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Liquidity preference theory is a classical model that proposes that an investor should mandate a higher interest rate or premium on securities with long-term maturities that are prone to high risk. Liquidity preference means the desire of the community to hold cash.

Overview of Theory Of Liquidity Preference

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The theory of liquidity preference was developed by world renowned economist, John Maynard Keynes. This theory was published in his book ‘The General Theory of Employment, Interest and Money’, to support his idea that speculative power has a major influence on demand for liquidity. Liquid investments are easier to cash in for full value. The most widely accepted liquid asset is referred to as cash. According to this theory, the short-term liquidity fetches a lower interest rate as investors here are not risking it for longer duration of time.

The motivating factor for an investor, when related to his investments for a longer period, has to be a higher rate of interest. And in fact, this is what generally most of the banks offer on deposit slabs these days. A three yer bond scheme may pay a interest rate of 2% and a 10 year bond might pay an interest rate of 4% and a 30 year treasury bond might pay a 6 percent rate of interest, or more.

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What you’ll learn:

Theory Of Liquidity Preference DefinitionOverview of Theory Of Liquidity PreferenceLiquidity Preference Theory driversLiquidity Preference theory and interest rates

Liquidity Preference Theory drivers

To determine the drivers of liquidity demand, Keynes classified different motives that drive the liquidity choices of an investor:

  • Transactions motive: Stakeholders prefer having liquid cash in hand to cover their short-term obligations, like daily transactions. The amount of liquidity depends on individual’s level of income, spending behavior, etc.  
  • Precautionary motive: The demand for precautionary liquidity refers to an individual’s preference to hold additional liquidity in order to address unforeseen or uncertain expenditure. These situations require a substantial outlay of cash. This could include health emergencies, breakdown of utilities, the other incidents, which are not recurring in nature.
  • Speculative motive: The speculative motive takes advantage of future changes in the interest rates of economy as a whole. When there is a fall in interest rates, eventually, the demand for cash flow increases, and investor may not be willing to invest and prefer to hold on to his assets until he sees a rise in interest rates. Speculative motive refers to an investors unwillingness to invest at the moment.

Liquidity Preference theory and interest rates

Interest rates significantly impact liquidity preference. When there is increased money supply in the market, or more cash available, consumption increases. This increase in demand creates a supply, demand mismatch leading to inflation. In response to this, central banks absorb the increased cash flow by using REPO auctions. On the other hand, when there is a liquidity crunch and demand is low central banks conduct reverse repo auctions to balance liquidity.

Some of these actions could lead to what economists call a liquidity trap.It refers to a situation where interest rates are no longer influenced to by fluctuations in money supply. It is an extreme effect of monetary policy and changes in money supply.

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Keynes theory signifies by integrating the theory of interest with the general theory of output and employment. Employment is subject to the level of investment and investment is influenced apart from marginal efficiency of capital, by the rate of interest. Keynes has combined the theory of interest with the theory of price. Interest is the value of money. Money is categorized as a commodity, itself. So, like the price of any commodity, it is also determined by the demand for and supply of money.

Critique of the Theory of Liquidity Preference

  • Indeterminate:

The theory of liquidity preference is indeterminate or unspecified as it fails to consider the different levels of income. This is an important factor which is very important in mapping the liquidity curve.

  • Narrow Version:

The theory provides little explanation on its influence on rate of interest. Rate of interest too gets influenced by various other important factors like rate of savings, level of income, inclination to consume, and marginal efficiency.

  • Complicated concept:

The theory has emphasized on a uniform system of liquidity which is not acceptable. The rate of interests on various loans differ from time to time. In actual practice, there are different degrees of liquidity, which is not taken into consideration while developing this theory.

  • Biased:

This theory is essentially one-sided and therefore cannot be universal. It lays more prominence on liquidity preference i.e., demand side and completely overlooks the investigation on factors related to supply side.

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