Which statement best distinguishes liquidity preference theory from expectations theory in shaping the yield curve?

• A. Liquidity preference theory ignores expectations.
• B. Expectations theory holds that yields reflect expected future rates.
• C. Liquidity preference theory adds a term liquidity premium; expectations theory says yields reflect expected future rates.
• D. Both theories predict a flat yield curve in all scenarios.

Answer: (C)

When we look at how the yield curve is shaped, two forces are in play: what investors expect about future short-term rates, and the extra return they require for tying up money in longer maturities. In expectations theory, long-term yields are simply determined by the expected path of future short-term rates, with no extra premium. In liquidity preference theory, there is an added term for the liquidity premium—a premium investors demand for holding longer maturities because of greater risk and lower liquidity. This premium typically grows with maturity, pushing long-term yields higher even if expected future short rates don’t rise.

So the key distinction is that liquidity preference theory incorporates a liquidity premium in addition to expectations about future rates, while expectations theory says yields reflect only the expected future short-term rates. That’s why the correct statement highlights the liquidity premium as the distinguishing feature.