This theory was developed by John Maynard Keynes in support of his idea that the demand for liquidity holds speculative power; investments that are more liquid are easier to cash in for full value. The theory suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings. According to the liquidity preference theory, interest rates on short-term securities are lower because investors are not sacrificing liquidity for greater time frames than medium or longer-term securities. This means investors demand progressively higher premiums on medium and long-term securities as opposed to short-term securities.
Keynes describes the liquidity preference theory in terms of three motives that determine the demand for liquidity (i.e. reasons for holding money):
- Transactions Motive: This states that individuals have a preference for liquidity (holding money) in order to guarantee having sufficient cash in hand for basic day-to-day needs. In other words, individuals have a high demand for liquidity to cover their short-term obligations, such as buying foodstuff, paying rent, transport fare, etc. Higher costs of living mean a higher demand for cash/liquidity to meet day-to-day needs.
- Precautionary Motive: This relates to an individual’s preference for additional liquidity in the event that an unexpected problem or cost arises that requires a substantial outlay of cash. These events include unforeseen costs like house or car repairs, hospital bills, etc.
- Speculative Motive: When interest rates are low, demand for cash is high and individuals may prefer to hold assets until interest rates rise. The speculative motive refers to an investor’s reluctance to tying up investment capital for fear of missing out on a better opportunity in the future.