Liquidity preference

Definition

Liquidity preference is the demand for money as a liquid asset, where individuals prefer to hold cash or cash-equivalents instead of investing in less liquid assets. This concept emphasizes the importance of liquidity in economic decision-making, particularly in how people choose to allocate their resources based on their expectations of future economic conditions. It reflects a fundamental distinction between different economic perspectives on the role of money and interest rates in influencing overall economic activity.

5 Must Know Facts For Your Next Test

1. Liquidity preference is a key element in Keynesian economics, illustrating how individuals' desire to hold cash can affect overall economic demand.
2. The liquidity preference curve shows the inverse relationship between the quantity of money demanded and the interest rate; as interest rates rise, the demand for liquid cash decreases.
3. In times of uncertainty or economic downturns, liquidity preference tends to increase as individuals and businesses opt to hold onto cash instead of making investments.
4. Liquidity preference can lead to lower investment levels during periods of high uncertainty, which can slow down economic growth.
5. The central bank may influence liquidity preference through monetary policy, adjusting the money supply and interest rates to stabilize the economy.

Review Questions

• How does liquidity preference illustrate the relationship between money demand and interest rates?
  • Liquidity preference demonstrates that as interest rates increase, the demand for holding liquid cash decreases. This inverse relationship highlights that individuals are less willing to hold onto cash when they can earn higher returns on investments. Conversely, when interest rates fall, people prefer to hold more cash because the opportunity cost of not investing is lower, leading to an increased demand for liquidity.
• Evaluate the implications of increased liquidity preference during economic downturns on investment levels.
  • When liquidity preference rises during economic downturns, individuals and businesses tend to hoard cash instead of investing it in projects or purchasing goods. This behavior can lead to reduced levels of investment, further contributing to sluggish economic growth. The reluctance to invest exacerbates the downturn by limiting job creation and innovation, ultimately hindering recovery efforts.
• Synthesize the role of liquidity preference within Keynesian economics and its effects on monetary policy decisions.
  • Within Keynesian economics, liquidity preference is crucial in understanding how individuals react to changes in economic conditions and interest rates. High liquidity preference can prompt central banks to implement expansionary monetary policies aimed at increasing the money supply and lowering interest rates. This approach seeks to reduce the barriers associated with holding cash, encouraging spending and investment, thus stimulating overall economic activity during periods of low demand.

Related terms

Money Supply: The total amount of monetary assets available in an economy at a specific time, which influences liquidity preference and interest rates.

Interest Rate: The cost of borrowing money or the return on savings, which impacts liquidity preference by influencing people's decisions about holding cash versus investing.

Keynesian Economics: An economic theory that advocates for government intervention to manage demand and emphasizes the role of liquidity preference in determining interest rates and investment.