Liquidity Preference Theory: Understanding Cash, Interest Rates & Aussie Finance 2025

With Australia’s financial markets evolving rapidly in 2025, understanding why people value cash over other assets is more relevant than ever. Liquidity preference theory, pioneered by economist John Maynard Keynes, helps explain the intricate dance between money demand, interest rates, and economic policy—a trio that underpins decisions made by households, businesses, and the Reserve Bank of Australia (RBA).

What Is Liquidity Preference Theory?

At its core, liquidity preference theory is about choice: given a menu of assets, why do people hold cash (or highly liquid assets) instead of putting all their money into higher-yielding but less accessible investments? Keynes argued that the answer lies in three key motives:

• Transactions Motive: People need cash to pay for everyday expenses and planned purchases.

• Precautionary Motive: Holding cash provides a safety net for unexpected expenses or emergencies.

• Speculative Motive: Investors keep cash on hand to pounce on future opportunities or avoid losses during periods of uncertainty.

According to the theory, the interest rate is the price of liquidity: the higher the rate, the greater the reward for locking up your cash in less-liquid assets. Inversely, when rates are low, cash becomes more attractive—even if it earns little or no interest.

Liquidity Preference in Australia’s 2025 Economy

Recent trends in Australia have brought liquidity preference theory into sharp focus. As the RBA maintained a cautious approach to interest rates in early 2025—leaving the cash rate at 4.35%—many Australians found themselves weighing the trade-off between holding cash and seeking returns in property, shares, or term deposits.

Key developments influencing liquidity preference this year:

• Mortgage market uncertainty: As fixed-rate home loans from the pandemic era continue to roll off, households are bracing for higher repayments and opting to keep more cash on hand for flexibility.

• Volatility in global markets: Ongoing geopolitical tensions and uneven global growth have made some investors wary, increasing the speculative motive to hold cash and wait for clearer signals.

• Digital wallet adoption: The rise of instant-access savings accounts and digital wallets is making it easier than ever for Australians to park cash in accessible, low-risk formats—blurring the lines between cash and near-cash investments.

According to the Australian Bureau of Statistics, household savings rates remain elevated compared to pre-pandemic norms, despite inflationary pressures. This signals a strong liquidity preference as families prioritise financial buffers over chasing higher returns.

Policy Implications: How the RBA Responds

Liquidity preference doesn’t just shape individual behaviour—it also guides monetary policy. When the RBA wants to stimulate the economy, it can cut rates to make holding cash less attractive, encouraging spending and investment. Conversely, raising rates rewards savers and can draw money out of circulation, cooling inflation.

In 2025, the RBA faces a delicate balance:

• Inflation management: With inflation hovering just above the 2–3% target band, the RBA has signalled a data-dependent approach, wary of reigniting price pressures if liquidity preference leads to pent-up consumer demand.

• Financial stability: The RBA monitors how much cash is flowing into riskier assets versus sitting on the sidelines. Too much liquidity preference can dampen growth, while too little may fuel asset bubbles.

Recent policy commentary suggests the central bank is closely watching household cash buffers, bank deposit flows, and the pace of credit growth as real-world indicators of liquidity preference.

Real-World Example: The Term Deposit Dilemma

Consider an Australian retiree in 2025, deciding between a 12-month term deposit at 4.2% or keeping cash in a high-interest savings account at 3.9%. Despite the marginally higher return, many opt for the latter, valuing the flexibility to access their money instantly. This behaviour—seen across both retail and business banking—illustrates liquidity preference in action, especially when future expenses or investment opportunities are uncertain.

Looking Ahead: How Should Australians Think About Liquidity?

Liquidity preference theory reminds us that money isn’t just about earning the highest possible return. It’s also about security, flexibility, and the peace of mind that comes from being ready for whatever comes next. As Australia’s economic cycle turns and new financial products emerge, keeping an eye on your own liquidity needs—and how they align with broader market trends—will remain essential for smart financial decision-making.