Final answer:
The liquidity preference theory suggests that investors prefer liquidity and require higher yields for longer-term investments, influencing the slope of the yield curve. The theory implies a typically upward sloping yield curve which can flatten or invert during liquidity traps or economic uncertainty.
Step-by-step explanation:
Liquidity Preference Theory and Its Implications for the Yield Curve
The liquidity preference theory was proposed by John Maynard Keynes and suggests that investors demand higher interest rates or yields for longer-term investments due to the increased risk and sacrifice of liquidity. Essentially, people prefer to have liquidity and are more likely to hold on to cash or short-term securities that can be easily converted to cash. This preference impacts the shape of the yield curve as investors have to be compensated more for the anticipated risks at longer maturities.
According to the theory, the slope of the yield curve reflects the balance between the supply of funds from savers and the demand for funds from borrowers. The supply curve for financial capital is influenced by the elasticity of savings, which is the percentage change in the quantity of savings divided by the percentage change in interest rates. The slope of the yield curve becomes steeper as the preference for liquidity increases, leading to higher long-term rates compared to short-term rates.
One implication of this theory for the slope of the yield curve is that during normal economic conditions, the curve is typically upward sloping, reflecting a premium for longer-term securities. However, under certain conditions such as a liquidity trap, where a change in monetary policy does not affect interest rates, the slope of the yield curve can flatten or even become inverse, indicating economic uncertainty or expectations of declining interest rates in the future.