What is Liquidity Preference Theory? Definition, Diagram and Liquidity Trap- The Investors book

And this theory gives immense importance to the liquidity factor of investment. According to this theory, short-term investments provide a lower interest rate because they provide liquidity to investors. Moreover, medium and long-term investments lead to higher interest rates because of their illiquid nature.

This results in a normal yield curve forming into a flat one. In other words, bond investors generally prefer short-term bonds and will not opt for a long-term debt instrument over a short-term bond with the same interest rate. Investors will be willing to purchase a bond of a different maturity only if they earn a higher yield for investing outside their preferred habitat, that is, preferred maturity space. However, bondholders may prefer to hold short-term securities due to reasons other than the interest rate risk and inflation. This theory argues that forward rates represent expected future spot rates plus a premium.

liquidity preference theory yield curve

The interest rate applicable for the returns is fixed and is known as a coupon rate. However, the yield keeps changing even when the interest rate remains constant. This is because Treasuries’ price constantly fluctuates in the trading market. The slopes as formed help analysts and investors understand the performance of the short-term and long-term investments, compare them, and accordingly make wiser investment decisions. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid.

L is a liquidity preference function if and if , where r is the short-term interest rate and Y is the level of output in the economy. Usually, factors like low inflation, depressed risk appetites, and slower growth support the price performance of long-term bonds. While higher inflation, elevated risk appetites, and higher inflation cause the yield to rise. Together, all these factors help to shape the direction of the long-term bonds. The second question is relevant when assessing to what extent monetary policy can be blamed for causing the crisis, notwithstanding if it was reasonable from an ex ante perspective.

Pure expectations theory

The demand for this type of money increases as the income level increases. The amount of liquidity desired depends on the level of income, the higher the income, the more money is required for increased spending. Keynes makes the rate of interest independent of the demand for investment funds.

liquidity preference theory yield curve

According to the Theory of Liquidity Preference, the short-term interest rate in an economy is determined by the supply and demand for the most liquid asset in the economy – money. The concept, when extended to the bond market, gives a clear explanation for axitrader review the upward sloping yield curve. Since investors strictly prefer liquidity, in order to persuade investors to buy long-term bonds over short-term bonds, the return offered by long-term bonds must be greater than the return offered by short-term bonds.

Conclusion of the liquidity preference theory

In such a situation, investors should aim for higher interest rates because short-term investments are more liquid than medium or long-term investments. Simply put, interest rates directly indicate the price of the money. Therefore, other things remaining constant, demand and supply of money determine the interest rate. We find that the transmission of liquidity traps depends critically on the nature of international financial markets. When financial markets are complete, and preferences are identical, all countries experience a liquidity trap simultaneously, because natural real interest rates are in that case equated across countries. Fiscal policy is a powerful tool to respond to a liquidity trap, but its use depends on a negative spillover to foreign markets, and generating large terms of trade depreciation.

For example, we can replace US Long Credit in our modified portfolio with Emerging Market Debt and achieve approximately the same end result in factor space. Mäki’s notion of realism is not the same as the concept general philosophy of science has formed on realism as the most tenably construed. In order to understand the dissimilarity it is insufficient to refer to how the naïve and the refined forms differ.

Also, the country with a higher level of asymmetric information about investment productivity attracts more FDI relative to FPI as the marginal benefits from private information are larger. The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model).

D) inflation is starting to increase, or is expected to do so in the near future. For example, Let’s take US Treasury that offers bond with a maturity of 30 years. The higher return would be the effect of the liquidity premium.

  • These advancements allow investors to take full advantage of the extra degrees of freedom a factor investing approach allows for.
  • The yield curve at any maturity simply depends on the supply and demand for loans at that maturity.
  • It depicts the relationship between interest rates and the amount of money people want to keep.
  • When the money supply increases with constant money demand, the rate of interest decreases and vice-versa.
  • As a result, the interest rate will begin to fall from OR1 until it reaches the equilibrium interest rate.

Notwithstanding many criticisms of the Liquidity Preference Theory, it is useful for identifying the effect of demand and the supply of money on interest rates. It shows the relationship between the motives of people with income and interest rates. It also asserts that monetary policy is not effective in the economy because of a liquidity trap during the depression in the economy.

The Theory of Liquidity Preference and an Upward Sloping Yield Curve

The yield difference between the two is called “spread.” A general rule of thumb is closer the yields, the more confident the investors are in the other bond. Also, the spread usually widens during recessions and contracts during an economic recovery. In an inverted-shaped yield curve, short-term yields are more than long-term yields. A Duke University professor in the 1990s found the development of inverted yield curves before the last five U.S. recessions.

In other words, stakeholders have a high demand for liquidity to cover their short-term obligations, such as buying groceries and paying the rent or mortgage. Higher costs of living mean a higher demand for cash/liquidity to meet those day-to-day needs. Short-term investors can make a profit by reading the shape of the curve and then adjusting their positions based on that. However, predicting how the yield curve may change is a very difficult task. The most commonly used yield curve compares three-month, two-year, five-year, 10-year, and 30-year U.S.

The yield at each maturity is independent of the yields at other maturities. We see, thus, that according to liquidity preference theory, the rate of interest is purely a monetary phenomenon. Productivity of capital has very little, though indirect, say in determining the rate of interest. How the rate of interest is determined by the equilibrium between the liquidity preference for speculative motive and the supply of money is shown in Fig. According to Keynes, the demand for money, i.e., the liquidity preference, and supply of money determine the rate of interest.

Yield Curve Theories

When the yield for shorter maturities is higher than the yield for longer maturities, the yield curve slopes downward and the graph looks inverted. An increase in the money supply leads to, temporarily, higher income levels and employment but in the long run, this only increases the rate of inflation. John Maynard Keynes created bdswiss review the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. Now if the supply of money decreases to M1S1, then LP curve cuts supply curvy at E2.

When the medium-term investment is likely to yield more than expected from both short-term and long-term securities, a humped curve emerges. Such curves are finexo review rare but indicate a slow and inactive economy. Speculative demand is the demand to take advantage of future changes in the interest rate or bond prices.

Individuals save money to cover the costs of illness, accidents, unemployment, and other unanticipated events. Businessmen must also keep cash on hand to satisfy their immediate demands, such as payments for raw goods, transportation, and labor. Therefore, this approach gives the liquidity component of investment a lot of weight.

B) exists when intermediate-term bonds have higher yields than either short-term or long-term bonds. C) rewards long-term investors for the additional risk they are assuming. D) generally results from actions by the Federal Reserve to control inflation.

Full BioRobert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital. He also said that money is the most liquid asset and the more quickly an asset can be converted into cash, the more liquid it is. We discussed the 5 theories of the term structure of interest rates.