Liquidity Function

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Money in the form of deposits offers the least risk, of all financial instruments. But its value is most eroded by inflation. That is why one always prefers to store the funds in financial instruments like stocks, bonds, debentures, etc. The compromise one makes in such investments is that (1) the risk involved is more, and (2) the degree of liquidity, i.e.


Liquidity preference is the desire to hold cash. The money in cash and the rate of interest which is demanded in exchange for it is a "measure of the degree of our disquietude (ICFAI Center for Management Research (ICMR), 2005)." The rate of interest, in Keynes' words, is the "premium which has to be offered to induce people to hold the wealth in some form other than hoarded money." The higher the liquidity preference, the higher will be the rate of interest that will have to be paid to the holders of cash to induce them to part with their liquid assets. The lower the liquidity preference the lower will be the rate of interest that will be paid to the cash-holders.
Transaction Motive: This motive is related to the "need of cash for the current transactions of personal and business exchanges." It is further divided into the income and business motives. The income motive is meant "to bridge the interval between the receipt of income and its disbursement", and similarly, the business motive is "the interval between the time of incurring business costs and that of the receipt of the sale proceeds."
Precautionary Motive: The precautionary motive relates to the "the desire to provide for contingencies regarding sudden expenditures and for unforeseen opportunities of advantageous purchases." Banks keep cash in reserve to m ...
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