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Liquidity preference

Liquidity preference is an economic theory advanced by John Maynard Keynes in his 1936 work The General Theory of Employment, Interest, and Money, positing that the demand for money as a liquid asset—rather than its supply alone—fundamentally determines the rate of interest by reflecting agents' willingness to forgo interest-bearing investments amid uncertainty.^[1]^[2] Keynes identified three motives underlying this preference: the transactions motive, driven by the need for cash in routine exchanges; the precautionary motive, arising from anticipated but unpredictable expenditures; and the speculative motive, stemming from expectations about future bond prices and interest rates, which leads agents to hold money when anticipating capital losses on fixed-income securities.^[3]^[4] This framework inverted classical loanable funds theory, emphasizing money demand's responsiveness to interest rates and psychological factors like confidence, thereby linking liquidity preference to broader macroeconomic dynamics such as employment and output fluctuations.^[2]^[5] While influential in post-World War II policy, the theory has faced empirical scrutiny, with evidence on its interest elasticity of money demand varying across regimes and often weaker than predicted, prompting refinements or alternatives from monetarist and Austrian perspectives that stress supply-side or intertemporal choice factors over speculative hoarding.^[6]^[7]

Historical Development

Pre-Keynesian Antecedents

The demand for money in pre-Keynesian monetary theory primarily centered on the transactions motive, where individuals and firms hold cash balances to facilitate exchanges rather than for speculative or precautionary reasons emphasized later. Irving Fisher's quantity theory, articulated in The Purchasing Power of Money (1911), formalized this as Md = PT/V, with money demand proportional to the price level (P) and transaction volume (T), divided by velocity (V), reflecting a functional need for liquidity in a barter-avoiding economy without explicit interest sensitivity.^[8] The Cambridge cash-balance variant, advanced by Alfred Marshall in the 1870s and formalized by A.C. Pigou in A History of the Bank of England (1917), reframed it as Md = kPY, where k represents the desired ratio of money to nominal income (Y), implying agents voluntarily retain a fraction of resources in liquid form to span payment intervals, though k was treated as stable and independent of interest rates.^[8] Earlier insights into non-transactional holdings appeared in analyses of uncertainty and hoarding. Henry Thornton, in An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), described how diminished "confidence between man and man" during commercial distress prompts a shift toward more liquid money forms, such as notes over bills, elevating liquidity preference amid fears of capital losses and linking it to market interest rates versus money's own-rate.^[9] This anticipated precautionary elements, as agents hoard to mitigate risks, though Thornton framed it within credit cycles rather than as a determinant of the pure rate of interest, which he viewed as real and productivity-driven.^[10] In the late 19th and early 20th centuries, extensions incorporated speculation and uncertainty. Robert Giffen, in Stock Exchange Securities (1877), linked asset price volatility to fluctuations in money demand, suggesting speculative activity draws funds into cash during anticipated downturns, prefiguring Keynes' speculative motive without positing it as interest-setting.^[11] Frederick Lavington, in The English Capital Market (1921), explicitly analyzed money holdings as a "reserve against uncertainty," where economic agents prefer liquid assets to buffer unpredictable outflows, emphasizing precautionary demand over mere transactions.^[11] Alfred Marshall, in Money, Credit and Commerce (1923), further integrated liquidity into interest theory by viewing short-term rates as influenced by the "economizing of capital," including cash management, though subordinated to real factors like time preference.^[11] These antecedents, rooted in the Banking School's endogenous money views (e.g., Thomas Tooke and the 19th-century debates), recognized liquidity's role in circulation and crisis but treated interest primarily as equilibrated by saving and investment productivity, not money's asset demand.^[11] Unlike Keynes' synthesis, pre-Keynesian frameworks lacked a unified schedule where liquidity preference directly governs interest as the price of money hoarding, often assuming velocity constancy or exogenous money supply.^[5]

Keynes' Formulation in the General Theory (1936)

In The General Theory of Employment, Interest, and Money, published in February 1936, John Maynard Keynes introduced liquidity preference as the demand for money held in cash form rather than interest-bearing assets, positing it as a key determinant of the interest rate alongside the money supply.^[1] Keynes rejected classical views that interest primarily rewards abstinence from consumption or equates to the marginal productivity of capital, instead arguing that the interest rate emerges from the equilibrium between the fixed quantity of money supplied by monetary authorities and the varying demand for money driven by agents' preference for liquidity.^[12] This formulation, detailed primarily in Chapters 13 ("The General Theory of the Rate of Interest") and 15 ("The Psychological and Business Incentives to Liquidity"), frames liquidity preference as a functional relationship—a "schedule"—linking the quantity of money demanded to the prevailing interest rate, typically downward-sloping because higher rates increase the opportunity cost of holding non-yielding cash.^[12]^[13] Keynes decomposed liquidity preference into three distinct motives, each contributing to the overall demand for money. The transactions motive arises from the need to facilitate routine purchases of goods and services, varying proportionally with income levels and relatively stable in the short run, as agents require cash to bridge the gap between income receipts and expenditures.^[5] The precautionary motive reflects a desire to hold idle balances against uncertain future contingencies, such as unexpected expenses or income shortfalls, with its magnitude influenced by economic instability and the availability of credit markets; Keynes noted that organized banking reduces but does not eliminate this demand.^[12] The speculative motive, unique to Keynes' innovation, stems from agents' assessments of future bond prices and interest rates: when current rates are expected to rise (implying falling bond prices), individuals hoard money to avoid capital losses, amplifying demand at low rates; conversely, anticipated rate declines prompt shifts to bonds for capital gains.^[5]^[13] Collectively, these motives yield a liquidity preference schedule where money demand falls as interest rates rise, since higher rates incentivize converting cash to interest-yielding assets, though speculative behavior introduces volatility tied to expectations of future rates.^[1] The equilibrium interest rate, per Keynes, is that level at which the money supply exactly matches aggregate liquidity preference, with no tendency for agents to alter their portfolios en masse.^[12] If money supply exceeds desired holdings at the current rate, agents buy bonds, driving rates down until equilibrium; excess demand prompts bond sales, raising rates. This mechanism underscores Keynes' emphasis on money's store-of-value function over its medium-of-exchange role in interest determination, challenging quantity theory assertions that velocity adjustments fully accommodate money supply changes without rate effects.^[14] Liquidity preference thus integrates psychological factors—conventions, uncertainty, and animal spirits—into monetary analysis, rendering interest endogenous to expectations rather than exogenously fixed by real factors alone.^[1]

