What is Liquidity Preference Theory in Economics?
Liquidity Preference Theory says that people have a preference for money since it can immediately be used for purchases.
“Liquidity” describes the ease via which an asset can be turned into a medium of exchange. Since “money” is the dominating medium of exchange, money is the most liquid asset.
Other assets have varying levels of liquidity—government bonds, for example, are somewhat less liquid than money but still relatively easy to sell, while selling a house or other real estate is much more difficult.
With all other factors held at a constant, according to the liquidity preference theory, consumers will take an asset with more liquidity. For example, a fixed payment asset paying 8% annually that is immediately liquid (equivalent to money) will always be preferred over that same asset with, say, a lockup period, transfer fees, or other liquidity bottlenecks.
Since in most real-world cases different degrees of liquidity accompany different types of assets, liquidity preference theory does not speak to any binary nor objective preference— consumers each weigh the importance of liquidity differently (their degree of risk aversion or risk neutrality as affecting their utility functions, for example) and thus make different allocation decisions.
While these individual preferences may vary, the core assertion of the liquidity preference theory holds true: people have a preference for money since it can immediately be used for purchases.
Additionally, note the following relationship, with income on the y-axis and money on the horizontal axis:
Generally, increases in income shifts money demand to the right, meaning that consumers will hold more money (keep more liquid assets) if their income is higher.
Hope that helps, and leave any questions in the comments! Check out my other articles on economics here (useful for studying, or just learning).
