Liquidity Preference Theory

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LIQUIDITY PREFERENCE THEORY

Definition (also called liquidity preference hypothesis)

Observation that, all else being equal, people prefer to hold on to cash (liquidity) and that they will demand a premium for investing in non-liquid assets such as bonds, stocks and real estate.

The theory suggests that the premium demanded for parting with cash increases as the period (term) for getting the cash back increases.

The rate in the increase of this premium, however, slows down with the increase in term.

Liquidity means the convenience of holding cash. Liquidity preference means desire to hold cash.

Everyone in this world likes to have money with him for a number of purposes. This constitutes his demand for money to hold.

According to Keynes, demand for money or liquidity preference is based on three motives:

1. Transactions motive

People like to hold some cash in order to meet their daily expenses in the interval between the receipt of income and its expenditure. The cash held by people under this motive depends upon the level of income and business activity. The transactions motive is income elastic, but interest inelastic.

2. Precautionary motive

Everyone lays something against a rainy day. Future is always uncertain. Hence people require cash to meet unforeseen contingencies like unemployment, sickness, accident etc. the demand for this motive depends on the level of income and the nature of the people. This motive is also income elastic, but interest inelastic.

3. Speculative motive

This motive relates to the demand for money to earn profits. Future is uncertain and unpredictable. Rate of interest in the market continues changing. No one can guess what turn the change will take. But everybody hopes with confidence that his guess is likely to be correct. It may or may not be so. Some money therefore is kept to speculate on these probable changes to earn profit. The demand for cash for the two...
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