Liquidity Preference Theory

Liquidity preference theory is John Maynard Keynes's explanation of how interest rates are determined. It holds that the rate of interest is the reward for giving up liquidity: the price that persuades people to hold their wealth in bonds or other assets instead of in money, which can be spent at once. The rate settles where the public's demand to hold money equals the quantity of money available, so in this view interest is a monetary phenomenon rather than simply the result of saving and investment.

Keynes set out the theory in The General Theory of Employment, Interest and Money (1936). He divided the demand for money into three motives: the transactions motive, the precautionary motive and the speculative motive. The theory is a building block of Keynesian economics, underpins the idea of the liquidity trap, and remains a standard part of teaching on interest rates and monetary policy.

Most people keep some cash or an easy-access account even though it earns little. They need it to pay the bills, they want a cushion in case something goes wrong, and sometimes they hold off buying investments because they think a better moment is coming. Each of these reasons is a preference for liquidity: the comfort of having money you can use right away.

Interest is what it takes to coax people out of that comfort. If everyone wants to hold more cash, borrowers must offer higher interest to get it; if people are happy to part with cash, rates can fall. Liquidity preference theory says this tug of war, not just the balance of saving and borrowing, sets the price of money.

Transactions motive

The transactions motive is the need to hold money to cover ordinary payments between one income receipt and the next: wages, rent, shopping and business bills. It rises with income and spending, because a larger economy has more payments to make. Keynes treated it as largely insensitive to interest rates. Later work by William Baumol (1952) and James Tobin (1956) showed that it does respond somewhat, since at higher rates people and firms economise on idle balances.

Precautionary motive

The precautionary motive is the wish to keep money aside for unexpected needs or opportunities, such as illness, job loss, a broken machine or a bargain. It also tends to rise with income, and it rises with uncertainty: in recessions and crises households and firms hold larger cash buffers. Modern liquidity management by banks and companies reflects the same idea.

Speculative motive

The speculative motive is the decision to hold money instead of bonds because the holder expects interest rates to rise. Since bond prices fall when rates rise, someone who expects higher rates can avoid a capital loss by waiting in cash. This part of money demand depends on the current rate compared with what people consider normal, so it falls as interest rates rise: higher rates increase the opportunity cost of holding money and make a later rise less likely.

In simple textbook form, real money demand combines an income-driven part and an interest-driven part:

• $M/P$ is the real quantity of money people wish to hold, equal in equilibrium to the money supply divided by the price level.
• $kY$ is transactions and precautionary demand, with $Y$ real income and $k$ the share of income held as money.
• $a - b\,i$ is speculative demand, which falls as the interest rate $i$ rises; $a$ and $b$ are positive constants.

Suppose $k = 0.2$, $Y = 1{,}000$, $a = 100$ and $b = 2{,}000$. At an interest rate of 3% money demand is $200 + (100 - 2{,}000 \times 0.03) = 240$. If the central bank raises the real money supply to 250, the rate must fall until demand rises to match: $200 + 100 - 2{,}000\,i = 250$ gives $i = 0.025$, or 2.5%. More money means lower interest, as long as people's preferences stay put.

Keynes presented the theory as a challenge to the older classical view, the loanable funds theory, in which the interest rate balances saving and investment. Dennis Robertson and others argued that the two approaches can be reconciled, since the flow of new lending and the stock of money held are linked. John Hicks's IS–LM model of 1937 combined them: the money market (liquidity preference) and the goods market (saving and investment) jointly determine output and the interest rate. In that model the quantity theory of money appears as a special case in which money demand does not respond to interest rates.

• Monetarist critique. Monetarists led by Milton Friedman argued that money demand is stable and only mildly sensitive to interest rates, so changes in money mainly affect spending and prices, and the velocity of money is predictable.
• Portfolio theory. Tobin's 1958 paper recast the speculative motive as a choice between safe money and risky bonds based on risk aversion, rather than on firm expectations of a normal rate.
• Endogenous money. Post-Keynesian economists stress that banks create deposits when they lend and central banks set short-term rates directly, so the money supply is not a fixed quantity as the basic model assumes.
• Policy practice. Today's central banks target an interest rate rather than a money stock, so money demand is accommodated at that rate. Liquidity preference still helps explain why demand for cash and deposits jumps in crises and why rates can get stuck near zero.

The theory also informs work on money markets, the liquidity premium in long-term yields and the term premium.

• John Maynard Keynes, The General Theory of Employment, Interest and Money (full text)