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What Is Liquidity choice Theory?
Liquidity preference Theory is a design that argues that an investor should demand a greater interest rate or premium ~ above securities with irreversible maturities that lug greater hazard because, all other determinants being equal, investors choose cash or other highly liquidholdings.
Liquidity choice Theory describes money need as measured with liquidity.John Maynard Keynes discussed the concept in his book The general Theory that Employment, Interest, and also Money (1936), discussing the connection between interest rates and also supply-demand.In real-world terms, the more quickly an asset have the right to be converted into currency, the more liquid it becomes.
just how Does Liquidity choice Theory Work?
Liquidity preference Theorysuggests that investors demand progressively greater premiums top top medium and also long-term securities as opposed to temporary securities. According to the theory, i beg your pardon was arisen by john Maynard Keynes in support of his idea that the demand for liquidity holds dangerous power, liquid investments are easier to cash in for full value.
Cash is typically accepted together the many liquid asset. Follow to the liquidity choice theory, interest rates on short-lived securities space lower since investors room not sacrificing liquidity for higher time frames than medium or longer-term securities.
KeynesintroducedLiquidity choice Theory inhis book The general Theory of Employment, Interest and also Money. Keynes defines the theory in regards to three motives that determine the demand for liquidity:
The transactions motive states that individuals have a preference for liquidity to insurance having sufficient cash on hand for basic day-to-day needs.In various other words, stakeholders have actually a high demand for liquidity come cover their momentary obligations, such as buying groceries and paying the rent or mortgage. Greater costs that living median a greater demand for cash/liquidity to satisfy those day-to-day needs.The precautionary motiverelates to an individual\"s preference for extr liquidityif one unexpected difficulty or expense arises that needs a an extensive outlay of cash. These events incorporate unforeseencosts like residence or car repairs.Stakeholders may also have a speculative motive.When interestrates are low, demand for cash is high and also they may prefer to hold assets until interest rates rise. The speculative motive refers to an investor\"s reluctance to tying up investment capital for fear of absent out on a far better opportunity in the future.
When greater interest prices are offered, investors provide up liquidity in exchange for higher rates. As an example, if interest rates are rising and also bond prices space falling, an investor might sell their low payment bonds and buy higher-paying bond or organize onto the cash and wait because that an even far better rate that return.
example of Liquidity choice Theory
A three-year Treasury note could pay a 2% attention rate, a 10-year treasury note might pay a 4% attention rate and a 30-year treasury bond might pay a 6% attention rate. Because that the investor to sacrifice liquidity, they have to receive a greater rate the return in exchange for agreeing to have the cash bound up for a longer period of time.
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