Core Theoretical Elements

Motives for Liquidity Preference

Keynes identified three primary motives for the demand for money as an asset, or liquidity preference: the transactions motive, the precautionary motive, and the speculative motive.^[13] These motives explain why individuals and businesses hold cash balances rather than fully investing in interest-bearing assets, with the transactions and precautionary motives primarily dependent on the level of income and economic activity, while the speculative motive varies inversely with the rate of interest.^[13] The transactions motive arises from the need to hold cash to bridge the time interval between the receipt of income and its expenditure on consumption and business transactions.^[13] This motive is subdivided into an income motive for personal expenditures and a business motive for dealers to cover the gap between purchases and sales.^[13] Its magnitude depends on the absolute level of income and the time lags in payment cycles, remaining largely independent of interest rates, as the opportunity cost of holding money for routine transactions is minimal compared to the convenience of liquidity.^[13] The precautionary motive involves holding cash reserves to meet unforeseen contingencies, such as sudden expenditures or advantageous buying opportunities, and to cover fixed obligations where borrowing might be costly or uncertain.^[13] This motive is strengthened by the degree of uncertainty in economic conditions and the availability of credit, but like the transactions motive, it correlates more closely with income levels than with interest rates.^[13] Keynes noted that organized markets reduce but do not eliminate this demand, as liquidity provides psychological security against variability in cash flows.^[13] The speculative motive, unique in its sensitivity to interest rates, stems from uncertainty about the future course of bond prices and yields, prompting holders to retain cash to profit from anticipated declines in interest rates (which increase bond values) or to avoid losses from rises.^[13] For instance, if current long-term rates are low, expectations of stability or further declines heighten the preference for money over bonds, as the potential gain from rate changes must outweigh the yield forgone.^[13] This motive dominates interest rate determination, as it renders the aggregate demand for money a decreasing function of the rate, with higher rates reducing the appeal of idle cash balances.^[13]

The Liquidity Preference Schedule and Interest Determination

The liquidity preference schedule, denoted as the function L(r), where r is the rate of interest, represents the total quantity of money that the public desires to hold at alternative interest rates, assuming a given level of income and output. This schedule slopes downward because a higher interest rate elevates the opportunity cost of holding non-interest-bearing money relative to interest-yielding assets like bonds, thereby reducing the amount of money demanded, particularly for speculative motives.^[1]^[12] The schedule comprises the transactions demand, which varies positively with income (L_1(Y)), and the precautionary and speculative demands, which respond inversely to r (L_2(r)), yielding the aggregate form M^d = L(Y, r) with \partial L / \partial r < 0.^[15] Interest rates equilibrate the money market by adjusting to align the liquidity preference schedule with the exogenously fixed money supply M^s, controlled by the monetary authority, such that M^s = L(Y, r).^[1] The money supply curve is vertical, reflecting its inelasticity to interest rate changes in Keynes's framework, while shifts in liquidity preference—due to changes in expectations about future rates or uncertainty—alter the schedule's position, prompting r to rise or fall to restore equality.^[12] For instance, heightened speculative demand during economic uncertainty steepens the schedule, elevating equilibrium r unless offset by increased M^s.^[16] This mechanism positions liquidity preference as the primary determinant of short-term interest rates, inverting classical views by treating r as a monetary phenomenon responsive to money demand rather than real productivity or thrift.^[6] Empirical representations often depict the schedule graphically, with r on the vertical axis and money holdings on the horizontal, intersecting the vertical M^s line at the equilibrium rate.^[15]

