The liquidity preference theory, created by economist John Maynard Keynes, explains that interest rates are set by the supply of and demand for money.

People prefer to hold liquid assets (cash) for three main reasons:

• Transactional: To pay for daily needs and expenses.
• Precautionary: To be prepared for unexpected emergencies.
• Speculative: To save money so they can invest when good market opportunities arise.

The interest rate acts as the price for giving up liquidity. It balances the public’s desire to keep cash on hand against the lost profit from not investing in interest-bearing assets.