Liquidity preference

Liquidity preference explains the interest rate as the price paid for giving up the convenience and security of holding money. Keynes distinguished money from less liquid assets because money can settle payments immediately, whereas bonds and other securities may have to be sold and can lose value. The demand for money therefore depends not only on income and the price level but also on the return expected from alternative assets.¹

In the simplest Keynesian model, the central bank or monetary authority determines the nominal money supply, while households and firms determine how much money they wish to hold. Equilibrium occurs where real money supply equals real money demand. If the supply of money rises while other conditions remain unchanged, people attempt to exchange surplus balances for bonds and other assets; bond prices rise and the interest rate falls. A shortage of desired balances produces the reverse movement.

Keynes grouped money holding into transaction, precautionary, and speculative motives. The transaction motive covers ordinary payments and tends to increase with income because a larger volume of purchases requires larger working balances. The precautionary motive reflects a desire to meet uncertain expenses, emergencies, or interruptions in receipts; it also generally rises with income and uncertainty.

The speculative motive concerns expectations about future interest rates and bond prices. When people expect interest rates to rise, they may prefer money because existing bonds would fall in price; when they expect rates to fall, they may buy bonds in anticipation of capital gains. This makes desired money holdings sensitive to expectations, not merely to current income. Keynes's framework thus connected monetary theory to asset-price expectations and to the possibility that confidence can change spending without an immediate change in income.¹

A liquidity trap is a situation in which very low interest rates make the public willing to hold additional money, weakening the usual effect of monetary expansion on rates and demand. In Keynes's formulation, expectations that rates cannot fall much further can make bonds appear vulnerable to price losses, so newly created money is absorbed into liquid balances rather than exchanged for securities. The result is a nearly horizontal portion of the money-demand schedule, often called the liquidity-preference trap.

The concept does not mean that monetary policy is always powerless at low rates. Modern analysis distinguishes the traditional money multiplier story from policies involving forward guidance, large-scale asset purchases, fiscal expansion, and changes in the interest paid on reserves. Nonetheless, liquidity preference helps explain why a central bank may find that expanding the monetary base has a muted effect when safe assets are strongly preferred and inflation expectations are subdued.²

Liquidity preference is broader than a simple preference for cash in a wallet. Keynes's money concept included highly liquid balances used for settlement, while later monetary economics separated narrow money from deposits and other near-money assets. The relevant decision is consequently about a portfolio: households and firms compare liquidity, expected return, risk, and the costs of converting assets into means of payment.

The theory also contains an important ambiguity about expectations. A rise in interest rates may reduce money demand through the opportunity cost of holding money, but a belief that rates will later fall can increase demand for bonds even before the change occurs. Later portfolio theories, including the asset-demand approach associated with James Tobin, formalized risk diversification and allowed money demand to respond to wealth as well as income. Empirical research has also shown that financial innovation and interest-bearing deposits can alter the relationship between money balances, income, and interest rates.³

Real money balances

The nominal quantity of money divided by the price level; they measure purchasing power rather than currency units alone.

Liquidity trap

A range of very low interest rates in which desired money holdings can rise substantially and conventional monetary expansion may have limited effects.

Speculative motive

The desire to hold money rather than interest-bearing assets because of expectations about future interest rates and asset prices.

Opportunity cost

The return forgone by holding money instead of an alternative asset.