What is the liquidity preference theory

Financial Markets Series - Part 5: Where does interest come from and what determines it?

January 26, 2016

In view of the dramatic demographic development in Germany, state pensions will in future be less and less sufficient to secure the standard of living of citizens in old age. At the same time, the prolonged phase of extremely low interest rates makes private old-age provision more difficult. Given these framework conditions, in order to invest money in such a way that it yields a reasonable return in the long term, it is essential for savers to know about our financial system, the most important financial markets and financial products. In a series of articles, MBVO therefore gives an overview of these areas. Episode 5 deals with the question of why there is interest and what determines it.

Swarms of economists have racked their brains about why there is interest at all and what its level depends on. Over time, two theories have prevailed, the liquidity preference theory and the interest rate expectation theory.

Liquidity preference theory

Proponents of this theory argue that people prefer to have their money as quickly as possible. You strive to be as “liquid” as possible. When you invest your money - from an economic point of view, you grant a loan - you forego immediate availability. According to the liquidity preference theory, the interest rate is the price that the borrower, for example the bank, pays the lender to forego liquidity for a certain period of time.

Interest rate expectation theory

This can be viewed as an extension of the liquidity preference theory. The lender refrains from being able to claim his money back at any time. The price for this is the interest. But it is not only the renunciation of consumption that plays a role in interest rate formation in the present. Because the rate of currency devaluation - i.e. inflation - can change during the term of the loan, there is a risk for the lender to suffer an inflation-related loss of value of his money at the end of the term. Therefore, he will ask for a higher interest rate if he thinks inflation will rise over the life of the loan. This means: The interest rate for loans with a certain term is also an indicator of the prevailing expectations in the market about the development of inflation.

Both the liquidity preference theory and the interest rate expectation theory are suitable for explaining the level and development of capital market interest rates. The interest rate level is different for different terms. As a rule, short-term loans / bonds have lower interest rates than long-term loans. In exceptional situations, it can be the other way around, in which case one speaks of an inverse interest structure.

Short, medium and long term rates

A distinction is made between short, medium and long-term interest rates. The very short-term interest rates refer to terms of less than one year and are also called money market rates. The capital market begins with a term of one year or more, with a term of up to three years being referred to as short-term capital market rates. This is followed by the medium-term range and from around seven years onwards the long-term range. The remaining term is always decisive for the assignment to a certain term range, not the original term.

The distinction between money market and capital market makes sense insofar as they are exposed to different influences. The money market is dominated by the central banks, i.e. in the euro area by the European Central Bank (ECB) or in the USA by the Fed. As the “bank of the banks”, the central bank sets the key interest rate at which the banks can borrow their money. The key interest rate is a very short-term interest rate with which the central bank controls the money market interest rate. Base rates have a major impact on the level of interest rates on short-term loans and balances.

However, beyond the very short-term maturities, the influence of the central bank is decreasing. The longer the terms, the more the interest rate is determined by the supply and demand for loans. The interest is thus formed in a market process. However, it must be said that this is normally the case. However, this normal case has not been the case in the euro zone (and other countries, such as Japan) for some time. Because the ECB is daring a historical experiment by operating what is known as “quantitative easing” (QE). In concrete terms, this means that it buys up bonds with different maturities on a large scale - and thus largely overrides the market mechanism. Incidentally, this exposes the ECB to suspicion of unauthorized state financing, which has been heavily criticized by a number of economists and politicians.

Click here for the series Financial Markets - Part 6: Rating and Yield.

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