Question

consider the liquidity preference theory of the term structure of interest rates. On average

Answer 1

The liquidity preference theory was given by Keynes. It gives the relation of interest rate in between the demand and supply of money. It states that an investor has demands for more liquid cash. If he/she puts in their money in an investment opportunity for long time period then they would expect higher interest rate. The reason for this is that since the investment is for longer time period so the investors feel that they will lose out on the liquidity of the money for a longer time period. Therefore, to compensate for the lack of liquidity, the investors demand high interest rate. This explains the term structure of the interest rates. It represents the relation between the interest rates and bond yields. The curve that represents this relationship is known as the yield curve. The yield curve moves upwards and depicts higher interest rate for longer maturity bonds. This is in accordance with the Liquidity Preference Theory.