The Liquidity Preference Theory

The Liquidity Preference Theory explains how interest rates are determined by the demand for cash (liquidity) versus the available supply of money. People and businesses prefer holding liquid assets like cash for convenience and security, especially when uncertain. When the demand for liquidity is high, interest rates tend to rise because lenders need to offer better returns to encourage lending. Conversely, if fewer people want to hold cash, interest rates tend to fall. Essentially, the theory highlights the balance between the desire for liquidity and the supply of money as a key driver of interest rates.