Liquidity Preference
Keynes's theory that people prefer holding liquid cash over illiquid assets, which determines the equilibrium interest rate.
What is Liquidity Preference?
Liquidity preference theory, developed by John Maynard Keynes in The General Theory of Employment, Interest and Money (1936), holds that interest rates are determined by the interaction of the money supply (set by the central bank) and the public's demand for liquid money balances. Keynes identified three motives for holding money rather than interest-bearing assets: the transactions motive (to fund day-to-day purchases), the precautionary motive (to cover unexpected expenses), and the speculative motive (to remain flexible to buy bonds when prices fall). When aggregate demand for liquidity exceeds supply, interest rates rise to restore equilibrium; when the central bank expands the money supply, rates fall. The theory underpins the IS-LM model and modern monetary policy transmission analysis.
Example
During the March 2020 COVID-19 market panic, investors liquidated bonds, stocks, and even gold to hold cash — a surge in liquidity preference. The Federal Reserve responded by flooding markets with liquidity through asset purchases and emergency lending, driving short-term rates toward zero to satisfy elevated demand for safe, liquid assets.
Source: Keynes, J.M. — The General Theory of Employment, Interest and Money (1936)