How does liquidity preference theory affect the shape of the yield curve?

Liquidity preference theory posits that investors have a preference for liquidity, meaning they prefer assets that can be easily converted into cash. This preference affects the yield curve by introducing a premium for holding less liquid, long-term securities. Investors are generally reluctant to tie up their funds for extended periods without compensation for the increased risk associated with lower liquidity.

As a result, the yield on long-term bonds must be higher than that of short-term bonds to entice investors to commit their money for longer durations. This creates an upward slope in the yield curve, reflecting that as the maturity of the bond increases, investors require greater yields to accommodate their aversion to decreased liquidity and the greater uncertainty associated with long-term investments. Hence, option B accurately captures how liquidity preference theory shapes the yield curve by linking investor behavior to the premiums demanded for long-term securities.