LIQUIDITY PREFERANCE -WAGES AND PROFITS

What is liquidity
Another word for convenience of money is liquidity. The more convenient, safe and flexible an asset is, as a means of payment , the more liquid we say it is. Money is the most liquid of asset.

Demand for money is a balancing act

Accounts two types

Liquid Asset (More convenient account)

Non Liquid Asset (Less convenient account) bond etc)

Less interest rate

More interest rate

Demand for money is a balancing act

If we keeps more of our asset in a convenient account we gain liquidity at the same time we have sacrifice the higher interest rates on a less convenient account.

More convenient account Less interest rate

Less convenient account

More interest rate

What will happen if the interest rate on less convenient account drops Then liquidity-becomes less costly and when the liquidity becomes less costly The people will demand for more liquidity In turn demand for money will rise.

Liquidity Preference
liquidity preference, is the premium that wealth holders demand for exchanging ready money or bank deposits for safe, non-liquid assets such as government bonds. liquidity preference referred to the relationship between the quantity of money the public wishes to hold and the interest rate. Liquidity preference in macroeconomic theory refers to the demand for money, considered as liquidity.

Liquidity Preference Hypothesis

Theory states that, all other things being equal, investors prefer liquid investments to illiquid ones.

This is because investors prefer cash and prefer investments to be as close to cash as possible. As a result, investors demand a premium for tying up their cash in an illiquid investment;
this premium becomes larger as illiquid investments have longer maturities.

 The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money.
According to Keynes, the public holds money for three purposes: to have on hand for ordinary transactions to keep as a precaution against extraordinary expenses and to use for speculative purposes

He hypothesized that the amount held for the last purpose would vary inversely with the rate of interest.

A. The transactions motive people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.

B. The precautionary motive people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.

C. Speculative motive people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

Liquidity Preference Curve

 Rate of interest and Demand for money are inversely related. Ra is the Equilibrium interest rate with a money supply of Ma. If the rate of interest goes down below Ra then the people will try to shift their non liquid assets to liquid money account. Since they cannot shift all their assets at once, their competition for liquid asset will drive the interest rate to Ra.

Liquidity trap if the interest rate is pushed down the demand for the money increases with out any limits as the interest rate falls towards Rt. If we increases the money supply, it could never push the interest rate below Rt. The Point Rt is called liquidity Trap. In 1990 Japanese Economic System behaved very much closer to this.

 Japanese economic system, in the late 1990's, behaved very much like it was at the "liquidity trap" interest rate level. In any case, interest rates can never go lower than zero, and Japanese interest rates in the late 1990's were sometimes so low that the zero lower limit would be relevant.

 Indeed, for a short period in 1998, it seemed as if the U. S. economy had a liquidity trap at an interest rate of several percent. But because they predicted these changes, the Fed adjusted the money supply to keep the interest rates more nearly stable, and they were successful on the whole

Liquidity preference- Wages and Profits

Wages and profit are directly related to liquidity preference. Falling in interest rate means falling in wages. Falling wages means falling demand, declining firms revenue and consequently falling expected profit. As the interest rates were falling profit expectations were too low hence no new investment took place.

Liquidity preference (venture capital)

In the venture capital world, the term liquidity preference refers to a clause in a term sheet specifying that, upon a liquidity event, the investors are compensated in two ways:
First, they receive back their initial investment/ multiple of it and any declared but not yet paid dividends. Second, the investors and all other owners (e.g. founders, etc.) divide whatever remains of the purchase price according to their ownership of the firm being sold, etc.

A liquidity event is a typical exit strategy of a company, since the liquidity event typically converts the ownership equity held by a company's founders and investors into cash. A liquidity event is not to be confused with the liquidation of a company, in which the company's business is discontinued.

Thank you