Liquidity premium is the amount of monetary return that one would be willing to forgo for the convenience or security of disposing of an asset quickly and with minimal or no cost. The power of disposal of an asset is measured in terms of how easily it can be sold as well as in terms of the degree of expected capital risk if the asset is liquidated (Keynes  1964, p. 226).
Each asset has an expected total return (an “own rate of return”) composed of q —the expected income from employing the asset in production; c —the carrying cost; a —the expected capital gains (appreciation or depreciation); and l —liquidity premium. An own rate of return for an asset is calculated in the following way: q - c + a + l. Thus liquidity premium is one of the elements that constitute the value of an asset. Assets are differentiated according to combinations of expected monetary returns and liquidity premiums they are anticipated to offer (Carvalho 1999, p. 126).
The state of expectations refers not merely to subjective assessments of what events might or might not occur but also to the anticipated costs of undertaking alternative courses of action (Kregel 1998). So long as there are alternative ways to store value and money is one of them, the option of not “using” money—that is, not purchasing capital assets—and hedging against uncertainty affects investment in less liquid capital assets (Davidson 1978). Thus liquidity premium is an expression of the “return” from holding money as an asset (Keynes  1964, p. 227). This return establishes the standard that expected yields of capital assets must achieve. In order for capital assets to be purchased, their prices must be at a level at which the expected yield (q - c ) equals the liquidity premium l. Consequently the expected return of a capital asset has to be such as to compensate for its degree of il-liquidity given the degree of uncertainty felt by asset holders. The degree of uncertainty determines the liquidity premium (Carvalho 1999, p. 127).
Liquidity reduces the uncertainty about fulfilling future commitments and, implicitly, about future income and capital returns. The willingness to borrow and purchase capital assets depends on business enterprises’ perception of borrower’s risk, whereas the willingness of banks to make the requested loans depends on their perception of lender’s risk (Minsky 1975). The assessment of these types of risks depends on the state of expectations and on the margins of safety or the amount of monetary returns that borrowers and lenders are willing to forgo to be liquid—in other words, on liquidity premium.
These margins of safety vary across time and geopolitical space with the tendency for perception of higher risks and thus with higher liquidity preference in developing countries (Dow 1995, p. 8). At the international level, this can result in a tendency for liquid portfolio investment rather than greenfield foreign direct investment in “emerging markets.” Because liquidity premium is a manifestation of the margin of safety thought necessary to deal with uncertainty and perceived capital risk, it enters the determination of domestic and global level composition of investment, output, and employment.
SEE ALSO Carrying Cost; Equilibrium in Economics; Equity Markets; Expectations; Financial Instability Hypothesis; Keynes, John Maynard; Liquidity; Minsky, Hyman; Money, Demand for; Risk; Uncertainty; Yield
Carvalho, Fernando. 1999. On Banks’ Liquidity Preference. In Full Employment and Price Stability in a Global Economy, eds. Paul Davidson and Jan Kregel, 123–138. Cheltenham, U.K., and Northampton, MA: Edward Elgar.
Davidson, Paul. 1978. Money and the Real World. London: Macmillan.
Dow, Sheila. 1995. Liquidity Preference in International Finance: The Case of Developing Countries. In Post-Keynesian Economic Theory, ed. Paul Wells, 1–14. Boston, Dordrecht, Netherlands, and London: Kluwer Academic.
Keynes, John M.  1964. The General Theory of Employment, Interest, and Money. New York: Harcourt Brace.
Kregel, Jan. 1998. Aspects of a Post Keynesian Theory of Finance. Journal of Post Keynesian Economics 21 (1): 111–124.
Minsky, Hyman. 1975. John Maynard Keynes. London: Macmillan.
Wray, Randall. 1990. Money and Credit in Capitalist Economies: The Endogenous Money Approach. Aldershot, U.K.: Edward Elgar.
"Liquidity Premium." International Encyclopedia of the Social Sciences. . Encyclopedia.com. (January 20, 2018). http://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/liquidity-premium
"Liquidity Premium." International Encyclopedia of the Social Sciences. . Retrieved January 20, 2018 from Encyclopedia.com: http://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/liquidity-premium
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