The concept of liquidity preference

Liquidity preference is a Keynesian idea that describes the reasons why individuals and businesses choose to keep some of their wealth as money rather than in other forms.

Motives for holding money

Households and firms hold money for different purposes, which can be grouped into three main motives.

The three main motives for holding money:

• Transactions motive - Money is held to cover day-to-day purchases and regular payments.
• Precautionary motive - Money is kept aside to deal with unexpected costs or to seize sudden opportunities.
• Speculative motive - Money is retained when the returns from financial assets, such as bonds, are considered low.

Factors affecting the transactions motive

The amount of money held for everyday transactions depends on specific economic factors that influence how much cash is needed for routine spending.

Key factors influencing the transactions motive:

• Income level - Higher incomes usually result in greater money holdings.
• Payment frequency - Receiving income less often, such as monthly rather than weekly, typically leads to holding more money.

Active and idle balances in money holdings

Money holdings can be classified based on their intended use.

Types of money balances:

• Active balances - These are funds held for transactions and precautionary motives, expected to be used soon.
• Idle balances - These refer to money kept for speculative reasons, often when returns on assets like bonds are low.

Interest elasticity and the role of bonds in speculative demand

The demand for money responds differently to interest rate changes depending on the motive, with government bonds playing a key role in the speculative aspect. Government bonds are securities that act as loans to the government.

Interest elasticity of money demand motives

• Transactions and precautionary motives - These are relatively interest inelastic, meaning changes in interest rates have little effect on how much money is held for these purposes.
• Speculative motive - This is interest elastic, so demand for money rises significantly when interest rates fall.

Inverse relationship between bond prices and interest rates

Bond prices and effective interest rates move in opposite directions. When bond prices increase, the effective interest rate decreases, and when bond prices decrease, the effective interest rate rises.

$\text{Effective interest rate (\%)}=\frac{\text{fixed interest payment}}{\text{current bond price}}\times 100$

Where:

• Fixed interest payment = Annual interest based on the bond's face value (£)
• Current bond price = Market price of the bond (£)

Speculative demand for money in relation to bonds

• High speculative demand - Occurs when bond prices are high and expected to drop, which corresponds to low interest rates, encouraging people to hold money instead of buying bonds.
• Low speculative demand - Happens when bond prices are low and interest rates are high, making bonds more attractive and reducing the desire to hold idle cash.

Worked example - Calculating effective interest rate after bond price change

A government bond has a face value of £1,500 and pays a fixed annual interest of 6% of its face value. Initially, the bond's market price is £1,500. Later, the price rises to £1,800. Calculate the effective interest rate at both prices.

Step 1: Identify the values

• Face value = £1,500
• Fixed annual interest = 6% of £1,500 = £90
• Initial bond price = £1,500
• New bond price = £1,800

Step 2: Calculate initial effective interest rate

$\text{Effective interest rate (\%)}=\frac{\pounds 90}{\pounds \mathrm{1,500}}\times 100=6\%$

Step 3: Calculate new effective interest rate

$\text{Effective interest rate (\%)}=\frac{\pounds 90}{\pounds \mathrm{1,800}}\times 100=5\%$

Step 4: Interpretation

The effective interest rate falls from 6% to 5% as the bond price rises from £1,500 to £1,800, illustrating the inverse relationship and why speculative demand for money might increase at lower rates.