Formal Representations and Extensions

Keynesian IS-LM Integration

John Hicks formalized the integration of Keynes' liquidity preference theory into a graphical framework known as the IS-LM model in his 1937 paper "Mr. Keynes and the 'Classics': A Suggested Interpretation," published in Econometrica. This model synthesizes the goods market equilibrium (IS curve, representing investment-saving balance) with the money market equilibrium (LM curve, derived from liquidity preference equating money demand to a fixed money supply). Hicks portrayed liquidity preference as the mechanism determining the interest rate, contrasting it with classical views where interest equilibrates saving and investment directly, emphasizing instead the role of money demand motives—transaction, precautionary, and speculative—in influencing nominal interest rates under conditions of uncertain expectations. The LM curve specifically emerges from Keynes' liquidity preference schedule, plotting combinations of real income (Y) and the interest rate (r) where money demand equals money supply (M^s / P, with P as the price level). Money demand (L(Y, r)) rises with Y due to higher transaction and precautionary motives, necessitating an increase in r to curb speculative holdings of money (as higher rates make bonds more attractive relative to idle cash balances), thereby restoring equilibrium.^[17] This upward-sloping LM relation implies that for a given money supply, expansions in income pressure interest rates upward, reflecting the inverse relationship between speculative liquidity preference and r as outlined in Keynes' Chapter 15 of The General Theory (1936). Hicks assumed a fixed money supply and price level for simplicity, rendering the LM curve positively sloped in (Y, r) space. In the full IS-LM equilibrium, liquidity preference interacts with the IS curve (derived from I(r) = S(Y), where investment falls with r and saving rises with Y) to yield simultaneous solutions for Y and r. Hicks demonstrated that shifts in liquidity preference—such as increased speculative demand amid uncertainty—shift the LM curve leftward, elevating r and potentially contracting Y if IS is downward-sloping, highlighting monetary policy's role in offsetting demand deficiencies. Keynes critiqued Hicks' static representation in correspondence (e.g., March 31, 1937), noting it underemphasized dynamic income effects on liquidity preference and savings, yet the framework became canonical for analyzing short-run macroeconomic adjustments.^[18] Empirical applications, such as post-World War II policy simulations, relied on this integration to model how central bank money supply adjustments influence r via liquidity preference elasticities.^[5] Post-Keynesian economists extended Keynes' liquidity preference theory by embedding it within a broader framework of fundamental uncertainty, endogenous money supply, and portfolio choices under non-ergodic conditions, where future outcomes cannot be probabilistically forecasted based on historical data. Unlike neoclassical refinements that sought equilibrium stability, these developments emphasized liquidity preference as a dynamic driver of asset allocation and financial fragility, influencing capital accumulation and investment financing without assuming full employment or market clearing.^[19]^[5] Hyman Minsky, a prominent Post-Keynesian, refined the speculative motive by linking liquidity preference to the financial instability hypothesis, positing that economic expansions erode margins of safety as agents shift from hedge to speculative and Ponzi financing, increasing vulnerability to liquidity shocks. In this view, liquidity preference determines asset prices through conventions—shared beliefs about future values—rather than rational expectations, amplifying boom-bust cycles as rising asset prices reduce the perceived need for liquid holdings until a "Minsky moment" triggers a rush for liquidity. Minsky argued that Keynes' liquidity preference underpins the valuation of capital assets, with interest rates reflecting not just money demand but the economy's tolerance for illiquidity amid evolving debt structures.^[20]^[21] Fernando Cardim de Carvalho generalized liquidity preference into a theory of asset choice, integrating it with capital accumulation where firms' liquidity holdings finance irreversible investments under uncertainty, rather than relying solely on external funds. This approach posits that liquidity preference hierarchies—preferences for money over other assets—shape long-term interest rates and growth paths, with banks accommodating demand endogenously but subject to regulatory and profitability constraints. Carvalho's framework highlights how distributional factors, such as wealth concentration, influence aggregate liquidity demand, challenging marginal productivity theories of interest.^[19]^[22] Tracy Mott's contributions further refined the theory by connecting liquidity preference to wealth distribution, arguing that interest rates emerge from the bargaining power of asset holders versus borrowers in a monetary production economy. Post-Keynesians like Mott critiqued orthodox extensions for ignoring money's role as a store of value under Knightian uncertainty, instead building models where shifts in liquidity preference propagate through balance sheets, affecting output without neutral long-run effects. Empirical applications, such as analyses of corporate liquidity hoarding post-2008, support these refinements by showing precautionary motives dominating amid volatile expectations.^[23]^[24] In endogenous money contexts, Post-Keynesians reconcile liquidity preference with horizontalist banking views: while households and firms demand liquidity for transactions and precaution, banks supply deposits to meet loan demands, with interest rates adjusting via central bank policy and liquidity premia rather than fixed money stocks. This avoids Keynes' potential indeterminacy in the General Theory by treating liquidity preference as a constraint on credit expansion, not its determinant, yet retains its centrality for explaining short-run fluctuations and crises.^[25]^[5]

Empirical Evaluation

Early and Historical Tests

Early evaluations of liquidity preference theory relied heavily on qualitative and observational evidence from the Great Depression, where heightened uncertainty led to increased hoarding of liquid assets. In the U.S., businesses demonstrated elevated liquidity preference by accumulating cash reserves; for instance, the top one percent of firms held unusually high ratios of liquid assets to receipts during 1930s downswings, thereby reducing funds available for investment and consumption.^[26] Banks similarly shifted toward greater liquidity preference between 1931 and 1933, with excess reserves rising sharply as institutions prioritized safety over lending, often countering Federal Reserve efforts to expand credit.^[27] These patterns aligned with Keynes' speculative motive, as economic distress amplified the desire for money as a store of value, contributing to persistent low short-term interest rates near zero despite monetary injections—a phenomenon interpreted as a liquidity trap.^[28] However, such observations faced immediate scrutiny from monetarist perspectives, which emphasized supply-side failures over demand-driven preference; Milton Friedman, for example, argued in analyses of the period that the Federal Reserve's contraction of high-powered money, rather than insatiable liquidity demand, primarily prolonged the downturn, rendering the trap concept empirically peripheral.^[29] Empirical support for the trap itself drew from correlations between money supply growth and stagnant rates, but lacked rigorous econometric isolation of speculative hoarding from other factors like banking panics.^[30] In the postwar era, initial quantitative tests emerged through rudimentary econometric estimations of the money demand function L(Y, i), central to liquidity preference, using U.S. data from the 1920s onward. Studies of yield curves across business cycles revealed consistent spreads—such as long-term government yields averaging 100 basis points above 91-day Treasury bills—attributable to risk aversion favoring short-term liquidity to avoid capital losses, with transaction costs further reinforcing the preference (e.g., higher fees for long-term trades).^[31] Developments in the 1940s and 1950s, including early macroeconomic models like those incorporating the LM curve, provided frameworks to estimate interest elasticity of money demand, often confirming negative responsiveness to rates and supporting Keynesian predictions, though results varied with data periods and assumptions about velocity stability.^[29] These efforts, while innovative, were limited by data scarcity and model simplicity, paving the way for later refinements but highlighting challenges in disentangling transaction, precautionary, and speculative motives.^[5]

