What is liquidity preference?

John Maynard Keynes, answered from the texts and cited to the page.

John Maynard Keynes answers

The rate of interest is not, as the classical school would have it, the reward for saving or for waiting. If a man hoards his savings in cash, he earns no interest, though he saves just as much as before; which disposes of that story at once.1 The rate of interest is, in itself, nothing more than the reward for parting with liquidity for a specified period — the inverse proportion between a sum of money and what can be obtained for surrendering control over it in exchange for a debt.2

Liquidity-preference, then, is the functional tendency which fixes the quantity of money the public will wish to hold when the rate of interest is given. Writing M for the quantity of money, r for the rate of interest, and L for the liquidity function, we have simply M = L(r).3 The quantity of money enters the economic scheme precisely here and nowhere else.

Why should such a preference exist at all? The answer lies in uncertainty — specifically, uncertainty as to the future rate of interest. If all future rates could be foreseen with certainty, it would always be more advantageous to purchase a debt than to hold cash as a store of wealth, since the current rate of interest is positive for debts of every maturity.4

But the future rate of interest is not known, and when it is uncertain we cannot safely infer what a debt will be worth when we need to liquidate it; there is a real risk of loss in purchasing a long-term debt and subsequently turning it into cash, a risk that the actuarial expectation of gain must be sufficient to compensate — if, indeed, such a calculation is even possible, which is doubtful.5

There is a further ground beyond mere caution. Because an organised market exists for dealing in debts, different people will estimate the prospects differently, and anyone who differs from the predominant opinion as expressed in market quotations has a positive reason for keeping liquid resources — in order to profit, if he is right, from the market's eventual correction.6

Expectations as to the future rate of interest, fixed by mass psychology, react on liquidity-preference in precisely the way that mass psychology fixes the marginal efficiency of capital; the market price settles at the point where the sales of the bears and the purchases of the bulls are balanced.7 One further clarification is worth pressing, because the older language of hoarding obscures more than it reveals.

Hoarding, if we mean by it an actual increase in cash-holding, is an incomplete idea — seriously misleading if it causes us to treat hoarding and not-hoarding as simple alternatives. The decision to hold cash is not taken absolutely; it results from a balancing of advantages, and we must know what lies in the other scale.8 Moreover, the total amount of cash held by the public cannot change as a result of public decisions alone, since the quantity of money is not determined by the public.

All that the propensity towards liquidity can achieve is to determine the rate of interest at which the aggregate desire to hold cash becomes equal to the available supply.9 Hence the conclusion that interest is the reward, not of not-spending, but of not-hoarding — a distinction the classical theory consistently overlooked, and which is, I think, the source of most of its confusion about what the rate of interest actually is.

Sources

  1. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.
    The General Theory of Employment, Interest and Money, pp. 183–184
  2. the rate of interest is, in itself, nothing more than the inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time.
    The General Theory of Employment, Interest and Money, pp. 183–184
  3. Liquidity-preference is a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference we have M=L(r).
    The General Theory of Employment, Interest and Money, pp. 183–184
  4. If the current rate of interest is positive for debts of every maturity, it must always be more advantageous to purchase a debt than to hold cash as a store of wealth.
    The General Theory of Employment, Interest and Money, pp. 184–185
  5. The actuarial profit or mathematical expectation of gain calculated in accordance with the existing probabilities—if it can be so calculated, which is doubtful—must be sufficient to compensate for the risk of disappointment.
    The General Theory of Employment, Interest and Money, pp. 185–186
  6. there is a further ground for liquidity-preference which results from the existence of uncertainty as to the future of the rate of interest, provided that there is an organised market for dealing in debts. For different people will estimate the prospects differently and anyone who differs from the predominant opinion as expressed in market quotations may have a good reason for keeping liquid resources in order to profit, if he is right, from its turning out in due course that the d's were in a mistaken relationship to one another.
    The General Theory of Employment, Interest and Money, pp. 185–186
  7. expectations as to the future of the rate of interest as fixed by mass psychology have their reactions on liquidity-preference... The market price will be fixed at the point at which the sales of the 'bears' and the purchases of the 'bulls' are balanced.
    The General Theory of Employment, Interest and Money, pp. 185–186
  8. the decision to hoard is not taken absolutely or without regard to the advantages offered for parting with liquidity;—it results from a balancing of advantages, and we have, therefore, to know what lies in the other scale.
    The General Theory of Employment, Interest and Money, pp. 190–191
  9. All that the propensity of the public towards hoarding can achieve is to determine the rate of interest at which the aggregate desire to hoard becomes equal to the available cash.
    The General Theory of Employment, Interest and Money, pp. 190–191