than they would by instead buying into the longer-dated or medium-dated debt securities.
It was the great interwar British economist John Maynard Keynes who first utilized the concept of Liquidity Preference. His understanding of the phrase centered on the important relationship between the amount of funds members of the public would hold and the associated interest rate. Keynes believed that there are only three reasons that consumers hold on to money. They need it for regular transactions. They also have to maintain some on the side in case of unusual and beyond normal budget expectations kinds of unforeseen costs. Finally, they need it for any speculative ventures. Keynes theorized that the amount of speculative cash they kept would have an inverse relationship to the then current interest rates.
The most crucial idea in Keynes’ concept holds that when the interest rates are low enough, money supply increases will no longer foster extra investment from the consumers. Instead, the speculative balances of individuals would attract this money. The reason for this would be that the rates of interest were simply too little to persuade cash holders to trade in their cash on hand in lieu of assets that were really far less liquid. The consumers have a feeling that lower interest rates will have to go back up at some point in the coming future. This liquidity preference idea was a cornerstone in Keynes attempts to make sense of the long and painful 1930’s decade-long, global depression.
Since the end of the Keynesian era in economics, education, and public policy, the categories which cover liquid assets have necessarily been significantly expanded. The dismal science of economics now connects the demand of consumers for money to a far larger number of different variables. Among these are the many competing additional means of holding wealth and the associated intrinsic yields to them. The interest rate as well as the individuals’ income level also plays a part in determining their behaviors ultimately with cash like equivalents.
It is always helpful to consider a real world tangible example to better understand the concept of Liquidity Preference. In the world of debt securities, investors will always require a gradually greater premium (or interest rate) on first medium maturity then longer maturity debt securities than they would on shorter maturity debt securities. In one example, a three year dated Treasury note could pay one percent interest, while the ten year example could pay two percent and the thirty year Treasury bond could offer four percent. For the Treasury bonds’ investors to agree to give up their liquidity for longer, they will insist on a greater interest rate return in lieu of tying up their funds for a sometimes substantially longer amount of time.