Liquidity Preference Theory

This post is not necessarily a blog entry or op-ed, but rather a brief stream of consciousness on Keynes Liquidity Preference Theory. Why do I want to write about this topic? I think it’s fascinating, and the implications of the Federal Reserve’s recent quantitative easing(QE3) can be observed within Keynes framework (a blog entry for another day.)

What is Liquidity Preference Theory? Essentially it expounds upon the demand for money. We can observe an equilibrium in the market for money easily by using Keynes method. The framework revolves around three basic factors: the supply of money, interest rates, and the demand for money.

The opportunity cost of holding money is the interest rate. By holding money, you are giving up on the interest rate you could be receiving from a variety of investment options. When the interest rate goes up, your opportunity cost rises, thus decreasing the demand for money. Individuals respond to incentives. When the interest rate rises, people will be less likely to hold funds. The opposite concept also applies. When the interest rate falls, the demand for money rises. People just want to keep their capital. That process is essentially what liquidity preference is all about. Just like the name implies, individuals will have a preference to maintain liquidity(cash/money.)