Liquidity Preference Theory

The liquidity preference theory of the term structure of interest rates combined with the expectations theory produces a yield curve that tends to be: A. Positively sloped most of the time, even though mkt participants do not always believe interest rates will increace in the future. B. Inverted when the economy is expected to be growing rapidly in the future. C. Flat when interest rates are expected to remain unchanged for the foreseeable future. D. Less positively sloped for illiquid bond than the yield curve for liquid bonds when interest rates are expected to increase in the future.


Agreed, A.

Agree A…liquidity scholars want more just for holding.

greedy bastards.

lol, A is the answer but I thought it was C. I thought the Liquidity preference theory looked at both, expectations on yields as well as a premium for holding a longer termed bond?

If interest rates are expected to remain unchanged, then the liquidity preference will force the yield curve higher. Think about it, draw a flat line, which implies no expected increase in future interest rates. Then add liquidity preference for holding long term securities; back end of the line shoots up! On a similar note, if long term interest rates are expected to decline, you might expect the curve to be inverted, but the effect of the liquidity pref. might make it look flat.

Okay i realised i didn’t answer you question. I dont think Liquidity pref. incorporates expectations on yields… it’s solely the added risk premium holders of long term securities demand for the length of their investments. Anyone willing to chime in on that?

i see what you’re saying from your first post. Even if I thought interest rates were going to remain flat than I would still expect a premium for holding onto a long term bond.