© 2000 John Petroff
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© 2000 John Petroff |
In addition to the return attributable to foregone earning profits (which is the compensation for non-use of money, just outlined), there is always an inconvenience for not having immediate control over one's own assets. This is a psychological element which is affected by customs and attitudes about the future. Some societies are more inclined to hold larger sums of cash for precautionary, transaction and/or speculative purposes.
Liquidity preference also changes with economic conditions. Velocity of money (i.e. how often the stock of money turns over in the hands of consumers) increases in prosperity (i.e. liquidity preference decreases), and decreases in recession (i.e. liquidity preference increases). In prosperity, spending is high compared to cash balances; not so in recession when larger cash balances are held in fear of a threatening future. Also, when an economy is in recession, rates of return on securities are depressed (because firms have poor profit pictures), and it is not wise to tie up all cash in low return securities because higher returns can be expected in the future as the economy recovers. Thus, for financial reasons as well as spending reasons, large volume of idle cash, i.e. high liquidity preference, pushes interest rates down in periods of economic slow down.
Finally, in countries with highly developed financial markets and high rates of saving, the need to hold large sums of money will be less because savers have easy access to their savings. For instance, lower interest rates in Japan and Switzerland can in part be traced to that (in addition to lower inflation). In 1995, Russia's high inflation discouraged holding rubles, but financial assets are not good substitutes for cash and financial market are illiquid (compared to Western financial markets). This caused large holdings in various hard currencies by Russians, or capital flight out of the country.
See review questions Q-2D3.1 through Q-2D3.8.
See research assignment R-2D3.1.
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