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Defining Liquidity

Liquidity consists of all cash and credit available to financial markets, once the immediate transactions needs of the real economy have been fulfilled

It is a sources and not a uses of funds definition. Money supply, a rival concept, is a uses of funds measure because it comprises bank deposits. Banks are no longer the dominant conduit for liquidity, and credit is a more powerful guide to purchasing power than deposit money.

Moreover, liquidity cannot be measured by interest rates, as the 2007/08 financial crisis has shown. For example, low base interest rates and tight liquidity mean wide spreads and a high effective cost of funds.

Liquidity transmits its influence to the real economy and financial markets through duration. Duration is a hybrid between liquidity preference and time preference, i.e. it measures the effect of liquidity over time. Investors and businesses target a desired duration and change their asset mix to attain these targets. Liquidity hastens and smooths this adjustment; illiquidity forces it to become abrupt and often disruptive. Changes in duration affect the composition of the capital structure and the mix of investments. Modern business cycles have become more cycles of duration than growth.

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