Liquidity is the ease of buying or selling an asset or a security without significant effects on the market prices (Baum, 2006). In the financial market, liquidity refers to the availability of credit or the ease of borrowing. Unlike a house, securities such as treasury securities, Eurodollar future contracts and the Standard & Poor’s 500 Index are all liquid since they can be easily converted into cash. In this case, liquidity refers to the ability of the central bank to provide money to the economy (Baum, 2006). This is reflected in the multiplier effects of the financial system. The level of interest policy rates is a times used to measure liquidity.
The level of liquidity is dependent on the ability of the Federal Reserve to run high-powered money. The Federal Reserve, therefore, creates the monetary base (total amount of money in public circulation and commercial bank deposits). The decline of the federal government budget deficit means that the government is manages to fund most of its budget from the Federal Reserve while using lesser money from the Federal Reserve to service previous debt (Tucker, 2007). This situation leaves the Federal Reserve with more potential to increase liquidity though the provision of securities which stimulates public expenditure in the financial market. Individuals and institutions can therefore, buy treasury securities thereby increasing the liquidity levels in the financial market (Tucker, 2007).
Treasury securities are often used by institutions and individuals as collateral in borrowing. This makes them a crucial source of liquidity for investment banks and other leveraged financial institutions. Heightened activity in the financial markets resulting from cheap and available collaterals increases the liquidity in the market (Tucker, 2007). Some economists see excess liquidity as an essential stimulator for economic growth through capital and marginal gains tax rate cuts. However, others opine that excess liquidity leads to general asset price instability.
Jim Glassman, a senior US economist suggests that liquidity is purely a question about Central Bank since the Central Bank provides high-powered money to the economy (Baum, 2006). Glassman, therefore, affirms that if the government budget deficit declines, then the Federal Reserve which is left to service lesser government debts, can provide more money to the Central Bank. This situation gives the Central bank more muscle to control the monetary base. He posits that when the Central bank targets at a price (or an interest rate) and not the quantity of money in question then it becomes impossible to tell whether there is excess liquidity or not. Glassman maintains that the surest way to tell whether an economy has is to use yield curves. The curves show the equilibrium of financial markets and the effects of Central Bank artificially adjusting short rates up.
In the face of decreasing government budget deficit leading to increased liquidity from the Central Bank, the Bank should be cautious not to fall into a “liquidity trap”. This scenario occurs when the Central Bank lowers its interest rates to encourage borrowing which institutions and individuals decline. “Liquidity traps” are different from credit crunches where commercial banks can’t offer credit due to insolvency. The lesser institutions and individuals borrow from the government; the lesser it fails to benefit from the loan interests (Tucker, 2007). This leaves the government reliant on the same amount of money to fund increasing budgetary demands thereby increasing the budget deficit.
Baum, C. (2006, November 24). What's Liquidity? Is There Too Much, Too Little? Caroline
Baum - Bloomberg. Bloomberg - Business, Financial & Economic News, Stock Quotes.
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September 2012 from <http://www.bankofengland.co.uk/publications/ speeches/2007/speech331.pdf>.