Modern Econometric Studies and Challenges

Modern econometric analyses of liquidity preference have increasingly focused on indirect tests via term structure models and money demand stability, leveraging techniques such as cointegration and survey-based expectations to address identification issues inherent in Keynes' framework. For instance, Yoon and Neupane (2024) applied cointegration tests to U.S. interest rate spreads between long-term corporate bond yields and the Federal Funds Rate from 1960 to 2023, revealing structural shifts since the 1980s driven by financial intermediaries' leverage ratios, consistent with liquidity preference influencing long-term rates through endogenous risk perceptions.^[32] Similarly, Dewachter and Maes (2015) used survey forecasts of interest rates to evaluate the liquidity preference hypothesis (LPH) for term premiums, finding partial support for monotonic increases in premiums with maturity but rejecting strict LPH due to varying risk aversion across horizons.^[33] Vector autoregression (VAR) models and generalized method of moments (GMM) have been employed to disentangle transaction, precautionary, and speculative motives, often incorporating financial innovation variables. A 1999 study by Longstaff tested LPH via nonparametric estimation of ex ante bond returns across maturities from 1926 to 1995, concluding that while short-term premiums align with liquidity risks, long-term deviations challenge the hypothesis's universality, attributing inconsistencies to time-varying investor sentiment.^[34] Post-2008 crisis applications, such as those examining zero lower bound episodes, have used dynamic stochastic general equilibrium (DSGE) extensions to assess liquidity traps, with evidence from Japanese and Eurozone data indicating heightened precautionary demand but unstable speculative components amid unconventional monetary policies.^[35] Persistent challenges in these estimations stem from the instability of aggregate money demand functions, first documented in the 1970s and persisting despite respecifications. Financial deregulation, electronic payments, and asset substitution have eroded stable relationships between money holdings, income, and rates, as evidenced in IMF surveys of global datasets showing parameter drift and omitted variable bias in Keynesian specifications.^[8] Identification problems arise from endogeneity—liquidity preference simultaneously determines and responds to interest rates—necessitating instrumental variables that often fail robustness checks due to weak exogeneity.^[36] Moreover, the speculative motive remains elusive, relying on proxies for unobservable expectations, which introduce measurement error and multicollinearity, particularly in high-frequency data where transaction and precautionary demands dominate.^[37] These issues have led critics to argue that liquidity preference lacks robust, out-of-sample predictive power compared to rational expectations alternatives, though Post-Keynesian refinements persist in emphasizing fundamental uncertainty over quantifiable risks.^[5]

Major Criticisms

Methodological and Logical Flaws

Critics from the Austrian school, such as Murray Rothbard, argue that Keynes' liquidity preference theory commits a methodological error by aggregating individual cash-holding decisions into a macroeconomic schedule without grounding it in the purposeful actions of individuals pursuing concrete ends through time-structured production processes.^[38] This approach overlooks how individuals hold cash balances to facilitate specific plans, rather than for nebulous "speculative" motives that dominate aggregate demand as Keynes posits, leading to a holistic view detached from praxeological foundations of human action.^[38] A key logical flaw lies in the theory's treatment of the speculative demand for money, which Keynes defines as dependent on expectations of future interest rates relative to the current rate, creating a circular dependency: the current rate equilibrates current liquidity preference, yet that preference hinges on forecasts of future rates shaped by the same equilibrating mechanism.^[39] This regress fails to resolve the ultimate ground for holding idle money balances, as transaction and precautionary motives presuppose ongoing economic activity tied to real productivity, which Keynes subordinates to monetary psychology without causal linkage to intertemporal choices like time preference.^[39]^[38] Furthermore, the theory logically severs interest rates from real economic factors, positing them as a residual of money supply against liquidity preference, which contradicts the equivalence of savings and investment in any equilibrium; hoarding savings as money cannot indefinitely suppress rates without price-level adjustments that restore real savings' role in capital allocation.^[40] Methodologically, this static equilibrium framework ignores dynamic market processes where entrepreneurial discovery and capital structure adjustments continually reshape liquidity needs, rendering Keynes' schedule an ahistorical snapshot unfit for causal analysis of rate determination.^[41] Keynes' dismissal of the loanable funds theory as illusory—claiming savings do not directly influence rates but evaporate into idle balances—exhibits a non sequitur, as even if some savings are hoarded, the marginal rate must still clear the market for present goods versus future goods, incorporating both productivity and thrift irrespective of monetary form.^[39] This conflation of monetary and real analysis methodologically privileges psychological states over objective scarcity relations, a flaw compounded by the theory's inability to predict rate movements without exogenous shifts in "animal spirits," undermining its explanatory power.^[5]

Empirical Shortcomings and Lack of Verifiable Support

Empirical tests of liquidity preference theory, which posits a stable demand for money as a function of income and interest rates equilibrating with fixed money supply to determine interest rates, have repeatedly encountered instability in the underlying money demand function. A prominent example is the "missing money" episode in the United States during the early 1970s, documented by Stephen Goldfeld, where previously reliable Keynesian money demand equations overestimated actual money holdings by significant margins—up to 10-15% deviations from predicted values—due to unexplained downward shifts in velocity.^[42] This breakdown persisted despite standard variables like GDP and short-term rates, revealing structural instabilities incompatible with the theory's assumption of a downward-sloping, relatively fixed liquidity preference schedule.^[8] Financial deregulation, innovations in payment systems, and shifts in asset substitutability during the 1970s and 1980s exacerbated these issues, leading to recurrent velocity puzzles and further misses in money demand predictions across OECD economies. For instance, U.S. M1 velocity declined sharply from 1981 onward, inverting earlier trends and rendering policy rules based on stable liquidity preference unreliable for interest rate forecasting or monetary targeting. Econometric analyses, including those employing cointegration and error-correction models, confirm that unadjusted Keynesian specifications exhibit parameter instability and omitted variable bias, with interest elasticity estimates varying widely (often between -0.1 and -0.5) across subsamples and failing predictive tests out-of-sample.^[43]^[44] Cross-country evidence reinforces these shortcomings, as applications in emerging markets like Nigeria from 1970-2010 show cointegrating relations but unstable short-run dynamics and velocity, with liquidity preference parameters sensitive to inflation shocks and institutional changes, limiting the theory's universal applicability. While refinements such as Divisia aggregates—incorporating user costs and substitutability—yield more stable functions in some postwar U.S. data, these diverge from Keynes' original formulation by introducing complexities absent in the speculative and transactions motives, suggesting the core theory lacks inherent empirical robustness without external patches.^[45]^[44] Direct tests of the speculative demand component, central to liquidity preference's interest rate mechanism, fare poorly, with survey-based or term structure data indicating that expectations of capital gains/losses on bonds do not consistently dominate as equilibrators; instead, inflation expectations and real factors explain rate variations more reliably, as evidenced by vector autoregressions on bond yields showing minimal liquidity-driven premia in non-crisis periods. This pattern holds in modern contexts, where central bank balance sheet expansions post-2008 have decoupled money supply from rates without corresponding liquidity preference adjustments, further undermining verifiable causal support for the theory.^[31]

