Liquidity Demand When the Opportunity Cost of MoneyIs a Perceived Total Return

Abstract

Since total bond returns contain a potential capital gain (or loss) component, there can be a wide divergence between a bond’s interest rate return and its perceived total return, depending on expectations about future interest rates and bond prices. It is possible for money demand to increase when bond interest rates are rising if one’s perception is of a declining total return. We study the liquidity demand behavior of a group of bond fund portfolio managers, for whom the perceived total return is paramount, and find evidence of a positive relationship between bond interest rates, the standard proxy for the opportunity cost of money, and the demand for cash balances. While these empirical results contradict the traditional presumption of a negative relationship between the demand for money and a bond interest rate return, they make economic sense if the perceived total return on a bond is the true opportunity cost of holding cash balances.