What it means
Keynes argued in his 1936 book The General Theory that people hold money for three reasons. The transactions motive is the need for cash to pay everyday bills.
The precautionary motive is the wish to have a reserve for emergencies, and the speculative motive is the wish to hold cash while waiting for a better chance to buy bonds or other assets at lower prices. The speculative motive links liquidity preference to interest rates.
When interest rates are high, holding cash means giving up a lot of income, so people hold less of it and buy bonds. When rates are low, the cost of holding cash is small, and people are happier to keep their money in cash.
From this, Keynes concluded that the interest rate is set by the demand and supply of money. The central bank controls the supply, and the public's liquidity preference determines the demand, so the interest rate moves to the level where the two are equal.
If the public wants more cash, rates rise unless the central bank supplies more. The idea also explains why longer-term loans and bonds usually pay a higher yield than shorter ones.
Lenders want extra compensation for locking up their money for longer, which is known as a liquidity premium. In a crisis, liquidity preference can rise sharply, and in extreme cases people hoard cash even at near-zero interest rates, a situation called a liquidity trap.
For businesses, the concept helps explain why firms hold cash reserves, why banks charge more for longer loans, and why central bank rate cuts do not always lead to more borrowing and spending. When confidence is low, the preference for cash can overwhelm the incentive of lower rates.
Managers can use this insight when judging how customers and lenders will behave in a downturn.
In practice
Real-world examples.
Example
A company expects an uncertain year and chooses to keep $2,000,000 in cash instead of investing it in longer-term bonds. The treasurer accepts a lower return in exchange for being able to meet any bill. She regards the lost interest as the price of flexibility, like an insurance premium.
Example
A bank offers 1% on a one-year deposit and 3% on a five-year deposit. The higher rate on the longer deposit compensates savers for giving up access to their money for longer.
Example
During a financial scare, households and firms move money from shares and bonds into bank deposits and government bills. Cash balances rise sharply even though the interest paid on them is very low. Economists read this as a rise in liquidity preference, driven by fear and uncertainty.
Formula
Calculation
Money demand = transactions and precautionary demand + speculative demand. A simple version is L = k x income + (a - b x interest rate).
Suppose a firm holds 20% of its income for transactions and precaution, and its speculative holding is $50,000 minus $5,000 for each percentage point of the interest rate. With income of $1,000,000, the first part = 0.20 x 1,000,000 = $200,000. At an interest rate of 4%, speculative demand = 50,000 - 5,000 x 4 = $30,000, so total demand = 200,000 + 30,000 = $230,000. At 6%, speculative demand = 50,000 - 5,000 x 6 = $20,000, so total demand = $220,000, showing that higher rates reduce the cash held.Case study
Seen in the real world.
Oakmoor Holdings is an illustrative, fictional company that held $5,000,000 of surplus cash. The finance director was tempted to buy long-dated bonds paying 2 percentage points more than a bank deposit, but worried about needing the money.
She applied the logic of liquidity preference by asking what premium she would require for giving up access to the funds for five years. She concluded that 2 percentage points on $3,000,000, which is 3,000,000 x 0.02 = $60,000 a year, was a fair reward for locking up that part of the cash but not for tying up all $5,000,000.
In this illustrative case, the company bought bonds with $3,000,000 and kept $2,000,000 in deposits. When an unexpected opportunity to buy a competitor's equipment arose in the next year, the cash was available and no bonds had to be sold at a loss. The finance director recorded the decision and the reasoning, so that the board could review it later.
Watch out
Common mistakes.
- Thinking liquidity preference means people hoard cash for no reason, when it reflects real needs for payments, protection and flexibility.
- Assuming lower interest rates always increase spending, when a strong preference for cash can blunt the effect.
- Confusing the liquidity premium with credit risk, since the first rewards locking up money and the second rewards the risk of non-payment.
Questions
People also ask.
Who developed the theory?
John Maynard Keynes, the British economist, set it out in The General Theory of Employment, Interest and Money in 1936.
What are the three motives for holding money?
The transactions motive, the precautionary motive and the speculative motive.
What is a liquidity trap?
A situation in which interest rates are so low that extra money from the central bank is simply held as cash and does not stimulate spending or lending.
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