Alternative Theories

Austrian Time Preference Approach

The Austrian school of economics maintains that interest rates originate from time preference, defined as the universal human inclination to prioritize present satisfaction over equivalent future satisfaction due to inherent uncertainty and temporality. This pure time-preference theory (PTPT) asserts that the originary or natural rate of interest reflects aggregate individual valuations in intertemporal trade, where savers with lower time preference exchange current consumption for future claims, equilibrating with borrowers seeking present funds for production.^[46]^[47] Formalized by Eugen von Böhm-Bawerk in Capital and Interest (1884–1909), the theory identifies time preference as the primary cause of interest, independent of productivity differentials or monetary influences, though Böhm-Bawerk incorporated technical advantages of present goods.^[48] Later refinements by Frank Fetter (1904) and Ludwig von Mises emphasized its subjective, psychological basis, stripping away productivity elements to focus solely on valuation discounting of future goods.^[46] Murray Rothbard integrated it into a broader catallactic framework in Man, Economy, and State (1962), arguing that market interest rates manifest the social average of time preferences, coordinating the structure of production across time stages.^[49] Unlike Keynesian liquidity preference, which derives interest from the demand for money holdings—transactions, precautionary, and speculative motives—the Austrian approach views such monetary hoarding as secondary and non-causal for real rates. Increased cash balances (hoarding) may influence nominal prices or money's purchasing power but do not alter the underlying real interest rate set by time preference in the saving-investment nexus.^[38] Rothbard critiqued liquidity preference for committing a "fallacy of mutual determination," positing vague equilibria between interest and money demand rather than tracing unilinear causality from individual actions; in PTPT, time preference unilaterally determines the consumption-investment proportion, with hoarding potentially signaling shifts in that preference rather than driving rates inversely.^[38] Empirically, Austrians argue that observed positive interest rates across history—typically 2–5% in stable economies—align with persistent positive time preference, as evidenced by voluntary saving behaviors and loan market clearing without zero or negative rates absent intervention.^[46] Deviations, such as artificially low rates from credit expansion, distort capital allocation, leading to malinvestment and cycles, but the equilibrium rate reverts to time-preference levels. This framework prioritizes praxeological deduction from human action over econometric aggregates, rejecting liquidity-driven traps as illusions stemming from monetary disequilibrium rather than inherent preference rigidities.^[38]

Loanable Funds and Quantity Theory Perspectives

The loanable funds theory posits that the interest rate equilibrates the supply of savings, derived from income not consumed, with the demand for investment funds to finance capital projects.^[50] In this framework, liquidity preference plays no independent role in determining long-run interest rates, as any increase in money hoarding would temporarily depress savings but ultimately adjust through real sector clearing without persistent monetary influence.^[51] Proponents, including neoclassical economists like Dennis Robertson, argued that Keynes's liquidity preference overlooks the behavioral identity between savings and investment, treating hoarding as a veil that does not alter the real equilibrium rate set by time preferences and productivity marginal returns.^[52] Critics of liquidity preference from the loanable funds viewpoint contend that it conflates stock monetary balances with flow decisions on saving and investment, leading to an erroneous emphasis on speculative motives over intertemporal choices.^[53] Empirical observations, such as post-World War II interest rate stability amid varying money demands, were cited to support loanable funds' resilience against Keynesian instability predictions, with savings curves shifting due to income growth rather than liquidity shocks.^[54] This perspective maintains that full employment restores classical savings-investment balance, rendering liquidity preference relevant only in transitional disequilibria, not as a fundamental determinant. The quantity theory of money, as restated by Irving Fisher and later Milton Friedman, views the demand for money primarily as a transactions motive proportional to nominal income, with velocity exhibiting long-run stability independent of interest rate fluctuations.^[55] Under this approach, liquidity preference's speculative demand introduces unnecessary volatility, as money is neutral in the long run, affecting prices via the equation MV = PY rather than real interest rates, which are anchored by real factors like productivity and impatience.^[56] Fisher's separation of nominal and real rates via the Fisher equation further diminishes liquidity preference's scope, attributing any monetary influence on nominal rates to expected inflation, not inherent money-holding preferences.^[57] Quantity theorists critiqued Keynes for underestimating stable money demand functions, evidenced by Friedman's 1956 empirical work showing velocity's predictability despite interest variations, challenging the instability implied by volatile liquidity preference.^[55] In policy terms, this implies central bank control over money supply targets prices and output gaps predictably, without the liquidity trap risks central to Keynesian analysis, as hoarding dissipates through price adjustments rather than sustained low rates.^[37] Historical data from the classical gold standard era (1870–1914), where interest rates correlated more with real growth than money stock changes, bolstered quantity theory's dismissal of liquidity preference as a primary driver.^[58]

Policy Applications and Real-World Relevance

Influence on Keynesian Monetary Policy

Liquidity preference theory forms the cornerstone of Keynesian analysis of monetary policy by determining the interest rate as the price that equates the supply of money, controlled by the central bank, with the demand for money driven by transactions, precautionary, and speculative motives.^[5] In this framework, expansionary monetary policy—such as increasing the money supply—lowers interest rates by shifting the supply curve rightward, provided the liquidity preference curve (demand for money) is not horizontal. Lower rates then stimulate investment by reducing the cost of borrowing, boosting aggregate demand and output. This mechanism underpinned early Keynesian advocacy for active monetary stabilization, as seen in the 1940s-1960s when central banks like the Federal Reserve targeted interest rates to manage economic cycles, assuming a downward-sloping liquidity preference function responsive to money supply changes.^[59]^[16] However, the theory highlights inherent limits to monetary policy effectiveness, particularly when liquidity preference rises sharply due to uncertainty or expectations of falling asset prices, causing agents to hoard cash and rendering interest rates sticky at low levels.^[5] In such scenarios, the speculative demand for money dominates, and additional money injections fail to reduce rates further, as individuals prefer liquidity over bonds without requiring higher yields. This elasticity of liquidity preference implies that monetary easing can crowd into idle balances rather than lending or investment, diminishing transmission to the real economy.^[25] The concept culminates in the liquidity trap, where the liquidity preference curve becomes perfectly elastic at or near the zero lower bound on nominal interest rates—Keynes estimated around 2% for long-term bonds in 1936 conditions—making further monetary expansion impotent.^[60] Here, policy influences evaporate because agents willingly hold unlimited cash equivalents, expecting no capital losses on bonds, thus severing the link between money supply and spending. This theoretical constraint shifted Keynesian policy prescriptions toward fiscal measures, like deficit spending, to bypass monetary impotence during depressions, as monetary tools alone cannot overcome pervasive liquidity hoarding.^[61]^[62] Post-2008 applications in New Keynesian models extended this to justify quantitative easing alongside fiscal stimulus, though empirical liquidity traps remain rare and debated, with evidence from Japan's 1990s stagnation showing partial monetary efficacy via unconventional tools despite high liquidity preference.^[63]^[60] Overall, liquidity preference reframed Keynesian monetary policy from a reliable stabilizer to a conditional tool, effective in normal times but subordinate to fiscal activism in crises, influencing frameworks like the IS-LM model where LM curve shifts (monetary policy) interact with liquidity-driven interest rate dynamics.^[16] This duality persists in modern central banking, where rate targeting assumes manageable liquidity preference, but trap risks prompt hybrid approaches combining monetary accommodation with fiscal support.^[64]

