Answer to Question #220245 in Microeconomics for Manshi

Question

Distinguish between time preference and liquidity preference. What part do they play in the theory of interest?

Answer 1

Time preference helps in explaining the time value of money. This model shows that individuals would prefer to spend today and save for later, so that interest rates will always remain positive.

On the other hand, Liquidity preference explains the demand for money. The Liquidity preference theory suggests that an investor should demand a higher interest rate or premium on securities with long term maturities which carry greater risks because, given that all other factors are equal, investors prefer cash or highly liquid holdings.