Liquidity
Liquidity
An asset is considered to be liquid if it can be: (1) easily exchanged; (2) quickly exchanged; and (3) exchanged at little or no cost. For example, currency (coins and paper money) is an extremely liquid asset, whereas consumer durables and housing are very illiquid assets. Other assets, such as money in the bank, stocks, and bonds, fall between these two extremes, depending on the nature of their market. Hence, if someone needed to sell illiquid assets to raise money, say, as a result of a bad income shock, he should expect a loss, because he will not get the full value of his illiquid assets in a distress sale.
Even though the goal of holding assets is to obtain a return, firms and consumers regularly hold currency, which offers no return. The reason for this, first put forth by John Maynard Keynes (1883–1946), is that “bills and call loans are more ‘liquid’ than investments, i.e., more certainly realizable at short notice without loss” ([1930] 1971, p. 59). According to John R. Hicks (1904–1989), this is the first time the term liquid was used to describe the ability of an asset to be converted to cash without suffering a loss, and sets the foundation for Hicks’s subsequent liquidity preference framework (a theory of nominal interest rate determination) and the IS-LM framework (a theory of determination of aggregate output and the interest rate) (see, for example, Mishkin and Serletis 2007).
These Keynesian models lead to the conclusion that an increase in the money supply (everything else remaining equal) lowers interest rates. This is known as the liquidity effect. However, Milton Friedman (1912–2006), the 1976 Nobel laureate in economics, argued that an increase in the money supply might not leave everything else equal, and that there are other possible effects of an increase in the money supply on interest rates, such as the income effect, the price-level effect, and the expected-inflation effect. In fact, the empirical evidence, mainly based on vector autoregressions (VARs), seems to indicate that money and interest rates are positively rather than negatively related, thereby producing a liquidity puzzle. There have been many attempts to unravel this puzzle (e.g., Eichenbaum 1992; Strongin 1995; Christiano et al. 1996). In general, as more variables are introduced and as the VAR specification is refined, it produces results consistent with traditional Keynesian and monetarist analysis (see, for example, Cochrane 1998).
A purely theoretical concept that is also due to Keynes is the idea of a liquidity trap —an extreme case of ultrasensitivity of the demand for money to interest rates. In this case, the money demand curve is completely flat in the liquidity preference framework and the LM curve is horizontal in the IS-LM framework, meaning that increases in the money supply are absorbed without any decline in interest rates. Thus monetary policy is without effect and fiscal policy is the only means of economic control. The empirical evidence, however, indicates that although the demand for money is sensitive to interest rates, a liquidity trap has never existed.
Over the years, several measures of liquidity have been employed. For example, for individual assets, liquidity can be measured by a liquidity premium —the lower the liquidity premium, the more liquid (and the more like money) the asset is. If one wanted to obtain an aggregate measure of liquidity, one would add the assets together, giving higher weights to those assets with lower liquidity premiums. In this regard, the money measures currently in use by central banks around the world (known as monetary aggregates) are simple-sum indices in which all financial assets are assigned a constant and equal (unitary) weight. This index is Mt in where xjt is one of the n components of the monetary aggregate Mt. This summation index implies that all financial assets contribute equally to the money total, and it views all components as dollar-for-dollar perfect substitutes. Such an index, there is no question, represents an index of the stock of nominal financial wealth, but cannot, in general, represent a valid structural economic variable for the liquidity services of financial assets in the economy.
In light of the foregoing arguments, there have been many attempts at properly weighting financial assets within a simple-sum aggregate. With no theory, however, any weighting scheme is questionable. William A. Barnett (1980) applied economic aggregation and index number theory and constructed monetary aggregates based upon W. Erwin Diewert’s (1976) class of superlative quantity index numbers. The new aggregates are Divisia quantity indices, named after François Divisia (1889–1964), who first proposed the index in 1925. The Divisia index (in discrete time) is defined as according to which the growth rate of the aggregate is a weighted average of the growth rates of the component quantities, with the Divisia weights being defined as the expenditure share averaged over the two periods of the change, for j = 1, …, n, where , is the expenditure share of asset j during period t, and π jt is the user cost of asset j, derived in Barnett (1978), which is the opportunity cost of holding a dollar’s worth of the j th liquid asset. Above rjt is the market yield on the j th asset, and Rt is the yield available on a benchmark asset that is held only to carry wealth between multiperiods. At the margin, the greater the difference between Rt and rjt, the greater is the liquidity services that asset j yields.
SEE ALSO Capital; Financial Instability Hypothesis; Financial Markets; Friedman, Milton; Interest Rates; IS-LM Model; Keynes, John Maynard; Leverage; Liquidity Premium; Liquidity Trap; Loans; Monetary Theory; Money; Money, Demand for; Neutrality of Money; Overlending
BIBLIOGRAPHY
Barnett, William A. 1978. The User Cost of Money. Economics Letters 1: 145–149.
Barnett, William A. 1980. Economic Monetary Aggregates: An Application of Aggregation and Index Number Theory. Journal of Econometrics 14: 11–48.
Christiano, Lawrence J., Martin Eichenbaum, and Charles Evans. 1996. The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds. Review of Economics and Statistics 78: 16–34.
Cochrane, John. 1998. What Do the VARs Mean? Measuring the Output Effects of Monetary Policy. Journal of Monetary Economics 41: 277–300.
Diewert, W. Erwin. 1976. Exact and Superlative Index Numbers. Journal of Econometrics 4: 115–145.
Eichenbaum, Martin. 1992. Comments on “Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy” by C. Sims. European Economic Review 36: 1001–1011.
Hicks, John R. Liquidity. 1962. The Economic Journal 72: 787–802.
Keynes, John Maynard. [1930] 1971. A Treatise on Money. 8th ed. Vol. 2. London: Macmillan.
Mishkin, Frederic S., and Apostolos Serletis. 2007. The Economics of Money, Banking, and Financial Markets. 3rd Canadian ed. Toronto: Pearson.
Strongin, Stephen. 1995. The Identification of Monetary Policy Disturbances: Explaining the Liquidity Puzzle. Journal of Monetary Economics 35: 463–497.
Apostolos Serletis