Role in Liquidity Traps and Financial Crises

In Keynesian economics, liquidity preference plays a central role in liquidity traps, where the speculative demand for money becomes infinitely elastic at near-zero interest rates, rendering expansions in the money supply ineffective for stimulating investment or output. As theorized by Keynes in 1936, when interest rates approach a lower bound—historically estimated around 2% for long-term bonds but effectively zero in modern contexts—households and firms hoard cash indefinitely, anticipating further declines in asset prices and preferring liquidity over yielding assets. This absolute liquidity preference neutralizes monetary policy, as additional money is absorbed into idle balances rather than circulating to lower rates or boost spending.^[65]^[66]^[60] Empirical invocations of the liquidity trap, such as Japan's "Lost Decade" from the early 1990s, attribute persistent deflation and stagnation to elevated liquidity preference despite the Bank of Japan's zero interest rate policy and quantitative easing starting in 2001, with money velocity falling to historic lows around 0.5 by the mid-2010s. Similarly, during the 2008 global financial crisis, U.S. Federal Reserve data showed the federal funds rate at 0-0.25% from December 2008, yet broad money demand remained high amid uncertainty, contributing to debates over whether a trap fully materialized or was mitigated by unconventional tools like asset purchases totaling $4.5 trillion by 2014. Critics, including monetarists like Milton Friedman, have argued such traps are rare or irrelevant in growing economies, but Keynesian analyses maintain they underscore the limits of monetary transmission when liquidity preference dominates.^[5]^[60] In financial crises, surges in liquidity preference amplify distress through hoarding and asset fire sales, as uncertainty heightens the precautionary and speculative motives for holding cash over riskier assets. Bank-level data from the 2007-2009 subprime crisis reveal that institutions anticipating securities write-downs—averaging 10-20% of assets for affected U.S. banks—increased liquid asset holdings by up to 15%, reducing lending and exacerbating credit contractions estimated at $2 trillion globally. This behavior aligns with liquidity preference theory, where perceived default risks drive a flight to cash, lowering money velocity (from 1.8 in 2007 to 1.4 by 2009 in the U.S.) and intensifying downturns via forced liquidations.^[67]^[68]^[69] Central bank liquidity provision counters this by addressing elevated premia, with ECB empirical evidence from euro-area crises showing that a 1 percentage point rise in the liquidity premium increased bank funding costs by 20-30 basis points, but targeted operations reduced non-performing loans by 5-10% and supported GDP growth by 0.5-1% annually. Such interventions validate the theory's policy implications, prioritizing lender-of-last-resort functions to restore confidence and moderate liquidity preference spikes, though long-term efficacy depends on resolving underlying balance-sheet fragilities rather than perpetual money injections.^[70]^[71]^[72]

