John Maynard Keynes, whose Keynesian economics significantly influenced federal fiscal policies during the Great Depression in the United States, first presented the liquidity preference theory in 1935. The liquidity preference theory asserts that investors strongly prefer to maintain their funds in liquid form, such as cash or checking accounts, rather than less liquid accounts or assets, such as stocks, bonds, and commodities. In order to promote long-term investments, banks offer interest to investors to compensate for their loss of liquidity. Investors expect interest rates for longer-term investments to exceed those for short-term investments, and these expectations drive the interest rate yield of investments.
Three reasons account for the investing behavior described by the liquidity preference theory. First, since the Great Depression, people normally expect and plan for hard times, keeping some spare cash around for emergencies. Second, people need money to pay bills and engage in business. Both of these motivations are largely dependent on income levels. Finally, people want to obtain the best return possible for their money, and they do not want to miss out on a better interest rate next year by having their money tied up in a long-term bond.
When interest rates are low, investors expect them to increase. They will hold their wealth in liquid accounts for transactions and buffers against crises. They decide against purchasing bonds, believing the yield is not worth the hassle of investing. They will wait to invest until interest rates rise.
When interest rates are high, investors expect them to fall. They will maintain a minimum amount of liquid resources to cover immediate expenses. In order to lock in high interest rates, they are likely to invest in long-term bonds. The demand for money is fully offset by the desire for high yields.
Demand for money decreases the velocity of the money supply. Economists calculate money velocity by dividing the gross domestic product (GDP) by the sum of the circulating money and funds deposited in checking accounts. Increases in the nation’s production of goods and services raise money velocity and decrease demand for money. Increased money velocity correlates with lower interest rates and an increased preference in liquidity.
The liquidity preference theory is a modification of the pure expectations theory. According to the pure expectations theory, the yield for a ten-year bond should be equivalent to the yield of two consecutive five-year bonds. Liquidity preference theory points out that there should be a premium for the ten-year bond due to the lower liquidity and higher risk of default associated with the longer contract. Consequently, the yield for a ten-year bond should be higher than that of the two consecutive five-year bonds.
A yield curve is a graphical representation of interest rates for increasing investment durations. When yield is plotted on the vertical axis and duration on the horizontal axis, the conventional yield curve slopes upward and to the right, indicating progressively higher yields with longer duration investments in accordance with the liquidity preference theory. This curve is called a positive yield curve, which indicates relative stability in interest rates. Although interest rates rise with duration, the rate at which the curve climbs slows down with increasing duration. The reasons behind the deceleration of the interest rate curve include the lower volatility and sensitivity of a bond to interest rate changes over time.