Liquidity theory is an important concept in macroeconomics that considers the relationship between interest rates and an individual's preferences between saving money to collect an interest rate or holding money as cash. There are various motivations behind the desire to hold liquid cash, and these motivations must be balanced against the financial gain an individual can expect from saving money.
An interest rate is a rate at which an individual is compensated for depositing money in a bank. For example, if an individual deposits $1 in a bank for one year at an annual interest rate of 6 percent, that dollar will be worth $1.06 at the end of the year. Interest rates are the primary incentive for saving money in a bank. Additionally, when individuals invest in bonds, they are tying up their money for a specified period of time in exchange for an interest rate.
There are several motives for holding money as liquid cash rather than depositing it into a bank. The first of these motives is the transactions motive. The transactions motive refers to an individual's desire to have cash available for basic everyday transactions. If an individual's money is tied up in investments, such as bonds, it cannot be used for day-to-day transactions.
The precautionary motive refers to the desire of individuals to have cash available for certain unexpected situations. These situations could include a sudden illness or accident, or even an unforeseen social situation. The effect of the precautionary motive and the corresponding amount of cash an individual will wish to have on hand typically increases with that individual's overall wealth.
The speculative motive refers to the impact on the demand for money of perceived opportunities to invest in certain future opportunities. If money is tied up in a bond and a sudden investment opportunity arises, the potential investor may not be able to capitalize on this potentially lucrative opportunity because her resources are dedicated to other investments.
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