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(PDF) Liquidity preference Theory - Academia.edu
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[3]
[PDF] Keynesian Theory 1930s-1950s - bingweb
The three divisions of liquidity-preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e. the need of cash ...
[4]
a critical analysis of keynesian liquidity preference theory of interest
Keynes identifies the Transaction, Precautionary, and Speculative motives as fundamental for liquidity preference. These motives highlight varying reasons ...
[5]
[PDF] Liquidity preference theory revisited: to ditch or to build on it?
Keynes's liquidity preference theory states that money, not saving, is needed for economic activity, and it is a theory of interest, often seen as the demand ...Missing: empirical evidence
[6]
Liquidity Preference Theory Explained: Definition, History, and Key ...
Discover Keynes's Liquidity Preference Theory—how liquidity ... The empirical evidence for the impact of liquidity preference on interest rates is mixed.
[7]
[PDF] The Validity of Keynes' Preference for Liquidity Principle in the ...
Feb 8, 2024 · Indeed, Keynes in the General Theory considered the money supply as exogenous, without giving more details on the behavior of private banks or “ ...
[8]
[PDF] Survey of Literature on Demand for Money: Theoretical Empirical ...
The roots of the modern theory of money demand began to implant from the early contributions of Leon Walras whose money demand theory is simply a part of his ...
[9]
[PDF] The nature of money and the theory of international trade: Thornton ...
The preference for more or less liquid forms of money depends on the “degree of confidence between man and man existing at the several seasons” (Thornton 1939, ...
[10]
Henry Thornton and the Development of Classical Monetary ... - jstor
7 Liquidity preference also depended on the difference between the market rate of interest and the own rate of interest on notes or bills (1978, 92, 94). Page 4 ...
[11]
[PDF] Where does Keynes' liquidity preference theory come from?
Jun 22, 2009 · It originated in his earlier works on the origin of economic depressions and criticism of policies of British banks. However, in the twenties, ...
[12]
Chapter 13. The General Theory of the Rate of Interest
As a rule, we can suppose that the schedule of liquidity-preference relating the quantity of money to the rate of interest is given by a smooth curve which ...
[13]
Chapter 15. The Psychological and Business Incentives To Liquidity
John Maynard Keynes The General Theory of Employment, Interest and Money. Chapter 15. The Psychological and Business Incentives To Liquidity.
[14]
The Liquidity-Preference Theory of Interest - jstor
Keynes's liquidity-preference theory of interest is that the interest rate is determined ... The General Theory of Employment, Interest, and Money ...
[15]
Theory of Liquidity Preference - Corporate Finance Institute
According to Keynes General Theory, the short-term interest rate is determined by the supply and demand for money. Holding money is the opportunity cost of ...
[16]
Full article: Interpretation of Chapter 17 of The General Theory and ...
There is thus a “schedule of liquidity-preference” (Keynes Citation1936, 171), which is equivalent to a downward-sloping money demand curve. When there is ...
[17]
Derivation of the LM curve
Jul 31, 1996 · The LM curve, "L" denotes Liquidity and "M" denotes money, is a graph of combinations of real income, Y, and the real interest rate, r, such that the money ...
[18]
Keynes's March 31, 1937 Message to Hicks About the IS-LM Model
Apr 11, 2018 · Keynes then told Hicks that “present income has a predominant effect in determining liquidity preference and savings that it does not possess in ...
[19]
POST-KEYNESIAN DEVELOPMENTS OF LIQUIDITY ...
The Post-Keynesian way to approach liquidity preference is, thus, to generalize it into a theory of asset choice and capital accumulation, along the lines set ...
[20]
[PDF] The Financial Instability Hypothesis: A Clarification
Minsky, Hyman P. Ph.D., "The Financial Instability Hypothesis: A ... 1937b) Keynes treated liquidity preference as determining the price level of capital and.
[21]
[PDF] Macroeconomics meets Hyman P. Minsky: the financial theory of ...
In conformity with Keynes, Minsky applied the convention approach (explicated in Keynes's chapter 12) to the liquidity preference theory of asset price (from ...
[22]
Liquidity preference, capital accumulation and investment financing
Liquidity preference, capital accumulation and investment financing: Fernando Carvalho's contributions to the Post-Keynesian paradigm · Author · Abstract.
[23]
Post-Keynesian liquidity preference theory four decades later
Nov 1, 2023 · In this piece, I look back at Mott's contribution to our understanding of liquidity preference, taking account of developments in Post Keynesian thought over ...
[24]
A liquidity preference approach to nonfinancial corporate liquid ...
Mar 20, 2024 · This paper examines the long-run pattern of the US nonfinancial corporate sector's liquid financial asset holdings in the period from 1951 to 2018.
[25]
[PDF] The role of liquidity preference in a framework of endogenous money
Abstract: In this paper we build a simple, almost pedagogical, Keynesian model about the role of liquidity preference in the determination of economic ...
[26]
The Role of Business Liquidity During the Great Depression ... - jstor
In 1930s downswings the top one percent of firms acquired unusually high ratios of liquid assets to receipts, thus withdrawing funds from the spending stream.
[27]
[PDF] CREDIT CHANNEL OR BANK LIQUIDITY PREFERE
The evidence shows there was a shift in bank liquidity preference in the U.S. during 1931-1933, a movement which at various points ran counter to the thrust of ...
[28]
Monetary Policy in Deflation: The Liquidity Trap in History and Practice
Jan 11, 2021 · The incomplete and erratic recovery from the Great Depression can be traced to a failure to pursue consistently expansionary policy resulting ...
[29]
[PDF] NBER WORKING PAPER SERIES THE GENERAL THEORY OF ...
For the GT, the econometric developments of the 1940s and 1950s provided a quantitative framework for showcasing Keynes's ideas and for developing a full ...<|control11|><|separator|>
[30]
[PDF] NBER WORKING PAPER SERIES LIQUIDITY TRAPS
The U.S. experience during the Great Depression and the Great Recession is the central empirical counterpart to the theoretical analysis in this review. We ...
[31]
[PDF] WHY LIQUIDITY PREFERENCE EXISTS
Similarly, death benefits may be regarded as con- strained short-term liabilities. 18 The empirical evidence that has been brought to bear on the issue of bias.
[32]
Liquidity Preference, Interest Rate Spread, and the Transformation ...
Oct 11, 2024 · This article examines empirical patterns of interest rate spreads between yields on long-term corporate bonds and the Federal Funds Rate ...
[33]
Testing the liquidity preference hypothesis using survey forecasts
This paper uses a novel approach to test the liquidity preference hypothesis for the term structure of interest rates. Instead of using bond returns as the ...
[34]
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[35]
[PDF] Testing the Liquidity Preference Hypothesis using Survey Forecasts
The liquidity preference hypothesis states that the premium increases monotonically with maturity. Fama (1984) found empirical evidence for the liquidity.
[36]
Assertion without Empirical Basis: An Econometric Appraisal of ...
... liquidity preference" for 1921-55; their treatment of the interdependence of money, income, prices, and interest rates; and their use of phase-average data.
[37]
