Liquidity Preference
Liquidity preference is the demand for money as an asset, that is, the desire to hold wealth in the form of money rather than in less liquid assets. Introduced by John Maynard Keynes, the concept explains why people hold money even though it yields little or no return, and it links the demand for money to the interest rate, to income, and to uncertainty. The interest rate, in this framework, is the reward for parting with liquidity, and it is determined by the interaction of the demand for money and its supply.
Motives for holding money
Keynes identified three motives for holding money. The transactions motive reflects the need for cash to conduct everyday purchases, and it depends on income and on the timing of receipts and payments. The precautionary motive reflects the desire to hold money as a buffer against unexpected expenses or shortfalls in income, and it depends on the uncertainty faced by the holder. The speculative motive reflects the desire to hold money as a store of value when the returns on other assets are expected to be low or negative, and it depends on expectations about future interest rates and asset prices.
Later analysis added further motives, including the portfolio motive, in which money is held as one asset among many in a diversified portfolio, and the buffer-stock motive, in which money is held to absorb shocks between income and expenditure. The relative importance of the motives depends on the economy, on the financial system, and on the alternatives available to holders.
Relationship to the interest rate
Liquidity preference is inversely related to the interest rate. When the interest rate is high, the opportunity cost of holding money, which is the interest forgone, is large, so holders economise on money and hold interest-bearing assets instead. When the interest rate is low, the opportunity cost is small, and holders are willing to hold more money. The demand for money therefore slopes downward with respect to the interest rate.
The relationship also depends on income, which raises the transactions demand, and on expectations, which influence the speculative demand. The demand for money is often written as a function of income and the interest rate, with the elasticity with respect to income positive and the elasticity with respect to the interest rate negative. The magnitude of these elasticities determines how the demand for money responds to changes in income and interest rates.
The liquidity trap
Keynes argued that at very low interest rates, the demand for money could become perfectly elastic, a situation called the liquidity trap. When rates are so low that holders expect them to rise, and hence bond prices to fall, they prefer to hold money rather than bonds, and any increase in the money supply is absorbed by the demand for liquidity without lowering the rate further. In such a situation, monetary policy loses its ability to stimulate the economy, and fiscal policy becomes the effective instrument.
The concept of the liquidity trap has been invoked to explain the experience of economies with near-zero interest rates, where central banks have resorted to unconventional measures, including asset purchases and forward guidance, to provide stimulus. The debate about the relevance of the trap, and about the effectiveness of alternative policies, is central to the analysis of monetary policy at the lower bound.
Monetary policy implications
Liquidity preference provides the basis for the monetary transmission mechanism. A central bank that increases the money supply, or lowers the policy rate, reduces the cost of holding money and encourages holders to shift into other assets, lowering interest rates and raising spending. The strength of this channel depends on the responsiveness of the demand for money to the interest rate and on the responsiveness of spending to interest rates.
The framework also informs the choice of instruments. When the demand for money is unstable, targeting the money supply leads to volatile interest rates, and central banks have generally moved to targeting interest rates instead. When the demand for money is sensitive to the interest rate, small changes in the money supply produce large changes in rates, and the central bank must be careful in its operations. The understanding of liquidity preference is therefore essential to the conduct of monetary policy.
Money demand and velocity
The demand for money is closely related to the velocity of circulation, the rate at which money turns over in transactions. If the demand for money is high relative to income, velocity is low, and a given money supply supports a given level of nominal income. The relationship between money, velocity, and income is expressed in the equation of exchange, which states that the money supply multiplied by velocity equals the price level multiplied by real income.
The stability of the demand for money, and hence of velocity, determines whether the money supply can serve as a reliable instrument of policy. When velocity is stable, controlling money controls nominal income. When it is unstable, as it became in many economies in the 1970s and 1980s, the relationship breaks down, and central banks turn to interest rates as the instrument. The analysis of liquidity preference therefore informs the choice of policy framework.
Financial innovation and the demand for money
Financial innovation changes the demand for money by altering the alternatives available. The development of interest-bearing deposits, of money market funds, and of electronic payments reduces the cost of holding money and changes the boundaries of what counts as money. These developments blur the distinction between money and other assets and make the monetary aggregates less stable as indicators.
The growth of digital payments and of new forms of value storage continues to change the landscape. If a form of money offers convenience and safety, the demand for it rises, while if it offers low returns relative to alternatives, the demand falls. Understanding these developments is important for interpreting movements in the monetary aggregates and for assessing the transmission of monetary policy, and it requires attention to the technology and to the institutions of the payment system.
International dimensions
Liquidity preference has international dimensions, because holders can choose among currencies. Where confidence in one currency is low, holders may shift into another, altering the demand for each and affecting exchange rates. The international demand for a currency as a reserve asset and as a medium for trade gives it an additional source of demand, which affects its value and the interest rates on assets denominated in it.
The international role of currencies also affects the transmission of policy. A currency that is widely used abroad may see its monetary conditions transmitted to other economies, through trade and financial channels. These linkages mean that the analysis of liquidity preference cannot be confined to a single economy, and that the interaction of monetary policies across countries matters for the global financial system and for the stability of exchange rates.