[PDF] The Keynesian Challenge to the Quantity Theory
The demand function for money has a particular empirical form. —corresponding ... liquidity function expressing the demand for M2, Keynes and his fol-.
[38]
(2) “Liquidity Preference” - Mises Institute
For the Keynesians consider the rate of interest (a) as determining investment and (b) as being determined by the demand for money to hold “for speculative ...
[39]
Keynes's errors in the liquidity preference versus loanable funds ...
Aug 6, 2025 · How Keynes could have been so persistently wrong in the liquidity preference versus loanable funds controversy remains a puzzling enigma.
[40]
The Loanable Funds Fallacy in Retrospect - Duke University Press
The theory of liquidity preference is probably the single most controver- sial of the core constituents of John Maynard Keynes's General Theory. (1936).
[41]
The Keynesian Liquidity Trap: An Austrian Critique
Oct 17, 2015 · This paper critiques the Keynesian liquidity trap from an Austrian perspective. The liquidity trap theory argues that at a given interest rate ...Missing: school | Show results with:school
[42]
International evidence on misspecification of the standard money ...
Goldfeld, 1976. Stephen M. Goldfeld. The case of the missing money. Brookings Papers on Economic Activity, 3 (1976), pp. 683-730. Crossref Google Scholar.
[43]
[PDF] Is Money Demand Really Unstable? Evidence from Divisia Monetary ...
Jan 3, 2022 · The study found evidence of stable money demand, especially with broad Divisia money, which outperformed simple sum measures.
[44]
[PDF] testing the validity of keynesian liquidity preference theory
The essence of this study is to test the validity of Keynesian Liquidity Preference theory as well as the velocity of money demand in Nigeria using annual time ...
[45]
None
Below is a merged summary of the Pure Time-Preference Theory of Interest (PTPT) in Austrian Economics, combining all the information from the provided segments into a concise yet comprehensive response. To maximize detail and clarity, I’ve organized key information into tables where appropriate, while retaining narrative sections for conceptual explanations. All unique details from each segment are included.
[46]
https://cdn.mises.org/The%20Pure%20Time-Preference%20Theory%20of%20Interest_2.pdf
[47]
Eugen von Böhm-Bawerk - Econlib
Economists have accepted both as valid reasons for positive time-preference. But Böhm-Bawerk's third reason—the “technical superiority of present over future ...
[48]
https://www.econlib.org/library/Enc/bios/BohmBawerk.html
[49]
Loanable funds theory versus liquidity preference theory
This paper argues that from a formal point of view there are no differences between the loanable funds and the liquidity preference theories of interest.
[50]
(PDF) Liquidity Preference Theory or Loanable Funds Theory
Oct 23, 2021 · In Keynes's approach, interest rates are driven up by rises in demand for money and scaled down by rises in money supply. On the contrary, this ...
[51]
Keynes's errors in the liquidity preference versus loanable funds ...
As a result, he regarded the two theories as “radically opposed” and thought that the loanable funds theory was a “wrong” theory with misleading policy ...
[52]
Liquidity Preference and Loanable Funds : Stock and Flow Analysis
Before concluding this section of the paper it might be well to digress on the relationship between the conclusion just reached and Keynesian monetary theory.
[53]
Keynesian vs. Loanable Funds Theory - EconomicsKey.com
Unlike Keynes, the loadable funds theory does not accept Ole notion that shifts in liquidity preference can affect the long-run equilibrium rate of interest.<|separator|>
[54]
[PDF] 1 “Quantity Theory of Money” by Milton Friedman In The New Palgrave
A frequent criticism of the quantity theory is that its ... a downward sloping liquidity-preference diagram with the nominal quantity of money on the.
[55]
20.1 The Simple Quantity Theory and the Liquidity Preference ...
Due to the speculative motive, real money balances and interest rates are inversely related. When interest rates are high, so is the opportunity cost of holding ...
[56]
Irving Fisher Demolishes the Loanable-Funds Theory of Interest
Aug 7, 2019 · Sometimes the Fisherian theory of the rate of interest is juxtaposed with the Keynesian theory by contrasting the liquidity preference theory ...
[57]
The Demand for Money: Quantity Theory vs. Keynesian Approach
The Quantity Theory links money supply to price levels, while the Keynesian approach sees demand as more complex, influenced by interest rates and expectations.
[58]
[PDF] Liquidity Preference and Monetary Policy Author(s)
Even if the risk of a rise in interest rates is no greater at low rates than at high, the compensation for bearing that risk approaches zero as the interest ...
[59]
How has Keynes's liquidity trap theory held up over time? - Econlib
Aug 17, 2019 · 1. Keynes believed the effective lower bound for long-term government bonds was about 2%; modern Keynesians correctly understand that long-term ...
[60]
The limits of monetary policy: from the liquidity trap to the zero lower ...
Apr 24, 2023 · This article analyzes the limits of monetary policy from a theoretical perspective. The analysis parts from Keynes's theory presented in the ...
[61]
Why did John Keynes believe that monetary policy to be less ...
Oct 19, 2020 · John Keynes believe that monetary policy to be less effective than fiscal policy for stabilising the level of economic activity, particularly in a recession.<|separator|>
[62]
Expectations-Driven Liquidity Traps: Implications for Monetary and ...
Jan 9, 2020 · We study optimal monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent ...
[63]
[PDF] Is There a Fiscal Free Lunch in a Liquidity Trap?
Aug 6, 2012 · Abstract. This paper uses a DSGE model to examine the effects of an expansion in government spending in a liquidity trap.
[64]
1. The Keynesian liquidity trap: an Austrian critique1 - ElgarOnline
Keynes famously argued that the interest rate is determined by liquidity preference, or the demand for money. Interest, according to Keynes, is the. “reward for ...
[65]
Liquidity Trap Defined: A Keynesian Economics Concept - ThoughtCo
Jan 31, 2020 · A liquidity trap is marked by the failure of injections of cash by the central bank into the private banking system to decrease interest rates.
[66]
Bank Liquidity Hoarding and the Financial Crisis: An Empirical ...
Jan 28, 2013 · I find that banks held more liquid assets in anticipation of future losses from securities write-downs.
[67]
Liquidity risk and bank performance during financial crises
We find robust evidence that liquidity risk hurt bank performance during the subprime crisis of 2007–09. An increase in liquidity risk reduced a bank's survival ...
[68]
[PDF] Liquidity Hoarding and the Financial Crisis: An Empirical Evaluation
This paper studies the main determinants of bank liquidity hoarding during the recent financial crisis. Consistent with theoretical explanations for the ...
[69]
The macroeconomic effects of liquidity supply during financial crises
Nov 28, 2024 · We provide empirical evidence for the effectiveness of liquidity policy by studying the causal effect of the liquidity premium on banks' funding ...
[70]
The macroeconomic effects of liquidity supply during financial crises
Dec 2, 2024 · We provide empirical evidence for the effectiveness of liquidity policy by studying the causal effect of the liquidity premium on banks' funding ...
[71]
Liquidity Preference - an overview | ScienceDirect Topics
The liquidity preference theory states that the yield curve should almost always be upward sloping, reflecting bondholders preference for the liquidity and ...<|separator|>